A trust fiduciary's duty to implement capital preservation strategies using financial derivative techniques

Real Property, Probate and Trust Journal, Spring 2001 by Borkus, Randall H

Editors' Synopsis: This Article reviews the history of trust doctrine and fiduciary duties, examines modern portfolio theory and analyzes the expansion of fiduciary duties and modern portfolio theory under the Restatement (Third). The author examines contemporary legal thought, case law, and fiduciary duties under the pension management requirements of the Employment Retirement Income Security Act of 1974. Finally, the Article explores plausible hedging strategies using financial derivatives or derivative-like products to maximize portfolio wealth. The author concludes that trust fiduciary duties require implementing and understanding modern hedging techniques.

I. INTRODUCTION

II. THE DEVELOPMENT OF FIDUCIARY DUTIES: THE COMMON LAW PRUDENT MAN STANDARD

III. MODERN PORTFOLIO THEORY

A. In the Beginning

B. Diversification

C. Contemporary Duties: Restatement (Third) of Trusts Section 227

1. The Prudent Investor Rule

2. The Conflict: Exercising Impartiality

3. The Smart Decision: Delegating Authority

IV. MARKET VOLATILITY, INNOVATION, AND DERIVATIVES: EMPLOYING RISK MANAGEMENT TECHNIQUES

A. Risk and Reality

B. The Corporate Duty

1. Making Sense of Hedging

2. Determining a Breach

C. Implied Acceptance of Derivatives Use

V. THE MODERN TRUSTEE'S DUTIES

A. A Duty to Hedge: The Changing Landscape

B. ERISA Duty: One Model to Consider

C. More on Trustee Liability

VI. PLAUSIBLE STRATEGIES A FIDUCIARY MAY CONSIDER

VII. CONCLUSION

I. INTRODUCTION

Trust fund management and fiduciary duties have long been an important part of Western civilization. These duties include the threat of personal liability of the fiduciary when trust assets underperform. In such cases, beneficiaries generally assume that a fiduciary's given investment decision was imprudent. Still, fiduciaries serve an important social function by managing trust assets. The importance of the trust is that it serves as a vehicle for the disposition of property.1 Such disposition allows for the smooth passage of property and wealth from one generation to another. Moreover, trust funds are as important to estate planning as water is to the human body. Therefore, trust funds and fiduciary management, coupled with a keen understanding of the duties involved, play an important role in the preservation of a family's long-term wellbeing.

Fiduciary or trustee duties have evolved over many years in Western civilization. The old English common law system struggled with these duties, and eventually the struggle filtered into the American common law system. This migration set the stage for a perpetual evolutionary process of trust fund management and fiduciary duties that continues even today. Moreover, with the advent of modern financial thought and innovation, contemporary fiduciaries have an arsenal of financial management tools compared to their predecessors in the early nineteenth century.

The traditional fiduciary was limited to conservative financial management tools such as savings accounts, certificates of deposit, and government bonds. Additionally, negative deviation in corpus returns resulted in personal liability for a trustee, regardless of the overall success of the aggregate trust fund. This system mandated that fiduciaries were judged on an investment-by-investment basis. This standard required that no single investment in a pool of investments in the trust could fail.2 Therefore, fiduciaries had no incentive to distribute trust corpus among an array of investments for fear that one poor result would subject them to liability. Fortunately, a modern expectation has replaced this antiquated and costly philosophy.

In the early 1990s, the world of trust fund management and fiduciary law witnessed a significant change with the adoption of the prudent investor rule under the Restatement (Third) of Trusts ("Restatement (Third)').3 The ensuing changes have created increased flexibility for trust managers and have also increased trust managers' duties. Central to these duties is the prudent investor standard and that standard's adoption of modern portfolio theory!

Under this contemporary theory, a trust fund's probability of success increases because of a balancing of risks and returns. The key factor of contemporary financial theory and fiduciary law is an expansion of fiduciary duties that, in certain instances, includes the use of financial derivatives and hedging strategies.

First, this Article briefly introduces and reviews the historical backdrop of trust doctrine and fiduciary duties. In addition, it briefly examines modern portfolio theory and analyzes the expansion of fiduciary duties and modern financial theory under the Restatement (Third). Risk and risk management are considered, and the corporate answers to risk management are examined. Then, this Article examines contemporary legal thought, case law, and fiduciary duties under the pension management requirements ofthe Employment Retirement Income Security Act of 1974 ("ERISA"), all of which evidence a shift of fiduciary responsibility that includes a duty to hedge risk. Next, this Article explores plausible hedging strategies using financial derivatives or derivative-like products to maximize portfolio wealth. Finally, this Article concludes that trust fiduciary duties require implementing and understanding modern hedging techniques.