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

11. THE DEVELOPMENT OF FIDUCIARY DUTIES: THE COMMON LAw PRUDENT MAN STANDARD

The original American prudent man standard evolved in the 19th century with the adoption of the old English standard.5 This rule required prudent trustee investment approaches that were no more than ultraconservative practices.6 The English fiduciary doctrine for trust fund investment resulted from the financial collapse of the South Sea Company.7 This doctrine protected trust corpus while creating a perpetual cash flow from consol bond investors for the English government which ensured the country's wealth would remain in England.

Unfortunately, early America did not enjoy a mature financial market or a stable government that was capable of issuing and backing such bond instruments.8 This forced the American common law system to construct its own version of trust doctrine and fiduciary duties.9

In the seminal case of Harvard College v. Amory,10 the Supreme Judicial Court of Massachusetts formulated the American version of the prudent man standard:11

All that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.12

The Harvard College standard was based upon the understanding that trust corpus was always subject to some risk regardless of the fiduciary's investment choices.13 Therefore, a trustee only needed to exercise good judgment and the care of a prudent man in order for the courts to interpret even speculative investments such as common stocks as prudent.14 The Harvard College decision afforded American fiduciaries a greater array of investment choices for investing trust fund corpus, which made a fiduciary's job much easier.15

Unfortunately, the mid-nineteenth century witnessed the deterioration of this broad-minded thinking as the courts redefined the Harvard College fiduciary standard.16 In King v. Talbot,17 the New York Court of Appeals held that fiduciaries who invested trust corpus in common stocks acted imprudently.18 The King decision restricted fiduciaries to investments in government-backed bonds and mortgage-backed securities.19 This wave of conservative thinking led to the creation of "legal lists,"20 which compiled acceptable fiduciary investments depending upon a given state's law.21 The only exception regarding common stock investments occurred when a trust document gave specific instructions to the fiduciary to make such investments.22

Time itself evidences the impractical and restrictive nature of legal lists.23 Consequently, the more flexible prudent man rule prevailed, and trust management, though still restrictive, was judicially handled on a caseby-case basis.24

Judicially created restrictions mandated that fiduciaries be judged on an individual investment basis while ignoring the overall results of welldiversified trust corpus.25 This ideology severely limited the spectrum of potential returns because fiduciaries relied predominantly upon conservative, non-competitive investments that courts viewed as prudent.26