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

C. Contemporary Duties: Restatement (Third) Section 227

1. The Prudent Investor Rule

The prudent investor rule sets an innovative standard for fiduciaries to follow when managing trust corpus.50 The rule creates a fiduciary standard that essentially warns against exercising extreme conservatism; excessively conservative strategies literally can create liability for fiduciaries.51 This standard came about in 1992 with the American Law Institute's ("ALI") adoption of the Restatement (Third).52 Specifically, section 227 is rooted in contemporary financial thought, commonly known as modern portfolio theory.53 Under section 227, trust fiduciary duties are commonly referred to as the "prudent investor rule."54 This rule reverses years of restrictive judicial precedent in an effort to reflect modern asset management strategies.55 Most importantly, section 227 merges contemporary portfolio theory and traditional trust doctrine.56

Presently, modern financial management theory has received wide acceptance throughout both the academic and practitioner communities of law and finance.57 This wave of acceptance is evidenced by the wide statutory adoption of contemporary trust investment doctrine in several states.58 Moreover, many states specifically have adopted the prudent investor rule or an investment management rule that is very similar.59

Section 227 weaves modern investment strategies, fiduciary duties, and historical trust principles together to create a protective web for beneficiary interests.60 Moreover, the Restatement (Third) clarifies trust fiduciary duties that require repeated balancing of risk and return multiples for a portfolio.61

When balancing risk and returns for a trust portfolio, the prudent investor rule requires a fiduciary to make reasonable decisions.62 In essence, the rule requires trustees to weigh the opportunity for higher expected returns against the inherent added risk that accompanies the higher expected returns.63 Unfortunately, the prudent investor rule falls short in defining exactly what an appropriate portfolio balance should resemble.64 Instead, the Restatement (Third) directs fiduciaries to evaluate the risk requirements of a particular trust by evaluating distribution requirements, specific documentation clauses, and the general purpose of the trust fund.65 Therefore, fiduciaries are left to their own reasonable interpretation when evaluating the investment risk/return questions of a specific trust.66

Nonetheless, fiduciaries can fulfill their duties to protect beneficial interests and avoid liability if they understand the ramifications of including compensable risks in a trust portfolio.67 This understanding requires a working knowledge of modern portfolio theory. Therefore, reasonable fiduciaries must possess a working knowledge of modern portfolio theory prior to applying the theory to trust fund management. Yet, even with a solid understanding of portfolio theory, fiduciary liability becomes more complicated when the fiduciary serves multiple masters.