On August 15, 2018, the Appellate Division of New Jersey’s Superior Court ruled that a corporate trustee had breached its fiduciary duty when it sold original trust investments in order to diversify the trust portfolio. In the Matter of the Trust of Ray D. Post, Appellate Division Docket No. A-0929-16T1. In Matter of Post, an unpublished decision, the court ruled that the trustee’s sale of the investments was a breach because it violated the grantor’s express instructions to retain property originally transferred to the trust.
It is has long been an abiding principle of law in the field of fiduciary investing that a trust must diversify the trust portfolio. Diversification “is the act of investing in a wide range of companies to reduce the risk if one sector of the market suffers losses.” Black's Law Dictionary, 7th edition, 1999. Otherwise stated, diversification is the opposite of putting all your eggs in one basket. Diversification involves “the receipt of a concentrated portfolio, and selling off the majority of the concentration before any hint of problems with the company or stock is received. Diversification is a sale which is done even when the subject company’s value is climbing.” Matter of Dumont, 2004 NY Slip Op 50647(U) (Surrogate’s Court, June 25, 2004), rev’d, 809 N.Y.S.2d 824, 26 A.D.3d 824 (2006).
A fiduciary’s obligation to diversify investments was codified in New Jersey by the adoption in 1997 of the Prudent Investor Act, N.J.S.A. 3B:20-11.1–N.J.S.A. 3B:20-11.12 (the “PIA”), which was based on a uniform model act that has been adopted by a great majority of the states. The PIA requires a fiduciary “to diversify the investments of a trust unless it is reasonably determined that, because of special circumstances, the purposes of the trust are better served without diversification.” Id.
Even before the adoption of the PIA, a New Jersey trustee had a duty to diversify investments. As the court observed in Erlich v. First Nat’l Bank of Princeton, 208 N.J. Super. 264 (Law Div. 1984), “[d]iversification has been the rule since the early case of Dickinson's Appeal, 152 Mass. 184, 25 N.E. 99 (1890).” Id. at 294.
Significantly, in Matter of Post, the trust instrument provided that “[t]he trustee shall retain, without liability for loss or depreciation resulting from such retention, the property received from the Grantor.” (Emphasis added). The grantor in Post had originally transferred to the trust publicly traded stock in Exxon and AT&T as well as an AT&T bond. The trustee held these concentrated positions from May, 1989, the date of the grantor’s death, through September 2000. At that point, the trustee began to sell the original trust investments and diversify the portfolio.
Prior to diversifying, the trustee sought the advice of counsel. Counsel initially advised that “the retention provision did not deprive [the trustee] of power to sell the stock,” and if the trustee chose to diversify, it could notify the trust beneficiaries and seek their consent, or it could seek authorization to deviate from the language of the trust in a court action. Shortly after the trustee commenced diversification, counsel warned, apparently based on recent court precedent, that the trustee “would be acting at its own peril” if it diversified without applying to the court for advice and direction. Id. Despite this advice, the trustee neither obtained the consent of the beneficiaries nor sought the approval of a court.
Once the beneficiaries learned of the trustee’s failure to follow the grantor’s instructions, they objected and sought damages from the trustee.At trial, the trustee argued that it had a duty to diversify in order to avoid a catastrophic loss, and that its decision to diversify was “routine good trust administration.” Id. It maintained that had it failed to diversify, it would have risked a claim for breach of fiduciary duty. Id. The trustee argued it had no duty to obtain the consent of the trust beneficiaries to diversify, as the management of the trust lies with the trustee and the beneficiaries “have no voice in investment policy.” Id. The trustee further argued it had no duty to seek court approval before diversifying because approval is for the benefit of the trustee, not the beneficiaries. Id. The trial court ruled against the trustee and found a breach had occurred.
On appeal, the court noted that under the PIA the grantor’s intentions are paramount, and if there is doubt as to such intentions application should be made to a court. Id., citing N.J.S.A. 3B:20-11.2(b). Importantly, “the prudent investor rule is a default rule that may be expanded, restricted, eliminated, or otherwise altered by express provisions of the trust instrument.” Id. In other words, the grantor’s intent as determined by the trust instrument controls over the duty to diversify. As the court noted, the statute provides that a fiduciary is not liable for reasonably relying on such express provisions, and that the trustee could apply to a court in order to deviate from the trust provisions for such reasons as are otherwise permitted by law. Id.
In Post, however, the court found that it was “beyond cavil” that the grantor had directed the trustee to retain the stock transferred to the trust, and, notably, that the grantor “specifically insulated his trustee from liability against any claim being raised if it failed to diversify.” Id. If, notwithstanding the retention provision, the trustee felt it was better to diversify, “it was obligated to seek authorization from the court before selling the trust’s corpus.” Id. (emphasis added), citing N.J.S.A. 3B:20-11.2(b). Accordingly, the court affirmed the trial court’s ruling in favor of the beneficiaries and found that the trustee had breached its fiduciary duty by failing to diversify, and awarded damages of more than $520,000.
Although an unpublished opinion, the rationale of the decision is significant in at least two respects. First, the decision recognizes that the duty to diversify is subordinate to an express provision in the trust instrument that directs a trustee to retain a prescribed investment position. Second, while not strictly prohibited from diversifying where the trust directs that investments be retained, a trustee must seek court intervention before selling trust corpus if it seeks to diversify in the face of such instructions. Based on the court’s ruling, it appears that even the consent of the beneficiaries might not have protected the trustee. The decision thus reflects that the duty to diversify, while part of the law throughout the country, is not a universal mandate and must be examined in view of the terms, purposes and circumstances of a particular trust.