When Holding a Single Stock Isn’t Imprudent

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award.

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In last month’s column, I explained that one of the fundamental, underlying goals of the great reformation of American trust investment law that began in the 1980s was to restore flexibility and generality to the Prudent Man Rule through creation of the Prudent Investor Rule. This was achieved with promulgation of the Restatement (Third) of Trusts (Restatement) in 1992 (with various refinements in subsequent volumes) and the Uniform Prudent Investor Act (UPIA) in 1994. Since then, the UPIA has been enacted into law by nearly every state in the Union, as well as the District of Columbia and the U.S. Virgin Islands.

Regular readers of this column will know that one of the virtues of prudent investing that I regularly preach is to provide portfolios that are broadly (across the funds comprising a portfolio) and deeply (within each fund in a portfolio) diversified to reduce risk (and enhance return). Such portfolios may contain thousands of securities from dozens of countries and include all the world's major asset classes.

Surely, then, a multimillion-dollar portfolio holding a single, measly stock must be imprudent per se, right? Well, maybe not.

I sometimes do expert witness and consulting work on the side in addition to my day job as a principal in a registered investment advisory firm. Over the years, I have been asked to take on cases in which I would need to opine about the prudence of nondiversified portfolios. In most of these instances, the side seeking to preserve such a portfolio as is has asked me to render an opinion that would justify its retention. I have always declined since I believe that, say, 75% of the value of a portfolio invested in one stock--without relevant supporting facts and circumstances--cannot be prudent or diversified.

There was, however, a case that I was asked to take on where the portfolio was invested 100% in one stock only. You cannot get a portfolio more underdiversified and imprudent, on its face, than that, in my view. This case actually involved 14 different portfolios held by a prominent family still very much involved in a product that its forebears began providing to consumers more than 135 years ago. (I have changed the facts of the case to protect the innocent but the issues raised in this discussion remain the same; still, all the portfolios involved here actually held only a single stock.)

Each of these portfolios was held by a separate family irrevocable trust. (Don't forget, the Restatement and the UPIA apply to the investment conduct of fiduciaries of private family trusts.) I had my hands full analyzing the terms of 14 family trusts--expressed by different attorneys in varying degrees of precision--drafted over a period of nearly a century.

After an intensive review of the facts and circumstances of the case, I decided to accept the charge--and the challenge--to justify that a portfolio, based on relevant supporting facts and circumstances, could hold but a single stock and yet legally be diversified prudently according to the tenets of modern prudent fiduciary investing.

Like any issue, there were two sides here. One side of the family wished to hang on to the stock while the other wanted to sell it and diversify the portfolios. How to analyze this and where to start? Well, the place to start an analysis of this type must be the trust instrument (i.e., the private family trust) in question. It is there that the trustor (i.e., the person, also known as the settlor in some states, who set up and funded the trust for the benefit of certain beneficiaries) presumably has expressed his or her wishes in establishing the trust clearly enough so that succeeding generations of trustees (i.e., fiduciaries) will be able to carry them out faithfully for the benefit of the trust’s beneficiaries (i.e., those who benefit from the largesse of the trustor’s trust property and/or income).

The sticking point here is that in drafting trust instruments, trustors often fail--even with the help of high-priced legal talent whether hired a hundred years ago or today--to make their intentions sufficiently clear to those who come after their demise. In this case, the language of the trusts expressed a strong desire for trustees to buy--and to keep buying whenever possible--the stock of the family business so as allow the family to retain effective control of it. It would have been an easier case for our side if the trust language had instead read something like this: "Trustees must buy the stock of the family business and never give it up or risk eternal damnation." If that had been the situation, though, I would have never run across this fascinating case.

The UPIA was used to analyze this case because, as noted, the legislature of virtually every state has enacted it into law. In my home state of California, for example, the UPIA is codified in Probate Code sections 16002(a), 16003 and 16045-16054.

Probate Code section 16046 reads, in part: "(a) Except as provided in subdivision (b), a trustee who invests and manages trust assets owes a duty to the beneficiaries of the trust to comply with the prudent investor rule. (b) The settlor may expand or restrict the prudent investor rule by express provisions in the trust instrument …"

Another way to understand the preceding snippet of section 16046 is to say that ordinarily the language of a trust instrument will be given effect without reference to the UPIA at all. In effect, then, the UPIA is default law. That is, only when the language of a trust instrument is, say, silent about a particular issue will the relevant rule of the UPIA apply. For example, if trust language instructs the trustee to, in effect, really, really diversify the trust portfolio a lot, the UPIA doesn't kick in because the language makes it reasonably clear as to what the trustee is supposed to do with respect to diversification: you'd better do it and reasonably thoroughly.

But if the trust's language says nothing about diversification, then the UPIA's general duty with respect to diversification--ye shall diversify a trust's assets unless it’s not prudent to do so--must be followed by the trustee. As Probate Code section 16048 reads: "In making and implementing investment decisions, the trustee has a duty to diversify the investments of the trust unless, under the circumstances, it is prudent not to do so."

Probate Code section 16047 lays out the standard of the Prudent Investor Rule and reads, in part:

"(a) A trustee shall invest and manage trust 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.

(b) 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. [By the way, this subsection (b) makes clear that the relevant unit of analysis for evaluating trust assets is the portfolio which underscores the significant influence of modern portfolio theory on the UPIA and the Restatement.]

(c) Among circumstances that are appropriate to consider in investing and managing trust assets are the following, to the extent relevant to the trust or its beneficiaries: ... (8) An asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries."

The language of the preceding subsection (c)(8) of Probate Code section 16047 became the battlefield upon which this case was fought: "An asset's special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries."

My argument that the stock of the family business should be retained in the trust portfolios--until the trusts terminated--was based on authorizing language in the trust instruments, relevant supporting language found in the UPIA and the Restatement, plus the following facts:

>The only asset ever held by any of the trusts was the stock in the family business.

>There was no indication in the record that family members ever considered funding the trusts with other than family stock.

>No family stock was ever used to pay estate taxes on the lives of family members; only other assets were used.

>All family member beneficiaries, including those who wished to sell the family stock, admitted that they had a "special relationship" to that asset given the family legacy with the family business, the length of time in which the business had existed as a going concern, the family’s ongoing relationship with the business both as members of the board of directors and as employees.

Were my arguments convincing to the judge in the case? Alas, I'll never know. The feuding family factions, after spending millions of dollars in litigation costs, decided to settle in the end. Still, the case was a fascinating one and demonstrated in spades that no type of investment or any course of action or investment strategy is imprudent per se.

Does this mean that all investments are prudent in some way or the other? Of course not. Rather, it means that an investment, or course of action or investment strategy, can be prudent only when it is consistent with the standards of modern prudent fiduciary investing and only when the facts and circumstances are in accord with those standards in the given situation.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.