Chasing Down the Devil: Standardsof Prudent Investment Under theRestatement (Third) of Trusts

Table of Contents I. Introduction 336 II. The Evolution of Fiduciary Investment Standards 337 A. Foundations of the Prudent Man Standard 337 B. Shortcomings of the Prudent Person Standard 342 C. An Introduction to the Prudent Investor Rule 345 III. An Overview of Modern Portfolio Theory 348 IV. Advancements Made Under the Restatement (Third) of Trusts 353 A. The Duty to Balance Risks Against Total Returns 353 B. The Duty to Diversify 355 C. The Duty of Impartiality 358 D. The Authority to Delegate 361 E. Expanding Liability for Trustees 364 V. The Practical Effects of the Prudent Investor Rule 366 A. A Current Perspective on Past Cases 366 1. Estate of Knipp 366 2. First Alabama Bank v. Martin 370 3. In re Bank of New York (Spitzer) ... 372 B. The Response Among the States 375 VI. Conclusion 381 I. Introduction Be sober, be vigilant; because your adversary the devil, as a roaring lion, walketh about seeking whom he may devour. - 1 Peter 5:81 For more than one hundred years, protecting trust principal while generating the highest income possible marked the fundamental purpose of fiduciary investment standards.2 In keeping with this purpose, trust doctrine evolved throughout the nineteenth and twentieth centuries to forbid speculative fiduciary investments.3 Because traditional trust doctrine caused ultimate liability for losses to the trust to sit like a devil on the shoulder of every trustee, the threat of losses encouraged investments in low-risk ventures only.4 Today, however, it is the corrosive effects of inflation that create the greatest threat for trustees.5 Increasingly, low-risk, interest-bearing securities fail to keep pace with inflation, and thus, inflation becomes the roaring lion, walking about, seeking to devour the trust.6 Unfortunately, the traditional restrictions on fiduciary investment largely remain in place.' Such restrictions now hamper a trustee's ability to be vigilant against this new adversary - the devil of inflation.8 The Restatement (Third) of Trusts emerges in response to this challenge. Drawing heavily from current investment techniques, it seeks to reformulate trust doctrine so that trustees may be flexible enough to avoid the effects of inflation.9 This effort takes shape in the form of the Restatement (Third)'s "prudent investor rule.'o Given the importance of the investment function to fiduciary administration, an understanding of this new standard for prudent investing is essential. In Part II, this Note provides a brief overview of the historical evolution of fiduciary investment standards." Part III provides an introduction for laypersons to the central features of modern portfolio theory- the conceptual foundation of the prudent investor rule.l2 Part IV demonstrates the recent progression of trust doctrine by reviewing the fundamental changes made by the Restatement (Third).13 Part V.A considers the practical application of the prudent investor rule by using it to revisit three prominent fiduciary investment cases.14 Part V.B assesses the effect of the new standard by reviewing the statutory response to the Restatement Third) among the states.l5 Part VI concludes by discussing recent demographic trends that make the use of trusts more important than ever. Part VI then recommends that state legislatures quickly move to adopt legislation reflecting the standards of the prudent investor rule so that trustees have the flexibility needed to respond effectively to those trends.l6 II. The Evolution of Fiduciary Investment Standards A. Foundations of the Prudent Man Standard England greatly influenced the development of "prudent" trustee investment practices in nineteenth-century America."7 The English fiduciary investment standard was the product of financial disaster, and it worked primarily to protect beneficiaries from losses caused by speculative trust investments. …