Recent New York cases highlight the perils of asset concentration
Reproduced with permission of Trusts & Estates magazine (March 2011)
Because a diversified asset portfolio is safer than a concentrated one, trustees who concentrate trust investments run a high risk of breaching the duty of prudence. In fact, Section 3 of the Uniform Prudent Investor Act (1994) requires diversification “unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”1 Unfortunately grantors, and even beneficiaries, sometime express a strong preference for one type of investment above all others. Expressing a preference can create severe tension between the trustee’s twin obligations to respect the grantor’s wishes and advance the beneficiary’s interests. Resistance to diversification from beneficiaries can also upset the already difficult relationship between current and future interests. Two recent lines of New York cases highlight the perils that can befall trustees who don’t balance these interests carefully.
It’s a Hard Knox Life
The first line of cases in late 2010, in which the New York Surrogate’s Court found trustee liability and then ruled on damages, concerned trusts set up by Buffalo, N.Y.’s prominent Knox family. For several decades, HSBC and its corporate predecessor served as trustee for seven Knox family trusts. In late 2005 and early 2006, HSBC resigned and commenced a proceeding for a judicial settlement of its account as the trustee of the Knox trusts. Having overseen millions of dollars worth of assets for several generations of Knox family beneficiaries, HSBC probably expected its years of service to be very lucrative. Instead, the beneficiaries successfully alleged negligence before the Surrogate’s Court, costing HSBC over $25 million in damages.
Much of the trouble sprang from the bank’s failure to diversify trust assets. Five of the seven rulings implicate asset concentration. We’ll focus on the longest-running and most-damaged trust, the Seymour H. Knox II Revocable Trust of 1957.2 That trust was initially funded with 5,000 shares of Woolworth (later Venator) stock and 5,200 shares of Marine Midland (later HSBC) stock. Though a fiduciary that invests in itself risks accusations of self-dealing, HSBC held its own stock for three decades. Meanwhile, HSBC held the Woolworth/Venator stock in an overweight position for four decades: by the mid-1990s, the stock still made up about 40 percent of the total trust portfolio.3 Although the Woolworth/Venator stock stopped paying dividends in 1995, HSBC held it until 1999.
Even when HSBC took steps to diversify the trust’s initial portfolio, it continued concentrating assets. Stock in Dome Petroleum, Ltd., purchased in 1969, represented over 40 percent of the trust’s holdings by 1989; stock in several other companies was held at various times in amounts greater than 20 percent of the total. This concentration of stocks occurred despite HSBC’s own policy against concentrating stocks at these levels.
HSBC justified these investments by claiming it was following orders. The Woolworth/Venator stock, for example, was held at the express request of the trust’s grantor, Seymour H. Knox II. By the 1990s, the then-beneficiary, Seymour III, was likewise counseling HSBC against divestment. HSBC also blamed both Seymour II and Seymour III for the trust’s unbalanced asset purchases and HSBC’s decision to retain its own stock as a major trust investment.
The Surrogate’s Court was unimpressed by HSBC’s arguments. A trust, the court observed, is just that: HSBC was entrusted with Seymour II’s assets and directed to use them for the benefit of Seymour III. Like all trustees, the trustee alone was obligated both by common law and statute to manage these funds prudently; the trustee couldn’t delegate this duty to other trust parties. In failing to manage the trust carefully, even though counseled against divestment by both the grantor and the beneficiary, HSBC breached its core responsibility as a fiduciary, putting itself on the hook for more than $21 million in damages to this one trust alone.
Don’t Blame the Instrument
Trustees can get some cover for concentrating assets if directed to do so by the trust instrument itself. But even then, trustees must be careful that they understand the instrument correctly.
Many of our regular readers will recall that J.P. Morgan Chase (Chase) learned this lesson in Matter of Dumont.4 Dumont’s 2010 companion case, Matter of Hunter, reiterates the point.5 Dumont and Hunter both involved a series of trusts in the Dumont family, whose origins can be traced back to a single testamentary trust (the Dumont Trust) created by Charles Dumont, who died in 1956. The Dumont Trust was funded almost entirely with Kodak stock. Dumont’s will, in a retention clause, instructed the trustee to retain that concentration of Kodak stock and released the trustee from liability for any resulting losses. The trustee was, however, allowed to divest if “some compelling reason other than diversification” arose.6 Chase retained the high concentration of Kodak stock in all the trusts until December 2001, despite a precipitous drop in Kodak stock value during the 1970s. This drop in value adversely affected both the Dumont Trust and several trusts for Charles’s descendants (which were at issue in the Hunter case). The trial court in Dumont held that Chase’s failure to diversify was a breach of duty in light of Kodak’s steep decline and low-income yield. As a result, the court assessed Chase damages of nearly $21 million.7 The appellate court reversed the trial court on a technicality, and though it also disagreed with the trial court on substance, it did so in dicta, causing some confusion as to how much a retention clause can sanction concentrated investments. In any event, Chase could have avoided exposing itself to expensive and risky litigation through the simple step of interpreting Charles’s will through the courts.
It’s less clear why Chase concentrated Kodak stock in the trusts at issue in Hunter, especially after the Dumont ruling. The trusts at issue in Dumont were funded in large part with Kodak shares that passed from the Dumont Trust, but nothing in the Hunter opinion suggests they were subject to the Dumont Trust’s retention clause. At trial, Chase offered several explanations for why it chose to retain the stock. The court derisively summarized Chase’s justifications as “a 23 year plan to diversify.”8 Since the Kodak shares in the various Hunter trusts originated with Charles, and the trusts in both cases were overseen largely by the same Chase employees, it’s at least plausible that Chase simply extended its practice of retaining Dumont’s shares from the Dumont Trust to its successor trusts.
Taken together, the fate of the Knox and Dumont/Hunter trustees highlight the perils of asset concentration. Trustees need to be aware of the fiduciary risks of asset concentration and regularly review trust portfolios to identify and address them. But when, as in Dumont and Knox, grantors or beneficiaries resist diversification, trustees are in a tricky position.
So what can a trustee do if he’s pressured to take an imprudent position? Because the duty of prudence test is very fact-specific, there’s no single way out of this conundrum, but there are a number of general steps that should always be taken. The banks in these cases were chided repeatedly for failing to regularly and adequately document their decision-making processes. Doing so might have saved them a heap of trouble. Ordinarily, the duty of prudence is measured not by performance in hindsight but by conduct throughout the trusteeship. But if a trustee’s decisions ultimately go poorly and he can’t show why he made them, it will be very hard to argue that he took the appropriate level of care after the fact. Papering the file with evidence of repeated and careful deliberations will help.
If the beneficiaries are all in agreement regarding retention, an asset retention agreement with a covenant to hold the trustee harmless may work. In other situations, petitioning the court for instructions may be appropriate. In the worst-case scenario, the most prudent course may be to resign.
1. A typical example of such a “special circumstance” would be when part of the trust’s purpose is to retain family control over a closely held corporation. This article assumes that the assets concentrated don’t directly relate to any trust purpose.
8. Hunter, supra note 5 at *11.
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