The Prudent Investor Rule as it Affects Fiduciary Investments
| Publication year | 1992 |
| Pages | 1887 |
| Citation | Vol. 21 No. 9 Pg. 1887 |
1992, September, Pg. 1887. The Prudent Investor Rule as it Affects Fiduciary Investments
Recent events in Colorado seem to indicate a lack of knowledge by fiduciaries of their obligation to observe what is commonly described as the "prudent investor rule." In one example, assets from several retirement plans were invested in hedged investment commodities, also known as covered call investments, which are considered to be a risky venture.(fn1)
This article discusses the limitations imposed on fiduciaries by the prudent investor rule.
A review of the Colorado statutes and case law is helpful but not definitive in determining the extent of the prudent investor rule. The statute(fn2) relating to investments under the Colorado Uniform Transfers to Minors Act ("UTMA") provides that the custodian should observe the state of care that would be observed by a prudent person dealing with the property of another. The custodian is not limited by any other statute restricting investments by fiduciaries.
In a recent case,(fn3) the Colorado Supreme Court held that investments in penny stocks were highly speculative and in clear violation of the prudent investor rule. The defendant custodian was the father of two minor children who were recipients of cash gifts from their grandfather. The defendant maintained 51.4 percent of the assets in stocks traded on national exchanges and 48.6 percent in penny stocks. All of the penny stocks except one suffered large losses.
The standard for investments under the Uniform Fiduciary Law(fn4) is more specific than that of the UTMA, as exemplified in CRS §15--1--304:
[Fiduciaries shall exercise the judgment and care, under the circumstances then prevailing, which men of prudence, discretion, and intelligence exercise in the management of the property of another, not in regard to speculation but in regard to the permanent disposition of funds, considering the probable income as well as the probable safety of capital. Within the limitations of the foregoing standard, fiduciaries are authorized to acquire and retain every kind of property, real, personal, and mixed, and every kind of investment, specifically including but not by way of limitation, bonds, debentures, and other corporate obligations, stocks, preferred or common, securities of any open-end or closed-end management type investment company or investment trust, and participation in common trust funds, which men of prudence, discretion, and intelligence would acquire or retain for the account of another.
In a leading case,(fn5) the trustee bank sold a controlling block of stock of The Denver Post without obtaining competitive offers for the shares. The bank relied on provisions in the will that allowed the bank to sell the stock at private sale at such price and terms as the bank should determine. The bank knew that more than one party would be interested, but refused to notify other parties and to obtain appraisals. Citing CRS §15-1-304, the court found that the bank had failed its fiduciary duty to protect the interest of the estate's beneficiaries.
As noted in a recent article in The Colorado Lawyer,(fn6) the Restatement Third of Trusts attempts to modernize the prudent investor rule. It does this by formulating the theory that an investment should not be analyzed solely on the basis of its own potential risks, but on the basis of its effects and position in an overall portfolio. Although the Restatement does not have the effect of law, a Colorado court might consider this authority in future decisions.
It is interesting that the Uniform Durable Power of Attorney Act (CRS §15--14--501) does not address the prudent investor rule. Therefore, if no conservator has been appointed, the estate's attorney could, in fact, make a risky investment, and the prudent investor rule would not apply if the principal or any other interested party later objected.
As seen from the cases, the prudent investor rule often is applied in connection with the investment of securities by
fiduciaries. A leading brokerage house(fn7) offers trust management and lists the following purchase criteria in their advertising:
Securities rated as follows by Standard & Poor's:
Common stocks rated B+ or higher.
Preferred stocks rated BBB or higher.
Debt securities rated BBB or higher.
Commercial paper rated A-2 or higher.
Foreign securities or other securities not rated by Standard & Poor's but rated A or B by the brokerage house rating system.
This same firm prohibits any trust account to trade in options, commodities or futuresMoney market instruments and mutual funds offered or managed by other companies owned by this organization.
In most situations, the statute(fn8) does allow investment in personal property. Nevertheless, fiduciaries should be cautious before investing in antiques, precious gems or metals (including gold and silver), stamp or coin collections or other assets that could increase in value but produce no income.
Investments in raw land would not be prudent. However, the purchase of residential or commercial buildings for lease purposes is not uncommon and, if based on an accurate appraisal, long-term investment in raw land may be within the rule. The obvious problem with raw land is its speculative nature and the uncertainty as to when it may increase in value.
Questions often arise regarding insured accounts at financial institutions. All banks, savings and loan associations and industrial banks in Colorado are now insured by the Federal Deposit Insurance Corporation ("FDIC"). Each account under a specific name or title is insured up to $100,000. Therefore, if a fiduciary has accounts at one bank which exceed $100,000 (even though no one account is in that amount), the amount in excess of $100,000 (including interest earned) will not be insured in the event of bank failure.
FDIC officials have indicated that, in the event of failure, the depositor (fiduciary) should have the full balance within three weeks.
Popular investments include money market accounts and certificates of deposit purchased through stock brokerage firms. Most of the institutions offer protection up to $500,000 under the Securities Investor Protection Corporation, a non-profit corporation that receives revenues from broker/dealers. This protection is subject to a maximum limit of $100,000 on cash claims.
Certain bonds insured by state and local governmental entities may be insured and are appropriate. Many brokerage firms follow the rule that the bonds must be AAA rated or insured to be within the prudent investor rule.
These investments are direct obligations of the U.S. government. Therefore, they presumably meet the prudent investor standard.
Fiduciaries should be aware of the prudent investor rule. If they are uncertain about a prospective investment, they should consult a professional fiduciary who invests assets on a continuing basis. A bank trust department or a trust company would be a good starting point. If in doubt, the fiduciary may obtain an informal opinion from the district court judge assigned to probate matters or from the Probate Court in Denver.
Footnotes
1. More than $195 million in investors' monies were lost by Hedged Investment Associates.
2. CRS §11--50--113(2).
3. Sartore v. Buder, 759 P.2d 785 (Colo. 1988), aff'd, Buder v. Sartore, 774 P.2d 1383 (Colo. 1989).
4. CRS §15--1--304.
5. Rippey v. Denver United States National Bank, 273 F.Supp. 718 (Colo. 1967).
6. Wade. "The 'New' Prudent Investor Rule," 20 The Colorado Lawyer 713 (April 1991).
7. Merrill Lynch Companies.
8. CRS...
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