Duty to Diversify: Default v. Mandatory Law

John H. Langbein, Mandatory Rules in the Law of Trusts, 98 Nw. U. L. Rev. 1105 (2004), available on LexisNexis. Mitchell Gans As state legislatures contemplate adopting the Uniform Trust Code (UTC), they should consider how it will interface with the Uniform Prudent Investor Act (UPIA). Consistent with the principles of modern portfolio theory, the UPIA imposes a duty on trustees to diversify investments in the absence of "special circumstances." However, the UPIA is a default statute and therefore appears to contemplate that the settlor may negate this duty. While the UTC is also, as a general rule, a default statute, it does contain fourteen mandatory rules that cannot be altered by the settlor. Among these rules is the requirement that the trust be maintained for the benefit of the beneficiaries. Depending on how one reads these uniform statutes, there is a potential conflict: Should a settlor's direction against diversification be respected on the rationale that the UPIA is a default statute, or should it instead only be respected where it does not result in a violation of the UTC's benefit-the-beneficiaries rule? In a 2004 article, Professor John Langbein examined the UTC's mandatory rules. He argued that the duty to diversify investments cannot be entirely waived by the settlor. Rather, just as a settlor cannot create a trust for capricious purposes, so, too, a settlor should not be permitted to waive the duty if it would violate the benefit-of-the-beneficiaries rule. In other words, the settlor's investment-related restrictions should not be respected if it would impair the value of the portfolio and thereby inure to the detriment of the beneficiaries. In his example involving IBM stock, Professor Langbein posited a case where the trust instrument directed the trustee not to diversify. He explained that modern portfolio theory has shown that such non-diversification creates a risk for which the investor is not compensated and that the settlor should not be permitted to impose foolishly this harm on the beneficiaries. He also posited a case involving a direction to invest solely in the stock of the bankrupt ENRON corporation, where the trust fund was modest in size and the beneficiaries were the otherwise destitute widow and orphans of the settlor. He concluded that no court would uphold such a restriction given the risk and reward profiles of the beneficiaries. Professor Langbein maintained that the benefit-the-beneficiaries rule is designed to articulate the policies underlying the capricious-purpose cases and should serve as an outer limit on the scope of investment-related restrictions that the settlor may impose. Continue reading "Duty to Diversify: Default v. Mandatory Law"

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