Fall 2012 Newsletter
The Trustee’s Duty to Diversify When the Grantor or Beneficiaries Desire Asset Retention
By Trey T. Parker
The law of prudence governing trustees generally requires the diversification of trust assets. Sometimes, however, the grantor or beneficiaries desire that the trustee retain a large asset concentration for the purpose of perpetuating the ownership of a family business, family real estate, or other assets of sentimental value. Under these circumstances, the tension between the duty to diversify and the wishes of the grantor or beneficiaries can lead to liability traps for the unwary trustee. This article discusses important issues that a trustee should consider when directed to invest in a manner that is inconsistent with the general rules of diversification and offers risk reduction techniques that trustees can employ to limit their liability.
Virginia has adopted the Uniform Prudent Investor Act (“UPIA”), which is modeled after the Restatement (Third) of Trusts (“Restatement”).1 Under the Prudent Investor Rule of the UPIA, a trustee has a duty to “invest and manage trust assets as a prudent investor would, by considering the purpose, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill and caution.”2 The Prudent Investor Rule requires a trustee to understand “modern portfolio theory,” which embraces the broad diversification of trust investments.3 The duty to diversify has been codified in the Virginia Uniform Trust Code (“Virginia UTC”) at § 64.2-783, which provides that “[a] trustee shall [emphasis added] diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”4
According to Virginia UTC § 64.2-783, a trustee is not required to diversify the assets of a trust if “special circumstances” exist. The question then is whether the desire for asset concentration by the grantor or beneficiaries may be classified as “special circumstances.” Unfortunately, the UPIA does not define the phrase “special circumstances.” The comments to the Restatement, however, provide that “the trustee’s decision to retain or dispose of certain assets may be properly influenced, even without trust terms bearing on the decision, by the property’s special relationship to some objective of the settlor that may be inferred from the circumstances, or by some special interest or value the property may have as a part of the trust estate or that it may have, consistent with trust’s purposes and the trustee’s duty of impartiality, to some or all of the beneficiaries. Examples of such property might be land used in a family farming operation, the assets or shares of a family business, or stockholdings that represent or influence control of a closely held or publicly held corporation.”5 Although the Restatement appears to support the retention of assets in accordance with the desire of the grantor or beneficiaries, a trustee cannot safely rely on a “special circumstances” determination alone. Therefore, a trustee seeking protection from potential liability must look beyond any “special circumstances.”
A trustee will have more protection if the language in the trust instrument authorizes or requires the trustee to retain a concentrated position. After all, Virginia UTC § 64.2-781 provides that the duty to diversify is a default rule that “may be expanded, restricted, eliminated, or otherwise altered by the provisions of a trust.”6 In addition, § 64.2-797 states, “A trustee who acts on reasonable reliance on the terms of the trust as expressed in the trust instrument is not liable to a beneficiary for a breach of trust to the extent the breach resulted from the reliance.”7 Therefore, a trustee may rely on trust terms that direct investments in a manner inconsistent with the general rules of diversification so long as the interpretation is reasonable and relied on in good faith.
In determining whether a trustee’s reliance on the terms of a trust is reasonable and in good faith, courts and the Restatement focus on the distinction between mandatory and permissible trust provisions. 8 A mandatory provision limits the trustee’s investment authority and is ordinarily binding on the trustee in managing the trust assets.9 A permissible provision merely authorizes a particular investment or pattern of investment.10 This distinction is significant because a mandatory provision often displaces the normal duty to diversify, whereas a permissive provision does not.11 Still, authority suggests that a mandatory provision may not displace the duty completely.12 For example, if circumstances arise that were not anticipated by the grantor, or deviation from a mandatory provision would further the purposes of the trust, the trustee may have a duty to ask the court to modify the terms of the trust.13
A relatively recent federal case applying Virginia law, W.A.K. ex rel Karo v. Wachovia Bank, N.A.,14 illustrates the aforementioned issues that confront a trustee when the grantor or the beneficiaries desire asset retention. In W.A.K., the grantor created a revocable trust and named her husband and Central National Bank (“CNB”) as co-trustees. The grantor funded the trust primarily with CNB stock.15 The grantor’s father was a founder of CNB, and for many years it was considered a family business.16 In the terms of the trust, the grantor empowered the trustees to take action “as they in their uncontrolled discretion may deem advisable,” including the ability “[t]o retain as permanent any now existing investments (including stock of the corporate Trustee or in any of its affiliates and holding companies) of the trust property” and “invest the trust property . . . without being confined to investments lawful through statute or otherwise for fiduciaries in the State of Virginia.”17
After the death of the grantor in 1974, the cotrustees retained the concentration of CNB stock at the direction of the trust beneficiaries, even after Wachovia Bank, N.A. (“Wachovia”), succeeded CNB through a series of mergers.18 In 2007, Wachovia stock suffered a substantial decline, as did that of most banking institutions, thereby decreasing the value of the trust.19 In 2009, suit was brought against Wachovia as trustee (the grantor’s husband had ceased to serve as co-trustee) on behalf of a minor remainder beneficiary alleging, inter alia, that Wachovia had breached its fiduciary duty by maintaining the concentration of stock.20
In deciding whether Wachovia breached its fiduciary duty, the court did not discuss whether “special circumstances” existed to warrant the retention of the CNB stock. Rather, the court focused on whether the language of the trust effectively waived the duty to diversify under the Prudent Investor Rule.21 The court held that the language of the trust waived the requirements of the Prudent Investor Rule as it related to the trust assets at the creation of the trust.22 Specifically, the court held that although the language of waiver was not so broad as to grant an unlimited waiver of the Prudent Investor Rule, the language unequivocally expressed the grantor’s intent that the trustee could maintain the initial assets of the trust and any assets transferred to the trust without being bound by the Prudent Investor Rule.23
Although the court in W.A.K. held that the language of the trust was sufficient to preclude liability of the trustee for retaining the stock concentration, a trustee should not rely on such language alone. Indeed, there are a variety of risk reduction techniques that trustees can take to limit their liability for retaining a concentrated position, including a judicial modification, trustee resolutions, and retention letters.
Judicial modification provides the greatest protection for a trustee. Virginia UTC § 64.2-729 permits modification of the terms of a trust upon consent of the settlor and all of the beneficiaries. If the settlor is deceased, a court may modify the trust upon consent of all the beneficiaries if the court concludes that such modification is not inconsistent with a material purpose of the trust. If one or more of the beneficiaries do not consent to the proposed modification, a trustee may ask the court to modify the terms of the trust pursuant to § 64.2-730, which allows for modification because of circumstances not anticipated by the settlor, or if the existing terms would be impracticable or wasteful or impair the administration of the trust.
If the trustee does not wish to pursue the option of judicial modification, the trustee may find limited protection through retention letters signed by the beneficiaries. Virginia UTC § 64.2-800 provides, “[a] trustee is not liable to a beneficiary for a breach of trust if the beneficiary consented to the conduct constituting the breach, released the trustee from liability for the breach, or ratified the transaction constituting the breach . . . .” Retention letters are effective only if the beneficiaries have been fully apprised of the effects that execution of the retention letters will have on their legal rights and how the direction to retain the concentration will relieve the trustee of the duty to diversify.24 Even if the beneficiaries sign the retention letters, the trustee may have a continuing obligation to keep the beneficiaries informed as to developments with respect to the concentrated position. Furthermore, retention letters may only bind the beneficiaries that sign them.
A trustee who does not seek judicial modification or retention letters from the beneficiaries may still be protected by adopting a trustee resolution. In the resolution, the trustee should state the desire of the grantor or beneficiaries that the assets of the trust remain concentrated without regard to diversification. This technique provides limited protection for the trustee, but it at least documents the reasons for holding the stock.
The dilemma a trustee faces when the grantor or beneficiaries desire asset retention is more complicated than many trustees realize. A trustee who follows the direction of the grantor or beneficiaries without considering the above issues may be the subject of surcharge litigation. Fortunately, there are solutions that allow a trustee to manage the risk of asset concentration and satisfy fiduciary duties.
Trey T. Parker is an associate attorney with Rack & Olansen, P.C., a law firm located in Virginia Beach, Virginia, that focuses on estates and trusts, fiduciary services, elder law, taxation and charitable entities. Mr. Parker concentrates his practice in the administration of trusts and estates, and representing fiduciaries and beneficiaries in estate and trust litigation. He obtained his law degree from the Washington and Lee University School of Law.
1. See Prefatory Note to the Uniform Prudent Investor Act (1994) (hereinafter “UPIA”).
2. UPIA § 2(a); Va. Code § 64.2-782(A).
3. See Prefatory Note to the UPIA.
4. Va. Code. Ann. § 64.2-783 (2012).
5. Restatement (Third) Trusts § 92 cmt. a (2007) (hereinafter “Restatement”).
6. Va. Code. Ann. § 64.2-781 (2012).
7. Id. § 64.2-797.
8. See e.g., Restatement § 91.
9. Id. cmt. e.
10. Id. cmt. f.
11. Id. cmt. e, f.
12. Id. cmt. e.
14. W.A.K. ex rel Karo v. Wachovia Bank, N.A., 712 F. Supp. 2d 476 (E.D. Va. 2010).
15. Id. at 479.
16. Defendant-Apellee’s Motion to Dismiss Appeal as Not Within the Jurisdiction of the Court at 2-3, W.A.K. ex rel Karo v. Wachovia Bank, N.A., No. 10-2023 (4th Cir. Oct. 18, 2010).
17. W.A.K., 712 F. Supp. 2d at 481.
18. Id. at 479.
19. Id. at 480.
21. Id. at 481.
23. Id. at 482.
24. See Va. Code. Ann. § 64.2-800 (2012). See also W.A.K, 712 F. Supp. 2d at 482-483 (where Wachovia obtained a retention letter from the current income beneficiary that acknowledged Wachovia’s advice regarding the benefits of diversification, directed Wachovia to maintain the existing concentration, and released and indemnified Wachovia against any resulting liability).