The Pi Lawyer: Different Animal, Same Stripes

• Citation: Vol. 10 No. 2
• Publication year: 2004
• Author: By Adam F. Streisand

THE PI LAWYER: DIFFERENT ANIMAL, SAME STRIPES

By Adam F. Streisand^*

I. INTRODUCTION

California's adoption of the Uniform Prudent Investor Act and the Uniform Principal and Income Act (the "UPIAs") liberated trustees from slavish adherence to inflexible investment rules and management decisions as well as rigid adherence to allocating receipts and disbursements. Trustees now have greater flexibility to invest for total return in accordance with modern portfolio theory, rather than focusing on assets in isolation or applying strict rules on adjusting principal to income. Greater flexibility, however, translates into more opportunities for beneficiaries to second-guess trustees who exercise their newfound discretion.

Since California's adoption of the UPIAs, trusts and estates lawyers have seen the rise of a new type of "PI lawyer." Like a "personal injury" attorney, the new "prudent investor" or "principal and income" lawyer knows that a case with subjective standards has value. When a case involves the exercise of discretion and the vagaries of investment strategy, the court's analysis and decision necessarily involves some subjectivity. The PI lawyer likes those odds, especially if he or she can find a conflict or a little bias or hostility to throw into the mix.

So what can trustees do to try to ward off the PI lawyers? How can these fiduciaries defend themselves in litigation involving UPIA issues? Will the Legislature take action to rescue trustees? These are questions this article seeks to answer.

II. THE PRUDENT INVESTOR RULE

Effective January 1, 1995, California adopted the Uniform Prudent Investor Act, defining what is commonly referred to as the prudent investor rule. Except as may be expanded or restricted by the trust instrument itself, "a trustee who invests and manages trust assets owes a duty to the beneficiaries of the trust to comply with the prudent investor rule."¹ The prudent investor rule requires that "[a] trustee shall invest and manage assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution."² By its own language, this standard applies to both investment and management decisions of trustees.³

The prudent investor rule instructs trustees to make investment decisions based on modern portfolio theory, rather than on an inflexible asset-by-asset analysis: "A trustee's investment and management decisions respecting individual assets and courses of action must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust."⁴ In order to fulfill this mandate, the Probate Code provides guidance by enumerating a number of factors that trustees should consider in making investment and management decisions:

(1) General economic conditions;
(2) The possible effect of inflation or deflation;
(3) The expected tax consequences of investment decisions or strategies;
(4) The role that each investment and action plays within the overall trust portfolio;
(5) The expected total return from income and the appreciation of capital;
(6) Other resources of the beneficiaries known to the trustee as determined from information provided by the beneficiaries;
(7) Needs for liquidity, regularity of income, and preservation or appreciation of capital; and
(8) An asset's special relationship or special value, if any, to the purposes of the trust or to one or more beneficiaries.⁵

One principle that emerges from these various duties is that a trustee must ordinarily strive to invest and manage trust assets in a manner that produces both reasonable income and adequate principal growth: "[t]he objectives of total return encompass not only income productivity but also returns to principal, with these competing interests being balanced in a way that is appropriate to the particular trust."⁶

In a split-interest trust, the beneficiary entitled to income differs from the ultimate remainder beneficiary. The tension between these conflicting interests can become a fertile ground for litigation. The income beneficiary has an interest in receiving as much current income from the trust as possible, because he will not benefit from the appreciation of principal. The remainder beneficiary has precisely the opposite objective. The Restatement of Trusts (Third) explains the trustee's duty in balancing these interests. It also notes what many income beneficiaries often overlook: that growth of the principal also tends to increase income flow over the duration of the trust:

If by the terms of a trust the trustee is directed to pay the income to a beneficiary during a designated period and on the expiration of the period to pay the principal to other beneficiaries, the trustee is under a duty to the income beneficiary to exercise care not only to preserve the trust property but to make it productive of trust income so that a reasonable amount of income will be available to that beneficiary. The trustee is also under a duty to the remainder beneficiaries to exercise reasonable

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care to preserve the trust property, and this duty ordinarily includes a goal of protecting the property's purchasing power. In some trust situations the trustee may invest with a goal of increasing the real value of the principal. It is important to note that protection or growth of the purchasing power of principal also tends to preserve or enhance the purchasing power of the income flow over the duration of the trust.⁷

As noted previously, "[t]he settlor may expand or restrict the prudent investor rule by express provisions in the trust instrument."⁸ In such case, "a trustee is not liable to a beneficiary for the trustee's good faith reliance on these express provisions."⁹ When the trust instrument varies the requirements of the prudent investor rule, the trustee's "duty to administer the trust according to the trust instrument" takes precedence.¹⁰

In sum, the prudent investor rule liberated trustees from stifling rules that required making each asset productive of income while preserving purchasing power. Instead, the prudent investor rule made it possible for trustees to invest according to Modern Portfolio Theory for total return. As will be seen, however, greater discretion and flexibility has delighted PI lawyers and engendered increased litigation.

III. FORMER AND CURRENT LAW REGARDING UNDERPRODUCTIVE TRUST ASSETS

Following the enactment of the Uniform Prudent Investor Act, there still remained certain vestiges of outmoded rules that impeded the ability of trustees to invest for total return. Former Probate Code § 16311, concerning underproductive assets, conflicted with the Prudent Investor Act, because it depended upon an asset-by-asset analysis. The former Uniform Principal and Income Acts of both 1931 and 1962,¹¹ as codified in former Probate Code § 16311, generally provided that if a trust asset had not produced average net income of at least one percent (1%) of its inventory value, upon its sale the income beneficiaries were entitled to receive from the sale proceeds an amount equal to the difference between the income actually received from the asset and a return of five percent (5%) per annum simple interest.¹²

In 1999, California enacted the Uniform Principal and Income Act of 1997, which among other things repealed former Probate Code § 16311. The new Act features a flexible approach more consistent with modern portfolio investing. Subject to certain conditions, a trustee now has discretion to reallocate part of trust principal to trust income if the trust's overall income yield is too low, or conversely, to reallocate part of trust income to trust principal if the trust's overall principal growth is inadequate.¹³

This change in the law reflects and implements California's endorsement of modern portfolio theory by allowing trustees to adopt investment strategies that focus on the overall productivity of a trust's investment portfolio, rather than on an asset-by-asset basis.¹⁴ In other words, a lower rate of productivity on some assets can be compensated for by a higher rate on other assets such that the overall average rate of return on the trust's investments as a whole is appropriate. The prior law was inconsistent with portfolio theory investing, because it required the trustees to make each separate asset produce at least one percent of income.¹⁵

Trustees and beneficiaries advocated for the...