Course 9—Abuse Involving the Diversification of Trust Investments

This course addresses a trustee’s failure to diversify trust investments as required under California’s Prudent Investor Act. As usual, let’s start with a basic understanding of the trust law we will apply to this problem

The Basics of California Trust Investing                                              

Under California’s Prudent Investor Act, a trustee has a duty to diversify the trust investments unless it is prudent not to do so. The duty to diversify applies to all trustee investment decisions unless the trust document expressly limits or eliminates this duty.

Trust-Investing Hypothetical: Sam as Abused Trustee

Let’s consider a hypothetical situation to demonstrate the problems that arise and the options you have when confronted with a California trustee who fails to diversify trust investments. After the hypothetical, we will discuss trust diversification in more detail.

In 1994, Linda Hamilton creates a revocable living trust and transfers her ten-unit apartment building, her personal residence, and her brokerage account into the trust. Linda is named the sole trustee during her lifetime, and her CPA, Ben, is named successor trustee.

Linda has one son, Sam. Sam has physical handicaps that make it difficult to walk, but he has full mental capacity. Sam is named as the sole beneficiary of Linda’s trust after Linda dies. In 2005, Linda creates a trust amendment that requires Sam’s share to be held in trust for Sam’s lifetime rather than distributed to him outright. Sam is named co-trustee of his trust to act with Ben. The “Sam trust” requires all income from the trust estate to be distributed to Sam, and as much of the principal as Sam needs for his health, support, maintenance, and education.

In 2010, Linda dies and Ben takes over as successor trustee of her trust. Ben reviews the trust document and 2005 trust amendment, but he decides not to create the Sam trust. Ben fails to tell Sam he is a co-trustee of the Sam trust. Instead, Ben chooses to administer the trust as if he were sole trustee.

Ben determines that the apartment building is in disrepair. Ben can either sell the apartment building and reinvest the proceeds or invest substantial money from the trust to improve the properties. Ben does not consult a financial planner; instead, he simply spends over half a million dollars repairing the apartment building. Ben also charges the trust both trustee fees and management fees to act as property manager of the apartment complex. Even after the repairs are completed, the apartment building incurs substantial expenses every month for costs of operation. The apartment generates net income of less than $50,000 per year.

After Linda’s death, Sam asks Ben if he can live in Linda’s home, which is part of the trust estate. Ben says no. Instead, Ben spends $100,000 of the trust money to fix up the home and then rents it for $2,500 per month, nearly $2,000 below the fair market value rent.

After the repairs to the real estate and Linda’s home, the trust only has $150,000 in investments left in the brokerage account. Ben claims this money cannot be used for Sam’s benefit because it must be kept in reserve to fund expenses on the apartment building.

After all the costs and fees incurred by the trust every year, Sam only receives $3,000 per month. From that money Sam must pay his rent, buy his food, and pay for a part-time caregiver. Currently the apartment building is valued at $6.5 million, and the personal residence is valued at $2 million. Ben refuses to sell any of the real estate and tells Sam he must make do with $3,000 per month because that is all the net income the trust produces.

Sam is frustrated with Ben’s actions. Sam would like to have more money to provide for his health and support, but Ben refuses to sell any property. And Ben receives only $36,000 per year, which is less than 0.5% of the total trust value.

When Sam consults with a lawyer and financial planner, he is told that he is being abused. The financial planner believes the trust assets should be diversified to protect the principal and increase the amount of income available for Sam’s benefit. The lawyer is shocked to learn that Sam is a named co-trustee but was never told he had the right to co-manage the trust estate.


Sam’s Options

It now appears that Ben has ignored his duty to diversify the trust assets and caused substantial harm to the trust estate. What can Sam do to recoup the losses he has sustained and to properly correct the trust investments now so no further harm comes to the trust assets? Here are the options:

  1. Petition for removal. File a petition to remove Ben as trustee and ask the court to suspend Ben immediately pending his permanent removal.
  2. Petition for accounting. File a petition to force Ben to prepare and file a proper trust accounting.
  3. Petition for surcharge. File a petition to surcharge Ben for the lost profits the trust has suffered.
  4. Trust contest. File a petition to invalidate the 2005 trust amendment.
  5. Request resignation. Ask Ben to resign and appoint a professional trustee.

Our Expert Recommendation

Sam has a big mess on his hands. On paper, Sam is a multi-millionaire and should be receiving support of more than $3,000 per month. Yet Ben has made additional distributions impossible by failing to diversify the trust assets. Currently, the trust assets are invested entirely in real estate.

Option 1: at Albertson and Davidson, LLP, we would first recommend that Sam seek Ben’s removal and suspension based on Ben’s failure to follow the trust terms (he never told Sam he was a co-trustee nor allowed Sam to act as co-trustee) and failure to properly diversify the trust assets. Ben has also breached the trust terms by failing to provide more substantial distributions to Sam.

For example, Sam should receive all trust income, but Sam also has a right to trust principal if he requires more money for his care and support, which these facts suggest he does. In that case, Ben has a duty to liquidate some of the real estate to make principal available for distribution. If the principal is illiquid because it is held in real estate, then Ben has a duty to sell the real estate to raise cash that can then be distributed to Sam. The same would be true if the trust owned stocks, bonds, or any other type of non-cash investment.

The problem here is that Ben is failing to treat Sam fairly. The trust was meant to benefit Sam quite generously, yet Ben has arranged the trust estate in a way that precludes Sam from accessing trust principal.

Every trustee has a duty to invest trust assets as a prudent investor would do, taking into account the purposes, terms, distributions requirements, and other circumstances of the trust (see California Probate Code section 16047(a)). Here, Ben has done none of that. Ben has invested the assets without any considerations to the distributions requirements of the trust. Ben has also blocked Sam from acting as co-trustee and having a say in how the assets are invested. The only way to remedy this problem is to remove Ben from being trustee.

Option 5: you certainly could start with option 5 and ask Ben to voluntarily resign. In our experience, that will rarely happen, but it’s worth a shot. If Ben refuses, then you can proceed by filing in court for Ben’s removal under option 1.

Option 2: a petition for an accounting may be desirable depending on the circumstances. The problem with requesting a full accounting in this type of case is that it could cost the trust tens of thousands of dollars to prepare the accounting. If you have access to the financial information, then preparation of a formal accounting may not be necessary.

We would also obtain financial information directly from the financial institutions by issuing subpoenas. If we can determine the financial issues based on the subpoenas, then an accounting may not be required. If there are confusing transactions or money missing, then an accounting may be required. It all depends on the circumstances of the case once you discover more information.

Option 3: a petition for surcharge may be appropriate depending on the circumstances. We would not automatically file for surcharge against Ben, but we might. It depends on (1) whether Ben stole any money from the trust, (2) whether Ben has any assets to collect from if we do file suit against him, and (3) whether there was any loss from the trust estate.

For example, Ben did invest substantial sums into the real estate, but if the real estate appreciated during the time Ben was acting as trustee, there may not be a financial loss. The real estate can now be sold, and the costs invested would be recouped in the form of financial gain. Let’s assume the property increased in value from $1 million to $5 million, with $500,000 spent on improvements and upgrades to the property. The investment may be reasonable under these circumstances since the real estate achieved a gain of $4 million. As such, there may be no financial loss to the trust estate. Ben still breached his duties by refusing to sell the real estate to allow for proper diversification of investments and distributions of principal to Sam, but Ben may not have caused financial harm to the trust assets.

If, however, the real estate lost value after Ben invested $500,000 in improvements and upgrades, then Ben may be liable for that financial loss. Of course, if Ben has no money, then suing him may be a lost cause. Again, it all depends on the circumstances after you discover further information. Don’t assume that you will sue the trustee for a financial loss. Instead, study the facts of your case and then make a good decision based on the likelihood of success.

Option 4: contesting the trust would never be a good option here because contesting the trust will not help with the investment problems. Also, the trust probably has a no-contest clause that would be triggered, thereby disinheriting Sam from everything if the trust terms are challenged. Sam has generous distribution terms under the trust. It is far better to enforce those distribution terms rather than contest the trust document and risk disinheritance.


The Law of Diversifying Trust Assets

The California Uniform Prudent Investor Act (found at Probate Code sections 16045 to 16054) imposes investment duties and rules on all California trustees. Every trustee must follow the terms of the Prudent Investor Act except to the extent excused by any express terms of the trust document.

The Uniform Prudent Investor Act requires trustees to invest trust assets as a prudent investor would by considering the purposes, terms, distribution requirements, and other circumstances of the trust. The trustee must use reasonable care, skill, and caution when investing.

The Prudent Investor Act also requires trustees to diversify the trust assets, unless under the circumstances it would be imprudent to do so. The investment rules incorporate the concept of Modern Portfolio Theory (MPT) into trust investing. Under MPT, the entire investment portfolio is considered when creating and implementing an investment plan.

In the past, each single trust investment was considered in isolation to all other trust investments. This meant that a trustee could be held liable if a single investment was viewed as imprudent. That is no longer the case under the California Uniform Prudent Investor Act. Under the act, all the investments are considered when determining whether the investment plan is prudent or not.

Why Diversify?

Diversification is a concept widely used in MPT where the risk of loss is spread over different asset classes. To say it in plain English: don’t put all your eggs in one basket. If you have all your money tied up in real estate, and real estate declines in value (as happened in 2008 during the Great Recession), then your entire investment portfolio will lose value. However, if you only have ten percent of your total investments in real estate, then a decline in real estate will only affect ten percent of your investment values. The other ninety percent can be spread out among stocks, bonds, cash, and other investment classes. By diversifying, you can manage your risk of loss by limiting the amount you invest in each type of asset.

Every trustee has a duty to distribute risk of loss by reasonable diversification of trust assets. (See Estate of Collins (1977) 72 CA 3d 663, 669.) A portfolio must be designed and implemented to take into account the proper diversification of trust assets among several asset classes.

Diversification is particularly important in trust investing where the primary goal is to maintain trust principal. Prudent trust investing still requires some income and growth potential for the investment portfolio, but protecting principal is more important for trusts because we want to protect the trust money for the beneficiaries.

For more information on diversification, take a look at this article, “Why Diversification Matters,” from Fidelity:

The Duty to Diversify—Why Is It Violated So Often?

Probate Code section 16048 requires every trustee, in making and implementing investment decisions, to diversify the investments of the trust unless under the circumstances it is prudent not to do so.

While the duty to diversify seems simple enough, it is often violated. The problems usually begin when a successor trustee takes over an existing investment portfolio. The successor trustee may believe that the investments made by the settlor (or prior trustee) must be retained or that they are automatically prudent because the settlor made the investments in the first place.

For example, assume that the settlor built and owned an apartment building for the last three decades. The settlor rented the units and lived off the rental income. And the apartment building is the only asset of the trust. After the settlor dies, the trust becomes irrevocable, and the successor trustee takes over management of the trust estate. Can the successor trustee continue to own and operate the apartment building? That depends on the circumstances.

If the trust requires the estate be held in trust for the lifetime of a child, and the child is entitled to regular income distributions, then the apartment building may not be the best investment. First, the apartment building is not diversified because it is the only asset of the trust estate. That means all the trust assets are tied up in real estate—a violation of the duty to diversify. And the only way in which to diversify the trust estate is to sell the apartment building and reinvest the proceeds.

Second, the apartment building may not provide the best return on investment. If there are substantial expenses for the apartment, then the costs may outweigh the rental income. In that event, a different investment may more easily produce income without any risk of paying expenses.

Third, the distribution requirements of the trust must be taken into account when structuring an investment portfolio. If money is needed for a beneficiary’s health and support, as was true for Sam in the chapter’s hypothetical, then the trustee may have to dip into principal, which can be impossible to do when the principal is real estate.

The bottom line: the successor trustee needs to make their own analysis for the proper investment approach for the trust. The trustee cannot simply maintain the status quo that the settlor created. What was good for the settlor may no longer be good for the trust beneficiary. The trust settlor had the right to violate the Prudent Investor Act because it was their money, whereas a successor trustee must follow the Prudent Investor Act because the money now belongs to the beneficiaries (especially where the trust has become irrevocable).

Once a successor trustee takes over, everything changes. The rights of the beneficiary(ies) changes, the duty to invest changes, the distribution requirements may change—it’s a whole new world. If the trustee does not create and implement a proper investment plan, then the Prudent Investor Act will be violated.

The Investor Policy Statement

Nothing under the Prudent Investor Act requires a trustee to have a written investor policy statement, but every trustee should have one anyway. An investor policy statement is a written document that sets out the risk and loss tolerance of the client and the investment plan the client should use to meet their goals. Nearly every financial institution has investor policy statement forms that you can customize with the help of your financial advisor.

Under the Prudent Investor Act there are many different factors a trustee must consider when creating an investment plan. Probate Code section 16047(c) requires trustees to consider:

  1. General economic conditions;
  2. The possible effect of inflation and deflation;
  3. The expected tax consequences of investment decisions or strategies;
  4. The role that each investment or course of 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

An investment plan must be created after taking into account the above considerations. And then that plan must be implemented, regularly reviewed, and adjusted when needed to meet the overall investment goals and objectives. In other words, there is a lot to consider, decide, implement, and review. How can a trustee possibly do all of that without a written investor policy statement? More importantly, why would a trustee do all of that without a written policy statement?

By having a written investment policy statement, the trustee can prove that they created and implemented a prudent investment plan. If notes are taken when meeting with the financial advisor, the trustee can prove that the investment plan was reviewed and any necessary changes were made to meet the investment goals. This type of proof is invaluable if the trustee is ever challenged for imprudent trust investing. And it has the added benefit of encouraging proper investing in the first place.

If you are a California trustee, do yourself a favor and create an investor policy statement with your financial advisor. If you are a California beneficiary, find out if your trustee has a written investor policy statement. If so, then you may be in good hands. If not, then be afraid, be very afraid . . .

In the case of Ben and Sam, Ben could have easily consulted a financial planner and created an investor policy statement. That plan should have included input from Sam since he was a named co-trustee. Once a plan was created, it could have been implemented to (1) benefit Sam, and (2) protect Ben from any future lawsuit for breach of his trustee duty to diversify trust assets. Sam’s case is especially egregious considering he had a trust worth $9.5 million, yet Sam was living on $3,000 per month. Even a modest investment return of 3% per annum would have given Sam over $20,000 per month in income. Why was Ben being so abusive? Who knows? But Sam has the right to stand up and fight back for his rightful trust distributions.

Trust investment problems, or financial mismanagement, can wreak havoc on your trust estate. If you have questions about your trust investments, feel free to contact us at Albertson & Davidson, LLP . Our firm has handled hundreds of trust investment problems.

In Sam’s case, he was the sole beneficiary, but what if Ben were treating another beneficiary more generously than Sam? The next topic of beneficiary abuse: a trustee’s duty to treat the beneficiaries fairly and equally.