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Fiduciary Risk and Litigation Update ABA Telephone Briefing/Webcast

Wednesday, Participant’s Guide August 18, 2004 2:00 p.m. – 4:00 p.m. (Eastern Time) 1:00 p.m. – 3:00 p.m. (Central Time) 12:00 p.m. – 2:00 p.m. (Mountain Time) 11:00 a.m. – 1:00 p.m. (Pacific Time)

Services provided by KRM Information Services, Inc. NMA008720

American Bankers Association Fiduciary Risk and Litigation Update Telephone Briefing/Webcast Wednesday, August 18, 2004 ♦ 2:00 – 4:00 p.m. ET

Table of Contents

TABLE OF CONTENTS... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I

SPEAKER & ABA STAFF LISTING ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . II

SPEAKER BIOGRAPHIES ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . III

PROGRAM OUTLINE... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . IV-V

CONTINUING EDUCATION CREDITS INFORMATION ... . . . . . . . . . . . . . . . . . . . . . . . VI

CPE SIGN-UP FORM .... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . VII

PROGRAM INFORMATION ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ATTACHED

EVALUATION FORM .... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ENCLOSED

AUDIOCASSETTE/CD ORDER .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ENCLOSED

Any transmission, retransmission or republishing of the audio or web portions of this briefing is strictly prohibited.

PLEASE READ ALL ENCLOSED MATERIAL PRIOR TO BRIEFING. THANK YOU.


II

Speakers and ABA Staff

SPEAKERS Lisa Bleier Senior Counsel II, Regulatory and Trust Affairs American Bankers Association 1120 Connecticut Avenue, NW Washington, DC 20036 PH: (202) 663-5479 Email: [email protected] Dominic J. Campisi, Esq. Evans, Latham and Campisi One Post Street, Suite 600 San Francisco, CA 94101 PH: (415) 421-0288 Email: [email protected]

ABA STAFF Joseph V. Mach, Jr. Industry Analyst American Bankers Association 1120 Connecticut Avenue, N.W. Washington, DC 20036-3902 PH: (202) 663-5487 Email: [email protected] Cari Hearn Marketing/Project Manager American Bankers Association 1120 Connecticut Avenue, NW Washington, DC 20036 PH: (202) 663-5393 Email: [email protected] Linda M. Shepard Project Manager American Bankers Association 1120 Connecticut Avenue, NW Washington, DC 20036 PH: (202) 663-5499 Email: [email protected]


III

Speaker Biographies

Lisa Bleier Lisa Bleier is Senior Counsel at the American Bankers Association focusing on employee benefit and tax trust issues. After completing her undergraduate degree at the University of Michigan, Ms. Bleier headed back to her home state of Pennsylvania for law school at the University of Pittsburgh School of Law. Upon graduation she worked on Capitol Hill as Legal Counsel and Legislative Assistant on all issues arising from the Education & the Workforce Committee for Congresswoman Marge Roukema (R-NJ). This included ERISA, employee benefit plan issues, education and health care. At the end of the 105th Congress, Ms. Bleier left Capitol Hill to work as Government Affairs Manager of the American Society of Pension Actuaries. Dominic J. Campisi, Esq. Not a Boomer, born in the Valley of the Heart’s Delight, now known as Silicon Valley. Cut apricots for drying starting age eight, moved to picking apricots, pruning trees, loading trucks, then tallyman for prune season. End up working for cannery, raking dried pits for cosmetics and pharmaceuticals. No future in the orchards (all replaced by houses). Switched to cutting comments, eight years of cross-examination debate and Jesuit education (BA Santa Clara University), still has annotated St. Thomas’ Commentaries on Metaphysics of Aristotle (no bids on Ebay). Decided to get more practical education, MPA, Woodrow Wilson School, Princeton. Joined US Justice Department working on racial mediation, dodged the draft less successfully than last two president, and current vice-president, speaker of house and president of Senate. Clearly no future in politics. Two years in US Army, subbasement of Pentagon in Directorate for Civil Disturbances Planning and Operations. Yale Law School, JD and an editor of Journal. “Honored in the Breech: Enforcement of the Law with Military Force,” Yale Law Journal, 1973. Chaired American Bar Association committee on Probate and Trust Litigation (1984-1988, vice-chair 1988-1996), chaired Ethics-Malpractice Committee (1996-2003) and co-chairs Bioethics Committee (2002-present), member Standing Committee on Bioethics and the Law, National Conference of Lawyers and Corporate Fiduciaries, ACTEC (Litigation Committee and chair of subcommittee on Fiduciary Surcharge and Damage Remedies), International Academy of Estate and Trust Law, National College of Probate Judges, and faculty of National Graduate Trust School. An editor and author of CEB California Trust and Probate Litigation. More publications than you would be remotely interested in reading. Still cross-examining people. Thirty-nine trials in probate, trust and investment cases, more mediations and arbitrations as neutral or judge pro tem. Much more fun than picking prunes.


IV

DRAFT Program Outline

TIMES SESSION & SPEAKERS

1:45 – 2:00 p.m. ET

Pre-Seminar Countdown

2:00 – 2:05 p.m. ET

Introduction Overview of Program Welcome Introduction of Moderator

KRM Information Services, Inc.

2:05 – 2:20 p.m. ET

Welcome, Speaker Introduction & Introductory Remarks Directed Trustee Liability Issues

Lisa Bleier American Bankers Association

2:20 – 2:50 p.m. ET

Fiduciary Risk and Litigation Update Duties of Directed Trustees Investment Duties and Liabilities

Dominic J. Campisi, Esq. Evans, Latham and Campisi

2:50 – 3:00 p.m. ET

Questions and Answers

3:00 – 3:25 p.m. ET

Fiduciary Risk and Litigation Update continued New Measures of Damages Investment Selection

Dominic J. Campisi, Esq. Evans, Latham and Campisi

3:25 – 3:35 p.m.

Questions and Answers


V

DRAFT Program Outline

TIMES SESSION & SPEAKERS 3:35 – 4:00 p.m.

Fiduciary Risk and Litigation Update and Closing Remarks Miscellaneous Decisions

Lisa Bleier American Bankers Association Dominic J. Campisi, Esq. Evans, Latham and Campisi


VI

CONTINUING EDUCATION CREDITS INFORMATION

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VII

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I. DUTIES OF DIRECTED TRUSTEES A. Duty of a Trustee When The Trust Authorizes Someone Else To Direct

Investments B. The Scope of Duty and Resulting Liability

1. ERISA Cases a. WorldCom – Directed trustee has potential liability if a

“prudent trustee would know” of the imprudent investment

b. Enron – Directed Trustee Has Potential Liability If It Has Notice (Knows or Should Know)” Of An Investment Breach.

c. Moench v. Robertson 2. Non ERISA Cases

a. Rollins v. Branch Banking and Trust Company of Virginia – Trustee Directed By Beneficiaries May Have Liability For Failure To Inform Beneficiaries of Deteriorating Condition of Company Stock

b. Duty of Investment Manager Or Custodial Agent Regarding Trust Investments

c. Liability For Failure Properly to Plan to Minimize Taxes d. Where No Investment Directives (and a client in prison) e. Liability of trustee for aiding and abetting broker in

Ponzi scheme f. Liability of depository banks when Trustees Defalcate g. Hobson’s Choice: when your agent improperly manages a

pension plan II. INVESTMENT DUTIES AND LIABILITIES

IV. The British Model: The Invisible Hand Was Actually Manipulating the Market

V. Analysis of Historic Investment Returns VI. Graham and Dodd: The Hunt for Undervalued Stocks VII. The Rational Investor is Discovered VIII. Market and Idiosyncratic Risk IX. Uncompensated Risk X. Increases in Stock Volatility and Idiosyncratic Risk XI. The Restatement Third of Trusts and the Uniform Prudent Investor Act XII. Liability for Failure to Diversify: Procedural Prudence Standard XIII. Behavioral Finance XIV. Duty to Minimize Cost: Double Dipping

III. A NEW MEASURE OF DAMAGES A. Damages Even When There Was No Loss Of Nominal Value

1. McCullough Trust: Surcharge Barred Where Nominal Value Of Trust Increased (Modestly) Over 63 Years

2. Estate of Scharlach: Appreciation Damages Allowed On 50% of Portfolio Due To Express Obligation To Invest In Equities

3. Pitt v. First Union Nat’l Bank: Surcharge Barred Where Trust Value Increased From $122,000 to $518,073 During 93 Years

4. Williams v. J.P. Morgan & Co.: Surcharge Allowed Where Portfolio Was Invested Exclusively In Bonds for 30 Years

B. Underperformance Is Not Necessarily A Breach C. Loss Plus Interest D. Disgorgement of Profit By Trustee E. What the Trust Would Have Earned But For The Breach

1. Meyer v. Berkshire Life Insurance Company: Courts May Estimate Damages. Damages Were Awarded On The Basis Of What A Moderate Risk Portfolio Would Have Returned

2. California Ironworkers: Damages Allowed On What The Trust Would Have Earned If The Excessive Investments In Inverse Floaters Had Been Invested In Appropriate Fixed Income Securities, Measured By A Benchmark

3. Noggle v. Bank of America: The Appropriate Measure Of Appreciation Was The Corporate Trustee’s Common Equity Trust Fund, Not An Objective Market Criteria Such As The S&P 500 Index

4. Scalp & Blade: Where The Breach Involves Deliberate Self-dealing, An Overall Market Index May Be An Appropriate Measure Of Damages

5. Other Cases

IV. INVESTMENT SELECTION A. Asset Allocation B. Risks of Closely Held Businesses

1. Authorizations and Exculpatory provisions a. Authorization in the trust instrument is the primary

defense b. Authorization by beneficiaries

V. MISCELLANEOUS DECISIONS

A. Removal of Trustee B. Liability of Trustee for Distributions While Claim Pending C. Trustee Fees D. Attack of the Canaries, or Where is Elliot Spitzer When We

Need Him? E. Conversion of Charitable Trust to Foundation F. Duty to Sue Self Reversed

© 2004 BY DOMINIC J. CAMPISI

FIDUCIARY RISK AND LITIGATION UPDATE


SPEAKERS

Lisa BleierLisa Bleier, Senior Counsel, Regulatory and , Senior Counsel, Regulatory and Trust Affairs, American Bankers Association, Trust Affairs, American Bankers Association, Washington, DCWashington, DCDominic J. Campisi, Esq.Dominic J. Campisi, Esq., Evans, Latham , Evans, Latham and Campisi, San Francisco, CAand Campisi, San Francisco, CA


Lisa BleierSenior CounselCenter for Securities, Trusts & Investments

I.I. EnronEnronII.II. WorldComWorldComIII.III. DOL ActionsDOL Actions

1


““Although a drop in stock price and Although a drop in stock price and general weakness in the company’s general weakness in the company’s performance is not sufficient to win performance is not sufficient to win judgment on a breach of the duty of judgment on a breach of the duty of prudence, it is enough to survive a prudence, it is enough to survive a motion to dismiss.”motion to dismiss.”


Duty of a Trustee When The Trust Authorizes Someone Else To Direct Investments.

Restatement Second of Trusts Restatement Second of Trusts §§185 compels the directed 185 compels the directed trustee to comply with the exercise of a directing power trustee to comply with the exercise of a directing power ““unless unless the attempted exercise of the power violates the terms of the the attempted exercise of the power violates the terms of the trust or is a violation of a fiduciary duty to which such persontrust or is a violation of a fiduciary duty to which such person is is subject in the exercise of the power.subject in the exercise of the power.””

The revisions to former The revisions to former §§184 in the Third Restatement state in 184 in the Third Restatement state in comment c that comment c that ““If, however, the nonIf, however, the non--participating trustee or participating trustee or trustees have reason to believe that the responsible trustee or trustees have reason to believe that the responsible trustee or trustees may be committing or about to commit a breach of trust,trustees may be committing or about to commit a breach of trust,the nonthe non--participating trustee or trustees have a duty to take participating trustee or trustees have a duty to take reasonable steps to investigate and, if necessary, to prevent reasonable steps to investigate and, if necessary, to prevent breach of trust.breach of trust.”” Restatement Third of Trusts, Prudent Investor Restatement Third of Trusts, Prudent Investor Rule, at 150. Rule, at 150.


Harris Trust and Savings Bank v. Salomon Smith Barney, Inc, 530 U.S.238, 120 S. Ct. 2180 (June, 2000).

““common law of trusts , which offers a common law of trusts , which offers a ‘‘starting point for analysis starting point for analysis [of ERISA]...[unless] it is inconsistent with the language of th[of ERISA]...[unless] it is inconsistent with the language of the e statute, its structure or its purposesstatute, its structure or its purposes’”’”

This is a twoThis is a two--way street: private trust decisions can be used to way street: private trust decisions can be used to construe the duties of ERISA trustees and ERISA decisions can construe the duties of ERISA trustees and ERISA decisions can serve as precedents to the shape of the common law and can serve as precedents to the shape of the common law and can be used to impose duties on private trustees. be used to impose duties on private trustees.

2


In re WorldCom Inc., 263 F.Supp.2d 745 (S.D.N.Y. 2003)

Merrill Lynch was named as the Plan Trustee. The Trust Merrill Lynch was named as the Plan Trustee. The Trust agreement provided that agreement provided that ““Except as required by ERISA, the Except as required by ERISA, the Trustee shall invest the Trust Fund as directed by the Named Trustee shall invest the Trust Fund as directed by the Named Investment Fiduciary, an Investment Manager or a Plan Investment Fiduciary, an Investment Manager or a Plan participant or beneficiary, as the case may be, and the Trustee participant or beneficiary, as the case may be, and the Trustee shall have no discretionary control over, nor any other discretishall have no discretionary control over, nor any other discretion on regarding, the investment or reinvestment of any asset of the regarding, the investment or reinvestment of any asset of the Trust.Trust.””

““[c]ontributions will be invested by the Trustee pursuant to [c]ontributions will be invested by the Trustee pursuant to written direction from Participants, each of whom has the right written direction from Participants, each of whom has the right to to choose among the investment alternatives selected by the choose among the investment alternatives selected by the Investment Fiduciary.Investment Fiduciary.””


The Court denies Merrill’s motion to dismiss

As a directed trustee Merrill Lynch was not As a directed trustee Merrill Lynch was not required to exercise its independent judgment required to exercise its independent judgment in deciding how and whether to invest in deciding how and whether to invest employee funds as directed, but that it had to employee funds as directed, but that it had to make sure that WorldCommake sure that WorldCom’’s directions (as s directions (as Investment Fiduciary) were (1) proper, (2) in Investment Fiduciary) were (1) proper, (2) in accordance with the terms of the plan, and accordance with the terms of the plan, and (3) not contrary to ERISA.(3) not contrary to ERISA.


““Merrill Lynch contends that it was required as a Merrill Lynch contends that it was required as a directed trustee to carry out investment instructions directed trustee to carry out investment instructions unless it was unless it was ‘‘clear on the faceclear on the face’’ of the instructions of the instructions that they violated ERISA or the Plan. It finds support that they violated ERISA or the Plan. It finds support for this view in the legislative history for ERISA. This for this view in the legislative history for ERISA. This is not an issue that must be resolved at this stage of is not an issue that must be resolved at this stage of the litigation. It would appear, however, that the the litigation. It would appear, however, that the standard that should apply to Merrill Lynchstandard that should apply to Merrill Lynch’’s conduct s conduct is the prudent person standard articulated in the text is the prudent person standard articulated in the text of the statute. See Koch v. Dwyer, No. 98 Civ. 5519 of the statute. See Koch v. Dwyer, No. 98 Civ. 5519 (RPP), 1999 WL 528 [18], at * 9(RPP), 1999 WL 528 [18], at * 9--10 (S.D. N.Y. 1999).10 (S.D. N.Y. 1999).””263 F. Supp.2d at 761, n.8263 F. Supp.2d at 761, n.8

3


ESOP status is not a complete defense

““Even in the context of an ESOP, which is designed Even in the context of an ESOP, which is designed to offer employees the opportunity solely to invest in to offer employees the opportunity solely to invest in the employerthe employer’’s stock, a fiduciary may be liable for s stock, a fiduciary may be liable for continuing to offer an investment in the employercontinuing to offer an investment in the employer’’s s securities, at least where the plaintiff can show that securities, at least where the plaintiff can show that circumstances arose which were not known or circumstances arose which were not known or anticipated by the settlor of the trust that made a anticipated by the settlor of the trust that made a continued investment in the companycontinued investment in the company’’s stock s stock imprudent, and in effect, impaired the purpose for imprudent, and in effect, impaired the purpose for which the trust was established. See which the trust was established. See Moench v. Moench v. RobertsonRobertson, 62 F.3d 553, 571 (3, 62 F.3d 553, 571 (3rdrd Cir. 1995).Cir. 1995).


Rebuttable Presumption of Propriety in ESOP

““In light of the analysis detailed above, keeping in In light of the analysis detailed above, keeping in mind the purpose behind ERISA and the nature of mind the purpose behind ERISA and the nature of ESOPs themselves, we hold that in the first instance, ESOPs themselves, we hold that in the first instance, an ESOP fiduciary who invests the assets in an ESOP fiduciary who invests the assets in employer stock is entitled to a presumption that it employer stock is entitled to a presumption that it acted consistently with ERISA by virtue of that acted consistently with ERISA by virtue of that decision. However, the plaintiff may overcome that decision. However, the plaintiff may overcome that presumption by establishing that the fiduciary abused presumption by establishing that the fiduciary abused its discretion by investing in employer securities.its discretion by investing in employer securities.””Moench, Moench, 62 F.3d at 571.62 F.3d at 571.


In re Enron ERISA Litigation, 284 F.Supp.2d 511 (S.D. Tex. 2003).

Northern Trust resigned as trustee of the Enron Northern Trust resigned as trustee of the Enron pension plan, triggering a blackout period in which no pension plan, triggering a blackout period in which no trades could be accomplished. The price fell from trades could be accomplished. The price fell from $33.84 to $10.00 per share. $33.84 to $10.00 per share.

Plan participants alleged in their subsequent class Plan participants alleged in their subsequent class actions that Northern Trust as custodial trustee actions that Northern Trust as custodial trustee breached fiduciary duties to them by not stopping or breached fiduciary duties to them by not stopping or delaying the blackout during the extreme delaying the blackout during the extreme circumstances, even though it could have. circumstances, even though it could have.

4


Liability where directed trustee knows or should know direction is a breach.

The court held that a directed ERISA trustee should not be The court held that a directed ERISA trustee should not be jointly liable for a directing fiduciaryjointly liable for a directing fiduciary’’s breach s breach ““except where the except where the directed trustee has notice (knows or should know)directed trustee has notice (knows or should know)”” of the of the breach. breach. This standard This standard ““makes good business sense to keep the costs of makes good business sense to keep the costs of administering such plans down and encouraging employers to administering such plans down and encouraging employers to establish them, but maintaining key protection for the plan establish them, but maintaining key protection for the plan participant or beneficiary where the directing trusteeparticipant or beneficiary where the directing trustee’’s failure to s failure to protect is more egregious.protect is more egregious.”” EnronEnron, 284 F.Supp.2d 511, at 591. , 284 F.Supp.2d 511, at 591. Contrast Meyer v. Berkshire Life Insurance Co., Contrast Meyer v. Berkshire Life Insurance Co., 250 F. Supp.2d 250 F. Supp.2d 544,574,D.Md. 2003) aff544,574,D.Md. 2003) aff’’d 372 F.3d 261(4d 372 F.3d 261(4thth Cir. 2004) (where Cir. 2004) (where beneficiaries selected plan custodian for no fee on condition thbeneficiaries selected plan custodian for no fee on condition that at insurance products would be included in investments, such insurance products would be included in investments, such insurance products would be excluded from liability for insurance products would be excluded from liability for imprudent investments). imprudent investments).


Ninth Circuit critique of Moench: Wright v. Oregon Metallurgical Corporation, 360 F.3d 1090 (9th Cir. 2004).

““The Third CircuitThe Third Circuit’’s intermediate prudence standard s intermediate prudence standard is difficult to reconcile with ERISAis difficult to reconcile with ERISA’’s statutory text, s statutory text, which exempts EIAPs [eligible individual account which exempts EIAPs [eligible individual account plans, including ESOPs] from the prudence plans, including ESOPs] from the prudence requirement to the extent that it requires requirement to the extent that it requires diversification. diversification. ……. . ‘‘If there is no duty to diversify If there is no duty to diversify ESOP plan assets under the statute, it logically ESOP plan assets under the statute, it logically follows that there can be no claim for breach of follows that there can be no claim for breach of fiduciary duty arising out of a failure to diversify, or in fiduciary duty arising out of a failure to diversify, or in other words, arising out of allowing the plan to other words, arising out of allowing the plan to become heavily weighted in company stock.become heavily weighted in company stock.’”’”


Non ERISA Cases

Rollins v. Branch Banking and Trust Company of VirginiaRollins v. Branch Banking and Trust Company of Virginia, 56 , 56 Vir. Cir. 147, 2001 WL 34037931 (Va. Cir. Ct. 2002)Vir. Cir. 147, 2001 WL 34037931 (Va. Cir. Ct. 2002)Directed trustee: "Investment decisions as to the retention, saDirected trustee: "Investment decisions as to the retention, sale, le, or purchase of any asset of the Trust Fund shall likewise be or purchase of any asset of the Trust Fund shall likewise be decided by such living children or beneficiaries, as the case madecided by such living children or beneficiaries, as the case may y be."be."Virginia Code Virginia Code §§2626--5.2 provides that where the trust authorizes 5.2 provides that where the trust authorizes some third party to direct investments, some third party to direct investments, ““the [directed] fiduciary, the [directed] fiduciary, or coor co--fiduciary shall be liable, if at all, only as a ministerial agenfiduciary shall be liable, if at all, only as a ministerial agent t and shall not be liable as fiduciary or coand shall not be liable as fiduciary or co--fiduciary for any loss fiduciary for any loss resulting from the making or retention of any investment resulting from the making or retention of any investment pursuant to such authorized direction.pursuant to such authorized direction.””Court sustains motion to dismiss for damages because of Court sustains motion to dismiss for damages because of retention.retention.

5


Don’t Celebrate Yet.

The Court cited the The Court cited the ““duty to impart to the duty to impart to the beneficiary any knowledge he may have beneficiary any knowledge he may have affecting the beneficiaryaffecting the beneficiary’’s interest and he s interest and he cannot rid himself of this cannot rid himself of this ‘‘duty to warn.duty to warn.’’ see see Restatement 2d Trusts Restatement 2d Trusts §§173173..””Thus the case was allowed to go forward on Thus the case was allowed to go forward on the allegations that the beneficiaries were the allegations that the beneficiaries were injured as a consequence of the trusteeinjured as a consequence of the trustee’’s s alleged breach of its duty to investigate and alleged breach of its duty to investigate and warn them of the deterioration of the closely warn them of the deterioration of the closely held business.held business.


Duty of Investment Manager Or Custodial Agent Regarding Trust Investments

The Uniform Prudent Investor Act permits a trustee to The Uniform Prudent Investor Act permits a trustee to delegate investment and management functions that delegate investment and management functions that a a ““prudent trustee of comparable skills could properly prudent trustee of comparable skills could properly delegate under the circumstances.delegate under the circumstances.”” UPIA UPIA §§ 9(a).9(a).An agent that accepts a delegation of investment An agent that accepts a delegation of investment functions functions ““owes a duty to the trust to exercise owes a duty to the trust to exercise reasonable care to comply with the terms of the reasonable care to comply with the terms of the delegation.delegation.”” UPIA UPIA §§ 9(b).9(b).Furthermore, Furthermore, ““By accepting the delegation of a trust By accepting the delegation of a trust

function from the trustee of a trust that is subject to function from the trustee of a trust that is subject to the law of this State, an agent submits to the the law of this State, an agent submits to the jurisdiction of the courts of this State.jurisdiction of the courts of this State.”” UPIA UPIA §§ 9(d).9(d).


Liability For Failure Properly to Plan to Minimize Taxes

Estate of NicelyEstate of Nicely, 2003 WL 22183940 , 2003 WL 22183940 (Pa. Com. Pl. 2003) deals with a claim (Pa. Com. Pl. 2003) deals with a claim that a bank serving as an agent in fact that a bank serving as an agent in fact for an elderly client should have been for an elderly client should have been liable for failing to place her assets in an liable for failing to place her assets in an appropriate estate planning vehicle appropriate estate planning vehicle such as a trust which could have such as a trust which could have minimized taxes and for failing to minimized taxes and for failing to undertake investment management.undertake investment management.

6


Power of Attorney Document gave bank broad powers over personal affairs.

The powerThe power-- holder bank caused a trust holder bank caused a trust instrument to be prepared and sent to the instrument to be prepared and sent to the family, it was never executed by the mother.family, it was never executed by the mother.

““The mere existence of a power of attorney, The mere existence of a power of attorney, without more, imposes no duty to exercise without more, imposes no duty to exercise any of the powers which are conferred any of the powers which are conferred therein. An attorneytherein. An attorney-- inin-- fact is only required to fact is only required to perform such actions and provide such perform such actions and provide such services as he agrees or undertakes to services as he agrees or undertakes to perform or provide.perform or provide.””


Don’t Celebrate yet.

““The agreement or undertaking may encompass all The agreement or undertaking may encompass all or only some of the powers which are enumerated in or only some of the powers which are enumerated in the power of attorney. The agreement or undertaking the power of attorney. The agreement or undertaking may be express or may be express or impliedimplied. It may be written or . It may be written or verbalverbal. It may arise from the conduct of the principal . It may arise from the conduct of the principal and agent, as in the case where one acts or fails to and agent, as in the case where one acts or fails to act in act in justifiable reliancejustifiable reliance upon anotherupon another’’s action or s action or inaction.inaction.””Change your powers of attorney to reflect that only Change your powers of attorney to reflect that only expressly selected powers are accepted and that expressly selected powers are accepted and that changes must be in writing.changes must be in writing.


No Good Deed Goes Unpunished

Hatleberg v. Norwest Bank WisconsinHatleberg v. Norwest Bank Wisconsin, 678 N.W.2d , 678 N.W.2d 302 (WI App, 2004)302 (WI App, 2004)Trustee was held liable for taxes resulting from a Trustee was held liable for taxes resulting from a defectively drafted Crummey provision in a trust, after defectively drafted Crummey provision in a trust, after the trustee pointed the defect out to the settlorthe trustee pointed the defect out to the settlor’’s s former estate planning attorney but failed to take former estate planning attorney but failed to take additional steps to rectify the problem as annual gifts additional steps to rectify the problem as annual gifts were made.were made.““Once Wells Fargo realized the trust was insufficient Once Wells Fargo realized the trust was insufficient for that purpose, it was negligent in advising [settlor] for that purpose, it was negligent in advising [settlor] to continue making deposits and assuring her the to continue making deposits and assuring her the trust would reduce her estate taxes.trust would reduce her estate taxes.””

7


Where No Investment Directives (and a client in prison)

Wachovia Bank of Georgia v. NamikWachovia Bank of Georgia v. Namik, 593 S.E. 2d 35 (Ct. , 593 S.E. 2d 35 (Ct. App. Ga. 2003) provides another example of litigation App. Ga. 2003) provides another example of litigation which could have been avoided by careful intake and which could have been avoided by careful intake and documentation.documentation.Iraqi citizen, General Ali, who came to the United States Iraqi citizen, General Ali, who came to the United States and transferred money from a Swiss bank account, and transferred money from a Swiss bank account, acquiring approximately $3,000,000 in CDacquiring approximately $3,000,000 in CD’’s.s.The General wanted no The General wanted no ““market risksmarket risks”” and requested that and requested that the funds be invested in the funds be invested in ““U.S. government issues.U.S. government issues.”” The The bank was unable to get further information from the bank was unable to get further information from the general, who had returned to Iraq, which turned out to be general, who had returned to Iraq, which turned out to be a fatal mistake.a fatal mistake.


Reversal on Appeal

The trial court held that the trustee had an implied duty to The trial court held that the trustee had an implied duty to minimize taxes stemming from the form trust and failed to minimize taxes stemming from the form trust and failed to properly invest the trust in appropriate investments.properly invest the trust in appropriate investments.

Reversed: Reversed: ““While the statute suggests that anticipated tax While the statute suggests that anticipated tax consequences may be taken into account, in this case consequences may be taken into account, in this case there was no obligation on the part of the Bank to look into there was no obligation on the part of the Bank to look into estate tax consequences. The record is devoid of any estate tax consequences. The record is devoid of any evidence showing that Ali requested the Bank to evidence showing that Ali requested the Bank to specifically make investment to minimize estate tax specifically make investment to minimize estate tax consequences to the Trust, and the Trust Agreement does consequences to the Trust, and the Trust Agreement does not impose any duty upon the trustee to take estate taxes not impose any duty upon the trustee to take estate taxes into consideration or to otherwise make any estateinto consideration or to otherwise make any estate--planning decisions.planning decisions.””


When your agent improperly manages a pension plan

The plaintiff doctors split their practices and The plaintiff doctors split their practices and divided their firmdivided their firm’’s pension plan for s pension plan for themselves and their employees. They themselves and their employees. They became the respective trustees of the divided became the respective trustees of the divided plans and hired Berkshire to manage the plans and hired Berkshire to manage the plan. An agent of Berkshire made the actual plan. An agent of Berkshire made the actual investments. On the condition that investments. On the condition that investments would be made in insurance investments would be made in insurance products, Berkshire waived fees for its products, Berkshire waived fees for its services. services. Agent allegedly churns the accounts.Agent allegedly churns the accounts.

8


Berkshire held liable for conduct of Agent.

The Court found: The Court found: ““Aside from the life insurance Aside from the life insurance components, the evidence established that the components, the evidence established that the doctorsdoctors’’ contributions were invested very contributions were invested very conservatively, notwithstanding the fact that no conservatively, notwithstanding the fact that no Berkshire representative conducted any analysis of Berkshire representative conducted any analysis of the participantsthe participants’’ tolerance for risk.tolerance for risk.”” 250 F. Supp.2d 250 F. Supp.2d at 552. at 552. The agent described his investment strategy: The agent described his investment strategy: ““he he ‘‘would rather have a return of your money than a would rather have a return of your money than a return on your money.return on your money.’”’” 250 F. Supp. 2d at 544 [well 250 F. Supp. 2d at 544 [well spoken but ill done]. spoken but ill done].


Trial Experts Undercut by Internal Projections

““Given BerkshireGiven Berkshire’’s own figures, the plaintiffss own figures, the plaintiffs’’ expertsexperts’’testimony, and the evidence summarized below testimony, and the evidence summarized below regarding the plansregarding the plans’’ lack of diversification and lack of diversification and concentration in lowconcentration in low--yield investments, the court yield investments, the court agrees with the plaintiff that a 6% rate of return (and agrees with the plaintiff that a 6% rate of return (and certainly a 2% or 3% rate of return) for these plans certainly a 2% or 3% rate of return) for these plans was unacceptably low.was unacceptably low.””“’“’If the plaintiff meets his initial burden of establishing If the plaintiff meets his initial burden of establishing a failure to diversify, the burden thereupon shifts to a failure to diversify, the burden thereupon shifts to the defendant to prove that even though not the defendant to prove that even though not diversified, the allocation was nonetheless prudent.diversified, the allocation was nonetheless prudent.’”’”250 F. Supp.2d at 565.250 F. Supp.2d at 565.


Court Can Approximate Amount of Damages

““while awards may not be speculative, while awards may not be speculative, see, e.g., see, e.g., Carras v. BurnsCarras v. Burns, 516 F. 2d 251, 259 (4, 516 F. 2d 251, 259 (4thth Cir. 1975), Cir. 1975), the court may approximate the extent of damages. the court may approximate the extent of damages. See, e.g., Martin v. FeilenSee, e.g., Martin v. Feilen, 965 F.2d [660, 8, 965 F.2d [660, 8thth Cir. Cir. 1992] at 672 (citing 1992] at 672 (citing Story Parchment co. v Paterson Story Parchment co. v Paterson Parchment Paper Co.Parchment Paper Co., 282 U.S. 555, 563, 51 S.Ct. , 282 U.S. 555, 563, 51 S.Ct. 248, 75 L. Ed. 544(1931)).248, 75 L. Ed. 544(1931)).”” 250 F. Supp.2d at 572.250 F. Supp.2d at 572.““The court finds that it would have been reasonable The court finds that it would have been reasonable to achieve a 10% to 12% rate of return on the plansto achieve a 10% to 12% rate of return on the plans’’investment components during the 1993 to 1997 time investment components during the 1993 to 1997 time frame, given the marketframe, given the market’’s performance at that time.s performance at that time.””

9


Investment Duties and Liabilities

South Sea Bubble leads Chancellors to limit South Sea Bubble leads Chancellors to limit investments to most conservative.investments to most conservative.Investment studies starting in 1925 show equities Investment studies starting in 1925 show equities outperform bonds.outperform bonds.Graham and Dodd: The Hunt for Undervalued StocksGraham and Dodd: The Hunt for Undervalued Stocks““The traditional riskThe traditional risk--return tradeoff does not seem to return tradeoff does not seem to hold with regard to the split between growth and hold with regard to the split between growth and value. The value series are offering more return and value. The value series are offering more return and less risk.less risk.”” Ibbotson, Stocks Bonds, Bills and Inflation Ibbotson, Stocks Bonds, Bills and Inflation 2004 Yearbook at 149. 2004 Yearbook at 149.


Active v. Passive Management

R. Fortin and S. Michelson, R. Fortin and S. Michelson, ““Indexing Versus Active Indexing Versus Active Mutual Fund Management,Mutual Fund Management,”” JPA Journal, September JPA Journal, September 2002, 2002, ““We find that, on average, index funds We find that, on average, index funds outperform actively managed funds for most equity outperform actively managed funds for most equity and all bond fund categories on both a beforeand all bond fund categories on both a before--tax and tax and afterafter--tax basis. However, actively managed Small tax basis. However, actively managed Small Company Equity (SCE) funds and International Stock Company Equity (SCE) funds and International Stock (IS) funds significantly outperform the index over (IS) funds significantly outperform the index over most of the study period. Managers of these funds most of the study period. Managers of these funds appear to be able to invest to take advantage of appear to be able to invest to take advantage of mispricing in these presumably less efficient mispricing in these presumably less efficient markets.markets.””


Low Cost Managed Funds Can Outperform

““We find that from 1982 through 2003, the synthetic We find that from 1982 through 2003, the synthetic Vanguard U.S. managed fund beat the synthetic U.S. Vanguard U.S. managed fund beat the synthetic U.S. index fund, which beat the Vanguard Total Stock index fund, which beat the Vanguard Total Stock Market Index Fund, regardless of whether we riskMarket Index Fund, regardless of whether we risk--adjust the returns. Moreover, on both riskadjust the returns. Moreover, on both risk--adjusted adjusted and nonand non--risk adjusted performance the U.S. risk adjusted performance the U.S. managed fund is the winner and the Total Stock managed fund is the winner and the Total Stock Market Index fund is the loser over the entire time Market Index fund is the loser over the entire time span, although for the period beginning in 1985, the span, although for the period beginning in 1985, the managed fund loses to the other two regardless of managed fund loses to the other two regardless of risk adjustment. risk adjustment. ““K. Reinker and E. Tower in K. Reinker and E. Tower in ““Index Index Fundamentalism Revisited,Fundamentalism Revisited,”” Journal of Portfolio Journal of Portfolio Management, Summer 2004Management, Summer 2004

10


Criticism of Modern Portfolio Theory (The Law in 39 States and D.C.)

Benoit Mandelbrot, the father of fractal geometry and Benoit Mandelbrot, the father of fractal geometry and grandfather of chaos theory, in The (Mis)Behavior of grandfather of chaos theory, in The (Mis)Behavior of Markets (2004) points out that Markets (2004) points out that ““The old financial The old financial orthodoxy was founded on two critical assumptions in orthodoxy was founded on two critical assumptions in BachelierBachelier’’s key model: Price changes are statistically s key model: Price changes are statistically independent and they are normally distributed.independent and they are normally distributed.””


Increases in Stock Volatility and Idiosyncratic Risk

““declines over time in the correlations among declines over time in the correlations among individual stocks and in the explanatory power of the individual stocks and in the explanatory power of the market model for a typical stockmarket model for a typical stock”” Have individual Have individual Stocks Become More Volatile? An Empirical Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk," February, 2001, Exploration of Idiosyncratic Risk," February, 2001, Journal of FinanceJournal of Finance““In the first two subsamples a portfolio of 20 stocks In the first two subsamples a portfolio of 20 stocks reduced annualized excess standard deviation to reduced annualized excess standard deviation to about five percent, but in the 1986about five percent, but in the 1986--97 subsample this 97 subsample this level of excess standard deviation required almost 50 level of excess standard deviation required almost 50 stocks.stocks. ““


Some Courts Will Deny Surcharge Where Poor Diversification

In In Martin v. U.S. BankMartin v. U.S. Bank, 664 N.W.2d 923 (Neb. 2003), the , 664 N.W.2d 923 (Neb. 2003), the Supreme Court affirmed a denial of surcharge where the trustee Supreme Court affirmed a denial of surcharge where the trustee had invested the large majority of the portfolio in bonds. had invested the large majority of the portfolio in bonds. Nebraska had adopted the UPIA prudent investor statute. The Nebraska had adopted the UPIA prudent investor statute. The appellate court, however, looked to the trust provisions callingappellate court, however, looked to the trust provisions callingfor payment of trust income to the settlorfor payment of trust income to the settlor’’s daughter plus s daughter plus invasion of principal in the trusteeinvasion of principal in the trustee’’s sole discretion for the s sole discretion for the surviving daughtersurviving daughter’’s s ““health, maintenance in reasonable comfort health, maintenance in reasonable comfort and best interests.and best interests.”” The Court concluded that The Court concluded that ““We cannot say We cannot say that the bank violated the standards codified [in the UPIA] by that the bank violated the standards codified [in the UPIA] by investing the large majority of trust assets in fixed income investing the large majority of trust assets in fixed income investments rather than investing the trust assets in equity investments rather than investing the trust assets in equity investments which, without the benefit of hindsight, may have investments which, without the benefit of hindsight, may have endangered the integrity of the trust principal.endangered the integrity of the trust principal.”” 664 N.W.2d at 664 N.W.2d at 929. 929.

11


Liability for Failure to Diversify: Procedural Prudence Standard

Chase Manhattan Bank was surcharged $20,958,303.31 by the Chase Manhattan Bank was surcharged $20,958,303.31 by the Surrogate Court in Surrogate Court in Testamentary Trust UW DumontTestamentary Trust UW Dumont , 2004 WL , 2004 WL 1468746 1468746 ----------(Surr. Ct. June 25, 2004). (Surr. Ct. June 25, 2004). The court held that the trustee should have divested 95% of The court held that the trustee should have divested 95% of concentration in Kodak stock under former Prudent Person concentration in Kodak stock under former Prudent Person Rule. Rule. Language expressing wish of testator that Kodak not be sold forLanguage expressing wish of testator that Kodak not be sold for

purposes of diversification was precatory: purposes of diversification was precatory: ““it is my desire and it is my desire and hopehope……..””But granted power to sell But granted power to sell ““in case there shall be some in case there shall be some compelling reason other than diversification for doing so.compelling reason other than diversification for doing so.””


Failure to Get Advice on Construction of Trust

Trustee failed to get a definition of Trustee failed to get a definition of ““compelling compelling reasonreason”” despite conflict in the two clauses. No despite conflict in the two clauses. No legal advice on issue obtained by trustee legal advice on issue obtained by trustee between 1972 and 1997. The needs of between 1972 and 1997. The needs of remaindermen were a compelling reason, based remaindermen were a compelling reason, based on duty of impartiality. Restatement , Second, of on duty of impartiality. Restatement , Second, of Trusts Trusts §§232. The court noted that the trustee 232. The court noted that the trustee routinely sold sufficient stock to pay the half of its routinely sold sufficient stock to pay the half of its compensation allocated to principal, treating this compensation allocated to principal, treating this as an admission of what is a compelling reason.as an admission of what is a compelling reason.


Court Focus on Procedural Prudence

““for over nineteen years, the bank gave complete and for over nineteen years, the bank gave complete and utter responsibility for this trust to one, nonutter responsibility for this trust to one, non--legally legally trained and rather freshtrained and rather fresh--onon--the field man.the field man.””““No meaningful discussion could be had on the No meaningful discussion could be had on the nuances of Dumontnuances of Dumont’’s language or the existence of s language or the existence of external circumstances possibly warranting sale, in external circumstances possibly warranting sale, in the mere two minutes of average attention the the mere two minutes of average attention the Dumont trust received from the IRC once per year.Dumont trust received from the IRC once per year.””““The IRC was not equipped to review interpretation The IRC was not equipped to review interpretation of the trust, the needs of the beneficiaries, the of the trust, the needs of the beneficiaries, the business dealings of Eastman Kodak or the realities business dealings of Eastman Kodak or the realities of the market.of the market.””

12


Staffing and Supervision Required

The court relied on an expert who opined that the The court relied on an expert who opined that the proper way to address unique terms was to utilize a proper way to address unique terms was to utilize a ““team resolveteam resolve”” and if no consensus was reached, to and if no consensus was reached, to obtain a legal opinion, and finally, a judicial obtain a legal opinion, and finally, a judicial interpretation. The court found no team approach and interpretation. The court found no team approach and ““the bank had no other adequate version of this the bank had no other adequate version of this methodology.methodology.””““within its own internal structure, it did not clearly within its own internal structure, it did not clearly specify whose job it was to handle questions of specify whose job it was to handle questions of document interpretations on management directives.document interpretations on management directives.””


Lack of Procedures to Deal with Falling Prices

““the bank never attempted to prospectively define any the bank never attempted to prospectively define any triggering criteria which would raise a red flag for the trust triggering criteria which would raise a red flag for the trust officer in charge to raise the necessity of n immediate and officer in charge to raise the necessity of n immediate and more inmore in--depth review. Good practice would dictate that depth review. Good practice would dictate that upon the occurrence of a preupon the occurrence of a pre--determined significant event determined significant event (such as a precipitous decline in stock value) the trust (such as a precipitous decline in stock value) the trust would undergo some form of intensive review to make would undergo some form of intensive review to make sure that fiduciary duty is being properly upheld. Good sure that fiduciary duty is being properly upheld. Good practice would dictate a beforepractice would dictate a before--the fall type of analysis to the fall type of analysis to attempt to identify proper triggers which would call for attempt to identify proper triggers which would call for such a review. Good practice would dictate complete such a review. Good practice would dictate complete documentation of all of these processes.documentation of all of these processes.””


Restatement (Second) of Trusts § 167Restatement (Third) of Trusts §27

A significant drop in stock value such that this duty to preservA significant drop in stock value such that this duty to preserve e is compromised, would dictate that a prudent action by the is compromised, would dictate that a prudent action by the trustee would be to sell the falling stock and attempt to regaintrustee would be to sell the falling stock and attempt to regainthe loses sustained to the corpus. Where prudence dictates the loses sustained to the corpus. Where prudence dictates sale, a retention clause if superseded. sale, a retention clause if superseded. In re Hubbell,In re Hubbell,, 302 N.Y. , 302 N.Y. 246, 97 N.E. 2d 888 (1951).246, 97 N.E. 2d 888 (1951).”” Ibid.Ibid. at 14 at 14 ““The risk presented by The risk presented by the concentration itself may not have been compelling reason the concentration itself may not have been compelling reason for sale, but the actual, substantial loss and lack of viable hofor sale, but the actual, substantial loss and lack of viable hope pe of long term gain of long term gain waswas. The Court finds that if the bank had been . The Court finds that if the bank had been prudently monitoring this trust, it would not have continued to prudently monitoring this trust, it would not have continued to retain the nearretain the near--exclusive concentration of Kodak stock as it did exclusive concentration of Kodak stock as it did until 2002. Therefore, the failure of the bank to adequately cauntil 2002. Therefore, the failure of the bank to adequately carry rry out its fiduciary duties directly resulted in objectantsout its fiduciary duties directly resulted in objectants’’ loss.loss.””

13


Duty to Minimize Cost and AvoidDouble Dipping

““In deciding whether to delegate, the trustee must In deciding whether to delegate, the trustee must balance the projected benefits against the likely balance the projected benefits against the likely costs. Similarly, in deciding how to delegate, the costs. Similarly, in deciding how to delegate, the trustee must take costs into account. The trustee trustee must take costs into account. The trustee must be alert to protect the beneficiary from must be alert to protect the beneficiary from ‘‘double double dipping.dipping.’’ If, for example, the trusteeIf, for example, the trustee’’s regular s regular compensation schedule presupposes that the trustee compensation schedule presupposes that the trustee will conduct the investment management function, it will conduct the investment management function, it should ordinarily follow that the trustee will lower its should ordinarily follow that the trustee will lower its fee when delegating the investment function to an fee when delegating the investment function to an outside manger.outside manger.”” UPIA UPIA §§9, comment. 9, comment.


Restatement Third of Trusts, Prudent Investor Rule, §227 at 50.

““ If the trustee also receives commissions from the If the trustee also receives commissions from the trust, they must be appropriate to the duties trust, they must be appropriate to the duties performed; and overall management costs to the trust performed; and overall management costs to the trust estate must not be unreasonable in light of estate must not be unreasonable in light of alternatives realistically available to the particular alternatives realistically available to the particular trustee. Because multiple layers of investment trustee. Because multiple layers of investment management costs can be a serious concern, the management costs can be a serious concern, the amount of the trusteeamount of the trustee’’s compensation may depend s compensation may depend on the nature of the investment program, the role on the nature of the investment program, the role played by the trustee, and the qualifications and played by the trustee, and the qualifications and services contemplated in the selection and services contemplated in the selection and remuneration of the trustee. Compare remuneration of the trustee. Compare §§188, 188, Comment Comment cc, on the expenses of employing agents., on the expenses of employing agents.””


A New Measure of Damages Restatement (Third) of Trusts §205

It provides that a trustee is It provides that a trustee is ““(a) accountable for any (a) accountable for any profit accruing to the trust through the breach of trust; profit accruing to the trust through the breach of trust; or (b) chargeable with the amount required to restore or (b) chargeable with the amount required to restore the values of the trust estate and trust distributions to the values of the trust estate and trust distributions to what they would have been if the trust had been what they would have been if the trust had been properly administered. In addition, the trustee is properly administered. In addition, the trustee is subject to such liability as necessary to prevent the subject to such liability as necessary to prevent the trustee from benefiting personally from the breach of trustee from benefiting personally from the breach of trust.trust.””Disgorgement can be for deterrence as well as to Disgorgement can be for deterrence as well as to compensate for losses.compensate for losses.

14


Disgorgement Where the Trustee has a Conflict

In In Nickel v. Bank of AmericaNickel v. Bank of America, 290 F.3d 1134 (9, 290 F.3d 1134 (9thth Cir. Cir. 2002), the Court reversed a trial court decision (991 2002), the Court reversed a trial court decision (991 F. Supp. 1175 (N.D. Cal. 1997)) holding that the F. Supp. 1175 (N.D. Cal. 1997)) holding that the proper remedy for overcharges in trusts containing proper remedy for overcharges in trusts containing fixed fee provisions was simple interest. On appeal fixed fee provisions was simple interest. On appeal the Court held that disgorgement was the proper the Court held that disgorgement was the proper remedy, in light of the fact that a breach of the duty of remedy, in light of the fact that a breach of the duty of loyalty was involved.loyalty was involved.““If the banks had taken the overcharges and thrown If the banks had taken the overcharges and thrown the money out the window, there would be no the money out the window, there would be no causation, and, if the banks could prove they had causation, and, if the banks could prove they had done this, the plaintiff would lose.done this, the plaintiff would lose.””


Profit: Net of Expenses and Some TaxesReturn on Equity, not Assets

Trial Court on remand denied deductibility of taxes Trial Court on remand denied deductibility of taxes based on overcharges.based on overcharges.Trial Court allowed deduction of taxes in calculating Trial Court allowed deduction of taxes in calculating profit based on overcharges, using return on equity. profit based on overcharges, using return on equity. Case settled before a published decision in the trial Case settled before a published decision in the trial court: reported $33,000,000. settlement.court: reported $33,000,000. settlement.


What Would Have been Earned But for Breach

In In California IronworkersCalifornia Ironworkers Field Pension Trust v. Loomis Sayles & Field Pension Trust v. Loomis Sayles & Co.Co., 259 F.3d 1036 (9, 259 F.3d 1036 (9thth Cir. 2001) the court affirmed a finding Cir. 2001) the court affirmed a finding that the investment advisor to a pension trust imprudently that the investment advisor to a pension trust imprudently invested too large a portion of the assets in inverse floaters, invested too large a portion of the assets in inverse floaters, and and approved the trial courtapproved the trial court’’s use of a benchmark yield for fixed s use of a benchmark yield for fixed income securities to calculate damages. income securities to calculate damages. ““It would be extremely It would be extremely difficult to arrive at even an approximate calculation of the yidifficult to arrive at even an approximate calculation of the yields elds which reasonably could have been expectedwhich reasonably could have been expected from different from different portions of the portfolio assuming appropriate investment. portions of the portfolio assuming appropriate investment. When precise calculations are impractical, trial courts are When precise calculations are impractical, trial courts are permitted significant leeway in calculating a reasonable permitted significant leeway in calculating a reasonable approximation of the damages suffered. approximation of the damages suffered. See Sutton v. EarlesSee Sutton v. Earles, , 26 F. 3d 903, 918 (926 F. 3d 903, 918 (9thth Cir. 1994).Cir. 1994).””

15


Limitations where no bad faith conduct

““If the period during which the trustee has failed to If the period during which the trustee has failed to make investments is not significantly prolonged, at make investments is not significantly prolonged, at least if the trustee is not guilty of bad faith or other least if the trustee is not guilty of bad faith or other serious misconduct, it would ordinarily be an serious misconduct, it would ordinarily be an appropriate exercise of equitable discretion to appropriate exercise of equitable discretion to measure the performance of proper trust investments measure the performance of proper trust investments only by applying a suitable rate of interest, based on only by applying a suitable rate of interest, based on the income yields of investments of generally the income yields of investments of generally comparable trusts.comparable trusts.”” Restatement (Third) of Trusts Restatement (Third) of Trusts §§211, com. F.211, com. F.


Janes and its Progeny

The trial court in The trial court in JanesJanes used the S&P 500 index as a measure used the S&P 500 index as a measure of damages, the appellate division rejected it, and the New Yorkof damages, the appellate division rejected it, and the New YorkCourt of Appeals firmly rejected such a remedy in cases where Court of Appeals firmly rejected such a remedy in cases where there is no "deliberate selfthere is no "deliberate self--dealing and faithless transfers of trust dealing and faithless transfers of trust property." property." In the Matter of Lincoln First BankIn the Matter of Lincoln First Bank, 90 N.Y. 2 41 , 90 N.Y. 2 41 (1997), 659 N.Y.S.2d at 172.(1997), 659 N.Y.S.2d at 172.Scalp & Blade Inc. and Scalp & Blade Scholarship Association Scalp & Blade Inc. and Scalp & Blade Scholarship Association v. Advest, Inc.v. Advest, Inc. 765 N.Y.S. 2d 92 ( App. Div. Oct. 2, 2003) the 765 N.Y.S. 2d 92 ( App. Div. Oct. 2, 2003) the court allowed trust the right to collect appreciation damages court allowed trust the right to collect appreciation damages based on a market index.based on a market index. ““involving claims of churning, involving claims of churning, investment unsuitability, or other acts of unauthorized trading investment unsuitability, or other acts of unauthorized trading by by defendantsdefendants……..””Account of BeinyAccount of Beiny, 2003 WL 21729779 (N.Y. Surr. 2003), 2003 WL 21729779 (N.Y. Surr. 2003)


Pure Heart, Empty Head

Toussaint v. JamesToussaint v. James, 2003 WL 21738974, (S.D. N.Y. , 2003 WL 21738974, (S.D. N.Y. 2003), the trustees of a pension plan sued their attorneys 2003), the trustees of a pension plan sued their attorneys and predecessor trustees for investing primarily in fixed and predecessor trustees for investing primarily in fixed income securities. The court held that the proper income securities. The court held that the proper measure of damages was what the trust would have measure of damages was what the trust would have earned but for the breach of trust. The court noted that earned but for the breach of trust. The court noted that ““a a pure heart and an empty headpure heart and an empty head”” are not enough to avoid are not enough to avoid liability for a duty to diversify.liability for a duty to diversify.Brown v.Brown v. SchwegmannSchwegmann, 861 So.2d 862 (La. App. 2004), 861 So.2d 862 (La. App. 2004)Sims v. HeathSims v. Heath, 577 S.E. 2d 789 (Ct. App. Ga, Nov. 22, , 577 S.E. 2d 789 (Ct. App. Ga, Nov. 22, 2002)2002)

16


40% of Returns Result from Asset Allocation

A comprehensive study by Roger Ibbotson and Paul Kaplan of A comprehensive study by Roger Ibbotson and Paul Kaplan of the returns of 91 balanced mutual funds over the 10 years the returns of 91 balanced mutual funds over the 10 years ending in March of 1998 and 58 pension plans for a fiveending in March of 1998 and 58 pension plans for a five--year year period ending in 1997, found that 40 percent of the difference iperiod ending in 1997, found that 40 percent of the difference in n returns among the various funds reflected asset allocations returns among the various funds reflected asset allocations against benchmark indices. Sixty percent, the study reported, against benchmark indices. Sixty percent, the study reported, reflected the reflected the ““managermanager’’s ability to actively overs ability to actively over-- or underweight or underweight asset classes and securities relative to the [asset allocation] asset classes and securities relative to the [asset allocation] policy and on the magnitude and timing of those bids.policy and on the magnitude and timing of those bids.”” R. R. Ibbotson and P. Kaplan, Ibbotson and P. Kaplan, ““Does Asset Allocation Policy explain Does Asset Allocation Policy explain 40, 90 or 100 Percent of Performance?40, 90 or 100 Percent of Performance?”” (2000) at 27. This can (2000) at 27. This can be located at Ibbotson.com. A shorter version can be found at be located at Ibbotson.com. A shorter version can be found at pages 121pages 121--126 of Ibbotson Associates, Stocks, Bonds, Bills, 126 of Ibbotson Associates, Stocks, Bonds, Bills, and Inflation, 2004 Yearbook. and Inflation, 2004 Yearbook.


Retention Language Imperiled

““A general authorization in an applicable statue or in A general authorization in an applicable statue or in the terms of the trust to retain investments received the terms of the trust to retain investments received as a part of a trust as a part of a trust estate does not ordinarily estate does not ordinarily abrogate the trusteeabrogate the trustee’’s duty with respect to s duty with respect to diversificationdiversification or the trusteeor the trustee’’s general duty to act s general duty to act with prudence in investment matters. The terms of with prudence in investment matters. The terms of the trust, however, may permit the trustee to retain all the trust, however, may permit the trustee to retain all the investments made by the settlor, or a larger the investments made by the settlor, or a larger proportion of them than would otherwise be proportion of them than would otherwise be permitted.permitted.”” (emphasis added) Restatement Third of (emphasis added) Restatement Third of Trusts Trusts §§229 com. d at 125.229 com. d at 125.


Changes in Circumstances Which Imperil the Trust

However changing circumstances may raise the trusteeHowever changing circumstances may raise the trustee’’s s duty to reduty to re--examine the situation where new risks or examine the situation where new risks or business performance require a change in the directed business performance require a change in the directed investment. As Section 229 of the Restatement states: investment. As Section 229 of the Restatement states: ““In In most instances a trustee should not take a settlormost instances a trustee should not take a settlor’’s s authorization to retain ;specific investments as special authorization to retain ;specific investments as special justification justification indefinitely if retention would otherwise be indefinitely if retention would otherwise be imprudentimprudent, especially if an apparent purpose of the , especially if an apparent purpose of the authorization become outdated by changed circumstances authorization become outdated by changed circumstances or passage of time.or passage of time.”” (emphasis added) Restatement Third (emphasis added) Restatement Third of Trusts at 125. of Trusts at 125.

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Retention Agreements with Beneficiaries

In re Estate of SaxtonIn re Estate of Saxton (NY Sur. 1998) 696 N.Y.S.2d (NY Sur. 1998) 696 N.Y.S.2d 573, 573, aff'd aff'd 274 A.D. 2d 110, 712 N.Y.S.2d 225(2000) 274 A.D. 2d 110, 712 N.Y.S.2d 225(2000) the will contained no restrictions on sale of the IBM the will contained no restrictions on sale of the IBM stock. The income beneficiary and the stock. The income beneficiary and the remainderpersons had signed an Investment remainderpersons had signed an Investment Direction Agreement in 1960 which "consented and Direction Agreement in 1960 which "consented and directed the trustee to continue to hold the stock directed the trustee to continue to hold the stock rather than following the normal banking procedure of rather than following the normal banking procedure of diversification and additionally held the bank diversification and additionally held the bank harmless from decreased in value of the investment." harmless from decreased in value of the investment." The IDA could be revoked on 30 day notice.The IDA could be revoked on 30 day notice.


Changed Circumstances

"A fiduciary should be entitled to rely on an "A fiduciary should be entitled to rely on an investment directive from the beneficiaries in investment directive from the beneficiaries in contravention of the normal policy of the bank contravention of the normal policy of the bank for a for a reasonable period of timereasonable period of time, or until such time that , or until such time that there is demonstrated disagreement among the there is demonstrated disagreement among the beneficiaries, provided however that the bank does beneficiaries, provided however that the bank does not completely abdicate its fiduciary responsibility to not completely abdicate its fiduciary responsibility to periodically advise the beneficiaries of timeperiodically advise the beneficiaries of time--tested tested formulas for protecting their investments from the formulas for protecting their investments from the inroads of a fluctuating market." Saxton, 686 inroads of a fluctuating market." Saxton, 686 N.Y.S.2d 579. (emphasis added)N.Y.S.2d 579. (emphasis added)


Proof of Disclosure of Risks in Retention Agreement

"Prior to the instrument being prepared and its "Prior to the instrument being prepared and its subsequent distribution to respondents, not a scintilla subsequent distribution to respondents, not a scintilla of evidence indicates that petitioner fully apprized of evidence indicates that petitioner fully apprized Saxton or respondents of the effects that their Saxton or respondents of the effects that their execution of the IDA would have on their legal rights execution of the IDA would have on their legal rights or how their direction to hold the entirety of the trust's or how their direction to hold the entirety of the trust's corpus in IBM stock would fall short of what would corpus in IBM stock would fall short of what would have been required of a prudent corporate have been required of a prudent corporate trustee."trustee."Estate of SaxtonEstate of Saxton, (App. Div. 2000) 712 , (App. Div. 2000) 712 N.Y.S.2d 225,231.N.Y.S.2d 225,231.

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Burden of Trustee to Show Comprehension

Estate of KramerEstate of Kramer, 2003 WL22889500 (Pa. Com. Pl.), 2003 WL22889500 (Pa. Com. Pl.) The The Court agreed with Scott on Trusts, Court agreed with Scott on Trusts, §§222.4, 222.4, ““that the that the scrivener/fiduciary has the burden of establishing that the scrivener/fiduciary has the burden of establishing that the client realized the implications of such a clause.client realized the implications of such a clause.We agree with the objectants that the various standards We agree with the objectants that the various standards by which a fiduciaryby which a fiduciary’’s conduct can be gauged are not s conduct can be gauged are not matters of common knowledge. We would venture a matters of common knowledge. We would venture a guess that, other than probate practitioners and judges guess that, other than probate practitioners and judges and professional fiduciaries, few people are conversant on and professional fiduciaries, few people are conversant on the topic.the topic.”” (emphasis added) 2003 WL 22889500 at 5. (emphasis added) 2003 WL 22889500 at 5. Court voided the exculpatory clause. Court voided the exculpatory clause.


Restatement (Third) of Trusts §27

Section 27 of the Third Restatement of Trusts (2003) Section 27 of the Third Restatement of Trusts (2003) provides in subsection (2) that Subject to the special rules provides in subsection (2) that Subject to the special rules of of §§§§46(2) and 47, a private trust, its terms, and its 46(2) and 47, a private trust, its terms, and its administration must be for the benefit of its administration must be for the benefit of its beneficiariesbeneficiaries……..””““In order to be valid, however, administrative and other In order to be valid, however, administrative and other provisions must reasonably relate to a trust purpose and provisions must reasonably relate to a trust purpose and must not have the effect of diverting the trustmust not have the effect of diverting the trust’’s funds or s funds or administration from that purpose in support of a purpose administration from that purpose in support of a purpose that does not meet the privatethat does not meet the private-- or charitable or charitable –– purpose purpose requirement of Subsection (1).requirement of Subsection (1).”” Comment b. Comment b.


The Dead Hand Won’t Help

““Further, on the possible invalidity of investment or management Further, on the possible invalidity of investment or management provisions that conflict with the interests of the beneficiariesprovisions that conflict with the interests of the beneficiaries, see J. , see J. Langbein, Langbein, ‘‘The Uniform Prudent Investor Act and the Future of Trust The Uniform Prudent Investor Act and the Future of Trust Investing,Investing,’’ 81 Iowa L. Rev. 641, 66381 Iowa L. Rev. 641, 663--665 (1996) (discussing a variation 665 (1996) (discussing a variation on the facts of the on the facts of the Pulitzer Pulitzer case, supra, and also discussing an case, supra, and also discussing an ‘‘objectivelyobjectively’’ imprudent direction to retain an undiversified portfolio with imprudent direction to retain an undiversified portfolio with no trust purpose or special beneficiary interest to justify it).no trust purpose or special beneficiary interest to justify it). Compare Compare Uniform Trust Code Uniform Trust Code §§412(b) (allowing, even without changed 412(b) (allowing, even without changed circumstances, modification of circumstances, modification of administrativeadministrative provisions that are provisions that are ‘‘wasteful or impair the trustwasteful or impair the trust’’s administrations administration’’) and George T. Bogert, ) and George T. Bogert, TrustsTrusts §§146 (hornbook, 6146 (hornbook, 6thth ed. 1987) (modification ed. 1987) (modification ‘…‘…due to the due to the unwisdom of the settlorunwisdom of the settlor’’s directions s directions …….which he thought would be .which he thought would be helpful but [proved] an obstaclehelpful but [proved] an obstacle’’ to sound administration of the trust). to sound administration of the trust). ““See Com. b. and Restatement, Second, of Trusts See Com. b. and Restatement, Second, of Trusts §§167; 167; seesee John H. John H. Langbein, Langbein, ““Mandatory Rules in the Law of Trusts,Mandatory Rules in the Law of Trusts,”” 98 Northwestern 98 Northwestern University Law Review 1105 (2004). University Law Review 1105 (2004).

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Removal of Trustee

In In Bergman v. BergmanBergman v. Bergman--DavisonDavison--Webster Charitable TrustWebster Charitable Trust, , 2004 WL 24968, (Tex. App, 2004) the Court affirmed removal of 2004 WL 24968, (Tex. App, 2004) the Court affirmed removal of a trustee of a charitable trust holding that where hostility exia trustee of a charitable trust holding that where hostility exists sts which which “’“’does or will affectdoes or will affect’’ the trusteethe trustee’’s performance of his s performance of his duties, then cause exists for his removal. duties, then cause exists for his removal. ““““Additionally, the hostility to which we refer is not limited onlAdditionally, the hostility to which we refer is not limited only to y to situations wherein the trusteesituations wherein the trustee’’s performance is affected. It also s performance is affected. It also includes those wherein it impedes the proper performance of the includes those wherein it impedes the proper performance of the trust, especially if the trustee made the subject matter of the trust, especially if the trustee made the subject matter of the suit suit is at fault. is at fault. Restatement (Third) of the Law of TrustsRestatement (Third) of the Law of Trusts §§37, 37, comment e(1) (2003); A. Scott & W. Fratcher, comment e(1) (2003); A. Scott & W. Fratcher, The Law of TrustsThe Law of Trusts§§107, p. 111 (4107, p. 111 (4thth ed. 1987).ed. 1987).


Following Your Trust Officer After Merger

In In Fleet Bank v. Probate AppealFleet Bank v. Probate Appeal, 2003 WL 21235439 , 2003 WL 21235439 (Conn. Super. 2003), the Superior Court approved the (Conn. Super. 2003), the Superior Court approved the removal of a corporate trustee when two longremoval of a corporate trustee when two long--term trust term trust officers moved to a different corporate trustee. Removal officers moved to a different corporate trustee. Removal was based on Connecticut Gen. St. was based on Connecticut Gen. St. §§45a45a--242(a)(4), which 242(a)(4), which authorized removal where authorized removal where ““there has been a substantial there has been a substantial change of circumstances or removal is requested by all of change of circumstances or removal is requested by all of the beneficiaries, the court finds that removal of the the beneficiaries, the court finds that removal of the fiduciary best serves the interests of all the beneficiaries fiduciary best serves the interests of all the beneficiaries and is not inconsistent with a material purpose of the and is not inconsistent with a material purpose of the governing instrument and a suitable cogoverning instrument and a suitable co--fiduciary or fiduciary or successor fiduciary is available.successor fiduciary is available.””


Suing the Escaping Trust Officers

In In Huntington NatHuntington Nat’’l Bank v. Hicksl Bank v. Hicks, 2003 WL , 2003 WL 22461815, (Mich. App. 2003), the court reversed a 22461815, (Mich. App. 2003), the court reversed a directed verdict in favor of trust officers who switched directed verdict in favor of trust officers who switched their employment to a second corporate trustee after their employment to a second corporate trustee after a merger had engulfed their former employer. The a merger had engulfed their former employer. The merged bank brought suit against the trust officers for merged bank brought suit against the trust officers for alleged misappropriation of trade secrets, breach of alleged misappropriation of trade secrets, breach of fiduciary duty, unjust enrichment, civil conspiracy and fiduciary duty, unjust enrichment, civil conspiracy and tortuous interference with contracts and prospective tortuous interference with contracts and prospective business relationships. business relationships.

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Where is Elliott Spitzer When We Need Him?

Several cases have enmeshed trustees of Several cases have enmeshed trustees of pension plans in liability claims for restricting pension plans in liability claims for restricting the timing activities of participants which the the timing activities of participants which the plan administrator either acquiesced in or plan administrator either acquiesced in or expressly authorized. expressly authorized. Borneman v. Principal Borneman v. Principal Life Insurance Co.Life Insurance Co., 291 F. Supp. 2d 935 (S.D. , 291 F. Supp. 2d 935 (S.D. Iowa 2003) and Iowa 2003) and American National Bank and American National Bank and Trust Co. of Chicago v. AXA Client Solutions, Trust Co. of Chicago v. AXA Client Solutions, LLC et alLLC et al, 2004 WL 438505 (N.D. Ill.). , 2004 WL 438505 (N.D. Ill.). Bad timing vs good timing.Bad timing vs good timing.

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Fiduciary Risk and Liability Update ©2004 by Dominic J. Campisi Evans Latham and Campisi [email protected]

I. DUTIES OF DIRECTED TRUSTEES

The “default” prudent investor rule set forth in the UPIA includes duties (a) to evaluate individual investments not in isolation but rather in the context of the trust portfolio as a whole and as part of an overall investment strategy with risk and return objectives reasonably suited to the trust, (b) to diversify investments, and (c) to review and implement decisions within a reasonable time after accepting trusteeship. However, the default rule “may be expanded, restricted, eliminated, or otherwise altered by the provisions of a trust,” and a trustee is not liable to a beneficiary to the extent that the trustee acts “in reasonable reliance on the provisions of the trust.” UPIA §1(b).

A. Duty of a Trustee When The Trust Authorizes Someone Else To Direct Investments.

Sometimes a trust document will authorize a settlor, a beneficiary, an investment

advisor, or some other person to direct the trustee concerning investments. If the trust suffers losses, or fails to realize gains, an issue may arise whether the trustee can be held liable even though she followed the directions in accordance with the trust document.

The catastrophes involving Enron, WorldCom and other meltdowns in public and private investments have left beneficiaries, investors, and pension plan beneficiaries with major losses and a fierce desire to find a deep pocket to fill theirs and those of their attorneys (not necessarily in that order). The gunsights have shifted from the malefactors who often were unable to find an early lifeboat to the corporate fiduciaries who have served in limited roles in investment programs: custodial trustees in pension plans, directed trustees in private trusts, agents for individual trustees and other fiduciaries, and financial institutions maintaining deposit or investment accounts for defalcating fiduciaries. All of these involve common issues:

1.What is the scope of duty undertaken by financial institution under trust or agency or depository agreements, generally involving duties under Restatement (Second and Prudent Investor) of Trusts §§184 and 185 and Uniform Prudent Investor Act §9.

a. The expectations of the parties reflected in the compensation paid for the duties undertaken. The Enron Court cited the hiring of the custodial trustee as being cost effective but concluded that the selection included the duties to investigate and warn, In re Enron ERISA Litigation, 284 F.Supp.2d 511,591 (S.D. Tex. 2003). Contrast Meyer v. Berkshire Life Insurance Co., 250 F. Supp.2d 544,574,D.Md. 2003) aff’d 372 F.3d 261(4th Cir. 2004) (where beneficiaries selected plan custodian for no fee on condition that insurance products would

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be included in investments, such insurance products would be excluded from liability for imprudent investments).

b. The reasonable expectation of the beneficiary/principal based on the representations and conduct of the institution.

2.The duty of the directed institution to reject directions, which violate either the

terms of the agreement or general fiduciary principles.

a. The duty of the institution to conduct an investigation of the direction or the wisdom of continuing to hold assets acquired pursuant to a past direction.

b. The duty of institution to warn the principal or the beneficiaries of adverse

information.

i. the two hat conundrum where dual roles impose conflicting duties ii. firewall protections raised by SEC restrictions on disclosure of

inside information. iii. Duty where the information is public?

c. Risk management steps to prevent claims or to minimize losses. B. The Scope of Duty and Resulting Liability

The risk stems from the general duty of the directed trustee to reject directions or seek instruction where the direction facially constitutes a breach of trust. Restatement Second of Trusts §185 compels the directed trustee to comply with the exercise of a directing power “unless the attempted exercise of the power violates the terms of the trust or is a violation of a fiduciary duty to which such person is subject in the exercise of the power.” The revisions to former §184 in the Third Restatement state in comment c that “If, however, the non-participating trustee or trustees have reason to believe that the responsible trustee or trustees may be committing or about to commit a breach of trust, the non-participating trustee or trustees have a duty to take reasonable steps to investigate and, if necessary, to prevent breach of trust.” Restatement Third of Trusts, Prudent Investor Rule, at 150.

1. ERISA Cases

Common Law/Restatement of Trust Duties Imposed on ERISA Fiduciaries

The United States Supreme Court dealt with the issue of the standard of care in Harris Trust and Savings Bank v. Salomon Smith Barney, Inc, 530 U.S.238, 120 S. Ct. 2180 (June, 2000). This was an ERISA case brought against the plan trustee and others stemming from losses sustained in the purchase of interests in several motel properties by

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the plan. Salomon allegedly had provided broker-dealer services to the Ameritech Pension Trust in the late 1980's. Salomon sold the properties to the trust. After the loss of the principal of the investment, the trustee sought to sue Salomon under ERISA. A major issue was whether ERISA provided for such a suit - the Supreme Court held that such a cause of action was appropriate. In finding that such a claim was appropriate, the Court had to deal with issues whether the trustee, allegedly at fault for an imprudent investment, could sue the seller. The Court held that the “common law of trusts , which offers a ‘starting point for analysis [of ERISA]...[unless] it is inconsistent with the language of the statute, its structure or its purposes’...plainly countenances the sort of relief sought by petitions against Salomon here.” The decision cited Restatement (Second) of Trusts §204, com. e to reject the argument that a culpable fiduciary could not seek redress from a seller: “Although the trustee bases his cause of action upon his own voluntary act, and even though the act was knowingly done in breach of his duty to the beneficiary, he is permitted to maintain the action, since the purpose of the action is to recover money or other property for the trust estate, and whatever he recovers he will hold subject to the trust.” The Court concluded that Salomon could be held liable for collusion with the trustee and for disgorgement of its profit if it had “actual or constructive knowledge of the circumstances that rendered the transaction unlawful.” The Decision held:

“It has long been settled that when a trustee in breach of his fiduciary duty to the beneficiaries transfers trust property to a third person, the third person takes the property subject to the trust, unless he has purchased the property for value and without notice of the fiduciary’s breach of duty. The trustee or beneficiaries may then maintain an action for restitution of the property (if not already disposed of) or disgorgement of proceeds (if already disposed of), and disgorgement of the third person’s profits derived therefrom.”

In Harris, liability was premised on the fact that the person dealing with the trustee could not have been a bona fide purchaser because of actual or constructive knowledge of the breach. This is a two-way street: private trust decisions can be used to construe the duties of ERISA trustees and ERISA decisions can serve as precedents to the shape of the common law and be used to impose duties on private trustees.

The Employee Retirement Income Security Act of 1974 (“ERISA”), 29 U.S.C. 1001 et seq. established a comprehensive statutory framework for employee benefit plans. ERISA permits an employer to establish a plan where the assets of the plan are held by a trustee, but management and control are “subject to the direction of a named fiduciary who is not a trustee,” or are “delegated to one or more investment managers.” 29 U.S.C. 1103(a). Furthermore, some plans permit a participant or beneficiary to

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exercise control over the assets of her individual account. Two recent high profile cases involving WorldCom and Enron demonstrate that a trustee of an ERISA plan who follows directions may nevertheless face liability for improper investments. In re WorldCom Inc., 263 F.Supp.2d 745 (S.D.N.Y. 2003) and In re Enron ERISA Litigation, 284 F.Supp.2d 511 (S.D. Tex. 2003).

a. WorldCom – Directed trustee has potential liability if a “prudent trustee would know” of the imprudent investment In WorldCom, the 401(k) Salary Saving Plan provided a number of different funds in which participants could choose to invest their account balances, including various equity funds and funds invested in WorldCom stock. Participants had discretion to allocate their investments among the alternatives offered, and to reduce or eliminate their investments in WorldCom stock at any time. The Plan designated WorldCom as the Investment Fiduciary with power and discretion to establish and change the investment alternatives among which participants could direct the investment of their accounts, and to review the performance of investment alternatives under the Plan.

Merrill Lynch was named as the Plan Trustee. The Trust agreement provided that “Except as required by ERISA, the Trustee shall invest the Trust Fund as directed by the Named Investment Fiduciary, an Investment Manager or a Plan participant or beneficiary, as the case may be, and the Trustee shall have no discretionary control over, nor any other discretion regarding, the investment or reinvestment of any asset of the Trust.” WorldCom, 263 F.Supp.2d 745, at 755.

The Plan provided that “[c]ontributions will be invested by the Trustee pursuant

to written direction from Participants, each of whom has the right to choose among the investment alternatives selected by the Investment Fiduciary.” WorldCom, 263 F.Supp.2d 745, at 755.

After the sudden collapse in the value of WorldCom stock, Plan participants

brought a class action and alleged that Merrill Lynch independently analyzed the Plan’s investment in WorldCom stock, knew that WorldCom securities were a potentially imprudent investment, gave investment advice for a fee or other compensation regarding WorldCom stock and other Plan assets, or had authority or responsibility to render such advice, and advised the Plan fiduciaries regarding Plan investments, but did not advise the Plan fiduciaries to investigate the prudence of continuing to offer WorldCom stock as a Plan investment. Merrill Lynch brought a Rule 12(b)(6) motion to dismiss, contending that as a directed trustee it was not liable and that it was required to carry out investment instructions unless it was “clear on the face” of the instructions that they violated ERISA or the Plan. The court referred to 29 U.S.C. § 1103(a) concerning directed trustees: “[A]ll assets of an employee benefit plan shall be held in trust by one or more trustees… [T[he

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trustee … shall have exclusive authority and discretion to manage and control the assets of the plan, except to the extent that – (1) the plan expressly provides that the trustee … [is] subject to the direction of a named fiduciary who is not a trustee, in which case the trustees shall be subject to proper directions of such fiduciary which are made in accordance with the terms of the plan and which are not contrary to this chapter …” WorldCom, 263 F.Supp.2d 745, at 761. In denying Merrill Lynch’s motion to dismiss, the court concluded that as a directed trustee Merrill Lynch was not required to exercise its independent judgment in deciding how and whether to invest employee funds as directed, but that it had to make sure that WorldCom’s directions (as Investment Fiduciary) were (1) proper, (2) in accordance with the terms of the plan, and (3) not contrary to ERISA. The court suggested that the applicable standard to apply to Merrill Lynch’s conduct would be the “prudent person standard articulated in the text of the statute.” WorldCom, 263 F.Supp.2d 745, at 761. To the extent that Merrill Lynch “followed instructions to invest employee funds in WorldCom stock when a prudent trustee would know that WorldCom’s decision to continue to offer its own stock to its employees as an investment option was imprudent, or otherwise in violation of WorldCom’s obligations under ERISA,” Merrill Lynch might be liable. Worldcom, 263 F.Supp.2d 745, at 762. The Court in Worldcom, 263 F. Supp.2d 745 (S.D. NY 2003) rejected claims that the directed trustee was absolved from responsibility for the failure of the pension plan investment in company stock, relying on the argument that it was only obligated to reject a direction which was “clear on the face” that it violated ERISA or the plan. “As a directed trustee, therefore, Merrill Lynch was deprived of discretion to manage and control the Plan’s assets generally, but retained the discretion, and indeed the obligation, to follow only ‘proper’ directions of the Investment Advisor, directions were made in accordance with the terms of the WorldCom Plan and which were not contrary to the ERISA statute.

Footnote 8: “Merrill Lynch contends that it was required as a directed trustee to carry out investment instructions unless it was ‘clear on the face’ of the instructions that they violated ERISA or the Plan. It finds support for this view in the legislative history for ERISA. This is not an issue that must be resolved at this stage of the litigation. It would appear, however, that the standard that should apply to Merrill Lynch’s conduct is the prudent person standard articulated in the text of the statute. See Koch v. Dwyer, No. 98 Civ. 5519 (RPP), 1999 WL 528 [18], at * 9-10 (S.D. N.Y. 1999).” 263 F. Supp.2d at 761. The Court held, “Even in the context of an ESOP, which is designed to offer employees the opportunity solely to invest in the employer’s stock, a fiduciary may be liable for continuing to offer an investment in the employer’s securities, at least where the plaintiff can show that circumstances arose which were not known or anticipated by the settlor of the trust that made a continued investment in the company’s stock imprudent, and in effect, impaired the purpose for which the trust was established. See Moench v. Robertson, 62 F.3d 553, 571 (3rd Cir. 1995). In Moench, the court opined that a corporate

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insider’s knowledge of the impending collapse of the corporation’s stock price, the ‘precipitous decline’ in the price of that stock, and the fiduciary’s own ‘conflicted status’ might constitute such a change in circumstances. Id. at 572.” The change of circumstances language tracks section 167 of the Restatement (Second) of Trusts and hence represents a settled proposition of common law, expanded here into the context of directed trustees. The Court in Moench cited the Third Restatement of Trust:

“The Restatement of Trusts provides that in investing trust funds, ‘the

trustee…has a duty to the beneficiaries to conform to the terms of the trust directing…investments by the trustee.’ Restatement (Third) §228. Thus, ‘[a]s a general rule a trustee can properly make investments in such properties and in such manner as expressly or impliedly authorized by the terms of the trust.’ Id. comment (d). However, trust law distinguishes between two types of directions; the trustee either may be mandated or permitted to make a particular investment. If the trust requires the fiduciary to invest in a particular stock, the trustee must comply unless ‘compliance would be impossible…or illegal’ or a deviation is otherwise approved by the court. Id.. comment (e). When the instrument only allows or permits a particular investment, ‘[t]he fiduciary must still exercise care, skill, and caution in making decisions to acquire or retain the investment.’ Id. comment (f).”

“In a case such as this in which the fiduciary is not absolutely required to

invest in employer securities but is more than simply permitted to make such investments, while the fiduciary presumptively is required to invest in employer securities, there may come a time when such investments no longer serve the purpose of the trust, or the settlor’s intent. Therefore fiduciaries should not be immune from judicial inquiry, as a directed trustee essentially is, but also should not be subject to the strict scrutiny that would be exercised over a trustee only authorized to make a particular investment. Thus a court should not undertake a de novo review of the fiduciary’s actions similar to the review applied in Struble v. New Jersey Brewery Employees’ Welfare Trust Fund, 732 F.2d 325 (3d Cir. 1984). Rather, the most logical result is that the fiduciary’s decision to continue investing in employer securities should be review for an abuse of discretion.

“In light of the analysis detailed above, keeping in mind the purpose

behind ERISA and the nature of ESOPs themselves, we hold that in the first instance, an ESOP fiduciary who invests the assets in employer stock is entitled to a presumption that it acted consistently with ERISA by virtue of that decision. However, the plaintiff may overcome that presumption by establishing that the fiduciary abused its discretion by investing in employer securities.” 62 F.3d at 571. In WorldCom the individual fiduciary Ebbers sought to avoid liability by pointing

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to his duties under securities law to avoid disclosing inside information. The Court rejected this: “But Ebbers’ potential liability to employees who invested in WorldCom stock through the Plan for violations of the federal securities laws cannot shield him from suit over his alleged failure to perform his quite separate and independent ERISA obligations. When Ebbers wore his ERISA ‘hat’ he was required to act with all the care, diligence and prudence required of ERISA fiduciaries. When a corporate insider puts on his ERISA hat, he is not assumed to have forgotten adverse information he may have acquired while acting in his corporate capacity. Plaintiffs’ allegation that Ebbers failed to disclose to the Investment Fiduciary and the other investing fiduciaries material information he had regarding the prudence of investing in WorldCom stock is sufficient to state a claim.” This analysis poses a very dangerous precedent for fiduciaries, particularly when they serve in multiple roles. The traditional firewall between corporation information learned on the business side in investment banking or lending information, information gained by the trustee’s brokerage arm, or information the trustee officer sitting on the board of a controlled trust asset, is under assault. Aggressive plaintiffs and government prosecutors energized by the successes in New York and Massachusetts are raising issues which threaten the structure of full service banking entities.

b. Enron – Directed Trustee Has Potential Liability If It “Has Notice (Knows or Should Know)” Of An Investment Breach. Northern Trust Company was the trustee of an Employee Stock Ownership Plan (ESOP) and other plans maintained by Enron. Northern Trust was in the process of resigning and transferring trusteeship to another trustee when Enron’s financial difficulties became public. During the conversion, there was a blackout period during which participant accounts were frozen. Allegedly the blackout period was from October 17, 2001 to November 14, 2001, during which time the price of Enron stock fell from $33.84 to $10.00 per share. Plan participants alleged in their subsequent class actions that Northern Trust breached fiduciary duties to them by not stopping or delaying the blackout during the extreme circumstances, even though it could have.

Northern Trust brought a Rule 12(b)(6) motion to dismiss. The court denied the motion.

As in WorldCom, the court noted that under 29 U.S.C. §1103(a)(1) a directed trustee will escape liability for actions performed pursuant to a named fiduciary’s direction if the directions are “proper” and “in accordance with the terms of the plan” and “not contrary to” ERISA. After an extensive review of statutory construction, legislative history, academic commentary, the brief of the American Banker Association, the common law, Department of Labor interpretations, and prior cases, the court held that a directed ERISA trustee should not be jointly liable for a directing fiduciary’s breach “except where the directed trustee has notice (knows or should know)” of the breach. Enron, 284 F.Supp.2d 511, 591. According to the court, this standard “makes good

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business sense to keep the costs of administering such plans down and encouraging employers to establish them, but maintaining key protection for the plan participant or beneficiary where the directing trustee’s failure to protect is more egregious.” Enron, 284 F.Supp.2d 511, at 591. This analysis is far removed from the realities of the situation, since none of these custodial or directed trustees would have priced their services at minimal levels had they known that they might be obligated to investigate and take action with respect to the offering, purchase or retention of stock of the company itself. The Department of Labor, reacting to criticism of its position regarding the duty to investigate with respect to fiduciaries who had appointed investment fiduciaries, in February of 2004 filed a Brief in the WorldCom action. There the DOL attempted to hedge its position:

“In disregard of this established body of law, the Williams court apparently misunderstood the Secretary’s position. In a footnote quoted by Defendants in their November 20, 2003 letter submission, Judge Holmes said ‘[T]he position argued by DOL would effectively expand the responsibility of any appointing authority…to be a guarantor for any and all actions by [the appointed fiduciaries.’ Williams, 2003 WL 22794417, at n.1. The Secretary has never suggested, however, that the duty to monitor requires the appointing fiduciary to second-guess every decision of its appointee, or to guarantee the wisdom of the appointee’s decision.*** “Accordingly, appointing fiduciaries are not charged with directly overseeing the investments and thus duplicating the responsibilities of the investment fiduciaries whom they appoint. At a minimum, however, the duty of prudence requires that they have procedures in place so that on an ongoing basis they may review and evaluate whether investment fiduciaries are doing an adequate job.” Brief at 6-7.

Regarding a potential duty to investigate (the element of “should know”), the court cited IIA Scott on Trusts § 185, to the effect that a directed trustee “is ordinarily under a duty to make a reasonable inquiry and investigation in order to determine whether the [directing fiduciary] is violating his duty.” Enron, 284 F.Supp.2d 511, 591.

c. Moench v. Robertson Moench v. Robertson, 62 F.3d 553 (3rd Cir. 1995) involved an ESOP Plan established by a bank holding company. The company stock fell from $18.25 per share in July 1989 to $0.25 per share in May 1991. Under the Plan, the ESOP Committee was empowered to direct the Plan trustee how to invest plan assets. A plan participant brought actions against the ESOP Committee (not the directed trustee) for breach of investment duties. The Committee defended on the grounds that it did not breach ERISA duties because it had no discretion to invest in anything other than company stock.

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The Third Circuit noted that ERISA contains specific provisions governing ESOPs. “While fiduciaries of pension benefit plans generally must diversify investments of the plan assets ‘so as to minimize the risk of large losses,’ see section 1104(a)(1)(C), fiduciaries of ESOPS are exempted from this duty. Specifically, ‘the diversification requirement ... and the prudence requirement (only to the extent that it requires diversification) ... is not violated by acquisition or holding of ... qualifying employer securities....’ 29 U.S.C. § 1104(a)(2). In other words, under normal circumstances, ESOP fiduciaries cannot be taken to task for failing to diversify investments, regardless of how prudent diversification would be under the terms of an ordinary non-ESOP pension plan.” Moench, 62 F.3d 553, at 568.

However, the court found that the plan did not absolutely restrict the Committee to investments in the company’s stock, and that therefore the fiduciary was not immune from liability. Rather, the fiduciary's decision to continue investing in employer securities should be reviewed for an abuse of discretion.

Moench held that “courts should be cognizant that as the financial state of the company deteriorates, ESOP fiduciaries who double as directors of the corporation often begin to serve two masters. And the more uncertain the loyalties of the fiduciary, the less discretion it has to act. Indeed, ‘”[w]hen a fiduciary has dual loyalties, the prudent person standard requires that he make a careful and impartial investigation of all investment decisions.”’ Martin v Feilen, 965 F.2d at 670 (citation omitted). As the Feilen court stated in the context of a closely held corporation: [T]his case graphically illustrates the risk of liability that ESOP fiduciaries bear when they act with dual loyalties without obtaining the impartial guidance of a disinterested outside advisor to the plan. Because the potential for disloyal self-dealing and the risk to the beneficiaries from undiversified investing are inherently great when insiders act for a closely held corporation’s ESOP, court should look closely at whether the fiduciaries instigated alternative actions and relied on outside advisors before implementing a challenged transaction.” Id. at 670-71. And, if the fiduciary cannot show that he or she impartially investigated the options, courts should be willing to find an abuse of discretion.” 62 F.3d at 572.

The decision in Moench has been criticized by the Ninth Circuit in Wright v.

Oregon Metallurgical Corporation, 360 F.3d 1090 (9th Cir. 2004). “The Third Circuit’s intermediate prudence standard is difficult to reconcile with ERISA’s statutory text, which exempts EIAPs [eligible individual account plans, including ESOPs] from the prudence requirement to the extent that it requires diversification. …. ‘If there is no duty to diversify ESOP plan assets under the statute, it logically follows that there can be no claim for breach of fiduciary duty arising out of a failure to diversify, or in other words, arising out of allowing the plan to become heavily weighted in company stock.’” Wright, 360 F.3d 1090, at 1097.

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2. Non ERISA Cases

a. Rollins v. Branch Banking and Trust Company of Virginia – Trustee Directed By Beneficiaries May Have Liability For Failure To Inform Beneficiaries of Deteriorating Condition of Company Stock

In Rollins v. Branch Banking and Trust Company of Virginia, 56 Vir. Cir. 147,

2001 WL 34037931 (Va. Cir. Ct. 2002) the beneficiaries held power to direct the investments of the trust. The trust provided, "Investment decisions as to the retention, sale, or purchase of any asset of the Trust Fund shall likewise be decided by such living children or beneficiaries, as the case may be." After a $25,000,000 loss in a concentrated holding, the beneficiaries sought surcharge against the trustee. Virginia Code §26-5.2 provides that where the trust authorizes some third party to direct investments, “the [directed] fiduciary, or co-fiduciary shall be liable, if at all, only as a ministerial agent and shall not be liable as fiduciary or co-fiduciary for any loss resulting from the making or retention of any investment pursuant to such authorized direction.” The Court held that the direction language barred a claim for failure to diversify and sustained the demur with respect to that issue.

However, the beneficiaries made an independent claim that the trustee had breached a duty to inform them of the deteriorating condition of the company that comprised the concentrated holding. The court overruled the demurrer on this claim, allowing the beneficiaries to proceed. “By statute and by common law, the duty to preserve ordinarily includes the duty to diversify the trusts’ investments. See Hoffman v. First Virginia Bank, 220 Va. 834, 839, 263 S.E. 2d 402, 407 (1980).” Direction language barred a claim for failure to diversify. 2001 WL 34037931 at 2. But the Court cited the “duty to impart to the beneficiary any knowledge he may have affecting the beneficiary’s interest and he cannot rid himself of this ‘duty to warn.’ see Restatement 2d Trusts §173.” Thus the case was allowed to go forward on the allegations that the beneficiaries were injured as a consequence of the trustee’s duty to investigate and warn them of the deterioration of the closely held business.

b. Duty of Investment Manager Or Custodial Agent Regarding Trust Investments

Many corporate fiduciaries act as investment managers or as custodial agents for trustees. The Uniform Prudent Investor Act permits a trustee to delegate investment and

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management functions that a “prudent trustee of comparable skills could properly delegate under the circumstances.” UPIA § 9(a). An agent that accepts a delegation of investment functions “owes a duty to the trust to exercise reasonable care to comply with the terms of the delegation.” UPIA § 9(b). Furthermore, “By accepting the delegation of a trust function from the trustee of a trust that is subject to the law of this State, an agent submits to the jurisdiction of the courts of this State.” UPIA § 9(d).

c. Liability For Failure Properly to Plan to Minimize Taxes

Estate of Nicely, 2003 WL 22183940 (Pa. Com. Pl. 2003) deals with a claim that a bank serving as an agent in fact for an elderly client should have been liable for failing to place her assets in an appropriate estate planning vehicle such as a trust which could have minimized taxes and for failing to undertake investment management. The trial court faced a very broad pre-printed power of attorney form which arguably authorized estate planning and investment management. Hence plaintiffs attacked Beaver Trust Company for failing to enter an appropriate estate plan or to prevent investment losses. This is the type of case which could have been avoided by clearly delineating in writing the actual scope of the duties undertaken and by providing a concise fee agreement, showing what the duties were and what compensation was provided for those services. Documenting the cost of services accepted and those rejected makes the defense of a claim much easier. The problem is that trust officers, incentivized and urged to sell services, often try to keep the door open for further services and hence muddy the water as to what was actually contracted and paid for. The courts look with some solicitude to beneficiaries and heirs who recite conversations about potential services and their belief that they got the encompassing service promised in marketing brochures and communications. Here the Court found that while the power-holder bank caused a trust instrument to be prepared and sent to the family, it was never executed by the mother. A trustee would have, at most, a duty to remind them of the consequences and urge adoption, but the choice is always with the client. Similar cases involving attorneys have absolved them of responsibility once they provided the documents and delay or procrastination by the client led to failure to adopt such plans. Here Beaver Trust was exonerated. “The mere existence of a power of attorney, without more, imposes no duty to exercise any of the powers which are conferred therein. An attorney-in-fact is only required to perform such actions and provide such services as he agrees or undertakes to perform or provide. The agreement or undertaking may encompass all or only some of the powers which are enumerated in the power of attorney. The agreement or undertaking may be express or implied. It may be written or verbal. It may arise from the conduct of the principal and agent, as in the case where one acts or fails to act in justifiable reliance upon another’s action or inaction.”

The court cited Onorato v. Wissahickon Park, Inc., 430 Pa. 416, 244 A.2d 22 (1968). This broad list of factors which could be used to find an agreement poses a terrible risk, since the beneficiaries can look to casual conversations, their subjective

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belief based on the conduct of the trust company personnel, and the documentation provided by the bank personnel. In this case the court found no agreement to perform estate planning or trust services or to manage the investments.

In Hatleberg v. Norwest Bank Wisconsin, 678 N.W.2d 302 (WI App, 2004), the

trustee was held liable for taxes resulting from a defectively drafted Crummey provision in a trust, after the trustee pointed the defect out to the settlor’s former estate planning attorney but failed to take additional steps to rectify the problem as annual gifts were made. Against the claim that the trustee had no duty, the trial court and appellate court held it liable based on the trustee’s “solicitation of the [settlor], its self-represented expertise in estate planning, and its continued insistence and reassurance that [settlor] could continue gifting to the trust to reduce her taxes, even after it was aware of a problem that had not been remedied.” 678 N.W. 2d at 308. The trustee had reviewed the trust after it was prepared by the settlor’s attorney, realized the defect in the trust and contacted the drafting attorney. Nothing was done to correct the error. The trustee allegedly continued to advise the settlor that annual gifts to the trust would be appropriate, despite knowledge of the defect. On appeal, the Court held that while the trustee “may have originally had to duty to review the trust for accuracy, it assumed the duty and found an error in the trust. It notified the original drafter, but this was insufficient because [drafter] was no longer [settlor’s] agent in any capacity. Wells Fargo solicited [settlor’s] business and repeatedly informed her it could use the trust to reduce her future estate taxes. Once Wells Fargo realized the trust was insufficient for that purpose, it was negligent in advising [settlor] to continue making deposits and assuring her the trust would reduce her estate taxes.” Ibid. No good deed goes unpunished.

In Head v. Wachovia Bank of Georgia, N.A., 2002 WL 389860 (Tenn Ct. App. 2002), the court on appeal affirmed the denial of surcharge by beneficiaries stemming from embezzlements from the elderly income beneficiary. Despite the fact that the trust officer was having an affair with the embezzler, there was no evidence of knowledge that funds were being embezzled. “No evidence was ever presented showing any involvement by [trust officer] with the embezzlement activities of Ms. Pennington or showing that he had any knowledge thereof.” 2002 WL 389860 at 2. The court held that “It is obvious from the purpose of the trust and clear desires and actions of the settlor/beneficiary that [trust officer] had no duty to oversee, or make any inquiry regarding her personal spending habits. As such, any failure to do so constituted no breach.” 2002 WL 389860 at 8. “Unless she requested the services of the bank in overseeing her spending, the bank was not required to, and based on her actions, even prohibited from questioning her personal spending habits.” 2002 WL 389860 at 12. In Taylor v. Marshall & Ilsley Trust Co., 2002 WL 1018415 (Wis. App. 2002), the court denied surcharge where the trustor had not funded the trust. The Court held that the responsibility for funding the trust rested with the trustor, not the trustee. Similarly, there was no duty to warn the settlor that if she married, her will would be revoked as a matter of law and her other assets would not pour into the trust. Since the marriage was not an “easily identifiable pitfall” within the knowledge of the trustee, there was no duty to warn the trustee not to marry until she had fully funded the trust.

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d. Where No Investment Directives (and a client in prison)

Wachovia Bank of Georgia v. Namik, 593 S.E. 2d 35 (Ct. App. Ga. 2003) provides another example of litigation which could have been avoided by careful intake and documentation. The case involved an Iraqi citizen, General Ali, who came to the United States and transferred money from a Swiss bank account, acquiring approximately $3,000,000 in CD’s. He was provided a revocable trust agreement which was explained and executed. The General wanted no “market risks” and requested that the funds be invested in “U.S. government issues.” The bank was unable to get information from the general, who had returned to Iraq, which turned out to be a fatal mistake for him and an expensive event for the trustee. He allegedly died in prison in 1990. The trustee invested the money in a tax free money market fund. Plaintiff, who had facilitated the transaction, sued to obtain the proceeds in an intestacy proceeding. Substantial estate taxes were paid, including $542,018.01 in interest, because of the delays in administration. The proceeds were ultimately paid to his heirs. The trial court held that the trustee had an implied duty to minimize taxes stemming from the form trust and failed to properly invest the trust in appropriate investments. The Georgia prudent investor statute directed a trustee to look at the tax consequences of investments. On appeal, the verdict was reversed. “While the statute suggests that anticipated tax consequences may be taken into account, in this case there was no obligation on the part of the Bank to look into estate tax consequences. The record is devoid of any evidence showing that Ali requested the Bank to specifically make investment to minimize estate tax consequences to the Trust, and the Trust Agreement does not impose any duty upon the trustee to take estate taxes into consideration or to otherwise make any estate-planning decisions.” 593 S.E.2d at 38.

e. Liability of trustee for aiding and abetting broker in Ponzi scheme. The Texas Court of Appeal in Sterling Trust Company v. Adderly et al, 119 S.W.3d 312 (Tex.App. 2003), upheld a jury verdict for over $6 million against a trustee of investments held for the benefit of various retirement accounts of elderly persons who invested with a broker in various securities and promissory notes. The project was in fact a ponzi scheme. Liability was charged against the trustee for aiding and abetting in the scheme, based on reckless disregard of truth or the law (despite findings of the jury that the trustee did not know about the false statements made to the purchasers). The court found sufficient evidence to support the jury verdict in the fact that the trustee approved the various stocks for IRA investments; knew that the advisor was also the owner of the companies in which he advised the purchasers to invest; knew that the advisor was commingling funds between the companies and between qualified and unqualified plans; allowed the advisor to hold the original notes, deeds of trusts, security agreements, and stock certificates; and did not obtain valuations on the investments held.

f. Liability of depository banks when Trustees Defalcate

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Two recent cases highlight the risks that depository banks face when third parties embezzle funds. In Sonders v. PNC Bank, 2003 WL 22310102 (not reported in F.Supp. 2d) (E.D. Pa. 2003), funds were placed in an account by Sonders, allowing withdrawals on the joint signature of Sonders and Congressman Edward M Mezvinsky. This certainly might raise concerns given the reputation of Congress and politicians in general. The bank lost the account card showing that both Sonders and Mezvinsky’s signatures were required for withdrawals, doing so negligently but not in bad faith. The politician then withdrew substantial sums. The bank sought to defend itself under the Uniform Fiduciaries Act, claiming there was no proof of bad faith. The court granted summary judgment for the bank, finding that “there were no suspicious circumstances so compelling and obvious as to require PNC to investigate whether Mr. Mezvinsky was breaching his fiduciary duty.” 2003 WL 22310102 at 13. In Melley v. Pioneer Bank, N.A., 834 A.2d 1191 (Pa. Super. 2003), a decision holding the depository bank liable was affirmed in part on appeal. In this case, an account was opened to receive the tort settlement for a disabled child, with the mother as a signatory. She allegedly withdrew funds and placed them in her own account rather than spending them for the benefit of the child. The Court reasoned that, “’A thing is done in ‘bad faith’ within the meaning of the [UFA], only when it is done dishonestly and not merely negligently.’ Manfredi v. Dauphin Deposit Bank, 697 A.2d 1025 (Pa. Super. 1997) appeal denied, 5523 Pa. 690, 717 A.2d 1028 (1998)], supra, at 1029. ‘The UFA does not permit a bank to ignore an irregularity where it is of a nature to place one on notice of improper conduct by the fiduciary. In such a case, the good faith test would not be met.’ Id., at 1030. Bad faith or dishonesty in this contest, is unlike negligence, willful. Davis v. Pennsylvania Co., 337 Pa. 456, 460, 12 A. 2d 66, 69 (1940). It amounts to an intentional desire to evade knowledge because of a belief or fear that inquiry would disclose a vice or defect in the transaction. Id.” The Court found that this case was irregular because the funds obtained from the law firm handling the tort settlement for the minor did not have restrictive language on them. The court held, “We find the irregularity of these transactions, given all four checks were drawn on an attorney’s account and made payable to mother as guardian of minor children, and two explicitly referenced court Orders, put the bank on notice that deposit into mother’s personal account was improper.”

g. Hobson’s Choice: when your agent improperly manages a pension plan Meyer v. Berkshire Life Insurance Company, 250 F. Supp.2d 544 (D. Md. 2003) illustrates the problems of allowing your agents to direct investments in pension plans. The plaintiff doctors split their practices and divided their firm’s pension plan for themselves and their employees. They became the respective trustees of the divided plans and hired Berkshire to manage the plan. An agent of Berkshire made the actual investments. On the condition that investments would be made in insurance products, Berkshire waived fees for its services. The agent, however, obtained commissions for purchasing insurance, annuities, and various mutual funds for the plans. The plaintiffs sued, claiming churning and imprudent investment of a substantial portion of the plans in

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insurance products. Berkshire sought to dismiss the state law claims which carried the risk of jury trial and punitive damages.

This proved a Hobson’s Choice, since the alternative was to admit that it acted as an ERISA fiduciary: no jury, no punitives. It then sought at the subsequent trial to deny its liability as an ERISA fiduciary. The Court forced it to honor its allegations on summary judgment and held it liable for the actions of its agent in buying an inappropriate amount of insurance or insurance backed products for the pension plans and for churning the account in order to obtain commissions. At trial the Court adopted the testimony of the plaintiff’s experts who opined that the insurance products were inappropriate because of their high cost and low yield. Moreover, the balance of the portfolio was conservatively invested and did not result in appropriate growth. The Court found: “Aside from the life insurance components, the evidence established that the doctors’ contributions were invested very conservatively, notwithstanding the fact that no Berkshire representative conducted any analysis of the participants’ tolerance for risk.” 250 F. Supp.2d at 552.

The agent described his investment strategy: “he ‘would rather have a return of your money than a return on your money.’” 250 F. Supp. 2d at 544 [well spoken but ill done]. The trustee or its investment advisor is required to determine the risk tolerance of the trust and its beneficiaries and to create a portfolio which meets those needs. Having failed to determine a risk tolerance, the trustee and the agent found themselves surcharged for failing to meet the risk tolerance of the beneficiaries demonstrated at trial. Too conservative can be as expensive as too risky. A Berkshire employee conceded on cross examination that “internal Berkshire documents listed projected rates of return for the plans ranging from 8% to 12%.” 250 F. Supp. 2d at 553. Courts and juries often find such internal projections useful in establishing benchmarks for performance, as in this case. Be careful what your marketing brochures and internal projections show—you ma be forced to concede that these provide a measure for appropriate performance when you do something inappropriate with a portfolio. The Court ruled: “Given Berkshire’s own figures, the plaintiffs’ experts’ testimony, and the evidence summarized below regarding the plans’ lack of diversification and concentration in low-yield investments, the court agrees with the plaintiff that a 6% rate of return (and certainly a 2% or 3% rate of return) for these plans was unacceptably low.” 250 F. Supp.2d at 553-554. The period of time was 1983 through 1997. The Court found inappropriate the high fees charged on fixed and variable annuities in the pension plan, the use of tax advantaged investments which provided no benefits in the pension plan, the fact that the agent “acted imprudently be rapidly churning the plans’ assets to generate commissions for himself, in addition to investing in excess life insurance policies and low-yielding annuities.”

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The Court, based on Berkshire’s admission of its status as ERISA fiduciary, nonetheless supported its decision by reference to dicta in the Sixth Circuit decision, Hamilton v. Carrell, 243 F.3d. 992 (6th Cir. 2001) (imposing liability on a non-fiduciary principal when the fiduciary agent breaches a duty ‘while acting in the course and scope of employment.’ 243 F. 3d at 1002-1003.” It also buttressed its decision (thus providing an alternative ground to support the decision on appeal) by citing American Federation of Unions Local 102 Health & Welfare Fund v. Equitable Life Insurance Society, 841 F.2d 658 (5th Cir. 1988) and Bannistar v. Ullman, 287 F. 3d 394, 408 (5th Cir. 2002). (“In the context of respondent superior liability, the issue is whether the principal, but virtue of its de facto control over the agent, had control over the disposition of plan assets.”). The Court held that under 29 USC §1104(a)(1)(C) and Olsen v. Hegarty, 180 F. Supp.2d 552, 566-567 (D. N.J. 2001), “’If the plaintiff meets his initial burden of establishing a failure to diversify, the burden thereupon shifts to the defendant to prove that even though not diversified, the allocation was nonetheless prudent.’” 250 F. Supp.2d at 565. Having shown that the account was invested in conservative income products for 12 of the 14 years in question, the failure to diversify had been proved, shifting the burden to the fiduciary. The Court concluded that “’A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard.’ Fink v. National Savings and Trust Co., 772 F.2d 951, 957 (D.C. Cir. 1985)…see also Olsen, 180 F. Supp.2d at 569.” 250 F. Supp.2d at 566. A failure to show that the principal reviewed the actions of the agent will leave it liable to the claim that it breached its duties. The Court based damages on proof of what the fund would have earned but for the breach, one of the alternative damage measures under Section 205 of the Third Restatement of Trusts (Investments, 1992). The Court cited Dardaganis v. Grace Capital Inc., 889 F.2d 1237, 1243 (2nd Cir. 1989), “If, but for the breach, the Fund would have earned even more than it actually earned, there is a ‘loss’ for which the breaching fiduciary is liable.” Measuring damages was difficult because of the multiple transactions in the accounts. The court, however, found that “while awards may not be speculative, see, e.g., Carras v. Burns, 516 F. 2d 251, 259 (4th Cir. 1975), the court may approximate the extent of damages. See, e.g., Martin v. Feilen, 965 F.2d [660, 8th Cir. 1992] at 672 (citing Story Parchment co. v Paterson Parchment Paper Co., 282 U.S. 555, 563, 51 S.Ct. 248, 75 L. Ed. 544(1931)).” 250 F. Supp.2d at 572. The court rejected plaintiffs’ expert claims that the asset mix should have been 10% fixed income and 90% equitities, or alternatively 30/70. It based damages on a 50/50 allocation between income producing assets and equities. 250 F. Supp.2d at 573. “The court finds that it would have been reasonable to achieve a 10% to 12% rate of return on the plans’ investment components during the 1993 to 1997 time frame, given the market’s performance at that time. ….Significantly, Berkshire itself predicted various rates of return for the plans, ranging from 8% to 12%.”

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However, since the Court found that the doctors understood that insurance had to be a component of the plan to get Berkshire’s services for free, “because the court finds that, aide from the life insurance policies, the plans’ assets were churned and invested imprudently, it will impose damages to remedy the losses incurred to the plans’ investment components only. “ Damages of $664,968 and $631,277 were assessed for the two plans. The Court also granted pre-judgment interest on the damages of 8% from 1998 to the date of judgment. The only happy note in the decision is the restriction of damages based on the plaintiffs’ acknowledgment that they selected Berkshire because it offered its services free when a minimum insurance investment was made. Hence, the terrible returns on the insurance policies were excluded from the damages. II. Investment Duties and Liabilities

The principles of the Restatement, Third, of Trusts and the Uniform Prudent Investor Act focus not so much on the results of specific investments but on the manner in which the portfolio is structured. Bad results from a carefully structured portfolio may not constitute a breach of trust; bad results from a poor economic plan will doubtless lead to surcharge. It is essential to evaluate the needs of the trust and its beneficiaries, fashion a defensible plan, and document the reasoning behind them. Absent conflicts of interests, breach of express duties stated in the trust, reckless behavior, or failure to monitor or supervise the actions of agents of the trustee, the trustee’s conduct will generally be measured on whether he or she has prudently exercised the discretion given them in the trust instrument or imposed by law. Only a clearly documented record of careful evaluation followed by an exercise of discretion will provide a persuasive defense after the catastrophe. Of course, if you are going to make decisions without regard to the risk and reward characteristics of investments, as the Uniform Prudent Investor Act commands, documentation will be damning. There is a fundamental disconnect between the real world of investing and Modern Portfolio Theory and its distaste for active management of investments by trustees. Most trustees actively manage portfolios, and use passive investment styles such an index or exchange traded funds for only a small portion of their investments. According to Vanguard, approximately 10% of equity mutual funds are index funds. The ICI Fact Book for 2003 at 98 reports that fiduciaries held $339 billion dollars of mutual funds out of a total mutual fund industry of $1,774 billion in equity, hybrid and bond funds. Mutual funds held approximately 20% of the US Corporate equities, meaning that most investors buy individual shares. Ibid. at 28. A standard which is followed by only a fraction of fiduciaries may be laudable, but is not a practical measure of the prudence of the investment performance of fiduciaries. When Modern Portfolio Theory and its preference for passive investment in index funds were first proposed in legal journals for application to trustees, reliance on a passive portfolio such as the S&P 500 index was not misplaced, since such a portfolio

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produced a 4% dividend. However, the rise in the market and the fall in cash dividends dropped the income under 3% by 1992, under 2% by 1998. The dividend rate had fallen to .9% in 2000. In 2001, the index produced a dividend return of 1.18%. Ibbotson SBBI 2002 Yearbook at 219. The continued fall in the market dropped the dividend to 1.39% for 2002. Ibbotson SBBI 2003 Yearbook at 229. Even with a healthier market and preferential tax treatment for corporate dividends, the S&P 500 produced dividends of 2% for the year 2003. Ibbotson SBBI 2004 Yearbook at 227. Under the 1962 Principal and Income Act, a fiduciary would have serious difficulty in providing for income beneficiaries using such an index fund as its primary investment vehicle. In a typical trust where income and principal gains are jealously segregated, this resulted in theory dictating reliance on an under-productive asset class. Ever nimble, the academic bar then moved to unitrust distribution models and equitable adjustment theories such as sections 103 and 104 to the revised Uniform Principal and Interest Act. These sections allow adjustment of income and principal returns so that the income beneficiary can share the benefits of the total return of a portfolio which now can be largely invested for equity growth. These corrective steps place substantial discretionary decisions on trustees. The Supreme Court of Maine faced this decision in deciding whether a surcharge should have been based on an S&P 500 index model or the results which an average Maine trustee would have obtained during the period in question. Estate of Wilde, 708 A.2d 273 (Me. 1998). While the decision turned on the absence of evidence provided the trial court on which to decide between two stipulated alternative damage measures, the alternatives themselves demonstrate the fact that the econometric position is far removed from current practice in private trusts. Moreover, the decision demonstrates that fiduciaries are judged by a standard of care based on regional markets, not necessarily on some single national standard. To understand the risks posed to fiduciaries by the Uniform Prudent Investor Act and the Third Restatement of Trusts one must have some historical background.

A. The British Model: The Invisible Hand Was Actually Manipulating the Market

Under English practice, trusts traditionally invested only in safe investments such as government bonds. The guarantee of Parliament of the debts of the King, starting in 1693, provided some secure basis for investing in government bonds. However, the pressures of paying for war with Louis XIV proved too much for the limited tax resources of the times. Consequently, Parliament turned to various alternative methods for financing government debt, including advance sales of custom revenues and lotteries (which paid in annuities which could be sold by winners at a discount). The experience of France in financing government debt with shares in the Mississippi Company led to the scheme to repay the existing English government debt by granting the South Sea Company the right to issue stock to be traded for government debt

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instruments held by investors. The Company had the monopoly on trading in the Pacific and Caribbean area, including the selling of slaves to Spanish colonies (unfortunately the Spanish did not cooperate after the treaty of Utretch and the actual income of the Company proved illusory). The bonds would then be canceled in return for the guaranteed payment by the government of 5% interest on the shares so issued. This would have allowed a lower interest rate than that carried by the 99 year bonds representing half of the outstanding government debt. However, the South Sea Company inflated the value of the stock by selling shares on margin to various political figures and the public, issuing public relations releases that would have done Enron proud. When the price of the shares had risen substantially, the exchange of bonds for the shares was a great success – until the bubble in the stock burst and the prices plunged along with the purported solvency of the South Sea Company. The trustees and other bondholders were left with enormous losses. J. Carswell, The South Sea Bubble (1960). Chancellors, facing widows and orphans with losses, decreed that trustees could henceforth invest only in government bonds. J. Langbein, “The Uniform Prudent Investor Act and the Future of Trust Investing,” 81 Iowa L. Rev, 641, 643 (1996). What followed was a slow development of broader investment alternatives for trustees. The example of the Directors of the South Sea Company was followed in America, with promoters and robber barons attempting to manipulate the prices of stock and being less than candid with shareholders and the public about the income and expenses of companies. A review of the Bubble or of Charles and Henry Adams’ Chapters of Erie (1871) show that the recent accounting and financial catastrophes have ample precedents. Cooking the books and one’s shareholders is as American as the Fourth of July barbeque, and has always had strong support from the politicians who shared the ribs at the celebration. Consequently, courts were slow to allow investments in anything but the most secure investments. The development of modern securities laws and accounting standards (in theory), allowed for the investment in equities in most States. Heavy reliance on government bonds continued for trusts, despite the risks of inflation in many periods of time.

B. Analysis of Historic Investment Returns Reliance on bonds as the fundamental investment was undercut by analyses of actual investment returns. In 1925 E. L. Smith published an analysis of the returns on government bonds and the stocks of large companies for the period 1836 through 1923. E. L. Smith, COMMON STOCKS AS LONG-TERM INVESTMENTS (1925). He found that a broad group of large-capitalization stocks beat investments of bonds over multiple-year periods, as well as some shorter periods. By 1973, Lorie and Hamilton had made similar comparisons between investments in government bonds and large-cap stocks for the period 1926 through 1965. Lorie and Hamilton THE STOCK MARKET: THEORY AND EVIDENCE (1973) at 21. Using the Standard & Poor's 500 as a measure of stocks, a comparison of buy and hold strategies for investments in stocks and bonds was made

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for 820 holding periods of one year or more. Bonds beat stocks in only 23 of 820 periods, mostly of relatively short duration and many centered on the Great Depression when equity prices were slow to recover and inflation was stifled. Op. Cit. at 214. In 1982, R. Ibbotson and R. Sinquefield compared total returns on the S&P 500 and federal debt instruments from 1926 through 1981. For most multi-year holding periods, stock total returns exceeded those of bonds. When corrected for changes in the Consumer Price Index, actual rates of returns fell far below the nominal rates supposedly garnered from bond investments, and were negative in some periods for bonds. Small capitalization stocks outperformed large cap stocks during many periods and over the 55 years studied. R. Ibbotson and R. Sinquefield Stocks, Bonds, Bills, and Inflation: The Past and the Future (1982). Such empirical studies have led some commentators to conclude that active investment management is not cost-effective, and that passive strategies such an index funds are the only prudent investment strategy. J. Langbein and R. Posner, "Market Funds and Trust Investment Law," part I, 1976 American Bar Research Foundation Journal 1 and 1997 American Bar Research Foundation Journal 1; Restatement (Third) of Trusts §227, General Note on Comments e through h at 74-82.

C. Graham and Dodd: The Hunt for Undervalued Stocks Investment analysis for much of the Twentieth Century centered on active investment management based on the investigation of individual companies and the search for undervalued securities. B. Graham and D. Dodd published Security Analysis in 1934, providing a rigorous analytic approach to selecting appropriate securities. There is still cogent academic support for this type of investment analysis, even in the age of Modern Portfolio Theory: B. Greenwald, J. Kahn, P. Sonkin and M. Van Biema, Value Investing: From Graham to Buffett and Beyond (2001). Ibbotson compared growth and value invests in small, madcap and large capitalization stocks from 1968 through the end of 2003, and found that “Value significantly outperformed growth across the market capitalization spectrum. In addition to outperforming their growth counterparts, value series did so with lower volatility. The traditional risk-return tradeoff does not seem to hold with regard to the split between growth and value. The value series are offering more return and less risk.” Ibbotson, Stocks Bonds, Bills and Inflation 2004 Yearbook at 149. The lure of undervalued stocks continues to find prudent individuals who seek out investments which have been temporarily rejected by the market. As Ibbotson concluded, “Several academic studies have shown that the market overreacts to bad news and under reacts to good news.” Ibid. at 167. Hence, particularly in smaller capitalization stocks and foreign markets, which are not efficient, investors can profit from active investment strategies. As stated in R. Fortin and S. Michelson, “Indexing Versus Active Mutual Fund Management,” JPA Journal, September 2002, “We find that, on average, index funds outperform actively managed funds for most equity and all bond fund categories on both a before-tax and after-tax basis. However, actively managed Small Company Equity (SCE) funds and International Stock (IS) funds significantly outperform the index over most of the study period. Managers of these funds appear to be able to invest to take advantage of mispricing in these presumably less efficient markets.” The

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authors note that in times of falling prices, actively managed funds have an advantage. “It appears that active fund management is better than investing in index funds when guiding portfolios through difficult times.” Because many index funds are based on S&P market weighted models, they concentrate in higher capitalization stocks, outperforming equally weighted funds in rising markets and crashing faster and deeper than such funds in falling markets. A basic advantage of index funds is their low cost. A study by K. Reinker and E. Tower in “Index Fundamentalism Revisited,” Journal of Portfolio Management, Summer 2004, explored the possibility that low cost actively managed funds might perform better against index funds that the broad studies, such as Fortin’s, which combine extremely expensive funds with low cost index funds. Reinker’s study looked to the Vanguard fund family which has a number of actively managed funds with low costs. The authors created portfolios of various Vanguard actively managed funds, corrected for the risk involved, and then compared them to comparable index funds in the Vanguard family. Their findings duplicated the results of Fortin regarding international funds. “However, the performance of the international index fund relative to the international managed fund is perpetually negative….” P. 19, n.17. The general conclusions were that the low cost actively managed funds did meet or beat the comparable index funds: “We find that from 1982 through 2003, the synthetic Vanguard U.S. managed fund beat the synthetic U.S. index fund, which beat the Vanguard Total Stock Market Index Fund, regardless of whether we risk-adjust the returns. Moreover, on both risk-adjusted and non-risk adjusted performance the U.S. managed fund is the winner and the Total Stock Market Index fund is the loser over the entire time span, although for the period beginning in 1985, the managed fund loses to the other two regardless of risk adjustment. “p. 20. In the market for closely held investments and real estate, the lack of efficient markets and the unique characteristics of investments can reward active management and justify the expense and concentration if care is taken in selection and supervision. However with the development of pooled investment vehicles, REITs and other investment securities, delegation to agents becomes practicable, allowing diversification, expense sharing, and entry into markets which would be impracticable with direct management alone.

D. The Rational Investor is Discovered

In 1952, Harry Markowitz, pondering why rational people would invest in risky investments (discounting stupidity, greed, the gambling instinct, poor investment advisors, and poor -- or deliberately manipulated – information) concluded that the cumulative actions of the marketplace must be dictated, or at least explained, by a rational calculation that one would invest in riskier investments because they were expected to return a larger reward to compensate for the risk. H. Markowitz, "Portfolio Selection,"7 Journal of Finance 77-91(March, 1952).

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The development of the Capital Asset Pricing Model was premised on the belief that the market for large capitalization stocks is efficient, in that all material information is quick assimilated and acted on and that consequently all of the one hundred dollar bills lying on the trading room floor have already been picked up. Subsequent analyses of financial markets led to the belief that individual stock movements are a random walk (actually a submartingale), making it difficult to predict the future movements of any individual issue. While the Third Restatement of Trusts treats these tenets of modern portfolio theory as holy writ, these concepts are in fact theories which even some supporters admit have not yet been demonstrated empirically or to the satisfaction of econometricians. Eugene F. Fama and Kenneth French, "The Cross-Section of Expected Stock Returns," Journal of Finance 47 (1992), "Some Recent Developments in Investment Research," 921 et seq in Bodie, Kane and Marcus Investments (3rd Ed. 1996); R.A. Haugen, The New Finance: The Case Against Efficient Markets (1995); A. Lo and A. Craig MacKinlay, A Non-Random Walk Down Wall Street (Princeton University Press, 1999). For an examination of the excess returns generated by various investment strategies, one should read J. O’Shaughnessey’s What Works on Wall Street, (1997), whose data rejects a random walk theory. Ibid. at 5. Benoit Mandelbrot, the father of fractal geometry and grandfather of chaos theory, in The (Mis)Behavior of Markets (2004) points out that “The old financial orthodoxy was founded on two critical assumptions in Bachelier’s key model: Price changes are statistically independent and they are normally distributed.” (Mis)Behavior at 11. He shows that each of these assumptions is incorrect based on empirical analyses of the movement of prices. In fact, price movements are correlated, as any student of momentum theory or an observer of the movements of the market-weighted S&P 500 index would have seen in the late 1990’s. Moreover, the distribution of prices does not fit in a bell shaped curve, since the right and left-hand tails of such distributions are much fatter than a normally distributed graph. In brief, the assumptions about price movement and the calculation of risk are seriously flawed.

One should also understand that the need to provide graphic demonstrations and models to explain economic processes dictates assumptions which are not always sensible. For example, under modern portfolio theory one needs to be able to graph efficient frontiers and risk curves so that one can chart the differences between different securities. To do this, one must be able to plot risk/return points and then come up with lines which demonstrate the best fit for the set of data points.

Economists following the capital asset pricing model have used the standard

deviation of points in order to graph them, using as their measure of risk the volatility of the security. They also use Beta as a measure of the extent to which the security or derivative moves relative to the "riskless investment" or the index portfolio. William Sharpe snagged his Nobel Prize using such analyses to create a Sharpe Ratio or Selection Sharpe ratio to measure the "excess return" of the asset over the benchmark. See W. Sharpe, "Capital Asset Prices: A Theory of market Equilibrium," Journal of Finance,

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September 1964. Beta is a common measure now used, measuring the changes in the stock or portfolio being analyzed against those of the riskless investment or index.

One must understand that variance in price is volatility, and that negative and

positive movements in price are weighed equally in calculating volatility. Such results are always subject to challenge since a stock, e.g. Dell Computer, can go up 400% in a year, but it can only fall 100% to zero (assuming all the intermediate variances average out; one can make a log adjustment to such figures to make them comparable).

Such a measure of volatility is meaningful only if the distribution of change is

symmetric about the mean, i.e. fits in a bell shaped curve. Mandelbrot has provided a mathematical and analytic critique of this assumption. Winners such as Dell by definition are not symmetric; bankrupt companies similarly lack symmetry as well as solvency in their volatility. Using the prophecies of the capital asset pricing model or modern portfolio theory to assess the risk of a portfolio can seriously underestimate the risks involved, as Long Term Capital Management and others of its ilk discovered. Reading (Mis)Behavior is a rewarding experience for those who suffer fight or flight reactions when confronted with mathematic or statistical technobabble.

One must be cautious about using Beta's in evaluating the risk of a portfolio without understanding that different financial firms use different measuring periods. In late February and early March, 1998 Bloomberg had Dell with a Beta of 1.39 based on 102 weekly measurements, Argus measured its Beta at 1.78 based on five-years of weekly measurements, while Standard and Poor's found Dell's Beta to be 2.03 based on 60 month-end data points. In April of 2001, after Dell has fallen substantially with the rest of the high tech market, Bloomberg rated Dell as having Beta of 1.24, Argus measured its Beta as 1.23, while Standard and Poor's listed it at 2.44. Argus and Bloomberg thus rated Dell as being more volatile when it was soaring in value than when it was falling faster than the large cap market as a whole. However, with 37 States and the District of Columbia adopting the Uniform Prudent Investor Act (four more have adopted portions of the Act) and the Third Restatement purportedly stating the common law of these United States, one cannot ignore such principles, whatever one's econometric doubts.

E. Market and Idiosyncratic Risk Disciples of Modern Portfolio Theory look at the risk of an investment, generally described as its volatility (movement over time, up or down), dividing it into market risk which affects all securities (wars, depressions, elections and other natural disasters) and idiosyncratic or firm-specific risk attributable to any company. The latter include all the afflictions to which a specific firm can be subject, whether resulting from management errors or brilliancies, competitive challenges, litigation or government actions, embezzlements etc. In an efficient market the economist's investor will assess the risk and embrace it for the potential reward, thus being compensated for the gamble of his or her or its principal.

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However, the host of misfortunes that can strike any specific company cannot be predicted. A perfectly good company can discover that its new merger partner cooked the books, despite all due diligence. A FDA certified drug will cause heart problems. A seasoned supplier of tires can suffer quality control problems and conceal them from the automobile manufacturer until long after a class of victims has attracted the attention of the vigilant class action bar. A patent can be rejected or a competitor can discover the better mouse gene. The antitrust division can wake up some day and read the Sherman Antitrust Act and lurch into action. A chief executive can push a merger first with a consulting firm and then with Compaq, sending one’s stock crashing. The plight of the David and Lucile Packard Foundation is a telling reminder of the risks of an undiversified portfolio. Sticking with the settlor’s company stock resulted in a sixty percent drop in the portfolio since the end of 2002. The portfolio fell from $13 billion in 1999 to $3.8 billion in September of 2002. Grants of $611 million were made in 2000, dropped to $451 million in 2001 and are projected to be $200 million in 2003. Up to fifty percent of the staff may have had to be cut according to the Foundation’s September 20, 2002 press release.

F. Uncompensated Risk

Apostles of Modern Portfolio Theory believe that the rational investor and the underlying dynamics of the financial markets provide compensation for the risks associated with the broad market. This is the benchmark. Since the risk of an individual stock is unknowable, only the market risk is compensated; the idiosyncratic risk is thus "uncompensated risk." Economists such as Elton and Gruber examined the naive concept of diversification from the viewpoint of Modern Portfolio Theory, using historic data on various portfolios of randomly selected stocks to determine how many would be required to reduce this uncompensated risk, leaving only market risk. Elton and Gruber, MODERN PORTFOLIO THEORY AND INVESTMENT ANALYSIS (2d Ed. 1989) at 35; adapted by Myer Statman, "How Many Stocks Make a Diversified Portfolio," Journal of Financial and Quantitative Analysis at 22 (September 1987). The most recent edition of their book Fifth Edition, 1995, at 61-63 found that expected portfolio variance dropped quickly, but provided little marginal change after thirty random stocks were selected. Hence one hears rubrics to the effect that a portfolio of twenty to thirty stocks eliminates most uncompensated risk. Fisher, Lawrence and Lorie, James, "Some Studies of the Variability of Returns on Investments in Common Stocks," Journal of Business at 43 (1970). The slope of this curve shown in Elton and Gruber is initially quite steep, dropping the expected portfolio variance from 46.619 for one stock to 11.014 for 10 randomly picked stocks. One would hope that careful diversification among industries, company size, countries, and other factors would provide even better reduction in uncompensated risk than random selection, particularly if one examines the covariance of constituent investments to dampen risk. The Third Restatement subscribes to this hope,

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stating that "Effective diversification, then, depends not only on the number of investments but also on the ways and degrees in which their responses to economic events tend to cancel or neutralize one another through negative or slight 'covariance.'" Restatement Third of Trusts §227, General Note on Comments e through h at 77. Conversely, if one "diversifies" by buying similar large cap stocks comprising the largest companies in the S&P500, one can find that their covariance is minimal, since they move with one another, magnifying rather than reducing risk of a loss. With closely-held businesses and real estate, the inefficiencies of the respective markets can compensate the investor for the risk. The difficulty is in evaluating the risk of each investment relative to the remainder of the portfolio and monitoring the investments for changes in circumstances which change the risk characteristics, sale values or future income prospects. Concentration and illiquidity pose serious issues for the selection and retention of such investments. It is not enough to have (or hire) expertise for the particular investment and evaluation of its part in the portfolio, the fiduciary needs to document its selection, management and review processes so that it can defend its portfolio choices when circumstances change. As a review of surcharge decisions shows, a key issue is finding liability is whether the trustee ignored internal guidelines which call for scrutiny for investments which represent more than 10% of a portfolio. Matter of Estate of Janes (1997) 90 N.Y. 41, 659 N.Y.S.2d 165, 171-172; Trusteeship of Williams (Minn. App. 999) 591 N.W.2d 743; Matter of the Estate of Rowe (2000) 274 A.D.2d 87, 712 N.Y.S.2d 662, 664; Matter of Estate of Saxton (2000) 274 A.D.2d 110, 712 N.Y.S.2d 225, 232. These provide a basis for liability because they are treated as industry standards or the admissions of the fiduciary contained in policy manuals. In holding real estate or closely held businesses in a trust, one must take care to examine the benchmarks contained in trust manuals against the percentage of the concentrated assets held. Justification of the risks of such concentrations is most important, particularly in your investment model calls for diversification.

G. Increases in Stock Volatility and Idiosyncratic Risk Burton Malkiel and others have examined the changing volatility of individual stocks, examining stock prices from 1962 to 1997. Campbell, M. Lettau, B. Malkiel, Y. Xu. Have individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk," February, 2001, Journal of Finance. The study found that firm-level variance displayed a significant and positive trend, more than doubling during the 35 years studied. In the broad market, volatility had not increased, however individual stocks had become much more volatile. They found “declines over time in the correlations among individual stocks and in the explanatory power of the market model for a typical stock” Op.Cit. At 5. Declining correlations among individual stocks mediate one another and hence result in stable volatility for the market while individual firms display higher volatility. The study concluded:

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"A conventional rule of thumb, supported by the results of Bloomfield, Leftwich, and Long (1977), is that a portfolio of 20 stocks attains a large fraction of the total benefits of diversification. Table 6 shows, however, that the increase in idiosyncratic risk has increased the number of stocks needed to reduce excess standard deviation to any given level. In the first two subsamples a portfolio of 20 stocks reduced annualized excess standard deviation to about five percent, but in the 1986-97 subsample this level of excess standard deviation required almost 50 stocks.[fn] To put the result another way, the increase in idiosyncratic volatility over time has increased the number of randomly selected stocks needed to achieve relatively complete portfolio diversification."

Op. Cit. At 21. The study also looked at volatility of the market, industry and firm level. Not surprisingly, the study found that volatility increased during recessions. The variance among these different levels was not uniform, leading the authors to conclude that diversification has become much more important during times of economic downturns:

"The counter cyclical behavior of all volatility measures has important implications for diversification of risk at different stages of the business cycle. Since market volatility is substantially higher in recessions, even a well- diversified portfolio is exposed to more volatility when the economy turns down. The increase in volatility is stronger for an undiversified portfolio, since industry and firm-level volatility also increase in economic downturns. Thus diversification is more important, and requires more individual stock holdings to achieve, when the economy turns down."

Op. Cit. at 26. An article in the January 29, 2001 Wall Street Journal, at page R 16, cited not only the Malkiel study but also an earlier study from the University of Nevada at Las Vegas by Gerald Newbould and Percy Poon, who found that investors needed to hold more than 100 securities to keep within 5% of the average risk of 40,000 stimulated portfolios created for the study. Gambling with a small portfolio is not acceptable, even in Las Vegas. To completely eliminate idiosyncratic risk, Malkiel in a AIMR Conference in 2002 concluded that you need 200 different stocks. AIMR Conference Proceedings, Equity Portfolio Construction, B. Malkiel, “How Much Diversification is Enough?” at

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26. Complete elimination of such risk is not practicable in some circumstances, since fifty randomly selected stocks provide virtually the same diversification as the S&P 500.

H. The Restatement Third of Trusts and the Uniform Prudent Investor Act The principles of modern portfolio theory were adopted in the Restatement Third of Trusts which provides in §227(b) that "In making and implementing investment decisions, the trustee has a duty to diversify the investments of the trust unless, under the circumstances, it is prudent not to do so." See also Uniform Prudent Investor Act §3. The UPIA adopted the standard of testing investments not in isolation, but in relationship to their rule and function in the total portfolio. UPIA §2 (b):

“A trustee’s investment and management decisions respecting individual assets must be evaluated not in isolation but I the contest of the trust portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust.”

The trial court, appellate division and New York Court of Appeals opinions in Matter of Lincoln First Bank, N.A., 630 N.Y.S.2d 472 (Sur. 1995), aff'd as mod. 643 N.Y.S. 2d 643 (1996), aff'd as modified sub nom Matter of the Estate of Janes, 90 N.Y. 2d 41 (1997) are a classic demonstration of the courts struggling to apply such principles. New York's highest court adopted the principles of the Third Restatement of Trusts as to portfolio theory, prior to that State's adoption of the Uniform Prudent Investor Act. 659 N.Y.S. 2d at 170. The case dealt with a failure to diversify a concentration of 71% of trust assets in Kodak stock and a subsequent fall in the price of the stock. While 40 States and the District of Columbia have adopted this Act to date, the adoption of total return portfolio analysis by a prestigious Court offers fiduciaries in States where the Act has not been adopted an argument that their conduct should be viewed under a portfolio analysis rather than investment by investment. Hence liability may be avoided for one sour investment whose risk characteristics were at the time of acquisition appropriate for inclusion in a portfolio which adequately balanced such risks. The Court of Appeals in Janes affirmed the holding of liability, pointing to the duty of the trustee to "take into consideration the circumstances of the particular trust that he is administering, both as to the size of the trust estate and the requirements of the beneficiaries. He should consider each investment not as an isolated transaction but in relation to the whole of the trust estate (3 Scott, Trusts §227.12, at 477 [4th ed])." In the Matter of Lincoln First Bank, 90 N.Y. 2 41 (1997) In Matter of Estate of Janes, (1997) 90 N.Y. 41, 659 N.Y.S.2d 165. the fiduciary defended its investment of 71% of the trust in Kodak stock by citing fundamental investment considerations for the individual stock, such as earnings, dividends, quality of management and so forth. Once blue chip status was determined, the fiduciary argued that it had met its duties. The trial, appellate division and Court of Appeals rejected this approach, requiring an examination of the overall portfolio and the appropriateness of

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this individual investment in the context of the portfolio, the terms and circumstances of the trusts and its beneficiaries. The Court of Appeals held that a trustee weighing the propriety of an investment should consider

"'the amount of the trust estate, the situation of the beneficiaries, the trend of prices and of the cost of living, the prospect of inflation and of deflation' (Restatement (Second) of Trusts §227, comment e. Other pertinent factors are the marketability of the investment and possible tax consequences (id., comment o). The trustee must weigh all of these investment factors as they affect the principal objects of the testator's or Settlor's bounty, as between income beneficiaries and remainder persons, including decisions regarding 'whether to apportion the investments between high-yield or high growth securities.' (Turano and Radian, New York estate Administration ch. 14, §P, at 409 (1986).

“Moreover, and especially relevant to the instant case, the various factors affecting the prudence of any particular investment must be considered in light of the 'circumstances of the trust itself rather than [merely] the integrity of the particular investment.'"

The court noted the testimony of experts at the trial who opined as to the volatility even of a blue chip growth stock which is so closely tied to "earnings projections" as well as the fact that "the investment risk arising from that volatility is significant exacerbated when the portfolio is heavily concentrated in one such growth stock."659 N.Y.S. 2d at 170. The Court of Appeals also cited the failure to consider the needs of the income beneficiary, particularly in light of the dividend of only 1.03%. The Court taught in upholding surcharge:

"Notably, there was proof that petitioner (1) failed initially to undertake a formal analysis of the estate and establish an investment plan consistent with the testator's primary objectives; (2) failed to follow the petitioner's own internal trustee review protocol during the administration of the estate, which advised special caution and attention in cases of portfolio concentration of as little as 20%; and (3) failed to conduct more than routine reviews of the Kodak holdings in this estate, without considering alternative investment choices, over a seven-year period of steady decline in the value of the stock." 659 N.Y.S.2d at 172.

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The Court of Appeals held that the trial court may determine within the entire period during which the investment was held, the "reasonable time" within which divestiture of the imprudently held investment should have occurred. In Estate of Cooper, 913 P.2d 393 (Wash. App. 1996) the trust in question had achieved gains from the sale of some original assets ; however the proceeds were invested in a fashion skewed to favor the trustee/income beneficiary. Despite the gain, the trustee was surcharged for an inappropriate investment mix and resulting loss to the remaindermen. "Overall trust performance is a factor in evaluating the performance of the trustee. But it is not by itself controlling. 'The court's focus in applying the Prudent Investor standard is conduct, not the end result.' J. Alan Nelson, The Prudent Person Rule: A Shield for the Professional Trustee, 45 Baylor L. Rev. 933, 939 (1993)." 913 P.2d at 398. The trustee was surcharged for investing "the estate assets almost exclusively in marketable securities, 87 percent in bonds, favoring again the income beneficiary--him." 913 P.2d at 399. The court found no plan behind the over allocation to bonds since the trustee could not have expected a small investment in securities to have garnered the gains actually received and the fixed income investments were not structured to equalize the overall risk of the portfolio. The trial court in Nickel v. Bank of America NTSA, 991 F. Supp. 1175, rev. on other grounds, Nickel v. Bank of America, 290 F.3d 1134 (9th Cir. 2002), rejected the use of the S&P 500 as a damage measure for a class of 2,500 trusts where trustee fees had been charged in excess of fixed fee provisions in the trusts over a period of more than 20 years. The court pointed to variety of risk tolerances and return requirements of the trusts in question and found that a single measure of investment performance would be inappropriate. This finding was sustained on appeal to the ninth circuit:

“The trouble with this methodology is that it does not reflect reality. The trusts had differing investment objectives, and those objectives sometimes changed during the lives of the trusts. The income beneficiaries and principal beneficiaries also had, at times, differing interests within individual trusts. There were different types of trusts. The liquidity needs of each differed. Taxes were an issue in some trusts, but not in others. Most of the trusts have been terminated. And some trusts held quantities of cash that were not invested. The application of averages, ratios, combined rates of return, and the like simply do not fit the facts of these widely disparate trusts. Nor do those applications address the facts that all of the trusts, under plaintiff’s methodology, would receive the benefit of a high rate of return, such as the Standard & Poors Five Hundred Index, when in fact many trusts did not bear the investment risks of that type of growth investment.”

991 F. Supp. At 1183-1184.

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There are virtually no cases where courts rigorously explore the appropriate portfolio allocations or the economic rationale for the decisions. Most surcharges involve conflicts of interest, Interfirst Bank Dallas N.A. v Risser, 739 S.W. 2d 882 (Tex. App. 1987), failures to obtain fair market valuations or expert advice in fixing sale prices, Jarrett v. United States National Bank of Oregon, 725 P. 2d 384 (Ct. App. Or. 1986), Lincoln National Bank and Trust Co. v. Shriner's Hospitals for Crippled Children, 588 N.E. 2d 597 (Ct. App. Ind. 1992), Vento v. Colorado Nat'l Bank, 907 P.2d 642 (Colo. App. 1995) or obviously imprudent risks such as placing the entire corpus in a junior deed of trust with inadequate margin of security. Estate of Collins, 72 Cal. App. 3d 663 (1977). In Stevens v. National City Bank, 544 N.E. 2d 612 (Ohio 1989) the diversification out of a concentration of 89% Dow and Union Carbide stock was attacked, based on language in the will requesting that such stock be retained. The Ohio Supreme Court reversed a surcharge and found that the retention language was merely precatory. The Court discussed the duty to diversify, the duty to make the trust productive, and the duty of impartiality in meeting the needs of the income and remainder beneficiaries. The expert advice adduced at the trial was that the portfolio should have been invested 50% in fixed income assets for the income beneficiary and 50% in equities. Another expert opined that "a portfolio for high income and growth of income for the life beneficiary would be constructed quite differently from a portfolio for principal appreciation on behalf of remainder beneficiaries, thus requiring diversification." 544 N.E. 2d at 618. The Ohio Supreme Court concluded that liquidation of the high concentration into a balanced portfolio was a "prudent and gradual diversification program." 544 N.E. 2d at 620. Absent the sales, various stock splits and dividends of Dow and Union Carbide would have resulted in higher income for the widow ($174,616) and a higher value of principal ($540,673). The portfolio allocation of 50/50 bonds and equities is one of the few court decisions discussing proper portfolio allocations. Since then a number of cases have examined the appropriate ratio of equities to bonds in assessing the performance of a trustee. In Noggle vs. Bank of America, 70 CA4th 853 (Cal. App. 1999) the court held that investing the entire portfolio in bonds was inappropriate and assessed damages based on the assumption that 50% should have been invested in equities. Estate of Scharlach, 809 A.2d 376 (PA Super. 2002) came to the same result regarding a portfolio for a trust for a child seriously injured at birth. In Meyer v. Berkshire Life Insurance Company, 250 F. Supp.2d 544 (D. Md. 2003), the court assessed damaged for imprudent investment of a retirement plan. The court rejected plaintiffs’ expert claims that the asset mix should have been 10% fixed income and 90% equitities, or alternatively 30/70. It based damages on a 50/50 allocation between income producing assets and equities. 250 F. Supp.2d at 573. In Martin v. U.S. Bank, 664 N.W.2d 923 (Neb. 2003), the Supreme Court affirmed a denial of surcharge where the trustee had invested the large majority of the portfolio in bonds. Nebraska had adopted the UPIA prudent investor statute. The appellate court, however, looked to the trust provisions calling for payment of trust income to the settlor’s daughter plus invasion of principal in the trustee’s sole discretion

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for the surviving daughter’s “health, maintenance in reasonable comfort and best interests.” The Court concluded that “We cannot say that the bank violated the standards codified [in the UPIA} by investing the large majority of trust assets in fixed income investments rather than investing the trust assets in equity investments which, without the benefit of hindsight, may have endangered the integrity of the trust principal.” 664 N.W.2d at 929. The Court cited a prudent man case from Arizona, Tovrea v. Nolan, 875 P.2d 144 (Ariz. App. 1993) in support of its decision. The premise of the UPIA is that equities held over a relatively long period will outperform fixed income investments, particularly when inflation comes to play. The trust was originally funded in 1989 with a farm and the balance in fixed income. The farm was sold in 1993, as well as certain private placements and limited partnerships (which the bank sold in some circumstances for less than their annual income, in breach of its duties). As of 1996, only 14% of the assets were invested in equities, with the balance in fixed income securities. 664 N.W.2d 923, 926. The daughter then removed the trustee under a trust power and moved to surcharge, along with her children, for failure properly to diversify. The trial court rejected the diversification claim but held the trustee had “unilaterally decided to liquidate these assets without regard to their historical and potential income production. The court found that this action was an abuse of discretion and that the bank took this action for its own convenience.” 664 N.W. 2d at 926. Faced with factual findings, the Supreme Court may have felt itself bound given evidence in support of the trial court decision. Given the age of the beneficiary (a child, not an elderly widow) and the obligation to provide income for her life, the decision seems oblivious to the investment standards in the UPIA. The court did affirm the denial of attorney’s fees for the successful trustee, pointing to its breach with respect to the limited partnerships. It held, “if a fiduciary is found guilty of a breach of duty or the court orders the fiduciary to account to the estate, the estate is not liable for the fiduciary’s attorney fees.” 664 N.W. 2d at 929. In the real world, very few investors have the scale of operations and sophistication to actually utilize econometric theories: large pension plans and endowments appear to be the main center of attention. The creation of investment software for desktops and from online services to evaluate Beta's and construct efficient frontiers for portfolios may change this. Such evaluation techniques are also being applied to various portfolio strategies. see e.g. J. O'Shaughnessy, What Works on Wall Street (1997)

I. Liability for Failure to Diversify: Procedural Prudence Standard

Chase Manhattan Bank was surcharged $20,958,303.31 by the Surrogate Court in Testamentary Trust UW Dumont , 2004 WL 1468746 (Surr. Ct. June 25, 2004).

The court held that the trustee should have divested 95% of concentration in Kodak stock under former Prudent Person Rule. Cites diversification as a breach of prudence,

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Matter of Newhoff, 486 N.Y.S. 2d 956 (App. Div. 1985) and In re Janes Estate, 630 N.Y.S. 2d 472 (1995). Language expressing wish of testator that Kodak not be sold for purposes of diversification was precatory: “it is my desire and hope….”

The clause was qualified, in that it “shall not prevent…my trustee…from disposing of

all or part of the stock of the Eastman Kodak Company in case there shall be some compelling reason other than diversification for doing so.”

Trustee failed to get a definition of “compelling reason” despite conflict in the two

clauses. No legal advice on issue obtained by trustee between 1972 and 1997. The needs of remaindermen were a compelling reason, based on duty of impartiality. Restatement , Second, of Trusts §232. The court noted that the trustee routinely sold sufficient stock to pay the half of its compensation allocated to principal, treating this as an admission of what is a compelling reason..

The court held that the test of prudence is conduct, not performance. Matter of Bank

of New York, 35 N.Y.2d 512, 323 N.E.2d 700 (1974). “Testimony on the record shows a lack of uniformity amongst the trust officers’ perceptions of the clarity of the phrase, a red flag that a legal opinion was needed. Instead, the bank’s employees downplayed or even ignored the exception phrase. Most seemed unclear as to whose job it would have been to even raise the issue. Ibid. at 7. There were no documents “regarding the trust’s terms, no documentation whatsoever as to the investment strategy of the trust or the performance of Eastman Kodak.***The complete lack of documentation alone is itself a breach of trust. Matter of John D. Rockefeller, Jr. , NYLJ, March 1, 2004 at 31. See also, In re Reckendorfer’s Estate, 307 N.Y. 165, 120 N.E. 2d 696 (1954). “ Ibid.

First: “for the first three years of this accounting period, there is a complete dearth of

evidence that the bank’s employees truly even noticed this trust. Then, for over nineteen years, the bank gave complete and utter responsibility for this trust to one, non-legally trained and rather fresh-on-the field man.” Ibid. at 8. Internal Review Committee annual minutes merely stated “Instrument Directs Retention, or something nearly identical. At no place on any of the IRC forms over the entire accounting period, was there any hint that Charles Dumont’s language was not absolute. None of the trust officers even hinted to the committee that there was any type of discretionary or interpretive issue involved.” Ibid. at 9. “No meaningful discussion could be had on the nuances of Dumont’s language or the existence of external circumstances possibly warranting sale, in the mere two minutes of average attention the Dumont trust received from the IRC once per year.” Ibid. “The IRC was not equipped to review interpretation of the trust, the needs of the beneficiaries, the business dealings of Eastman Kodak or the realities of the market. This is not so much due to problems with the forum itself or its professional composition as it was due to the manner and lack of frequency in which the trusts were presented. The IRC was little more than a reason for the trust officers to pick up the file, and possibly to communicate to each other in order to generate paperwork for an amalgamation of superiors to almost blindly sign their approval.” Ibid.

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“The employees responsible for the management were given near exclusive control on document interpretation with no true check on their actions. This allowed for the development of a default management plan whereby no active involvement on the bank’s behalf was required. This allowed for the development of a default management plan whereby no active involvement on the bank’s behalf was required. The precedent which precipitated, a ‘maintain Kodak stock at all costs’ mindset, allowed the bank to avoid performing any portfolio management while still collecting its standard fiduciary commissions. “ The court noted that the bank had no problem determining that sale of Kodak to pay its annual commissions was a “compelling reason.” Ibid. at 9, n. 4.

The court relied on an expert who opined that the proper way to address unique terms was to utilize a “team resolve” and if no consensus was reached, to obtain a legal opinion, and finally, a judicial interpretation. The court found no team approach and “the bank had no other adequate version of this methodology.”

Second: “within its own internal structure, it did not clearly specify whose job it was

to handle questions of document interpretations on management directives.” Ibid. at 10. “…apparently the bank had holes in its personnel coverage of duties as well a an imperfect review procedure.” Ibid.

Third: “the bank never attempted to prospectively define any triggering criteria which

would raise a red flag for the trust officer in charge to raise the necessity of n immediate and more in-depth review. Good practice would dictate that upon the occurrence of a pre-determined significant event (such as a precipitous decline in stock value) the trust would undergo some form of intensive review to make sure that fiduciary duty is being properly upheld. Good practice would dictate a before-the fall type of analysis to attempt to identify proper triggers which would call for such a review. Good practice would dictate complete documentation of all of these processes.” Ibid. at 10.

A review should have been done on the death of the widow, despite the existence of a

sprinkle power in favor of the child prior to her mother’s death. “The death of Blanche Hunter was a triggering event for the trust, in that afterward Margaret Hunter became the sole measuring life by which the investment horizon would be determined.” Ibid. at 11 The sprinkle power was limited by the mother’s death and all income had to be distributed to the daughter. Her right to receive income changed the investment analysis, in that they should have analyzed the trust terms, looked at the performance of Kodak, and determined the needs of the income beneficiary. The income beneficiary “had a right to receive income, and with it, a right to demand a reasonable yield from the trust.” Ibid. at 11. The acceptance of the beneficiary was tainted by the communications of the trustee informing her that her grandfather had mandated retention of the Kodak stock.

“Where the fiduciary is administering an estate under directive of a retention clause, it

is incumbent upon that fiduciary to develop a uniform understanding of the testator’s words, basing such a definition on the input of an experienced team of industry professionals, preferably under the guidance of in-house legal advice. It is also critical that the fiduciary’s actions reflect an understanding that a retention clause does not

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exculpate itself from poor judgment and laziness, but instead that a retention clause almost requires a greater level of diligence and work, as prudent management of the estate will demand a delicate balancing act. “ Ibid. at 12-13.

“Nor does the bank’s interpretation pass the test articulated in Hubbell, where a

strongly worded retention clause must still be subject to the element of prudence. A trustee has a duty to preserve the corpus of the trust. Restatement of Trusts, 2d §176. See also Restatement of Trusts 2d, §181. A significant drop in stock value such that this duty to preserve is compromised, would dictate that a prudent action by the trustee would be to sell the falling stock and attempt to regain the loses sustained to the corpus. Where prudence dictates sale, a retention clause if superseded. In re Hubbell,, 302 N.Y. 246, 97 N.E. 2d 888 (1951).” Ibid. at 14 “The risk presented by the concentration itself may not have been compelling reason for sale, but the actual, substantial loss and lack of viable hope of long term gain was. The Court finds that if the bank had been prudently monitoring this trust, it would not have continued to retain the near-exclusive concentration of Kodak stock as it did until 2002. Therefore, the failure of the bank to adequately carry out its fiduciary duties directly resulted in objectants’ loss.” Ibid. It cited the fall of the stock in 1974 and low income yield as reasons to compel a sale. It rejected the defense that the beneficiary had ample income. “The law protects the wealthy no less than the poor. The duty to produce reasonable income is a duty to the trust itself, not the income beneficiary.” Ibid. at 15 In Holder v. First Tennessee Bank, N.A. , 2000 WL 349727 (Tenn. Ct. App. 2000), the Court similarly construed provisions of a trust and concluded that the trustee that diversification was a compelling reason to sell the stock, reversing a trial court declaration that diversification was not required. The trust provided that “Only for the most compelling reason is the Trustee to make any change in the stocks put in this trust. However, change is to be permitted if the need for change appears to the Trustee to be clearly in the best interests of the beneficiaries of this trust….” 2000 WL 349727 at 1. The trustee had testified that”in his opinion as Trustee, maintaining the majority of the Trust’s corpus in one stock represented an ‘undue risk’ to the corpus and the beneficiaries. Therefore, [trustee] felt that diversification of the Trust assets by sale of stock was in the best interest of the beneficiaries.” Ibid. at 3.

J. Behavioral Finance

The term “risk and return objectives” mentioned in the UPIA comes from modern portfolio theory, which posits that an investor must be willing to undertake greater risk or volatility to gain greater returns. The premise is that markets (such as the large capitalization segment of the U.S. stock exchanges) are efficient to some degree, in that information about a stock is quickly translated into prices that reflects the present value of future revenue streams. Larry Harris, Trading and Exchanges: Market Microstructures for Practitioners, Oxford University Press (2003), p. 240. The movement of stocks is frequently described as a random walk, implying that it is futile to predict an asset’s future price. Hence when the UPIA Section 8 directs fiduciaries to minimize expenses, should they merely resort to passive investment in an S&P 500 index or exchange traded

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fund, since it serves as a surrogate for the whole market? Alternatively, should they only use passive strategies for all asset classes, rather than actively manage through mutual funds or advisors? As shown in D. Campisi and P. Collins, “Index Returns as a Measure of Damages in Fiduciary Surcharge Cases”, 140 Trusts & Estates 18 (June, 2001), index funds are not efficient in many markets. Moreover, asset allocation studies show that choosing multiple asset classes provides superior returns and less volatility than reliance on the S&P 500 index. Hence, active management can be appropriately used.

Of course, if no one were any good at selecting investments it would be unnecessary to delegate that function and imprudent to pay extra for it. But recent studies suggest people can profit even in an efficient market, in part because there is always someone who must sell or buy something for external reasons, such as a need for liquidity. “Those investors are willing to ‘pay up’ for the privilege of executing their trades immediately,” allowing the efficient trader to find a counterpart for a profitable trade. Harris, at 240. Moreover, people sometimes “trade on what they think is information but is in fact merely noise.” Harris at 243. Such people may be misled by their brokers or friends, or simply have a delusional confidence in their investment abilities.

The empirical evidence shows, at best, that markets are “semistrong-form

efficient” in that “easily obtained and easily interpreted public information” is quickly acted upon by efficient traders to move the market price close to its fundamental value. Ibid. Since it takes time for information to filter out to traders, and since efficient traders attempt to mask their trades by executing over time so that their insights are not poached by others,. There is a time lag before even public information is disseminated and its consequences for future revenue of an investment is translated into price. Moreover, how efficiently stocks are priced “depends on the costs of acquiring information, and how much liquidity is available to informed traders.” Op. Cit.at 243. Hence traders may not want to incur the expense of obtaining information or may find that the market in question is too illiquid for them to cash in on the information. Hence there is a need for specialists with the funding and incentives to look for information and the execution skills to act on such information. Whether it is the specialty trader in an illiquid and opaque emerging market or a hedge fund operator with the megacomputer necessary to uncover pricing anomalies and exploit them, there is an opportunity to utilize such skills if the trustee has the assets and risk and return characteristics to take advantage of them.

One must raise some questions about the efficiency of the market, since otherwise

sophisticated traders would find it impossible to profit from participation. As noted in D. Sornette, Why Stock Markets Crash (Princeton University Press 2003) at 47:

“Grossman and Stiglitz .. went even further. They argue that perfectly informationally, efficient markets are an impossibility, for if markets are perfectly efficient, the return on gathering information is nil, in which case there would be little reason to trade and markets would eventually collapse. Alternatively, the degree of market inefficiency determines the effort investors are willing to expend to gather and trade on information, hence a nondegenerate market equilibrium will arise only when

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there are sufficient profit opportunities, that is, inefficiencies, to compensate investors for the costs of trading and information gathering.” The market, however efficient, cannot serve as a perfect match for the performance of individual investors. Measuring the closing prices daily at 4pm on a stock exchange tells us little about the movement of stocks during the day. Some people trade on valid information, some are misled by their brokers or friends or delusional confidence in their investment abilities. Some trading is done by large funds which need to raise cash to pay redemptions, pay faculty salaries, rebalance portfolio’s, or harvest tax gains or losses. There are lots of external reasons why individuals trade, other than profit maximization or efficient valuation of the prices of a given stock. The market does not die (we hope), it does not need to liquidate to pay estate taxes, it does not face tax efficiency concerns, it simply is an exchange where stocks are sold. Statistics about trading volumes or prices or trends may be totally irrelevant to evaluating the performance of an individual trust with real liquidity needs and frictional costs such as taxes and trading expenses. Lots of individuals can “beat” the market simply because they have to enter or exit and need not wait for annual or ten-year reports to see how they have done. Once the trustee has to sell to pay his beneficiaries or make capital distributions to remaindermen who want cash or change portfolio strategies to reflect changes in the income or growth requirements of a specific trust, its performance will differ from the results of an index of the market in which it is participating. Why can people profit even in an efficient market? Because there are people trading on any given day who must sell or buy something for external reasons, allowing the efficient trader to find a counterpart for a profitable trade. As Sornette points out, “The profits earned by these industrious investors may be viewed as economic rents that accrue to those willing to engage in such activities. Who are the providers of those rents? Black gave us a provocative answer: noise traders who trade on what they think is information but is in fact merely noise. More generally, at any time there are always investors who trade for reasons other than information (for example, those with unexpected liquidity needs), and those investors are willing to ‘pay up’ for the privilege of executing their trades immediately. Sornette, supra, at 48.

Moreover, how efficiently stocks are priced “depends on the costs of acquiring

information, and how much liquidity is available to informed traders.” Harris at 243. These recent analyses suggest there is a need for specialists with the funding and incentives to look for information and the execution skills to act on such information. Whether it is the specialty trader in an illiquid and opaque emerging market or a hedge fund operator with the megacomputer necessary to uncover and exploit pricing anomalies, there is an opportunity to utilize such skills if the trustee has the assets and risk and return characteristics to take advantage of them. Such experts can spread the cost of information gathering, so that they can provide it to fiduciaries at a fraction of the cost which the non-specialist would otherwise pay.

In addition, various psychological and empirical studies in the developing field of

behavioral finance have recently provided compelling explanations for the volatility of

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stock and financial prices. Behavioral finance argues that in many instances, strutting investors would be better off delegating their duties to emotionless professionals.

The Nobel Prize for Economics awarded to behavioral finance theorist Daniel Kahneman in 2002 validates the influence of such alternative explanations for the market. As noted by Robert J. Shiller, (author of famous Irrational Exuberance) in his 2002 treatise “From Efficient Market Theory to Behavior Finance”: “After all the efforts to defend the efficient markets theory there is still every reason to think that, while markets are not totally crazy, they contain quite substantial noise, so substantial that it dominates the movements in the aggregate market. The efficient markets model, for the aggregate stock market, has still never been supported by any study effectively linking stock market fluctuations to subsequent fundamentals.” October, 2002 at 12 (Cowles Foundation for Research in Economics, found at http://Cowles.econ.yale.edu/P/cd/d13b/d1385.pdf).

A review of Shiller’s writing is worth the while of any investor, from Irrational

Exuberance (Broadway, 2000) published at the crest of the breaking bubble to “Human Behavior and the Efficiency of the Financial System” which also can be accessed at the Cowles website and discusses such useful topics in explaining financial markets as “regret and cognitive dissonance,” overconfidence, magical thinking and that important subset of financial players afflicted with “quasi-magical thinking.” It is a quick primer to understanding the insights of behavioral finance, but should be reviewed when alert and anxious to learn why markets behave as they do. Behavioral finance provides explanations for the variations in pricing and the psychological explanations for seemingly irrational behavior that the econometricians dismiss as noise in a world that they posit must be rational. In fact, the analysis of behavioral finance shows that investors, both individual and corporate, cripple their performance by overconfidence, by overreacting to price movements, by regret or fear that they will miss the next big thing or fail to bail when the other lemmings are running. Cognitive dissonance allows investors to ignore losses (bad markets or luck) and attribute gains to illusory skills and thus overestimate their capabilities.

K. Duty to Minimize Cost of Investments : Double Dipping “In deciding whether to delegate, the trustee must balance the projected benefits against the likely costs. Similarly, in deciding how to delegate, the trustee must take costs into account. The trustee must be alert to protect the beneficiary from ‘double dipping.’ If, for example, the trustee’s regular compensation schedule presupposes that the trustee will conduct the investment management function, it should ordinarily follow that the trustee will lower its fee when delegating the investment function to an outside manger.” UPIA §9, comment.

“Concerns over sales charges, compensation, and other costs are not an obstacle to a reasonable course of action using mutual funds and other pooling arrangements, but they do require special attention by a trustee. Because the differences in the totality of the costs described above can be significant, it is important for the trustees to make careful

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cost comparisons, particularly among similar products of a specific type being considered for a trust portfolio. See §188, comment f, on the general duty to incur only appropriate and reasonable expenses.

“Even assuming fiduciary care in comparing costs and avoiding excessive

charges, fund managers inevitably must be compensated in one way or another. If the trustee also receives commissions from the trust, they must be appropriate to the duties performed; and overall management costs to the trust estate must not be unreasonable in light of alternatives realistically available to the particular trustee. Because multiple layers of investment management costs can be a serious concern, the amount of the trustee’s compensation may depend on the nature of the investment program, the role played by the trustee, and the qualifications and services contemplated in the selection and remuneration of the trustee. Compare §188, Comment c, on the expenses of employing agents.” Restatement Third of Trusts, Prudent Investor Rule, §227 at 50.

The use of mutual funds or outside managers thus pose questions about the fees that the trustee can charge. A number of States require trustees to eliminate double dipping when they use affiliates to provide proprietary mutual funds or investment specialists. This is accomplished by reducing the trustee fees by the amount of an advisory fee charged by the fund or manager or by removing the value of the assets delegated to an outside manager from the trust’s fee base. If the advisory fee is less than the trustee’s ordinary fee, the trustee keeps the balance for its services as custodian, recording keeping, asset allocation, preparation of tax returns and other discretionary functions. But what about the third-party or unrelated mutual fund, hedge fund, or specialty manager? How much should the trustee reduce its fees, if any, under the comments to §9 of the UPIA and to §227 of the Third Restatement? III. A New Measure of Damages

The measure of damages was one of the major innovations of the Third Restatement, looking at investments on a portfolio basis (rather than each investment in isolation) and allowing appreciation damages in certain circumstances based on what a broad market index would have returned. Restatement, Second, of Trusts §205 provided alternative damage measures: a) any loss of depreciation in value of the trust resulting from the breach, b) any profit made by the trustee through the breach of trust, or c) any profit which would have accrued to the trust if there had been no breach. Restatement, Third, of Trusts (1992) modified the language of §205. It provides that a trustee is “(a) accountable for any profit accruing to the trust through the breach of trust; or (b) chargeable with the amount required to restore the values of the trust estate and trust distributions to what they would have been if the trust had been properly administered. In addition, the trustee is subject to such liability as necessary to prevent the trustee from benefiting personally from the breach of trust.”

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The Uniform Trust Code (2000) authorizes damages for the greater of: “(1) the amount required to restore the value of the trust property and trust distributions to what they would have been had the breach of trust not occurred; or (2) the profit the trustee made by reason of the breach.”

As already noted, the UPIA looks at investments on a portfolio basis, rather than each investment in isolation. The combined effect of the UPIA and the changes to the Restatement (as reflected in the comments to Restatement (Third)) is to allow for appreciation damages in some circumstances based on what an appropriate market index would have returned for the portfolio, or segment of a portfolio, affected by the breach. However, a market measure such as the S&P 500 index may not be appropriate in most cases. The evolving basis for damages may curtail a line of cases that denied damages where an investment breach nonetheless caused no loss to the nominal value of the trust. On the opposite side of the coin, if a trustee’s investment conduct was prudent under the appropriate standard, portfolio underperformance will not necessarily be a breach. The remedy of loss plus interest is still available, as is the remedy of disgorgement.

Under the Restatement, Second, courts found too little information on which to base a measure of damages bottomed on an index return (see Reporter’s Notes to §§205 and 208-211, Restatement, Third, of Trusts at 167-168), and faced an absence of investment vehicles by which a trustee could invest in such index portfolios. The development of a robust index fund and ETF industry and the development of a statistical record of market segment performance by Ibbotson and others have remedied these difficulties. Of the $7 trillion invested in mutual funds, approximately 8.7% is invested in index funds, according to Vanguard. Proprietary index funds operated by banks comprise about 9.6% of all index funds. In Dennis v. R.I. Hospital Trust Nat. Bank (1st Cir. 1984) 744 F.2d 893, 900, the Court of Appeals reversed a damage measure based on the rate of inflation. The trial court had held that the investment strategy represented a breach, and based damages on the .4% shortfall of the corpus measured against inflation during the 1950's. The Court held:

We reach a different conclusion, however, in respect to the additional 0.4 percent, designed to reflect 'appreciation.' Neither the court nor the parties have provided us with any reason to believe that the trustee would have outperformed inflation. There is no evidence in the record suggesting that a hypothetical reinvestment of hypothetical proceeds from a hypothetical 1950 property sale would have yielded real appreciation over and above inflation's nominal increase. We have found no information about the performance of an average, or typical trust. And the general publicly available sources offer insufficient support for a claim of likely real increase. See R. Ibbotson & R. Sinquefield, [Stocks, Bonds, Bills and Inflation: The Past

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and the Future (1982)]. Moreover, one can imaging reasonable disagreement about whether any such hypothetical real appreciation would belong to the life tenant or to the remainderman. These factors lead us to conclude that, in addition 0.4 percent interest for real appreciation, the district court exceeded its broad remedial powers.

In the 1982 edition of Trusts and Trustees, Bogert discussed these problems in terms of the difficulty of proving what should have been acquired. G. Bogert, Trusts and Trustees §702 at 211-212 (1982 ed.). In a prescient comment, Bogert suggested that a court might be convinced to award damages based on the average prices of the types of securities which were appropriate for investment in the trust. §702 at 213. The Restatement Third, faced with detailed financial information and readily available investment vehicles for invested in broad indices, expressly authorized the use of such measures of damages.

The S&P 500, one of the measures frequently cited as an appropriate index, had a spectacular rise, climbing 251% from 1994 through the end of 1999. However, the same momentum factors that led to its rise based on the engine of large growth stocks, reversed after the peak of March of 2000 when the index value exceed $1527, then the growth leaders collapsed in the dotcom crash, accounting scandals, and the end of the telecommunications boom.

The S&P 500 index dropped 46.6% from its apex as of the end of the third

quarter of 2002 (dropping 9.06% in 2000, 12.02% in 2001, and 22.10% in 2002). As of December 31, 2003, the index carried a value of $1,111.916, 27 percent below its peak. Despite such recent reversals, the use of the measure in earlier periods can still provide a major enhancement of damages over simple interest or other measures. For example, the index was valued at $459 at the end of 1994, a rise of 240 percent (assuming reinvestment of dividends and no correction for inflation). Moreover, the context of the case may justify the use of other benchmarks, as for example where the improper investment was in a fixed income portion of the portfolio. See, infra, California Ironworkers Field Pension Trust v. Loomis Sayles & Co., 259 F.3d 1036 (9th Cir. 2001). Restatement, Third, of Trusts § 211 provides that

“If the duty was to acquire any property constituting a proper investment for the trust, charge the trustee with the amount of the funds the trustee failed properly to invest, adjusted for the amount of the total return, positive or negative, that would have accrued to the trust estate had the funds been invested in a timely fashion, this return to be based on a total return experience for suitable investments of generally comparable trusts.”

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The Reporter’s notes to §211 notes the variety of measures of damages which could be applied when an improper investment scheme causes the trust to lose what it should have earned:

“This approach can be carried out by referring the to performance of all or a relevant portion of the proper investments of the trust in question, to the performance of all or part of the portfolios of comparable trusts, or to the performance of some suitable securities index or other benchmark portfolio.” (Emphasis added

Restatement, Third of Trusts, §211, Reporter’s notes at 168. The flexibility of the equity court to fashion a measure appropriate to the circumstances is emphasized in the new investment provisions of the Restatement. Comment f to §211 notes:

“If the period during which the trustee has failed to make investments is not significantly prolonged, at least if the trustee is not guilty of bad faith or other serious misconduct, it would ordinarily be an appropriate exercise of equitable discretion to measure the performance of proper trust investments only by applying a suitable rate of interest, based on the income yields of investments of generally comparable trusts. In such a case the court would not look to a total return figure; that is, damages would not take account of capital gain or appreciation, nor of losses in value, that might have resulted in a suitable trust portfolio from general changes in stock and bond values in the security market. This approach would be particularly justified in such cases if a recovery based on some representative measure of total return performance of trusts appears highly speculative.” (Emphasis added).

The case law since the adoption of the Restatement has tended to avoid the extreme measure of index returns where no conflicts or serious act of bad faith are involved. The Court of Appeals in Janes affirmed the holding of liability, pointing to the duty of the trustee to "take into consideration the circumstances of the particular trust that he is administering, both as to the size of the trust estate and the requirements of the beneficiaries. He should consider each investment not as an isolated transaction but in relation to the whole of the trust estate (3 Scott, Trusts §227.12, at 477 [4th ed])." In the Matter of Lincoln First Bank, 90 N.Y. 2 41 (1997) The trial court in Janes used the S&P 500 index as a measure of damages, the appellate division rejected it, and the New York Court of Appeals firmly rejected such a remedy in cases where there is no "deliberate self-dealing and faithless transfers of trust property." 659 N.Y.S.2d at 172. Hence the Court of Appeals decision was based on

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similar concerns to those stated in comment f to §211 above. While the use of interest reduced damages by $2,000,000, the fiduciary was still hammered for $4,065,029 plus prejudgment interest and $326,302. for commissions and attorneys' fees, plus post-judgment interest, costs and disbursements. The Uniform Prudent Investor Act and the Third Restatement attempt to use such theories to establish a standard of conduct and a standard for measuring damages. When you actually prosecute or defend such a case, the facile theories and glib generalizations of econometric theorists provide little assurance and much opportunity for courtroom humor as econometricians meet reality.

A. Damages Even When There Was No Loss Of Nominal Value

1. McCullough Trust: Surcharge Barred Where Nominal Value Of Trust Increased (Modestly) Over 63 Years

In McCullough Trust, 21 Fiduciary Reporter 2d .135 (O. C. Allegheny 2001) the

nominal value of the trust increased modestly over 63 years. The value was $25,189.60 in July of 1935. In 1998 the distribution to the remainder beneficiaries was $70,977.32. During the 63 year life of the trust there had been $97,003.82 in income distributions and fees. The Court held that since the nominal value of the trust had increased, there was no basis for surcharge. Prior decisions limited surcharge to circumstances where there was a "depreciation in the value of principal resulting from the breach of duty," citing In re Mendenhall, 398 A.2d 951, 954 (Pa. 1979) and Killey Trust, 29 Fiduciary Rep. 437 (O.C. Phila. 1979). Additional factors were laches (remainder beneficiaries had obtained information on the trust assets in 1968 but failed to object, witnesses had died, etc.) and acquiescence by the income beneficiaries in the investment program.

2. Estate of Scharlach: Appreciation Damages Allowed On 50% of Portfolio Due To Express Obligation To Invest In Equities

In Estate of Scharlach, 809 A.2d 376 (PA Super. 2002), the Orphans court at trust

inception had discussed a 50% allocation to stocks. However, the trustee failed to diversify for 8 years, investing only in bonds. There was no loss in the nominal value of the trust. However, the court allowed damages based on what the trust should have earned on a 50% allocation to stocks during the 8 years.

3. Pitt v. First Union Nat’l Bank: Surcharge Barred Where Trust Value Increased From $122,000 to $518,073 During 93 Years

In Pitt v. First Union Nat’l Bank, 262 F. Supp. 2d 593 (D. Md. 2003), a 1907 trust had been funded with $122,000, and was worth $518,073 at closing in 2000. The court followed McCullough, supra, denying surcharge on summary judgment based on the fact that the nominal amount of the 1907 trust had increased in value.

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4. Williams v. J.P. Morgan & Co.: Surcharge Allowed Where Portfolio Was Invested Exclusively In Bonds for 30 Years

In Williams v. J.P. Morgan & Co., 296 F. Supp. 2d 453 (SDNY 2003) is the

latest decision in a surcharge action involving the placement of funds in a New York trust account in anticipation of a treaty which would have taxed Brazilian citizens on income earned in foreign accounts. The accounts were invested in tax exempt bonds as a means of avoiding potential reporting of income and possible taxation in Brazil. The treaty was never enacted. However the trustee failed to change the investments so that there was only miniscule growth between 1971 and 2001 when the beneficiaries objected. The trustee defended, seeking summary judgment on the grounds that there had been no nominal loss in value, although the account grew only $10,000 between 1975 and 2001. Plaintiffs alleged that it had lost 70% of its purchasing power during the period. The court rejected the argument of the trustee regarding no loss of nominal damages: “[U]nder Morgan’s reasoning, as long as the trust suffered no diminution of principal, merely breaking even would always immunize the trustee from claims for breach of fiduciary duty. Consequently, simply by insulating principal from any prospect of loss, the trustee would be under no obligation to exert any effort to improve the value of the trust and would risk no exposure to liability for absence of long term performance of the account. Such a constrained, categorical result cannot be correct.” 296 F. Supp. 2d 453 at 457.

B. Underperformance Is Not Necessarily A Breach

Since the test under the Third Restatement and the Uniform Prudent Investor Act is the overall investment plan and its suitability given the risk and return needs of the trust, liability should not be assessed merely because a properly constructed portfolio did not obtain the highest performance obtained by other trusts or indices. A number of cases have denied liability and rejected damages where a reasonable portfolio nonetheless underperformed some benchmark. In Matter of Jakobson Trust, (Surr. 1997), 662 N.Y.S.2d 360, the Surrogate denied a requested surcharge of a trustee for keeping 24.5% of the corpus in a single security. “The test is prudence, not performance, and mere inferior investment performance cannot be the basis for a finding of imprudence (Matter of Janes, supra)." 662 N.Y.S. 2d at 362. In Helman v. Meendelson, 769 A.2d 1025 (Md. App. 2001, the court dealt with a surcharge action where the sale of a closely held business resulted in proceeds which grew from $420,000 to $20 million during the time in question. “Although the AGM Trust might have generated greater growth if the trustees had chosen different investments, we cannot say that they were acting imprudently or only for the benefit of the income beneficiary....” In Trusts of Kuo Ching, 717 N.Y.S. 2d 512 (App. Div. 2000) the court affirmed a denial of a surcharge. “Although it might appear with the benefit of hindsight, that the assets of the subject trusts might have been more profitably invested by the petitioner, ‘a

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mere error of investment judgment [does not] mandate a surcharge. Our courts do not demand investment infallibility, nor hold a trustee to prescience in investment decisions’ (Matter of the Accounting of the Bank of New York, as Trustee of Discretionary Common Trust Fund ‘E’ ...35 N.Y. 2d 512, 323 N.E.2d 70.”

C. Loss Plus Interest

In some cases, the damages allowed on an investment breach may be loss plus interest. The flexibility of the equity court to fashion a measure appropriate to the circumstances is emphasized in the new investment provisions of the Restatement. Comment f to Restatement Third of Trusts §211 notes:

“If the period during which the trustee has failed to make investments is not significantly prolonged, at least if the trustee is not guilty of bad faith or other serious misconduct, it would ordinarily be an appropriate exercise of equitable discretion to measure the performance of proper trust investments only by applying a suitable rate of interest, based on the income yields of investments of generally comparable trusts. In such a case the court would not look to a total return figure; that is, damages would not take account of capital gain or appreciation, nor of losses in value, that might have resulted in a suitable trust portfolio from general changes in stock and bond values in the security market. This approach would be particularly justified in such cases if a recovery based on some representative measure of total return performance of trusts appears highly speculative.” (Emphasis added). In Matter of Estate of Janes, (1997) 90 N.Y. 41, 659 N.Y.S.2d 165 (discussed

above), the New York Court of Appeals assessed damages based on the value of the Kodak stock that should have been diversified plus interest (less the dividends which had been received).

In In re Estate of Saxton (NY Sur. 1998) 696 N.Y.S.2d 573, aff'd 274 A.D. 2d 110, 712 N.Y.S.2d 225(2000) (discussed above), the court held that the measure of damages on failure to diversify IBM stock should have "computed interest on the full value of the stock at the time when it should have been sold and then deducted the value of the stock when actually distributed, as well as the dividends and other income attributable to the retained stock." 712 N.Y.S.2d at 233. see Dumont, supra.

Matter of Estate of Rowe (2000) 274 A.D. 2d 87, 712 N.Y.S.2d 662 also involved IBM stock. The court surcharged the trustee, awarding compound interest to the value of the stock, then deducting the value at the close of the account or at the time of sales, as well as dividends received.

In Testamentary Trust of Hamm, 707 N.E. 2d 524 (Ohio App. 1997) Court stated that a trial court had discretion over the rate of interest, and could select "the legal rate, at the usual rate of return on trust investments or at some other rate considered to be equitable and fair..." 707 N.W. 2d at 530. It held that "generally, however, the trustee is

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charged only with interest at the usual rate of return for trust investments and not the legal rate, absent a showing of willful misconduct or breach of the duty of loyalty." Ibid. It further held that "interest in these cases is simple, rather than compound, unless there is a showing of intentional misconduct or bad faith." Ibid.

D. Disgorgement of Profit By Trustee

The object of damages awards is twofold: first, to compensate for losses sustained as a result of the breach and second, to induce trustees to comply with their obligations by making them disgorge any profit they have made or by imposing a penalty on them. Restatement (Third) of Trusts '205. Frachter, Scott on Trusts '205; Redke v. Silvertrust, 6 Cal.3d 94, 107(1971).

In Coster v. Crookham, 468 NW2d 802, 806 (Ia, 1991) the trustee was

surcharged for all of the profit obtained by the use of trust funds to purchase stock for the trustee personally.

In Bartelt v. Bartelt, 522 So.2d 907, 908 (Fla. App. 1988), where the fiduciary

estate contributed 40% of the investment, it was entitled to recover 40% of the net profits after return of the invested capital.

Where the trustee has borrowed trust funds, the profits improperly garnered by

the trustee may be disgorged, less the interest paid to the trust on the loan. Estate of Stowell, 595 A2d 1022, 1026 (Me. 1991).

In Nickel v. Bank of America, 290 F.3d 1134 (9th Cir. 2002), the Court reversed a trial court decision (991 F. Supp. 1175 (N.D. Cal. 1997)) holding that the proper remedy for overcharges in trusts containing fixed fee provisions was simple interest. On appeal the Court held that disgorgement was the proper remedy, in light of the fact that a breach of the duty of loyalty was involved.

Bank of America settled the Nickel case after the trial court, on remand, ruled on the methodology for determining how damages are to be calculated with respect to the “disgorgement of profit” alternative contained in Restatement, Second, of Trusts §205. The case settled for a reported $33 million dollars. The trial Court held that return on equity was the appropriate methodology, thus increasing damages where the bank was leveraged, rejecting a return on money available to lend (return on assets); partially allowed deduction of taxes, as discussed below; rejected the deduction of dividends in calculating profits, and limited the period of damages. The trial court on remand concluded: “As courts have explained, disgorgement in the trust context is intended merely to ‘make sure that the fiduciary is not allowed to keep any ill-gotten profits.’ Courts therefore reject disgorgement awards that exceed the amounts actually retained by the defendant. See, e.g., Hateley v. S.E.C., 8 F.3d 653, 655 (9th Cir. 1993) (reversing an order of disgorgement that required defendant to pay the ‘total amount of [unlawful] commissions that were generated’ rather than the “amount of

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commissions … actually retained”); Litton Indus., Inc. v. Lehman Bros. Kuhn Loeb. Inc., 734 F. Supp. 1071, 1077 (S.D.N.Y. 1990) (holding that requiring ‘disgorgement of all fees and commissions without permitting a reduction for associated expenses and costs constitutes a penalty assessment and goes beyond the restitutionary purpose of the disgorgement doctrine’). The Ninth Circuit in Nickel itself made this point forcefully when it stated: “If the banks had taken the overcharges and thrown the money out the window, there would be no causation, and, if the banks could prove they had done this, the plaintiff would lose.” Nickel v. Bank of America 290 F.3d 1134, at 1138. “It follows, then, that sums not retained as profits or used to make profits must be deducted from revenues in order to determine the proper amount of disgorgement. California courts have long-recognized this in formulating remedies for breach of trust. See, e.g., Savage v. Mayer, 33 Cal. 2d 548 (1949) (affirming judgment requiring trustee who charged beneficiary a higher price for stock than the trustee paid to refund an amount equal to the actual value of the stock less the actual purchase price); Edgar, 50 Cal. App. 2d at 836 (rejecting testimony concerning rental value of land sold in violation of trust because ‘[t]hey were basing their value mainly upon the peculiar situation of this particular land and the gross value of crops produced thereon …, without considering the cost of production, planting, harvesting and sacks, and without considering the personal element of skill, industry and management’). This necessarily entails, among other things, that expenses such as state and federal income taxes that reduced the banks profits must be taken into account when determining the bank’s profits. See, e.g., Weiss v. Weiss, 984 F. Supp. 675, 677-78 (S.D.N.Y. 1997) (holding that disgorgement of trustee’s profits earned from stock dividends should include a credit in defendant’s favor for any taxes paid on those dividends); Tegtmeyer v. Tegtmeyer, 40 N.E. 2d 767, 769 (Ill. App. 1942) (profits disgorged reduced by taxes and costs).”

As a result, the conceptually correct way to calculate disgorgement takes taxes into account in three separate places.

First, there is the fee overcharge itself. If the overcharge was $100, but $40 went to the government as taxes, then only $60 remains in the bank’s hands as “ill-gotten” profit from the breach of trust. Second (assuming no continuing overcharge for simplicity’s sake), the profit generated in the next year from the overcharge should be measured as $60 times the profit rate, not $100 by the profit rate, since only $60 remained in the bank’s hands to generate profit. Third, the profit rate should be measured by the total after-tax net income generated by loans and investments, divided by the total assets available to loan or invest. This is because the revenue generated by the $60 is subject to tax, and the bank retains only the amount left after taxes. Thus, in many cases, disgorgement under section California Probate Code Section 16440(a)(2) should be less than reimbursement with interest under section 16440(a)(1).

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That is not to say, of course, that if plaintiffs establish liability they might not be made whole. Rather, under section 16440(a)(1), the trusts would, at a minimum, be entitled to repayment of the overcharge plus interest. Disgorgement comes into play if repayment of the loss with interest would leave the bank with ill-gotten profits still in its coffers. But plaintiffs cannot get more than the bank actually retains under the guise of seeking disgorgement. If loss with interest is greater than disgorgement, then loss with interest is the appropriate remedy. On remand the trial court ignored the first two calculations and used only the third, thus magnifying the measure of profits calculated. It held that the money received as overcharges was repaid, and thus represented damages. Since damages would be calculated without reference to the taxes paid by the trustee on their receipt, it rejected consideration of the taxes paid by the trustee in calculating its profit.

E. What the Trust Would Have Earned But For The Breach

1) Meyer v. Berkshire Life Insurance Company: Courts May Estimate Damages. Damages Were Awarded On The Basis Of What A Moderate Risk Portfolio Would Have Returned

Meyer v. Berkshire Life Insurance Company, 250 f. Supp.2d 544 (D. Md. 2003)

dealt with pension plans that had been subjected to churning and to inappropriate investment selections. The court found that “while awards may not be speculative, see, e.g., Carras v. Burns, 516 F. 2d 251, 259 (4th Cir. 1975), the court may approximate the extent of damages. See, e.g., Martin v. Feilen, 965 F.2d [660, 8th Cir. 1992] at 672 (citing Story Parchment co. v Paterson Parchment Paper Co., 282 U.S. 555, 563, 51 S.Ct. 248, 75 L. Ed. 544(1931)).” 250 F. Supp.2d at 572. The court awarded damages based on what an appropriate portfolio based on moderate risk tolerance would have returned during the period of time, based on expert opinion.

2) California Ironworkers: Damages Allowed On What The Trust Would Have Earned If The Excessive Investments In Inverse Floaters Had Been Invested In Appropriate Fixed Income Securities, Measured By A Benchmark.

In California Ironworkers Field Pension Trust v. Loomis Sayles & Co., 259 F.3d

1036 (9th Cir. 2001) the court affirmed a finding that the investment advisor to a pension trust imprudently invested too large a portion of the assets in inverse floaters, and approved the trial court’s use of a benchmark yield for fixed income securities to calculate damages. “It would be extremely difficult to arrive at even an approximate calculation of the yields which reasonably could have been expected from different portions of the portfolio assuming appropriate investment. When precise calculations are impractical, trial courts are permitted significant leeway in calculating a reasonable approximation of the damages suffered. See Sutton v. Earles, 26 F. 3d 903, 918 (9th Cir. 1994).”

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3) Noggle v. Bank of America: The Appropriate Measure Of Appreciation Was The Corporate Trustee’s Common Equity Trust Fund, Not An Objective Market Criteria Such As The S&P 500 Index.

In Noggle v. Bank of America, 70 CA4th 853 (Cal. App. 1999) the court of

appeals affirmed a decision surcharging the trustee for investing primarily in bonds, in violation of its duty of impartiality.

Since 1984 California has followed a portfolio investment model. The

beneficiaries argued that they were "entitled to appreciation damages based upon objective market criteria" i.e. an S&P 500 type of measure. The trial court disagreed, holding that the "most accurate rate of appreciation for the determination of...damages… would be the rate of appreciation experienced[d] by the common equity funds utilized by the [B]ank." The Court on appeal found that it was "undisputed that whatever portion of the trust estates that should have been invested in assets that would have benefited the remaindermen over their parents would have been invested in the Bank's common equity trust fund. It follows that it was appropriate for the probate court to approve the referee's calculation of damages based on the amount the trusts actually would have earned."

4) Scalp & Blade: Where The Breach Involves Deliberate Self-dealing, An Overall Market Index May Be An Appropriate Measure Of Damages.

In Scalp & Blade Inc. and Scalp & Blade Scholarship Association v. Advest, Inc. 765 N.Y.S. 2d 92 ( App. Div. Oct. 2, 2003) the court reversed a jury instruction which denied a trust the right to collect appreciation damages based on a market index. The defendants included an advisor to the board of a charitable trust who also served as a trustee. The claims included churning and other inappropriate investments. The trial court had relied on Matter of Janes, 90 N.Y. 2d 41, 681 N.E. 2d 332 for such denial. The Court held that Janes dealt with mere investment negligence and did not reject the application of appreciation damages where the fiduciary’s misconduct consisted of deliberate self-dealing and faithless transfers of trust property. 765 N.Y.S. 2d at 99. The Court held that in a case “involving claims of churning, investment unsuitability, or other acts of unauthorized trading by defendants, an appropriate measure of damages in plaintiffs’ ‘gross economic loss, adjusted for the overall market’s performance.’” 765 N.Y.S.2d at 100.

5) Other Cases In Account of Beiny, 2003 WL 21729779 (N.Y. Surr. 2003), a trustee was surcharged for the present value of assets which had been diverted into Lichtenstein accounts in any effort to shift money to one sibling in violation of the terms of the trust. In Toussaint v. James, 2003 WL 21738974, (S.D. N.Y. 2003), the trustees of a pension plan sued their attorneys and predecessor trustees for investing primarily in fixed income securities. The court held that the proper measure of damages was what the trust

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would have earned but for the breach of trust. The court noted that “a pure heart and an empty head” are not enough to avoid liability for a duty to diversify. Summary judgment was denied where there was a question about whether the lay trustees should have obtained expert assistance in investing at least a portion of the trust.

In Brown v. Schwegmann, 861 So.2d 862 (La. App. 2004), the Court on appeal found that the trustee had breached his duties as trustee in investing the trust primarily in the family business, by diverting trust income to a partnership from which he personally obtained loans and financial benefit, and by investing in the partnership when it began to fail and ultimately went into bankruptcy. The court noted with respect to the investment in the family grocery business:

“Although investing solely in the family business may have been wise

during the senior Schwegmann’s prosperous administration of the business, as the business declined in financial strength such a plan ceased being prudent management of trust funds. Clearly, after the partnership began declining in value in 1996, investing the trust property solely in the family business was not prudent—particularly by a trustee with appellee’s specialized knowledge of financial health of the Schwegmann companies—or designed to protect and preserve the trust property in the interest of the beneficiary.”

861 So.2d at 869. The matter was remanded for calculation of damages based on the alternative measures contained in La. Rev. Stat. 9:2201, which is patterned on Restatement Second of Trusts §205. Sims v. Heath, 577 S.E. 2d 789 (Ct. App. Ga, Nov. 22, 2002), affirmed a jury award against executors of $1,000,781 in compensatory damages and remitted $404,633 in punitive damages to $250,000. Liability was based on delays in selling estate property which deprived the plaintiff of any income on her inheritance. Damages were assessed per OCGA § 53-12-193(a)(3): “[a]ny amount that would reasonably have accrued to the trust or beneficiary if there had been no breach of trust with interest.” Georgia did not adopt the Uniform Prudent Investor Act, but did adopt a portfolio investment model similar to that of California’s prudent man rule. The damage statute quoted is based on Restatement Third of Trusts §205. IV. Investment Selection The term “risk and return objectives” mentioned in the UPIA comes from modern portfolio theory, which posits that an investor must be willing to undertake greater risk or volatility to gain greater returns. The premise is that markets (such as the large capitalization segment of the U.S. stock exchanges) are efficient to some degree, in that information about a stock is quickly translated into prices that reflects the present value of future revenue streams. Larry Harris, Trading & Exchanges: Market Microstructures for Practitioners, Oxford University Press (2003) at p. 240. The movement of stocks is

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frequently described as a random walk, implying that it is futile to predict an asset’s future price. Hence when the UPIA Section 8 directs fiduciaries to minimize expenses, should they merely resort to passive investment in an S&P 500 index or exchange traded fund, since it serves as a surrogate for the whole market? Alternatively, should they only use passive strategies for all asset classes, rather than actively manage through mutual funds or advisors? As shown in D. Campisi and P. Collins, “Index Returns as a Measure of Damages in Fiduciary Surcharge Cases”, 140 Trusts & Estates 18 (June, 2001), index funds are not efficient in many markets. Moreover, asset allocation studies show that choosing multiple asset classes provides superior returns and less volatility than reliance on the S&P 500 index. Hence, active management can be appropriately used.

Of course, if no one were any good at selecting investments it would be unnecessary to delegate that function and imprudent to pay extra for it. But recent studies suggest people can profit even in an efficient market, in part because there is always someone who must sell or buy something for external reasons, such as a need for liquidity. “Those investors are willing to ‘pay up’ for the privilege of executing their trades immediately,” allowing the efficient trader to find a counterpart for a profitable trade. Didier Sornette, Why Stock Markets Crash (Princeton University Press 2003) at 48. Moreover, people sometimes “trade on what they think is information but is in fact merely noise.”Ibid. Such people may be misled by their brokers or friends, or simply have a delusional confidence in their investment abilities.

Moreover, recent analyses show that markets are, at best, only somewhat

efficient. Harris at 240. Since it takes time for information to filter out to traders, and since efficient traders attempt to mask their trades so that their insights are not poached by others, there is a time lag before even public information is disseminated and translated into price. Moreover, how efficiently stocks are priced “depends on the costs of acquiring information, and how much liquidity is available to informed traders.”Id. at 243. These recent analyses suggest there is a need for specialists with the funding and incentives to look for information and the execution skills to act on such information. Whether it is the specialty trader in an illiquid and opaque emerging market or a hedge fund operator with the megacomputer necessary to uncover and exploit pricing anomalies, there is an opportunity to utilize such skills if the trustee has the assets and risk and return characteristics to take advantage of them. Such experts can spread the cost of information gathering, so that they can provide it to fiduciaries at a fraction of the cost which the non-specialist would otherwise pay.

A. Asset Allocation

Asset allocation studies point to empirical evidence that investment in diverse asset classes can provide superior returns and reduce the volatility of a given portfolio. In one classic study, Roger Gibson, Asset Allocation: Balancing Financial Risk (McGraw Hill, 2000) at 163,1 compared the returns of portfolios composed of single investments in either the S&P 500, the EAFE Index which is a sampling of common stocks in 20 European and Pacific Basin countries, the National Association of Real Estate Investment Trusts Equity Index, or the Goldman Sachs Commodity Index from 1972 through 1997.

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It compared single index portfolios with all possible combinations of the four market sectors. The investments in single markets had lower returns and higher volatility, including much worse performance in certain bad markets when compared to portfolios containing equal weights of all four sectors.

“The four-asset-class portfolio has a compound rate of return 1.2 percentage points higher than the average compound returns of its components. That is, a $1 investment in a continuously rebalanced portfolio of all four components has a future value of $31.89 compared with an average future value of $25.18 for the four components standing alone. The four-asset-class portfolio has 47 percent less volatility than the average volatility levels of its components. Also, the Sharpe ration of the four-asset-class portfolio shows that it has generated nearly twice as much volatility-adjusted return as the average of its components.” The task of asset allocation can result in a major component of the total return of a trust’s investments. A comprehensive study by Roger Ibbotson and Paul Kaplan of the returns of 91 balanced mutual funds over the 10 years ending in March of 1998 and 58 pension plans for a five-year period ending in 1997, found that 40 percent of the difference in returns among the various funds reflected asset allocations against benchmark indices. Sixty percent, the study reported, reflected the “manager’s ability to actively over- or underweight asset classes and securities relative to the [asset allocation] policy and on the magnitude and timing of those bids.” R. Ibbotson and P. Kaplan, “Does Asset Allocation Policy explain 40, 90 or 100 Percent of Performance?” (2000) at 27. This can be located at Ibbotson.com. A shorter version can be found at pages 121-126 of Ibbotson Associates, Stocks, Bonds, Bills, and Inflation, 2004 Yearbook.

The study clarifies earlier studies of Gary Brinson and colleagues reporting that 90 percent of variability of certain pension plan performance over time was the result of asset allocation policy. Thousands of professionals have misinterpreted and incorrectly cited these studies results, leading them to erroneously conclude that active management accounted for only a tiny fraction of portfolio performance at best. John Nuttall, “The Importance of Asset Allocation,” which can be found at http://publish.uwo.ca/~jnuttall/.

In fact the Brinson studies dealt with the returns over time of individual pension plans and did not measure the performance differences among the various funds. Those studies showed that if a manager started out with one allocation, variance in the weightings over time explained 90 percent of the variance.

A problem with constructing a portfolio is that various investment classes can

perform well and poorly within a year or two. A review of the Callan Periodic Table of Investment Returns from 1983 through 2003 shows that the best performers constantly change. From 1995 through 1996, the Barra S&P500 Growth index was the top sector in performance, it was second in 1999, sixth in 2000, and fifth from 2001-2003.. The Lehman Brothers Bond index lagged in performance, ranking 7th in 1995, 8th in 1996, 7th in 1997, 5th in 1998, 7th in 1999, and then 2nd best in 2000 and 2001. The bond index ranked first in 2002 and last in 2003. The Russell 2000 Value index moved from 6th to

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4th to 3rd, was last in performance in 1998 and 1999, and best in 2000 and 2001, then 4th in 2002 and second in 2003. Callan Periodic Table of Investment Returns. A trustee to be prudent must evaluate whether to invest in various asset classes, based on the size of the trust, its terms, its liquidity needs, and its beneficiaries’ risk tolerance and time horizons. This task is difficult and significant—so that to be truly prudent trustees need to evaluate their own abilities, then delegate to other managers when they cannot adequately perform some or all investment functions. Real estate or REIT’s or entities holding real estate can provide a useful diversification in a portfolio. “Because the real estate market is composed of noninterchangeable, unique, nonliquid properties, it is probably less efficient than the stock and bond markets. This inefficiency may give rise to exploitable opportunities for skilled investors to secure superior investment results. At the same time, however, the search and transaction costs involved with real estate investments are often high relative to other investment alternatives.” R. Gibson, ASSET ALLOCATION (3rd Ed. McGraw Hill, 2000) at 157.

Gibson analyzed the impact of adding real estate investment to other asset classes. As discussed above, a portfolio with 4 asset classes, including REIT’s, had a higher return and lower volatility, with better performance in bad years, than single asset portfolios. Gibson computed the Cross-correlation of Equity REIT’s with other asset classes for the period 1973 through 1994. The correlation between the REIT’s and other asset groups were as follows: US Treasury Bills, -.09; Long term corporate bonds, .27; International bonds, .13; large company stocks, .65; small company stocks, .75; International stocks, .41. Op. Cit. at 182-183. Hence adding real estate to portfolios including these other classes provided reduced volatility. Gibson determined that holding more than 30% in REIT’s reduced performance of the portfolio “slowly at first and then at a faster rate.” He found that using REIT’s with a weighting between 15 and 30% provided an efficient allocation. Op. Cit. at 192-195. REIT’s, of course, are more readily traded than other entities holding real estate and more liquid than ownership of the property itself. However, the analysis should provide some insight as to proper weightings. A single parcel or entity with several parcels may have very different volatility and return characteristics that a diversified group of equity REIT’s, much as you might get a different return on hotel REIT’s as compared to a diversified portfolio.

The idiosyncratic risk is, of course, a crucial difference. A single parcel or group of properties linked by region or productive use (farm, factory, timber, apartments etc.) may face a catastrophic earthquake, hurricanes, tornado’s, toxics, changes in land use permits, elections of actors as governors, changes in demand and so forth, resulting in major losses of income and principal value. Hence care must be taken to evaluate and insure against the applicable risks or to obtain court approval for the investment after disclosing the risks involved.

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A 2001 study by Ibbotson for the NAREIT demonstrated that REIT stocks were useful tools for asset allocation because of low correlations with other asset classes. Inclusion of REIT’s increased total return and lowered volatility. Given the large distributions made from such REIT’s, one can understand the effect on volatility in markets where the value of stocks is falling. In some sense these securities buffer the portfolio in the same way as bonds. The correlations with bonds, however, are relatively low, providing additional rationale for their inclusion in a portfolio. The REIT index had a .32 correlation with the Wilshire 5000, .18 with the NASD composite, .29 with the S&P 500, and .46 with the Russell 2000. The study can be found on the NAREIT website.

A 2003 Study by J. Thompson, Jr. of Ibbotson, “Real Estate in a Robust Portfolio,” showed that adding REITs to a portfolio, between 1972 and 2002, increased the total return (from a geometric mean of 10.17 to 10.65) and reduced the volatility (standard deviation went from 11.53% to 11.01%). The study compared allocations of 50% stocks, 40% bonds and 10% cash with 40% stocks, 30% bonds, 10% cash and 20% REITs . Between 1992 and 2002, the study methodology increased the geometric mean total return from 9.22% to 9.56% and reduced the standard deviation from 11.70 to 9.76.

The office of the treasurer of the University of California in a March, 2003 study found that allocations of between 5%-9% to direct real estate investments or REITs produced better returns and reduced volatility. It found that over the ten year period ending 12/31/2002, the NCREIF index enjoyed returns of approximately 9% with standard deviation of 3.2%. Timberland enjoyed a 10% return and a standard deviation of 8%. The NAREIT index topped 10% return and a standard deviation of approximately 15. It similarly found low correlations with other investments (NCREIF had correlations of .17 for the S&P 500, .15 for the Russel 3000, .29 for the S&P Utilities index, and .21 with timberland. The Special Real Estate Issue of The Journal of Portfolio Management in September of 2003 provides a variety of scholarly studies evaluating the use of direct investments in real estate and REIT’s in asset allocations. All of these studies dealt with diversified real estate portfolios, whether in direct investments or through REITs. The 5 to 9% allocation to real estate involved in the University of California study seems supported by the recent studies.

When a single property is included as a major portion of a fiduciary portfolio, the idiosyncratic risks are large. Properties can fall in value as many did in the 1990-1991 period of real estate rescession. Toxics, earthquakes, floods, hurricanes, Al Quida, forest fires, and other uninsurable risks can destroy the value of a real estate investment. A single tenant can go bankrupt. A strawberry warehouse can remain cool and empty if there is a market shift. Your refrigerated Budweiser warehouse may stay empty if your tenant loses its franchise. The neighborhood can be blighted or gentrified to the extent that your existing use no longer is marketable. Hence care must be taken to protect the concentration by use of retention language in the instrument, court orders authorizing the concentration, and disclosures to the beneficiaries of the risks involved.

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B. Risks of Closely Held Businesses Bogert, Trusts and Trustees §676 at 56:

“In order to make such property productive, the trustee would need special business talents which are not usually possessed or reasonably to be expected. He should not engage in a trade or business. The management of land or goods as an owner involves an undue amount of risk and speculation. Furthermore, these assets are not liquid as the property of a trust should be. They cannot quickly and without much risk of sacrifice be converted into cash for distribution purposes.”

The historic rule and rulings of many judges dealt harshly with the trustee or other fiduciary who attempted to manage a business as part of a fiduciary estate. The factors stated by Bogert are typical of such decisions. More flexibility has been provided to fiduciaries in recent years, by statute and by drafting practice, but the risks remain large. The Uniform Prudent Investor Act enacted in over 42 States and the District of Columbia deals expressly with the duty to diversify and highlights the risks of placing a disproportionate amount of an estate’s assets in one entity, even a closely watched closely held business. The Restatement Third of Trusts provides the legal underpinnings of the UPIA, dealing with the duty to diversify in the context of a closely held business: “Except as otherwise provided by the terms of the trust, the trustee is ordinarily

under a duty to the beneficiaries to diversify the trust portfolio....This may require the trustee to convert investments received as a part of the trust estate even though those assets are not otherwise either improper investments for the trustee or of a type unsuitable to the trust’s investment objectives. Thus, if a trustee receives a testator’s residuary estate in trust and half of the trust estate consists of the shares of a particular corporation, the trustee is ordinarily under a duty to sell some or all of the shares and to invest the proceeds in other assets so that the trust portfolio will not, without some special justification, include an excessive amount of the securities of a single corporation or carry an unwarranted degree of uncompensated risk.”

(Emphasis added) Restatement Third of Trusts § 229, com. d at 123. Uncompensated risk is a term of art in modern portfolio theory dealing with the idiosyncratic risk associated with an individual investment, as opposed to market risk where the hidden genius of the market properly values investments based on their risk and return. Thus a diversified portfolio contains a risk which is compensated by the market pricing. A single investment has unknowable volatility (up or down) and hence cannot be properly priced for the risk, resulting in uncompensated risk which should be avoided. Since most States have adopted the UPIA (Pennsylvania and Massachusetts have not adopted the “risk and return” provision of the Act), this type of analysis underpins the evaluation of any closely held business as part of a fiduciary estate. Even though few judges have any comprehension or adherence to such theories and analysis, there are a

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multitude of experts who will appear before the surrogate or probate or chancery judge to opine about the risks of such investment (generally when the closely held business or concentrated investment has crashed, lending credence to their assessment of the risk). Hence it is of paramount importance for the fiduciary to analyze the situation of the concentrated or closely held business investment and to document the steps taken to determine that the risk was appropriate, that the trustee properly managed the asset as a prudent fiduciary would, that the authorizations for the holding of such assets were sufficient, and that discretion was exercised in an appropriate fashion. Closely held assets also pose a number of other problems not encountered in typical trust investment portfolios based on securities, debt instruments and the occasional house. Management of a business leads to obligations to minority shareholders, to beneficiaries who expect fiduciary conduct rather than business judgments, difficulties in sale of assets, and liabilities to third parties who may be injured by the products or processes which create them. You can not only lose the value of the investment, but the other trust assets and the assets of the trustee may be liable for liabilities which would never be faced by the trustee holding a stock or bond from a publicly traded entity in the same line of business. As noted in the Restatement, “The trustee’s duty of impartiality is not to be overlooked in these matters. (See §227, Comment I) It usually presents income productivity considerations that were not of concern during the settlor’s lifetime. And in some of these situations, the duty will require a difficult balancing or accommodation of significant differences that may exist in the needs or objectives of different beneficiaries.” Restatement Third of Trusts §229 com. d at 123-124. Hence, in addition to the risk associated with an illiquid and closely held business, the trustee must continually examine whether the rewards available to the income and remaindermen are appropriate. The business might have met the settlor’s need of building a valuable asset or meeting extraordinary income requirements, but these same requirements may not be shared by the various classes of beneficiaries. Where beneficiaries serve as employees or directors of closely held businesses, the problems of meeting the duty of impartiality become quite difficult. The first generation of income beneficiaries may be content with reinvesting cash flow or profits into the company because their needs have been met by other bequests or their own compensation from the business, the next generation or the charitable beneficiary may have very different perspectives and needs. Similarly, where beneficiaries also hold shares of stock or where the assets in the trust may be taxed at their deaths, the illiquid nature of the entity and the difficulty of valuing it may pose serious problems. The younger beneficiaries may attempt to buy out their relatives’ shares at bargain prices or find their own shares crushed by sales or repurchases financed by the trust or the entity. Particularly in partnership or Subchapter

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S situations, resolving estate tax liability can place the trustee in difficult situations where they cannot reasonably balance the interests of the various beneficiaries.

1. Authorizations and Exculpatory provisions. a) Authorization in the trust instrument is the primary defense. However, as exculpatory clauses, these may be strictly construed. “A general authorization in an applicable statue or in the terms of the trust to retain investments received as a part of a trust estate does not ordinarily abrogate the trustee’s duty with respect to diversification or the trustee’s general duty to act with prudence in investment matters. The terms of the trust, however, may permit the trustee to retain all the investments made by the settlor, or a larger proportion of them than would otherwise be permitted.” (emphasis added) Restatement Third of Trusts §229 com. d at 125. Some recent courts have followed such retention language to protect the trustee when the concentrated investment crashed. In Atwood v Atwood, 25 P3d 936 (Ok. App. 2001) the beneficiaries sued the trustee for retaining 70-80% of the value of the trust in a single stock, AMP. Most of the stock was sold in 1998 at a substantial profit. The beneficiaries claimed that if the stock had been sold earlier, the trust would have been worth substantially more. Their expert showed a loss of present value of $440,000 and loss of future value of $1,696,000. The trustee moved for summary judgment, with its expert showing that the retention of the concentrated position prevented investment scenario’s which ranged from zero value to $150,000 less than the actual value. In the face of these disparities, the court granted summary judgment for the trustee. Usually, when there are disputed facts, summary judgment is denied. On appeal the court acknowledged that disputed facts required reversal. However, it noted that an alternative basis for granting summary judgment existed, since the trust instrument provided the trustee to “retain cash or other assets, whether or not of the kind hereinafter authorized for investment, for so long as they may deem advisable” and to invest “without being limited in the selection of investments by any statutes, rules of law, custom or usage.” It found this language significant. The beneficiaries argued that these general statements were trumped by the diversification requirements of Oklahoma’s versions of the Prudent Man standard, and then the Uniform Prudent Investor Act after 1995. The Court, however, noted that the Oklahoma statute until 1995 provided that “A trustee may retain in trust any property originally received into the trust and any substitution therefore without liability for such retention.” The trust had been created in Minnesota and then moved to Oklahoma. The Court looked to similar retention language in Minnesota statutes and then looked to In re Trusts for Hormel, 504 N.W.2d 505 (Minn. App. 1993), for the proposition that retention language dealing with original assets may mitigate the duty to diversify. It also cited the case for the proposition that where broad discretion is granted to a trustee, the court should not interfere. It held that “the Prudent Investor Rule does not make an absolute requirement that the trustee diversify.” 25 P.3d at 944. It held that in the summary judgment action the beneficiaries had failed to rebut

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the trustee’s argument that the instrument and laws authorizing retention of original assets permitted the concentrated position. Hence it affirmed the summary judgment based on this separate argument. However changing circumstances may raise the trustee’s duty to re-examine the situation where new risks or business performance require a change in the directed investment. As Section 229 of the Restatement states: “In most instances a trustee should not take a settlor’s authorization to retain ;specific investments as special justification indefinitely if retention would otherwise be imprudent, especially if an apparent purpose of the authorization become outdated by changed circumstances or passage of time.” (emphasis added) Restatement Third of Trusts at 125. Reliance on a general statute to support operation of a closely held business faces the same problem: if circumstances change, the trustee may have an obligation to re-evaluate the investment and diversify. Hence relying on authorization in Uniform Trustee Powers Act §3(c) (3) may work for several years after inception, but the trustee still retains the duty to evaluate the investment as the prudence of the investment is undercut by its performance, by changes in the economy, or changes in the needs or risk tolerance of beneficiaries who value their personal security and financial well being more than grandpa’s company. .See, Estate of Saxton.(App. Div. 2000) 712 N.Y.S.2d 225. b) Authorization by beneficiaries. The trustee, often urged by beneficiaries who wish to retain their ancestor’s company (or their sinecures as officers of the company), may accept agreements by the beneficiaries to authorize the imprudent concentration. In Walton Trust, 23 Fiduc. Rep. 2d 365 (Orphans Ct. 2003), the court rejected a surcharge claim against the trustee for investing the trust in favor of the remaindermen at the expense of the income beneficiary. The income beneficiary’s heir sued following her death, claiming that an allocation of 72% to equities and 26% to bonds (2% to cash) unfairly penalized the income beneficiary (and her heir). The Court held that the annual statements, while not pellucid, disclosed the investment mix. It held that a competent beneficiary with knowledge of the “facts and of his rights” can be barred a remedy where she consents or affirms the investment strategy. “Acquiescence may be implied from the ‘failure of the beneficiary to object within a reasonable time, although aware of the facts and continually receiving benefits from the investment.” Citing Macfarlane’s Estate, 177 A. 12, 15 (Pa. 1940). No objection, other than to request diversification was made in the thirty years in which the income beneficiary received accountings with schedules showing the investments. “In light of these circumstances, Mrs. Walton’s silence, coupled with her continual acceptance of the income benefits from the trust as it was administered, can only be interpreted as acquiescence to the general investment scheme and binding upon her heirs or successor-in-interest, i.e., her nephew, Mr. Grogan. See Wilbur’s Estate, 5 A. 2d 325 (Pa. 1939).” 23 Fiduc. Rptr. at 370. In re Estate of Saxton (NY Sur. 1998) 696 N.Y.S.2d 573, aff'd 274 A.D. 2d 110, 712 N.Y.S.2d 225(2000) the will contained no restrictions on sale of the IBM stock. The income beneficiary and the remainderpersons had signed an Investment Direction

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Agreement in 1960 which "consented and directed the trustee to continue to hold the stock rather than following the normal banking procedure of diversification and additionally held the bank harmless from decreased in value of the investment." The IDA could be revoked on 30 day notice. The trustee had little contact with the remaindermen, with one receiving no communications whatsoever for 18 years. Commencing in 1982 the remainderpersons received annual reports and started meeting with trust officers in 1984. The beneficiaries began to ask that the trust be diversified out of IBM, particularly when the increase in the capital gains rate to 28% was imminent. One of the beneficiaries wrote in 1987 to request diversification, expressing their concern for the risks involved (although she later wrote to rescind her demand after being informed of the capital gains taxes that would have to paid as the price of diversification). The trustee pointed to the capital gains consequences of sale and relied on the Investment Direction Agreement. A surcharge action followed the death of the income beneficiary. The Court construed this conduct as follows:

"It is abundantly clear from anyone sitting through the trial and listening to the testimony of [trust officer], that in addition to his blind reliance upon a nearly 30 year old IDA agreement he was obsessed with the concept that the remaindermen in this trust should take the IBM stock in kind at the death of the life tenant, hold the stock for their entire life, run the stock through their own estates, permitting their heirs to pick up a stepped-up basis. He failed to take into consideration the needs or desires of the majority of the beneficiaries of this trust, he violated his own bank's policy, and seemed to have no conception in what a dangerous position he was placing his employer by not at least responding to the beneficiaries' demands with a comprehensive diversification plan." 686 N.Y.S.2d at 577.

After the initial trustee was purchased in 1992, IBM was placed on the merged institution's sell list. The income beneficiary died before any diversification was undertaken. The trustee defended against claims that IBM had fallen precipitously in the last years of the trust, pointing to the IDA, to consent and acquiescence by the beneficiaries, and to their ratification of the policy to keep 100% invested in IBM. The bank argued that the income beneficiary was content with the concentration in a single stock. The Court concluded that "A fiduciary should be entitled to rely on an investment directive from the beneficiaries in contravention of the normal policy of the bank for a reasonable period of time, or until such time that there is demonstrated disagreement among the beneficiaries, provided however that the bank does not completely abdicate its fiduciary responsibility to periodically advise the beneficiaries of time-tested formulas for protecting their investments from the inroads of a fluctuating market." 686 N.Y.S.2d 579. (emphasis added)

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The Court in Donato v. Bankboston, N.A. (D. R.I. 2000) 110 F. Supp.2d 42, dealt with a number of provisions on which the trustee relied to avoid liability for alleged imprudent concentrations in a single security. The trust in question authorized the retention of original assets. In this case, the securities were convertible debentures of CML Group. These, however, had been converted to common stock. The court noted that in some situations, "a security substituted for an original security 'as a result of a reorganization, recapitalization, or other cause' is not subject to the provisions of a retention clause," but holding that this was true only if it is "substantially the equivalent of the old" security." 110 F. Supp. 2d at 50. The court noted that the convertible debentures offered liquidation preferences, while the common stock did not. It cited Bogert, Trusts & Trustees, §682 at 126-127 (2d ed. 1982) for the proposition that "if in any material respect there has been a change in the nature of the ...risk, security, or priority, the new property ought not to be held under the [retention] authorization clause." 110 F. Supp 2d at 51. The court decided to "err on the side of caution" and hold that the retention language did not justify the holding of the common stock. The trust instrument also authorized investment in "securities not ordinarily considered appropriate for trust investments" and retention of amounts "disproportionately large for trust investments." The court held that such language should be strictly construed and that it merely absolved the trustee for "per se" imprudence in violating normal prudence standards. It cited Restatement (Third) of Trusts §228 com. g for the rule that such provisions are to be strictly construed and "do not ordinarily result in a broadening" of the prudent man standard. 110 F. Supp 2d at 49. Absent words such as "absolute" or "uncontrolled" discretion, a grant of the "broadest discretion" did not reduce the standard of review of conduct from prudence to "abuse of discretion." The trust, however, further provided that the trustee was to be exculpated except in cases of "negligence or bad faith." Hence, the court concluded that it could hold the trustee liable on a negligence standard. Poor drafting. Estate of Stralem (Surr. 1999) 695 N.Y.S.2d 274, involved an in terrorem or no contest clause, requiring the beneficiaries to accept the trustee's account. Citing legislative comments, the Court had no problem holding that such restrictions violated public policy and were void. The court cited the Commission comments to a statutory provision subjecting such clauses to extreme scrutiny: "The increasing practice of testamentary draftsmen and corporate fiduciaries in vesting in testamentary fiduciaries almost unlimited powers with a minimum of obligations, is a serious potential menace not only to the rights of a surviving spouse but of the children and other dependents of the testator and all persons interested in estates. This tendency must be curbed. The primary duties of ordinary care, diligence and prudence...and of absolute impartiality among the several beneficiaries...are of the very essence of a trust, and an impairment of these or similar obligations of a fiduciary are contrary to public policy." 695 N.Y.S. 2d at 720. The court concluded that "the common theory throughout the cases on the subject is that 'the attempted exoneration of the fiduciary for any loss, unless occasioned by

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"willful neglect or misconduct", is a nugatory provision amounting to nothing more that a waste of good white paper.'...In today's jargon such provisions are a waste of 'good computer bytes.'" 695 N.Y.S. 2d at 720. The court held the provisions void and negated any forfeiture for challenging the provisions. In Estate of Saxton, (App. Div. 2000) 712 N.Y.S.2d 225, the court upheld a surcharge of a corporate trustee for investment breaches, despite the claim that a written Investment Directive Agreement signed by all beneficiaries expressly approved holding all of the trust assets in a single stock. On appeal, the Appellate Division rejected the argument that the investment directive constituted an enforceable contract, pointing out the duty of the trustee to inform the beneficiaries of the consequences of such an agreement:

"Prior to the instrument being prepared and its subsequent distribution to respondents, not a scintilla of evidence indicates that petitioner fully apprized Saxton or respondents of the effects that their execution of the IDA would have on their legal rights or how their direction to hold the entirety of the trust's corpus in IBM stock would fall short of what would have been required of a prudent corporate trustee." 712 N.Y.S.2d 225, 231.

In Estate of Kramer, 2003 WL22889500 (Pa. Com. Pl.), the court held that an exculpatory provision in favor of the trustee was invalid in light of the fact that the trustee was a law partner of the scrivener. The Court cited Restatement (Second) of Trusts §222(3) “To the extent to which a provision relieving the trustee of liability for breaches of trust is inserted in the trust instrument as the result of an abuse by the trustee of a fiduciary or confidential relationship to the settler, such provision is ineffective.” 2003 WL 22889500 at 3. The Court held that “The mere fact that the trustee draws the trust instrument and suggests the insertion of a provision relieving the trustee of liability does not necessarily make the provision ineffective.” 2003 WL 22889500 at 4. The Court examined the factors discussed in comment d to §222 (fiduciary relationship, whether the provision is drawn by the fiduciary “or by a person acting wholly or partially on his behalf’ and whether the settler had independent advice. The Court agreed with Scott on Trusts, §222.4, “that the scrivener/fiduciary has the burden of establishing that the client realized the implications of such a clause. In this matter, we agree with the objectants that this burden was not met. It is clear the decedent was an intelligent man and a sophisticated businessman who would have read all of the provisions of his proposed will closely. …We agree with the objectants that the various standards by which a fiduciary’s conduct can be gauged are not matters of common knowledge. We would venture a guess that, other than probate practitioners and judges and professional fiduciaries, few people are conversant on the topic.” (emphasis added) 2003 WL 22889500 at 5. Hence it voided the exculpatory clause. This is one of the few decisions where the Court rules of the level of understanding of a settlor, particularly an intelligent businessman, finding that such a person would not be cognizant of the consequences of such a waiver of the standard of care. Absent proof by the trustee of the settlor’s

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understanding, and given the lack of independent advice, the court found that the trustee failed to sustain its burden of proving the validity of the provision. Exculpatory provisions are often illusory. It is much better to act prudently than find to your dismay that the authorizing provisions or agreement are void. C. Authorization by the Court. The order of the supervising probate or equity court may provide protection, but only if the facts were provided in sufficient detail so that the risks involved were fully explained. Again, where circumstances change the risk of the asset (or where other assets are utilized for distributions, increasing the concentration as in Donato), the trustee may be required to seek a reaffirmation of the order in light of the new conditions. Section 27 of the Third Restatement of Trusts (2003) provides in subsection (2) that Subject to the special rules of §§46(2) and 47, a private trust, its terms, and its administration must be for the benefit of its beneficiaries….” Comment b states:

‘The settlor of a particular trust has considerable latitude in specifying the manner in which a trust purpose is to be pursued. In order to be valid, however, administrative and other provisions must reasonably relate to a trust purpose and must not have the effect of diverting the trust’s funds or administration from that purpose in support of a purpose that does not meet the private- or charitable – purpose requirement of Subsection (1).

Restatement Third of Trusts volume 2 at 5. The comment then looks at investment or management provisions which may be invalid due to conflicts with the interests of the beneficiaries, undermining retention or non-diversification provisions:

“Further, on the possible invalidity of investment or management provisions that conflict with the interests of the beneficiaries, see J. Langbein, ‘The Uniform Prudent Investor Act and the Future of Trust Investing,’ 81 Iowa L. Rev. 641, 663-665 (1996) (discussing a variation on the facts of the Pulitzer case, supra, and also discussing an ‘objectively’ imprudent direction to retain an undiversified portfolio with no trust purpose or special beneficiary interest to justify it). Compare Uniform Trust Code §412(b) (allowing, even without changed circumstances, modification of administrative provisions that are ‘wasteful or impair the trust’s administration’) and George T. Bogert, Trusts §146 (hornbook, 6th ed. 1987) (modification ‘…due to the unwisdom of the settlor’s directions ….which he thought would be helpful but [proved] an obstacle’ to sound administration of the trust). “

Ibid. at 8. Hence restrictions on investment duties may be invalid if they harm the interest of

the current and future beneficiaries to favor the dead hand of the settlor. See Com. b. and Restatement, Second, of Trusts §167; see John H. Langbein, “Mandatory Rules in the Law of Trusts,” 98 Northwestern University Law Review 1105 (2004).

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V. Miscellaneous Decisions

A. Removal of Trustee

In Bergman v. Bergman-Davison-Webster Charitable Trust, 2004 WL 24968, (Tex. App, 2004) the Court affirmed removal of a trustee of a charitable trust holding that where hostility exists which “’does or will affect’ the trustee’s performance of his duties, then cause exists for his removal. “ citing Akin v. Dahl, 661 S.W. 2d 911, 913-914 (Tex. 1983); Lee v. Lee, 47 S.W. 3d 767, 792 (Tex. App. 2001, pet. den). The Court cited Restatement Third of Trusts §37 as additional support for the proposition that removal is appropriate where the conduct impedes the proper performance of the trust: “Additionally, the hostility to which we refer is not limited only to situations wherein the trustee’s performance is affected. It also includes those wherein it impedes the proper performance of the trust, especially if the trustee made the subject matter of the suit is at fault. Restatement (Third) of the Law of Trusts §37, comment e(1) (2003); A. Scott & W. Fratcher, The Law of Trusts §107, p. 111 (4th ed. 1987).” 2004 WL 24968 at 1. The trustee in questioned had taped trustee meetings over the objections of fellow trustees. “This act cast a chill upon the conversation of the trustees. At least one witness stated that it became ‘impossible to have a decent conversation,’ that the taping was ‘disruptive,’ and that it precluded the trustees from expressing ‘sensitive data or ideas….’ ‘You can’t express a devil’s advocate type position…because somebody will take that out of context and can be devastating to you,’ he opined.” 2004 WL 24968 at 2. The trustee allegedly pushed a scholarship for children of an employer of the trustee’s son. He also allegedly used profanity and intimidation at the meetings.

In Fleet Bank v. Probate Appeal, 2003 WL 21235439 (Conn. Super. 2003), the Superior Court approved the removal of a corporate trustee when two long-term trust officers moved to a different corporate trustee. Removal was based on Connecticut Gen. St. §45a-242(a)(4), which authorized removal where “there has been a substantial change of circumstances or removal is requested by all of the beneficiaries, the court finds that removal of the fiduciary best serves the interests of all the beneficiaries and is not inconsistent with a material purpose of the governing instrument and a suitable co-fiduciary or successor fiduciary is available.”

In Huntington Nat’l Bank v. Hicks, 2003 WL 22461815, (Mich. App. 2003), the court reversed a directed verdict in favor of trust officers who switched their employment to a second corporate trustee after a merger had engulfed their former employer. The merged bank brought suit against the trust officers for alleged misappropriation of trade secrets, breach of fiduciary duty, unjust enrichment, civil conspiracy and tortuous interference with contracts and prospective business relationships. The trust officers allegedly resigned, sent letters on the letterhead of their new employer to former customers, informing them of their new affiliation. Many of the trust customers allegedly transferred the accounts to the new bank. At trial, the court granted a directed verdict, taking the case from the jury. On appeal, the court held that the directed verdict had been

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improper, since it did not review the evidence in the light most favorable to the plaintiff. Given the fact that 77 accounts left the newly merged bank in the two and a half months after the departure of the former trust officers, the court held that this provided evidence of cause and effect (in light of an attrition rate of 3% under normal circumstances), making a directed verdict improper.

B. Liability of Trustee for Distributions While Claim Pending

In Arluk Medical Center Industrial Group, Inc. v. Dobler, 116 Cal. App. 4th 1324, 11 Cal.Rptr. 3d 194 (Cal. App. 2004), the court denied a claim by a creditor that the trustee was liable to it for distributions made during the pendency of its litigation against the deceased settlor of the revocable trust. California had reacted to the problem faced by the trustee of a trust when the extent of a deceased settlor’s liabilities to third parties may not be known. The legislature provided an optional procedure, similar to a notice to creditors in a probate, to provide notice to the deceased settlor’s creditors and require claims to be filed within a 120 days period from notice. Here the trustee did not avail himself of this procedure. The claimant, after finally obtaining a judgment, found that the trust had distributed its assets pursuant to its terms. The Court rejected the argument that the trustee acted at its own risk when he declined to exercise the notice procedure. Under the claims provision, if no notice was provided, a subsequent judgment creditor against the deceased settlor could seek to satisfy its judgment against distributes. 116 Cal. App. 4th at 1333-34, 11 Cal. Rptr 2d at 199. The Court denied the claim by the judgment creditor against the trustee. “There is simply no authority, either in statute or the common law, for imposing such a duty on a trustee. The statutes governing trustee duties make clear that a trustee ‘has a duty to administer the trust solely in the interest of the [trust’s] beneficiaries.” ([Cal. Prob. C. ]§16002, subd. (a), italics added.) Nothing in the statutory scheme governing trusts, either expressly or implicitly, establishes a competing duty to withhold otherwise authorized distribution to beneficiaries to preserve trust assets in favor of a third party with a disputed claim.” 116 Cal. App.4th at 1335, 11 Cal. Rptr. At 201.

C. Trustee Fees

In In re W.W. Smith Charitable Trust, 2003 WL 22862665 (Pa. Super. 2003), the Court affirmed additional trustee fees for the corporate trustee of a charitable trust following a merger. The prior trustee had liquidated the concentrated stock in the initial portfolio, resulting in an increase in value in the trust from $50, 741,301 in 1976 to $179,576,657 in 2000. Under the prior compensation scheme, known as the Taxis Rule, where the trustee was required to invest primarily in bonds, compensation was based on income, lest the fees erode the fixed income investment portfolio. Ibid. at 3. The newly merged trustee sought fees based on principal, arguing that its services were of an extraordinary nature and seeking back compensation. The Court held that “A party seeking to modify a compensation agreement in a trust instrument need only show either the circumstances were beyond the original contemplation of the parties or that there is no other capable corporate fiduciary” citing Duncan Trust, 391 A. 2d 1051, 1055 (Pa., 1978). Although the trustee, in an exercise of candor or caution, admitted that it would

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be willing to continue to manage this huge trust for compensation based on income, the Court allowed compensation based on principal. “But the standard that First Union must meet is not that there exists no willing competent trustee (a subjective/anecdotal burden), but that the compensation is so low that no competent trustee (an objective standard) would be willing to serve and that the trust would be substantially impaired. First Union did demonstrate this through the evidence.” 2003 WL 22862665 at 10. The Court authorized future compensation to be increased. The logic is somewhat unclear, since First Union was willing to serve. Does this mean that the Court felt that the trustee was not competent? The decision may not provide a useful precedent to other trustees.

D. Attack of the Canaries, or Where is Elliot Spitzer When We Need Him?

After multiple settlements obtained by the SEC and New York against various mutual fund companies for, inter alia, market timing abuses, it is worthwhile to consider that market timing itself is not necessarily illegal. It may be done in violation of a prospectus restricting sales within specified periods, but the practice of frequent trades may be otherwise lawful. Several cases have enmeshed trustees of pension plans in liability claims for restricting the timing activities of participants which the plan administrator either acquiesced in or expressly authorized. Borneman v. Principal Life Insurance Co., 291 F. Supp. 2d 935 (S.D. Iowa 2003) and American National Bank and Trust Co. of Chicago v. AXA Client Solutions, LLC et al, 2004 WL 438505 (N.D. Ill.).

E. Conversion of Charitable Trust to Foundation In Brown v. Ryan, 788 N.E. 2d 1183 (Ill. App. 2003) the Court affirmed the

decision of the trial court to authorize the transfer of assets upon the termination of a charitable trust (by its terms) to a perpetual charitable foundation with the trustees as board members, rejecting the contention of the Illinois Attorney General that the assets of the trust should be distributed to charitable beneficiaries. The Attorney General argued that the expense of a foundation would reduce the distributions needlessly. The trust, by its terms, was to have been terminated in 1996. The trustees delayed for three years in terminating the trust and then sought to transfer the appreciated assets to a foundation in which the trustees would serve. The court authorized the transfer of assets to a foundation with no fixed termination date. The Court held that “Here, there is nothing in the Trust Agreement to suggest that when assets of the trust remain after 50 years, and are then distributed for a charitable purpose as directed, the corpus must be distributed to a charity with a fixed termination date.” 788 N.E. 2d at 1191. The Court rejected the allegation that the expenses of the foundation in question would exceed those which would be incurred by some other charitable organization.

F. Trustee, Don’t Sue Yourself

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The Appellate Division in In re Hunter, 775 N.Y.S. 2d 42 has reversed the Surrogate Court’s decision, In Estate of Hunter, ___N.Y.S.2d___ (N.Y. Surr. Dec. 31, 2002), 2002 WL 31941470. The surrogate court had held that objections to a final account could be raised with respect to conduct of JP Morgan, the trustee, as the executor of the settlor’s estate and conduct as co-trustee. The Court held that prior orders approving accounts were not res judicata with respect to issues which had not been clearly raised and passed on. The will in question established trusts for two grandchildren,(a) and (B), providing that if the income beneficiary of either were to die without issue or exercising a power of appointment, the remaining assets would flow into the other trust. After the death of the beneficiaries in (A) Trust, the surviving beneficiary in the (B) Trust sued the executor and co-trustee of the (A) trust for failure to diversify the estate. The Dumont case, supra, dealt with the surcharge in the A trust brought by its successor income beneficiary. The Surrogate Court had held that the trustee had the duty to disclose whether there had been compliance with the duty under Restatement (Second) of Trusts §177 , comment a, at 383: “‘The trustee is under a duty to the beneficiary to take reasonable steps to enforce any claim which [it] holds as trustee against predecessor trustees***or in the case of a testamentary trust against the executors of the estate *** to redress any breach of duty committed by them.’” Ibid. It also cited Restatement (Second) of Trusts § 223. The trustee objected to this approach, claiming that New York had only applied such rules when the predecessor was a different person or entity. The Court rejected this defense, following the rule cited in Pepper v. Zions First Nat. Bank, 801 P.2d 144 [Utah]; Matter of Zemske, 305 NW2d 755, 762 [Minnesota]l Matter of First Nat. Bank of Mansfield, 37 Ohio St. 2d 60, 307 N.E. 2d 23 [Ohio]; Matter of Estate of Winston, 99 Ill. App. 3d 278, Ill. Dec. 756, 425 N.E. 2d 973 [Illinois]. “As stated by the Supreme Court of Utah (Pepper v Zions First Nat. Bank, supra, at 153-154):

‘The policy that underlies the rule we adopt gives full effect tot he trust principle that “a trustee owes a duty to the beneficiary on taking over the property from the executor to examine the property tendered and see whether it is what which he ought to receive.” (G. Bogert, Trusts and Trustees, § 583m at 359 [rev’d 2d ed. 1980]). That duty should not be diluted on a theory that the duties of an executor and trustee are merged for res judicata purposes when one party acts in both capacities. There is no sound reason to diminish the protection the law affords beneficiaries who rely on fiduciaries for their protection.’”

2002 WL 31941470 at 4. On appeal, the Court rejected this approach since formal notice of the petitions had been given, thus requiring the heirs to object. “Far from negating application of the doctrine of res judicata, the fact that the petitioner in this case functioned in a multiplicity of roles, or ‘wore multiple hats,’ as executor and trustee, is a circumstance that, in light of the provisions of SCPA 2210(10), warrants the conclusion that the docrine of res judicata should apply with, if anything, stronger force than usual. “ 775 N.Y.S. 2d at 44. Since

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formal notice of the final account of executor had been given, the “Decrees noted above are binding on all persons over whom jurisdiction was obtained and who were afforded a full opportunity to litigate the issues embraced in those decrees, including the objectant herein….” Ibid. The objection of the beneficiary went to a high concentration of Kodak stock in the estate, claiming that the executor should have warned the heirs about the risk of maintaining a concentration of Kodak stock in the estate. That holding of Kodak stock was disclosed in the accounting presented. “Here, there is no indication that any fraud on the part of the petitioner prevented the objectant from raising any issues during the proceedings that culminated in the 1977 and 1981 Decrees.” The dissent in the appellate division argued that “However, one of the issues in this Eighth (B) trust accounting is the failure of Chase, in its separate capacity as the Eight (B) Trustee, to object to the co-executors’ acts of keeping the estate invested in Kodak stock as it precipitously declined in value. This is a separate and distinct issue, like the other raised by the objectant, addressed to Chase’s alleged failures to act in its capacity as co-trustee of the Eighth(B) Trust, which could not have been raised, and thus was not embraced in, the earlier accountings.” 775 N.Y.S. 2d at 55.

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PAYMENT METHOD: All cassette/CD orders must be prepaid in US dollars. Please check your payment option: � Visa � MasterCard � American Express/Optima � Discover � Check – Make payable to KRM. (Services provided to ABA by KRM Information Services, Inc.) Card #: Expiration

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Phone: KRM Customer Service Dept. 1-800-775-7654

ABA 2004 TRUST AND ESTATE PLANNING TELEPHONE BRIEFING SERIES

The American Bankers Association 2004 Trust and Estate Planning Telephone Briefing Series offers an easy and economical way for your staff to receive timely information on a variety of estate planning and trust administration topics. The telephone briefings are two-hour presentations featuring nationally recognized attorneys, Thomas W. Abendroth and Charles D. Fox IV, partners with the Chicago law firm Schiff Hardin LLP. For complete descriptions of the 2004 Trust Telephone Briefings, visit www.aba.com and click “Conferences/Schools.”

Selected Highlights of the ABA 2004 Trust and Estate Planning Telephone Briefing Series UPCOMING FALL TELEPHONE BRIEFINGS Special Problems in Fiduciary Income Tax (September 2) Various issues that are quite important with respect to fiduciary income tax will be discussed. This briefing will be a follow-up to the session that was done last year as a general introduction to fiduciary income tax. Planning for the Single Individual (October 7) Many of the steps that should be taken when doing lifetime and testamentary planning for a single individual will be examined in this program. This topic is becoming increasingly important especially in light of the growing number of non-marital relationships between individuals. Trust Constructions and Reformations (November 4) This session will examine the steps that can be taken when a trust is no longer fulfilling its purpose. Both charitable and non-charitable trusts will be examined to see the important considerations in the construction of provisions in a trust and when a trust can and cannot be reformed. Recent Developments (December 2) Various developments over the year 2004, with respect to the estate tax, gift tax, generation-skipping tax, and income tax and the effect of these developments on fiduciaries, trust beneficiaries, and clients and customers will be examined. AUDIOCASSETTES/CDS NOW AVAILABLE Ramifications of the Phase-Out of the Federal State Death Tax Credit The impact on planning and trust administration of the phase-out of the federal state death tax credit and the movement of many states to a decoupled or separate state death tax system will be examined.

Taxation of Charitable Entities This session will be an examination of the current rules governing the taxation of charitable entities and steps that can be taken to minimize those taxes. It will include a review of some of the important rules of private foundations, as well as split interest trusts such as charitable remainder trusts and charitable lead trusts. Planning for S Corporations and other Closely-Held Business Issues Many of the issues affecting S Corporations and how individuals can plan for trusts, estates, and other entities that hold an S Corporation will be examined. Marital Deduction Planning Basic aspects of planning for couples – the unlimited marital deduction will be examined. Planning for the marital deduction has become more important in light of the increase in the applicable exclusion amount brought about by the 2001 Tax Act and the reduction in rates. This program will look at effective ways to take advantage of the marital deduction and ensure that gifts qualify for the marital deduction. Planning for Valuation Discounts This program will examine different strategies for obtaining discounts for estate tax and gift tax valuation purposes. A discussion of discounts for family limited partnerships and limited liability companies and fractional interests in real estate will be discussed. The IRS position on discounts for family limited partnerships and limited liability companies will also be discussed. Four Easy Ways to Register or Order Audio Recordings! Online: www.aba.com, Phone: 800-775-7654 Fax: 800-676-0734,or Mail: KRM Information Services, Inc. PO Box 1187, Eau Claire, WI 54702.

2004 Trust & Estate Planning ABA Telephone Briefing Series REGISTRATION FORM

Name: ______________________________________________________________________________

Title: _______________________________________________________________________________

Institution: ___________________________________________________________________________

Street Address: _______________________________________________________________________

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Daytime Phone/Fax: ___________________________________________________________________

E-mail address*: (please print clearly) _____________________________________________________

Check this box if you wish to receive the URL accessing the program conference materials and dial-in instructions via e-mail. (If so you must provide e-mail address above).

Check this box if you are unable to receive your program conference materials via e-mail and we will ship the dial-in instructions and materials to you. *If you wish to discontinue receiving information or prefer to receive information via email, please fax your contact information to (202) 827-5053 or email it to [email protected]. REGISTRATION FEES Each site license entitles you to ONE phone connection at ONE location where an unlimited number of listeners can participate.

Programs – Offered 2:00-4:00 p.m. ET Site License Fee* Total

Title/Topic Seminar # ABA Member

Non-Member

Special Problems in Fiduciary Income Tax 9/2/04 ABT8207-0 $235 $350

Planning for the Single Individual 10/7/04 ABT8208-0 $235 $350

Trust Constructions and Reformations 11/4/04 ABT8209-0 $235 $350

Recent Developments 12/2/04 ABT8210-0 $235 $350

Audiocassettes/CDs Now Available for previously held Briefings: Ramifications of the Phase-Out of the Federal State Death Tax Credit

ABT8202-0 $235 $350

Taxation of Charitable Entities ABT8203-0 $235 $350

Planning for S Corporations and Other Closely-Held Business Issues

ABT8204-0 $235 $350

Marital Deduction Planning ABT8205-0 $235 $350

Planning for Valuation Discounts ABT8206-0 $235 $350

Any transmission, retransmission or republishing of the audio portion of these briefings is strictly prohibited. Total Payment Due

If you are outside of the U.S. or U.S. territories, additional phone charges need to be applied – Please contact KRM at (715) 833-5426 for more information.

All registrations must be prepaid in US dollars. Please check your payment option: Visa MasterCard American Express/Optima Discover Check– Make payable to KRM. Services provided to ABA by KRM Information Services, Inc.

Card # ___________________________________ Expiration Date _____________________

Signature ____________________________________________________________________

4 EASY WAYS TO REGISTER... Register today online at www.aba.com, by phone, fax or mail Register online at www.aba.com and click on “Conferences/Schools.” Or, have your credit card information ready and call 800-775-7654. Or, fax the form with credit card information to 800-676-0734, or mail it to KRM Information Services, PO Box 1187, Eau Claire, WI, 54702.

4 Easy Ways to Register…

Online:

www.aba.com

Fax: 800-676-0734

Telephone: 800-775-7654

Mail:

KRM Information Services, Inc. PO Box 1187

Eau Claire, WI 54702

ABA offers a satisfaction guarantee, which entitles you to a 100% refund of your registration fee. To

register a complaint or request a refund, please

submit a written notice to Linda Shepard,

1120 Connecticut Ave, NW, Washington, D.C. 20036.

Or, call 202-663-5499. ABA endeavors to resolve all such requests within 60

days of receipt of written notice. ABA's 2004 Trust

and Estate Planning Telephone/Webcast Briefing Series has been approved for 2 CPE and 2.5 CTFA credits

for each briefing. The American Bankers

Association is registered with the National

Association of State Boards of Accountancy (NASBA), as a sponsor of continuing professional education on

the National Registry of CPE Sponsors. State boards

of accountancy have final authority on the acceptance

of individual courses for CPE credit. Complaints

regarding registered sponsors may be addressed to the National Registry of CPE Sponsors, 150 Fourth Avenue North, Suite 700,

Nashville, TN 37219-2417. NASBA phone number

615-880-4200, Website: www.nasba.org.

4 EASY WAYS TO REGISTER … Register today by phone, fax, mail or online at www.aba.com.

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