March 2011 Professional Notes Newsletter
Investment Standards for Charitable Trusts Under New York Law
Everyone worries about investing, but for trustees and boards of directors, it is one of the most important fiduciary obligations. A number of developments, including the enactment of the Uniform Principal and Income Act (UPIA) and the New York Prudent Management of Institutional Funds Act (NYPMIFA) on the one hand, and the after-effects of the recent financial crisis, including the Madoff scandal, on the other, have influenced how trustees and directors approach investment decisions.
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Different standards apply depending on the form in which a charity is organized. This issue of Professional Notes focuses on investment standards applicable to charitable entities organized under trust law. Future issues will consider the implications of NYPMIFA for corporate-form charitable organizations. Because The New York Community Trust actually is two organizations—The New York Community Trust, in trust form, and Community Funds, Inc., a New York not-for-profit corporation—we are acutely aware of the differences in standards.
Standards for Trustees and Executors
Before 1995, New York’s “prudent man rule” required each investment to be considered separately; an investment could be deemed imprudent even if the overall portfolio did well. The Prudent Investor Act (the Act) now embodied in New York Estates, Powers & Trusts Law (EPTL) §11-2.3 encourages trustees to invest for total return, a significant change from prior law, which promoted the preservation of principal.
The prudent investor rule, as codified by the Act, makes it clear that no individual investment is inappropriate or imprudent per se; it stresses the investment of the entire portfolio and the conduct of the fiduciary rather than the performance of an individual investment. The executor or trustee is expected to “exercise reasonable care, skill, and caution to make and implement investment and management decisions as a prudent investor would for the entire portfolio taking into account the purposes and provisions of the governing instrument.” As described below, the individual or corporate fiduciary must pursue an investment strategy that takes into account the particular circumstances of the trust and its beneficiaries, the appropriate level of risk, and the probable effects of inflation.
In the case of a trustee with special investment skills—a bank or paid professional investment advisor or any other trustee that represents that he or it has special investment skills—the standard requires the trustee to exercise “such diligence in investing and managing assets as would customarily be exercised by prudent investors of discretion and intelligence having special investment skills.” NYPMIFA does not apply to trusts that have noncharitable trustees, such as banks or individuals.
Factors to Be Considered An executor or trustee must pursue an overall investment strategy that enables him to make “appropriate” present and future distributions to the beneficiaries. Rather than enumerate acceptable investments (as New York law did prior to 1970), the Act sets forth a non-exclusive list of factors to be considered in devising an investment strategy, including:
- size of the portfolio;
- nature and expected duration of the trust or estate;
- liquidity and distribution requirements of the governing instrument;
- general economic conditions;
- possible effect of inflation or deflation;
- expected tax consequences of investment decisions or strategies and of distributions of principal or income to the beneficiaries;
- role that each investment plays in the overall portfolio;
- expected total return of the portfolio from both income and appreciation of capital; and
- present and future distribution needs of the beneficiaries for distributions, to the extent reasonably known to the trustee.
Related trusts, the beneficiaries’ other assets and resources, and the special value of particular assets to one or more of the beneficiaries are other circumstances that may be taken into account.
Executors’ Strategies May Differ Executors of estates also are subject to the requirements of the prudent investor standards, but the effect on them may be different from the effect on trustees. Because of the expected short duration of an estate, an executor may determine, in consultation with the estate’s beneficiaries, that there is no need to diversify. Or the executor may create a conservative portfolio designed to preserve the estate assets pending distribution and seek little or no growth. However, if the estate’s assets subsequently will be held in trust under the will, the executor may well want to invest for a longer horizon and anticipate the risk and the return objectives of the trust to be funded.
Diversification The prudent investor rule establishes a strong presumption in favor of diversification: the trustee must diversify the trust’s portfolio unless he determines that the purposes and terms of the governing instrument do not require it and it is in the beneficiaries’ best interest not to do so. Moreover, the fiduciary is required to determine within a reasonable time whether to retain or dispose of the initial assets held by the trust or estate.
Although it may be possible to draft a trust instrument that limits a trustee’s duty to diversify, such language is often construed by courts as merely permissive and therefore will not relieve a trustee of liability for failing to act prudently. The Dumont case in New York suggests the perils for a fiduciary who relies on a retention clause without also having established a meaningful process for investment review, documentation, and communication with both income and remainder beneficiaries. In Dumont, the testator’s will provided in relevant part as follows with respect to the testator’s Eastman Kodak stock:
It is my desire and hope that said stock will be held by my said Executors and by my said Trustee to be distributed to the ultimate beneficiaries under this Will, and neither my Executors nor my said Trustee shall dispose of such stock for the purpose of diversification of investment and neither they or it shall be held liable for any diminution in the value of such stock …The foregoing provisions shall not prevent my said Executors or my said Trustee from disposing of all or part of the stock … in case there shall be some compelling reason other than diversification of investment for doing so.
The Surrogate interpreted the language to require
that the fiduciary … hold Kodak stock as long as was feasible, ideally until the end of the trust’s term, as long as the trust’s primary purpose, the benefit of Dumont’s family [including both income and remainder beneficiaries], was being accomplished. Prudent management of the trust would dictate that the trustee was not to blindly manage the corpus but rather hold the Kodak stock, keeping an eye on the Kodak Company, the market, and the needs of the [income and remainder] beneficiaries, to continually ensure that the trust was accomplishing its purpose. Sale was not prohibited, just not to be pre-emptively or lightly undertaken.
Although the Monroe County Surrogate’s $20 million surcharge of the trustee was reversed on appeal, the Surrogate’s interpretation of the will stands—and the parties endured an expensive legal battle that went on for more than five years. Because the trust was so badly depleted by the prolonged retention of Kodak stock, the trustee received reimbursement out of the trust for only a fraction of its legal fees.
Effect of Inflation Although prior law did not require a fiduciary to invest assets to protect the principal from erosion by inflation, the prudent investor rule identifies the probable effect of inflation as a key factor to be considered. As a result, it generally will be necessary to show that the investment strategy was designed to achieve reasonable growth.
Fiduciary duty is no longer fulfilled by traditional “capital preservation”—maintaining the same dollar value of a trust. If a portion of the portfolio is to be invested in bonds or other fixed-income securities that do not appreciate in value over time, the strategy probably also should include investments with potential for growth to counteract the erosion of the purchasing power of the portion invested in bonds.
Appropriate Level of Risk The trade-off between risk and return may be the trustee’s most difficult task. The fiduciary must determine the appropriate level of risk that conforms to the objectives of the trust and ensure that it will also meet any distribution requirements that the will or trust agreement has imposed. Since the trustee or executor is charged with the obligation to at least preserve the real value of the portfolio, he generally must assume as much risk as necessary to prevent inflation from eroding the value of the fund as a whole.
In determining the appropriate allocation of the portfolio among the categories of investments for a trust, the fiduciary will have satisfied the requirement of considering the “market” risk. In theory, at least, returns correlate with risk in each investment category; the more volatile the type of investment, the greater the potential return on the investment. However, the appropriate degree of risk varies with the purposes of the trust and the needs of the beneficiary. As noted in the 1994 Report of the National Conference of Commissioners on Uniform State Laws, a program set up by the trustee of a trust for an elderly beneficiary with limited resources would be very different from that of a trustee of a discretionary trust for a minor who is supported by his or her parents.
In addition, there is risk that is unique to each particular asset and not compensated for by the market. The market may rise over time, but the value of a particular stock or an industry can be depressed for reasons unique to that company or industry. As noted above, the prudent investor rule emphasizes the need to protect the portfolio from this risk by diversifying the investments. An exception might be a trust specifically designed to hold a closely held business interest.
Investing for Total Return The law encourages trustees to focus on total return from both ordinary income and capital appreciation. The total return concept allows greater investment latitude in the case of an instrument that gives broad discretion to pay or accumulate income and to distribute principal to the beneficiary.
This spur to total return may have little practical effect if the governing instrument of the trust strongly preserves the distinction between principal and income. Take the example of a trust with no or limited principal invasion provision and whose purpose is to provide support for the beneficiary, to whom all income must be paid. The trustee cannot ignore the beneficiary’s need for income (generally interest and dividends) and invest exclusively in growth securities, even though they might produce a greater total return. Similarly, if the trust is to qualify for the marital deduction and is required by federal tax law to pay all of its income to the surviving spouse, it will be necessary to continue to focus on the production of ordinary income. For this reason, the Uniform Principal and Income Act, discussed below, empowers a trustee to allocate traditional accounting income to principal and to allocate capital appreciation to income “to enable the trustee to make appropriate present and future distributions.”
Delegation A significant change brought about by the prudent investor rule permits a trustee to delegate discretionary investment authority to an investment advisor. However, in delegating investment authority, the trustee must exercise “care, skill and caution” in:
- selecting a suitable advisor, taking into consideration the delegated functions, the nature and value of the assets involved, and the advisor’s expertise;
- establishing the scope and terms of the delegation consistent with the purposes of the governing instrument;
- periodically reviewing the advisor’s exercise of the delegated function and compliance with the terms of the delegation; and
- controlling the overall cost of the delegation.
The investment advisors themselves become liable as fiduciaries in the investment process as a result of the delegation. Unique to New York law, both the delegee-investment advisor and the delegating trustee are liable for the delegee’s decisions. The original draft of the statute had expressly provided that prudent delegation and monitoring would have relieved the trustee of liability for the investment advisor’s acts.
EPTL §11-2.3 (b)(5) requires a fiduciary with special investment skills (i.e., the professional trustee) to exercise those skills and provides that performance will be judged accordingly. This suggests that a trustee with special skills may not delegate authority to another except in areas outside the trustee’s expertise.
Varying the Rules It is important to bear in mind that the prudent investor rule is a default provision and applies only to the extent that the terms of the governing instrument do not provide otherwise. Other standards or guidelines may be prescribed, provided they are not contrary to public policy.
The draftsman may want to provide investment guidance to the trustees by stating the primary purpose of the trust in the instrument. For example, an instrument could require that a trust be invested to provide maximum income and safety, regardless of the impossibility of growth and the resulting likelihood that the real value of the principal will be diminished by inflation, or it might emphasize growth for a child who has limited need for current income.
Documenting Procedures To ensure compliance with the law, a trustee or executor should determine and document the objectives of the trust, the investment strategy designed to meet those objectives, and the procedures to be followed in pursuit of that strategy.
Liability As previously noted, the delegation of investment responsibility will not relieve a fiduciary of liability for the acts of the investment manager. A trustee is not liable to a beneficiary to the extent that the trustee acted “in substantial compliance” with the prudent investor standard or in reasonable reliance on the express provision of the governing instrument. Despite this statutory language, cases in the diversification area suggest caution in relying on language in the governing instrument that purports to relieve the trustee of an obligation to diversify.
Considerations in a Post-Madoff World Volumes could be written about the effect of the 2008 financial crisis on decision-making by fiduciaries. One important topic has been the legal liability of a fiduciary whose investment decisions resulted in losses when Madoff Investment Securities LLC failed in late 2008. When can a fiduciary acting in good faith be held liable for an investment manager’s fraud? To what extent must the fiduciary investigate an investment manager or understand the investment practices of an investment fund (such as the funds managed by entities associated with Ezra Merkin)? Will the IRS seek to show that a Madoff investment violated the “jeopardy investment” rules applicable to private foundations and some split-interest charitable trusts, creating excise tax liability under IRC Section 4944? It may be years before we know the answers to these questions, but at a minimum, the Madoff scandal refocused fiduciaries on some fundamental issues, including the role of third party custodians and the risks of relying on the financial success (and accompanying enthusiasm) of other investors, rather than on an independent and thorough assessment of investment fundamentals.
The financial crisis of 2008 also focused fiduciaries on liquidity, specifically, the need to understand at the outset the exit requirements and liquidity limitations of an investment and to weigh those factors against both the liquidity needs of the trust or estate and the potential financial risk that prolonged periods of illiquidity may present, particularly in a volatile financial landscape.
Power to Adjust Between Income and Principal
Modern investment theory, which supports investing for total return without regard to the distinction between principal and income, has little impact if the governing instrument of the trust preserves that distinction, as in the case of a trust that pays all income to a beneficiary. UPIA was adopted in New York nearly 10 years ago; under its provisions, EPTL §11-2.3(b)(5) empowers a trustee to allocate traditional accounting income (such as dividends and interest) to principal and, conversely, to allocate capital appreciation, which traditionally would be treated as principal, to income “to enable the trustee to make appropriate present and future distributions.” Alternatively, the Act authorizes a trustee to elect to treat a trust as a unitrust, relieving him of the obligation to determine what amount should be allocated to principal or income using the “power to adjust.”
UPIA allows the trustee to make discretionary allocations if he determines that such an adjustment would be “fair and reasonable” to all of the beneficiaries. In determining whether to make such discretionary allocations between income and principal, a trustee should consider the criteria to be used in setting investment strategy under the prudent investor rule, as well as the following factors:
(i) intent of the settlor as expressed in the instrument; nature of the trust assets; extent to which trust assets are used by a beneficiary; and whether an asset was purchased by the trustee or received from the settlor;
(ii) net amount otherwise allocated to income under Article 11-A and the increase or decrease in the value of principal assets; and
(iii) whether and to what extent the terms of the trust give the trustee the power to invade principal or accumulate income and the extent to which the trustee has done so, or whether the terms prohibit the trustee from invading principal or accumulating income.
UPIA further provides that a trustee may not make an adjustment:
(i) with respect to a charitable remainder unitrust, as described in IRC §664;
(ii) that changes the amount otherwise payable to a beneficiary as a fixed annuity or unitrust amount;
(iii) from any amount that is permanently set aside for charitable purposes unless the income therefrom is also devoted to charitable purposes;
(iv) if having or exercising the power to adjust causes an individual to be treated as the owner of all or part of the trust for income tax purposes;
(v) if having or exercising the power to adjust causes all or part of the trust assets to be included for estate tax purposes in the estate of an individual who has the power to remove or appoint a trustee;
(vi) if the trustee is a current beneficiary or presumptive remainderman of the trust;
(vii) if the adjustment would benefit the trustee directly or indirectly (not including the possible effect on a trustee’s commission); or
(viii) if the trust is an irrevocable lifetime trust that provides income be paid for life to the grantor, and having or exercising the power to adjust would cause any public benefit program (such as Medicaid) to consider the adjusted principal and/or income to be considered an available resource.
Language in the trust instrument that otherwise limits a trustee’s power to make adjustments between principal and income will override the foregoing rule only if it is clear from the terms of the trust that such language is intended to deny the trustee the power to adjust.
If a court finds that the trustee has abused his discretion, the court may restore principal and income, in whole or in part, by requiring the trustee to distribute more, or to withhold, future distributions. If the court finds that the trustee was dishonest or arbitrary and capricious in the exercise of his discretion and is unable to restore the trust beneficiaries to their appropriate positions, the trustee may be required to make up the difference.
Some commentators have suggested that the exercise or non-exercise of the power to adjust be evaluated annually and that trustees may have an affirmative duty to advise beneficiaries that they possess such a fiduciary power in the first instance. In addition, a fiduciary may petition the court to determine whether a proposed exercise (or non-exercise) of the adjustment power would be an abuse of discretion.
Unitrust Option Alternatively, a trustee (but not an executor) may elect to have the trust effectively treated as a 4 percent unitrust. In this event, under EPTL §11-2.4, references to “income” in the governing instrument are deemed to refer to the unitrust amount, which is set at 4 percent by the statute, and is measured against the net fair market value on the first business day of the trust year. For trusts that are more than three years old, the average of three years’ net asset value (current plus two immediately prior years) is used. If additional contributions are made to the trust’s principal or distributions are made from the trust’s principal, the statute provides for the adjustment of the trust’s net asset calculation, resulting in a different unitrust amount.
The trust’s expenses, including trustee’s commissions, do not reduce the unitrust amount. Commissions are charged to principal, rather than following the usual 1/3 – 2/3 split between income and principal. As a result, these expenses effectively are borne by future beneficiaries of the trust, except to the extent that the costs reduce net asset value used to calculate the unitrust amount.
Valuing Trust Assets In order to calculate the unitrust amount, the net asset value must be determined. Net asset value is the aggregate of the fair market value of each trust asset, less any interest-bearing obligations of the trust. Valuing property other than marketable securities can pose difficulties, and such assets may not be good candidates for transferring into a trust. Closely held businesses are particularly difficult to value.
Certain Residential and Tangible Personal Property The statute provides that if these assets are owned by the trust but in the possession or control of a current beneficiary, they are not taken into account in determining net asset value. The unitrust amount with respect to these assets is deemed to be equal to the right to use such property.
Specific Bequests and Devises Any property that is specifically given to a beneficiary also is not included in net asset value. An example is a trust that owns rental real estate set aside for the benefit of the settlor’s daughter. The property is not included in net asset value for purposes of calculating the unitrust amount and the income earned on the payment is allocated to the daughter and is not available to fund the unitrust payment.
Real Property and Other Property Not Regularly Traded The statute directs the trustee to value at least annually assets that are not regularly traded in an active market, and the determination of value is deemed conclusive if made reasonably and in good faith. This requirement does not mean the trustee has to obtain a new appraisal every year. Rather, it is in the trustee’s discretion to determine when a new appraisal is needed. The statute protects the trustee’s determination from a later challenge by beneficiaries by presuming that the trustee’s determination is to be made “reasonably” and “in good faith” unless a court proceeding is brought within three years of the close of the trust year with respect to which the trustee’s determination was made.
The trust instrument may provide for the unitrust alternative, in which case the instrument may by its terms provide a different unitrust percentage, or the unitrust option may be elected by the trustees or trust beneficiaries, or made applicable by a court determination. The election must be made on or before the end of the second full trust year after the assets are transferred into the trust. The date of creation of the trust can be important; the statute provides that when an existing trust continues in existence for new beneficiaries upon the termination of all interests of prior beneficiaries, a new trust is deemed to have been created.
A court proceeding can be brought at any time to have the unitrust rules apply, or, if unitrust treatment was elected but is no longer appropriate, to have the UPIA (EPTL §11-A) provisions apply. The latter may occur when the trust disposes of illiquid assets. The Heller case demonstrates that trustees with a beneficial interest in a trust (in that case, as remainder beneficiaries) may make the unitrust election, even if such election has the initial effect of significantly reducing the income distribution to the life income beneficiary (despite the fact that an interested trustee would be prohibited from exercising the power to adjust). As the Appellate Division of the Second Department observed,
Admittedly … the unitrust election can inure to the financial benefit of the trustee in his or her capacity as remainderman. But that is not always the case. The state of financial facts which may have given rise to the election will not necessarily endure for the life of the trust. Markets change and with them the respective benefits of the election to the income and remainder interests. Thus, an election that may initially have appeared to be to the trustee’s advantage may not ultimately be so.
The Surrogate’s Court is empowered to review a trustee’s unitrust election at any time and assure its fairness by examining the relevant factors, including the factors the trustee is required to consider before making a unitrust election, namely:
(i) nature, purpose and expected duration of the trust;
(ii) intent of the settlor;
(iii) identity and circumstances of the beneficiaries;
(iv) needs for liquidity, regularity of payment, and preservation and appreciation of capital;
(v) nature of the trust assets; extent to which they are used by a beneficiary; and whether an asset was purchased by the trustee or received from the settlor.
These criteria are similar to those set forth for the trustee’s determination of an investment strategy and the exercise of the adjustment power.
Tax Law Implications Because the definition of income turns on local law, the power to adjust and the unitrust option under New York law may affect the taxation of trusts. Under federal tax regulations, the definition of income for income, gift, estate, and generation-skipping transfer taxes will respect a reasonable apportionment between income and principal or a unitrust substitute between 3 and 5 percent. For example, a QTIP, which must entitle the spouse to all income for life, will continue to qualify for the marital deduction even though state law permits a reasonable apportionment between income and principal or the substitution of a unitrust amount for income.
The power to adjust and the unitrust alternative could create problems for pooled income funds. In a pooled income fund, the income beneficiary receives his share of income earned for life. The pooled income fund is a taxable entity, and claims a deduction for distributions to income beneficiaries as well as a charitable deduction for net long-term capital gains set aside for charitable purposes. Thus, a pooled income fund generally will be taxed on net short-term capital gain that is not required to be distributed to income beneficiaries. Treas. Reg. §1.642(c)–2(c) provides that the charitable deduction is not available to a pooled income fund if under either the governing instrument or state law a unitrust amount is paid or adjustments may be made to income or principal because the long-term capital gain may be used in the future to make payments to the income beneficiaries. Accordingly, the governing instrument for a new pooled income fund should specifically deny the trustee the power to make adjustments or use the unitrust alternative.
A trustee may want to seek professional advice to meet the requirements of the applicable law and take full advantage of the opportunities it may present. The power to adjust between income and principal or to treat a trust as a unitrust will enable trustees to invest for total return, but such increased discretion also potentially increases a fiduciary’s exposure. Accordingly, a trustee of a trust governed by New York law will want to become familiar with these rules and may want to seek periodic legal advice.
Other issues in this series:
For further reference, see:
EPTL §11-2.3: Prudent Investor Act
EPTL §11-2.3A: Judicial Control with Respect to Fiduciary’s Power to Adjust
EPTL §11-1.7: Limitation on Powers and Immunities
EPTL Article 11-A: New York Uniform Principal and Income Act
EPTL §11-2.3(b)(5): Power to Adjust
EPTL §11-2.4: Optional Unitrust Provision
SCPA §2309(3): Commissions
SCPA §2312(5): Commissions of Corporate Trustees
IRC §4944: Jeopardizing Investment of Private Foundations
Treas. Reg. §1.642(c)–2(c)
Treas. Reg. §1.643(b)–1
Treas. Reg. §20.2056(b)–5(f )(1)
Treas. Reg. §20.2056(b)–7(d)(1) and (2)
Treas. Reg. §25.2523(e)–1(f )(1)
Treas. Reg. §26.2601–1(b)(4)(i)(D)(2)
Uniform Prudent Investor Act, drafted by the National Conference of Commissioners on Uniform State Laws (1994)
In re Charles G. Dumont, 791 NYS 2d 868 (Monroe Co. Surr. Ct. 2004), rev’d in part, 809 NYS 2d 360 (App. Div. 4th Dep’t 2006), appeal denied, 813 NYS 2d 689 (App. Div 4th Dept 2006), appeal denied, appeal dismissed, 855 NE 2d 1167 (2006), reargument
denied, 860 NE 2d 93 (2006)
Matter of Jacob Heller, 800 NYS 2d 207 (App. Div. 2nd Dept. 2005), aff ’d, 849 NE 2d 262 (Ct. App. 2006)
B. Corrigan and C. Gibbs, Exercising the Power to Adjust Between Principal and Income, New York Law Journal, January 31, 2011 (Trusts and Estates Supplement)
S. Serk, Rethinking Trust Law Reform: How Prudent is Modern Prudent Investor Doctrine?, 95 Cornell L. Rev. 851 (July 2010)
C. Cline, The Uniform Prudent Investor and Principal and Income Acts: Changing the Trust Landscape, 42 ABA Real Property, Probate & Trust J. 611 (Winter 2008)
S. Porter, Emerging Issues Under the Prudent Investor and Principal and Income Acts, ALI-ABA Course of Study Materials (July 2007)
L. Hirschson, The Unitrust Alternative: A Framework for Total Return Investing, 42 Tax Management Memorandum, No. 23 (Nov. 5, 2001)
S. Gary, Regulating the Management of Charities: Trust Law, Corporate Law, and Tax Law, 21 Hawaii L. Rev. 593 (1999)
E. Brody, The Limits of Charity Fiduciary Law, 57 Md. L. Rev. 1400 (1998)
J. Blattmachr and S. Polk, A Practical Look at the Prudent Investor Rule, The Chase Review (October 1995)
(c) The New York Community Trust 2011.
By Jane L. Wilton, general counsel, The New York Community Trust
This material was developed for the use of professionals by The Trust. It is published with the understanding that neither the publisher nor the authors are engaged in rendering legal, accounting, or other professional advice. If legal advice or other expert assistance is required, the services of a professional should be sought.