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John H. Langbein, Mandatory Rules in the Law of Trusts, 98 Nw. U. L. Rev. 1105 (2004), available on LexisNexis.

As state legislatures contemplate adopting the Uniform Trust Code (UTC), they should consider how it will interface with the Uniform Prudent Investor Act (UPIA).  Consistent with the principles of modern portfolio theory, the UPIA imposes a duty on trustees to diversify investments in the absence of “special circumstances.”  However, the UPIA is a default statute and therefore appears to contemplate that the settlor may negate this duty.  While the UTC is also, as a general rule, a default statute, it does contain fourteen mandatory rules that cannot be altered by the settlor.  Among these rules is the requirement that the trust be maintained for the benefit of the beneficiaries.  Depending on how one reads these uniform statutes, there is a potential conflict: Should a settlor’s direction against diversification be respected on the rationale that the UPIA is a default statute, or should it instead only be respected where it does not result in a violation of the UTC’s benefit-the-beneficiaries rule?

In a 2004 article, Professor John Langbein examined the UTC’s mandatory rules.  He argued that the duty to diversify investments cannot be entirely waived by the settlor.  Rather, just as a settlor cannot create a trust for capricious purposes, so, too, a settlor should not be permitted to waive the duty if it would violate the benefit-of-the-beneficiaries rule.  In other words, the settlor’s investment-related restrictions should not be respected if it would impair the value of the portfolio and thereby inure to the detriment of the beneficiaries.  In his example involving IBM stock, Professor Langbein posited a case where the trust instrument directed the trustee not to diversify.  He explained that modern portfolio theory has shown that such non-diversification creates a risk for which the investor is not compensated and that the settlor should not be permitted to impose foolishly this harm on the beneficiaries.  He also posited a case involving a direction to invest solely in the stock of the bankrupt ENRON corporation, where the trust fund was modest in size and the beneficiaries were the otherwise destitute widow and orphans of the settlor.  He concluded that no court would uphold such a restriction given the risk and reward profiles of the beneficiaries.  Professor Langbein maintained that the benefit-the-beneficiaries rule is designed to articulate the policies underlying the capricious-purpose cases and should serve as an outer limit on the scope of investment-related restrictions that the settlor may impose.

In a 2008 article, Professor Jeffrey Cooper considered the validity of investment-related restrictions in light of the benefit-the-beneficiaries rule, suggesting that courts called upon to interpret the UTC should reject Professor Langbein’s reading and inviting legislatures to rework the UTC language in order to foreclose this reading.1  In Professor Cooper’s view, the UPIA makes the duty to diversify a default rule.   As such, he argues, a settlor should be permitted to fully negate the duty in the instrument.  In support of his argument, he posits several hypotheticals.  Two estate-planning-driven transactions will first be considered.  First, he posits a life insurance trust, where as a practical matter the insurance policy is often the only trust asset.  Second, he focuses on a GRAT, a type of trust where tax advantages are more easily secured if each trust holds a single investment.  In both cases, a non-diversified portfolio is an essential part of the plan.  He argues that, if Professor Langbein’s version of the benefit-the-beneficiaries rule were applied, the trustee would be required to diversify and thereby undermine the planning advantages sought by the settlor.   He also posits transactions that are not estate-planning driven.  In one, an investor creates a trust at a time when the markets and the economy have recently collapsed; the investor is concerned about preservation of capital and is therefore unwilling to allow the trustee to invest in equities.  Professor Cooper questions whether, in such circumstances, a direction that the trustee invest only in fixed income would run afoul of Professor Langbein’s version of the benefit-the-beneficiaries rule.  As for Professor Langbein’s IBM hypothetical, he concedes that requiring the trustee to hold only IBM stock might be foolish, but argues that the settlor should be permitted such foolishness.

In a 2010 reply article, Professor Langbein argued that the UPIA must be read in the context of fundamental trust-law principles.2  That is, it must yield to the mandatory benefit-the-beneficiaries rule in the UTC.  In his view, Professor Cooper’s argument is a textualist one that fails to consider the overriding nature of the benefit-the-beneficiaries rule.  He reiterated his IBM example, maintaining once again that the settlor should not be permitted to foolishly impose such harm on the beneficiaries.  As for the life-insurance trust and the GRAT, Professor Langbein indicates that, in any given case, there may be offsetting advantages that make non-diversification appropriate.  As the UPIA indicates, diversification is not required if special circumstances justify a departure from this norm.

Professor Langbein also points out that, in the case of the GRAT, there is offsetting compensation for the risk of holding a single asset in the trust.  Presumably, the compensation he contemplates is the tax advantage.  Although Professor Langbein is not explicit about this, he may be read as suggesting that non-diversification undertaken in order to achieve a tax advantage is per se not inimical to the interests of the beneficiaries.  The same reasoning could perhaps be extended to other kinds of irrevocable trusts, which are typically created to achieve a transfer-tax advantage. He also makes the point that, in determining whether a portfolio is sufficiently diversified, it is appropriate to consider all of the resources otherwise available to the beneficiary – but presumably not the settlor’s other resources which might eventually be bequeathed to the beneficiary.

Conclusion

Where a state that has already enacted the UPIA is contemplating the adoption of the UTC, consideration should be given to the interface between these two statutes.  The enacting legislation should contain explicit language indicating whether the UTC’s benefit-the-beneficiaries rule is intended to trump the default aspect of the UPIA.  If the UTC is made paramount, an important question lurking in the background is whether a trustee acting under a non-diversification direction would have a duty to seek judicial relief – and whether any such duty could be negated in the instrument.3  In the absence of a duty, a trustee could follow the direction without concern about liability.   But if a duty is imposed, the trustee could not comfortably ignore the direction.  In the final analysis, the duty issue has the potential to affect significantly trustee behavior where the settlor directs against diversification.

  1. Jeffrey A. Cooper, Empty Promises: Settlor’s Intent, The Uniform Trust Code, and the Future of Trust Investment Law, 88 B.U. L. Rev. 1165 (2008). []
  2. John H. Langbein, Burn The Rembrandt? Trust Law’s Limits on the Settlors Power to Direct Investments, 90 B.U. L. Rev. 375 (2010). []
  3. The UTC contemplates no such duty. See the commentary under § 412; but see Restatement of Trusts (Third), § 66. []
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Cite as: Mitchell Gans, Duty to Diversify: Default v. Mandatory Law, JOTWELL (September 13, 2010) (reviewing John H. Langbein, Mandatory Rules in the Law of Trusts, 98 Nw. U. L. Rev. 1105 (2004), available on LexisNexis), https://trustest.jotwell.com/duty-to-diversify-default-v-mandatory-law/.