What a Professional Trustee Must Know About Investment

This is not intended to be a legal treatise.  It is a personal view, though based upon a legal perspective, of the level of investment knowledge a professional trustee ought to have or to acquire in order to be able to meet the standards for trustee conduct which are imposed under the law.  The paper updates one originally produced by the writer in August 1998.  Its message seems to have stood the test of time over almost two decades. The paper is addressed to persons who act as trustees as part of a profession or business and to those who advise such persons. It is also likely to be more relevant to trustees of trusts whose assets extend beyond, say, the family home, into broader fields of investment. 

The starting point is the prudent person investment test. Its expression is well known.  A trustee is obliged under section 13B of the Trustee Act 1956 to exercise “... the care, diligence and skill that a prudent person of business would exercise in managing the affairs of others”.  That test is amplified for any trustee whose profession, employment or business is or includes acting as a trustee.  For such people section 13C of the Act requires that the level of care, diligence or skill be that of a prudent person engaged in that profession.  Despite a Law Commission review of trust law, the statute remains the same.  Legislative change may come but it is not here yet. 

What does this statutory expression of prudence in investment actually require?  What is the standard against which trustees, especially professional trustees, should measure their actions?  How are those standards likely to change? 

This paper attempts to answer those questions by examining the following propositions: 

 CLEAR LIMITATIONS ON TRUSTEES' OBLIGATIONS

Before examining in more details the four suggestions referred to above, it is necessary to mark out some clear limits.  The first and obvious limit is that trustees are not obliged to be expert in the management of trust assets.  Others may be engaged to provide expertise although, at least for the present, a trustee may not delegate away completely his or her obligation to make the final investment decisions.  Such decisions will only be genuine (as opposed to expressions of a de facto delegation) if the Trustee has been able to make a meaningful assessment of the information supplied by an expert adviser. That means that, although expertise may not be required of the trustee, he or she must have sufficient knowledge to assess expert advice critically.  Without that knowledge the trustee is in no position to be able to make a decision which is reasoned, independent, and the product of a sensible assessment of the expert advice that has been tendered.  The question is how much knowledge is required and of what sort? 

Next, it is clear that a trustee is not a surety or insurer of the fund.  A trustee is not obliged to undertake the management of trust assets on the basis that any and all loss will be avoided.  It follows also that a trustee is not obliged to ensure that the very best return possible is sought and achieved for the assets which are held in trust. 

It is worth recalling also that a trustee is not expected to be stripped of personal preferences, beliefs or fears. Indeed, the trustee may bring those to bear in the course of deciding how to invest assets under the trustee’s control. However, he or she must do so genuinely in the interests of the trust. There s an overarching obligation to behave reasonably. This involves recognising those preferences, beliefs and fears and taking them into account in a sense that involves a more critical awareness of them than simply following them by rote. In all of this the trustee must do his or her best in the interests of the beneficiaries, something which is normally taken to mean in their financial interests. 

Finally, both the Trustee Act and the instrument by which the trustee is appointed will each bear on the risk a trustee has to liability for poor investment decision-making. The statute is relevant in the following respects: 

 
In addition to the possibility that a trust deed may express a contrary investment intention, many will limit or exclude liability on the trustee for mistakes or for loss occasioned to the trust fund, including by the diminution of invested assets, except in the case of deliberate dishonesty. Most modern trust deeds seek to limit to the greatest extent possible trustee liability for poor investment decisions. One reason for this is the fact that the pool of willing trustees in New Zealand is small and too onerous a set of investment obligations would make too many people unwilling to serve as a trustee. Another may be that those who establish trusts do not want their disgruntled beneficiaries being able to take shots at them when they see “what might have been”. Limitations of this sort may not be sensible and they are certainly not a complete “get out of Jail free” card for trustees. There is an irreducible core of trust obligations which cannot be avoided, the breach of which will give rise to liability despite express limitation clauses. 

These limitations make it clear that trustees are not supposed to be infallible, expert and completely impartial.  Trustees are human.  They will make mistakes.  They are allowed to! But they must act honestly and reasonably in the interests of their beneficiaries. The limitations also mean that in most cases it is too simplistic to say that the prudent investment test applies according to its tenor.  There will be other elements that determine the standard at which a trustee will be expected to operate, but the fact that a trustee may be able to call some of these limitations in aid of a defence does not mean that he or she will avoid the potential discomfort, inconvenience and cost of a claim being brought.   

The object of a professional trustee, or of an adviser to one, should be to ensure that the trustee follows appropriate practices and processes, the cumulative effect of which minimises the risk of a claim being made because of an investment mistake.  The remainder of this paper considers one such practice or process, namely the way in which trustees make their investment decisions. 

The duties which are imposed upon trustees are summarised in a number of texts and commentaries.  The duties associated with investment fall generally under the duty trustees owe to manage their trust efficiently and effectively, and to act reasonably and prudently.  Case law dealing with discharging the duty of efficient management shows beyond question that a trustee can never be passive and hope to fulfil the duty.  Amongst other things the limitations already covered are sometimes regarded as only applying when it can be shown that the Trustee has behaved as expected, in all respects other than the investment outcome. 

The duty of management carries with it the obligation to familiarise oneself with the trust deed, to take stock of assets and liabilities and ensure that the assets are properly held. It also requires a trustee to identify the background, circumstances, needs, abilities and disabilities of beneficiaries. These all necessitate a level of inquiry by the trustee.  A person taking over trusteeship of an existing trust must investigate the way in which trust affairs are being managed and take action as a consequence of that investigation.  The process of monitoring and reviewing the management and administration of the trust and its assets also involves inquiry into the way the assets are invested or deployed. 

Inquiry is not undertaken as an end in itself.  Inquiry is useless unless it produces a result.  The result sought from inquiry is information or knowledge and even that is not the end in view.  A trustee can only adequately fulfil the duty of efficient management which comes with a trustee appointment if the trustee has made diligent inquiry, is fully informed of the matters which affect the trust, and is therefore in a position to respond to, or to take any necessary action on, them.  The end to which the process of inquiry is directed is proper decision-making:  to act or not to act in a particular way or to a particular end, and to have reached that point in an informed and principled way. 

A Joint Working Party reported to Government in 1986 with the suggestion that the old list approach to trustee investments should be replaced with a “prudent person” test. At that time it made a number of pertinent observations.  It recognised that the move to a prudential test for investment would impose higher standards on New Zealand trustees, especially those of smaller trusts.  The authors of the Working Party Report noted that in moving to such a test trustees would face some difficulties.  The first was whether they possessed the expertise “necessary to select an advisor...  and to assess critically the advice they are given”.  The second difficulty was whether advisors able to provide the necessary guidance were readily available at a reasonable expense. 

Without debating the second of these difficulties, the first issue identified by the Joint Working Party accepted out of hand that in order to be able to acquit themselves of the responsibilities which a “prudent person” investment test would impose, trustees would need to develop sufficient knowledge and expertise themselves to be able to assess critically the advice they are given. 

The assumption made by the members of the Joint Working Party is not surprising.  If a trustee is unable to assess the strengths and weaknesses of advice, to determine whether further advice should be obtained and whether (or on what basis) to prefer one recommendation over another, it cannot possibly be said that the trustee is properly exercising his or her powers.  

It is one thing to seek advice, weigh it, challenge it if necessary, confirm it by obtaining further advice, and then reach a measured decision as to the way in which investment or management of trust assets should be undertaken.  It is quite another to hand that function over to someone who is perceived to be an outside expert and who is simply left to apply their supposed expertise to the process.  Unless the trust instrument is carefully drafted that is an impermissible delegation by the trustee.  

Delegation may be permitted by the trust instrument or it can be achieved by means such as the appointment of an advisory trustee to assist with investment decisions, so that trustees are absolved of liability if they follow the adviser’s direction. Another possibility is for a settlor to reserve the right of investment management during his or her lifetime so that this never falls to the trustees.    

Moreover, the rule against delegation does not prevent trustees entering into arrangements with an investment adviser under which the adviser exercises discretion to make or change an investment (under the current regulatory regime, a Discretionary Investment Management Service or “DIMS”). These arrangements will generally still have to be reported to the Trustee in some way and in most cases the trustee will reserve the right to require the adviser to change a decision it has made.  The Trustee is ultimately responsible for the decisions, despite the manager’s discretion. A DIMS does not absolve the trustee entering into it from responsibility for the investment outcomes delivered at the discretion of the adviser. A DIMS which does not reserve any vestige of oversight to the Trustees might well amount to the impermissible delegation of the trustees’ investment responsibility, at least under current law. 

The complete delegation of investment responsibility away from the trustee may be permitted if the law changes to allow it.  That may be a response to an ever more complex investment world in which it could be impractical for New Zealand to continue to impose on a small pool of potential trustees too onerous a set of investment obligations.  But the law has not moved to this yet, and it may not. 

It is fundamental, therefore, to the proper performance of his or her duties that the trustee obtain an appropriate level of knowledge so as to sustain an acceptable level of critical analysis of advice which is given about the investment or management of trust assets. Passivity as a trustee is generally inconsistent with the proper exercise of trustee duties and that is nowhere clearer than in terms of knowledge or learning which bears upon the conduct of a trusteeship.
 
5          WHAT IS SUFFICIENT KNOWLEDGE?

The only guidance in deciding what level of knowledge should be obtained comes from the statutory expression of the prudential investment test itself.  Though it may be unhelpful at first blush to say it, the level of knowledge required is that which, from time to time, will permit the professional trustee to determine whether, on the basis of the information being supplied, the investment and management of trust assets is being undertaken on a prudent basis, given the circumstances of the trust.
 
If the answer lies within the prudential test, what points can be made about that?  First, there is the expression of the test itself. The notion of prudence is of wisdom, care, circumspection and discretion; being careful to avoid undesired consequences. It, and the variations from which it has been drawn, have always directed the attention of trustees to those people in their community who are regarded as being prudent with their own and other people’s money.  This gives a contemporary and developing yard stick by which any trustee ought to be able to measure his or her capabilities.

The yard stick is not to look at those whom you regard as successful or smart or slick, or who necessarily make the biggest returns, but to look to the steps usually taken by those who are careful, circumspect and discreet in the investment and management of their own and other’s assets.  Few would suggest that those who fit that description in today’s world act without knowledge of, or at the least an instinct for, the markets which produce the return on which they rely.  Those who might make such a suggestion need to wake up quickly because the very measure by which prudence in the modern age is determined is changing fast. 
 
The products of the information age are no longer the preserve of the smart and the slick.  The careful, the circumspect and the discreet have them too.  You do not have to be a Queen Street merchant banker to access market information any more.  Rural and provincial New Zealand accounts for more than a fair share of connections to the internet, where countless commentators clamour to pitch their particular investment wisdom.  The professional trustee must be aware of changes in available information as they occur and be prepared to adopt them.  It is debatable, also, whether the person who offers professional trusteeship ought to be asking “must I?”  The better question is probably “should I?”  Perhaps it is better to be a standard setter rather than a standard follower, as long as the standard being set is a higher or better one than normal.
 
Probably the most important thing to be said about the prudential test in this regard is that what may be prudent today may be regarded as imprudent or wanting when measured against the standards of tomorrow.  The growth of information means, quite simply, that as we come to know more, views based on less knowledge are less likely to be considered prudent.  To take one example, the advisor who 20 years ago asserted a  prophetic ability to pick stocks consistently that “beat the market” without what might be thought of as disproportionate risk, could probably not make that assertion today and be considered serious. Many seem still to make such claims but the professional trustee who accepted such an assertion in the face of the contrary evidence that is now readily available, may not be acting prudently according to the standards that evidence suggests. This is not a hard and fast rule, but is an observation on the extent to which the scientific understanding of how markets operate has changed over time and the way such understanding could affect expectations of investment behaviour by professional trustees.
 
That is not to say that one must anticipate the standards of tomorrow and apply them now.  Case law indicates quite clearly that trustees are not required to endow themselves with prophetic wisdom, or to ignore the perceived wisdom of their time. However, as that wisdom changes it is inevitable that a trustee’s behaviour must change also.
 
As the standards adhered to in the investment community at large rise, so do the expectations on trustees which are inherent in the prudential investment test.  Though prophetic wisdom is not expected, anyone who purports to practice as a professional must be aware of developments which may affect the investment and management of the trust’s assets, to be able to assert successfully, and on a continuing basis, that the threshold of prudence has been satisfied.  It follows, that, as with all professions, the profession of trustee requires a commitment to consistent and continuing “up-skilling”. 

When the first version of this paper was written, the information age was relatively new and it was travelled via what was often called an information “super highway”.  The breathlessness of that description has been overtaken by the simple expectation that, as part of everyday life, we should be able to find any fact or opinion that has been or is being expressed in our global village. The ready availability of information, commentary, criticism, analysis and statistical material affecting investment decisions is trite.  

Equally clear is that the means by which information is available will continue to expand.  Those in our community who set the benchmark of prudent investment have access to and actively obtain much more information than was available to their antecedents.  Those who follow them will have more and different tools with which to process, arrive at and implement their decision-making.  Therefore, as the information “mores” of our community change, the measure of what knowledge the prudent person of business should seek out before making an investment will also change. 

Anyone who has seen the amount of raw investment data now available from the internet knows that the challenge no longer lies in obtaining information.  Indeed, there is often too much of it.  Now the challenge lies in distinguishing between information which is relevant and that which is dross, and analysing the pertinent information sufficiently well to arrive at a good decision; a prudent decision. 

I do not advocate that trustees must be able to sort all this information and analyse it as it relates to investment markets or asset classes.  That would be contrary to the principle that trustees are not required to be expert themselves.  What I do say, however, is that the trustee who is ignorant of these markets and so is unable critically to engage those experts who make it their job to analyse them and offer investment recommendations, is failing as a trustee.  After all, if the modern prudent investor is equipping him or herself with knowledge of these markets in order to be in them, how can the modern professional trustee, whose actions are to be measured against the same standard, expect not to? 

The professional trustee who cannot show a process of inquiry, engagement on issues, debate and decision-making, will be susceptible to claims from disappointed beneficiaries if the advertised expertise of those on whom the trustee relies for advice falls short of expectations, and the performance of and return from trust assets is manifestly inadequate. 

I emphasise the “manifest” inadequacy of returns.  Claims against trustees will never be upheld when they relate to the margins of what would be regarded as an unacceptable or an acceptable return.  To date New Zealanders have been very tolerant of the investment performance of professional trustees.  But what is a manifest inadequacy may well change over time.  When the information tools exist, as they do now, to show how much money a trust investment portfolio might have earned compared with what it did, tolerance for suboptimal performance is highly likely to erode, and quickly. 

The sheer volume of investment-related information is both a curse and, potentially, a great protection for the professional trustee.  It is a curse because the “noise” created by so much information can crowd out simple truths.  The professional trustee must still be vigilant of the “snake-oil salesman” who today touts his investment message from website or blog.  But the information that reinforces simple truths about investment has now developed to such an extent that, once found, it is hard to ignore. 

It is possible now to measure the historic returns of virtually every type of security across any number of markets and for decades past.  It is possible to determine whether any stock types have performed better than others year on year.  It is possible to track historical returns for benchmark indices over very considerable periods.  All that information is available freely.  It takes a little effort to find and use it, but it equips the professional trustee with a raft of inquiry tools with which to test investment propositions of those from whom he or she receives advice. 

While not having to be an expert, the modern professional trustee must therefore have a broad understanding of the way the available investment markets operate, must be able to bring an understanding of current and forecast economic factors to bear upon the advice he or she is receiving, must ensure that if certain investments, investment instruments or vehicles are being recommended, he or she has an understanding of them and must be able critically to assess the worth of that recommendation. While a trustee need not always get it right, no trustee can afford to receive investment advice and say, “I don’t get it at all”.
 
© G D Clews, November 2015