Queensland University of Technology Law and Justice Journal
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Queensland University of Technology Law and Justice Journal |
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W A
Lee[*]
Within the last five years all Australian jurisdictions, following a New
Zealand lead, have abolished the old statutory list of authorised
trustee
investments and have given trustees an unlimited investment
power.[1] In England s 3 of the
Trustee Act 2000 provides that “a trustee may make any kind of
investment that he could make if he were absolutely entitled to the assets
of
the trust”. The power is made subject to duties of care.
The new
Australasian legislation provides that:
A trustee may, unless expressly
prohibited by the instrument creating the trust –
| (a) | invest trust funds in any form of investment; and |
| (b) | at any time, vary an investment. |
In New Zealand the wording of (a) is “in
any property”.
There is also a specific power enabling trustees to
purchase a dwelling house as a residence for a
beneficiary.[2]
As well as
liberating trustees with respect to their investment powers the legislation
places significant constraints upon them.
The legislation imposes a standard of conduct on trustees when investing
in the following terms.
(1) Subject to the instrument creating the
trust, a trustee must, in exercising a power of investment -
(a) if the
trustee’s profession, business or employment is or includes acting as a
trustee or investing money on behalf of
other persons, exercise the care,
diligence and skill that a prudent person engaged in that profession, business
or employment would
exercise in managing the affairs of other persons; or
(b)
if the trustee is not engaged in such a profession, business or employment,
exercise the care, diligence and skill that a prudent
person would exercise in
managing the affairs of other persons.
(2) A trustee must exercise a power
of investment in accordance with any provision of the instrument creating the
trust that is binding
on the trustee and requires the obtaining of any consent
or approval with respect to trust investments.
(3) Subject to the instrument
creating the trust, a trustee must, at least once in each year, review the
performance (individually
and as a whole) of trust
investments.[3]
The prudent
person test has a long comparative jurisprudential history.
In the United States in 1830 in Harvard College v
Amory,[4] the Massachusetts Court
had to decide whether to follow the lead of the English courts and specify what
investments trustees might
and might not make, or whether to adopt a generalised
approach. The court ruled as follows:
All that can be required of a
trustee to invest is that he shall conduct himself faithfully and exercise a
sound discretion. He is
to observe how men of prudence, discretion and
intelligence manage their own affairs, not in regard to speculation but in
regard
to the permanent disposition of their funds, considering the probable
income, as well as the probable safety of capital to be invested.
This
classic statement is recognised as the first authoritative explication of the
“prudent person” rule for the investment
of trust funds.
However as time went by the courts applied the rule in a manner that
restricted its flexibility and attracted criticism on a number
of grounds. It
was said that the courts in the United States:
| (a) | focussed on individual assets rather than the trust portfolio as a whole – known as “anti-netting”; |
| (b) | confined its attention to voluntary trusts, and in particular trusts for successive beneficiaries, i.e. capital and income trusts, sidelining commercial trusts; |
| (c) | failed to develop rules for the purpose of protecting the purchasing power of the trust fund; |
| (d) | developed an artificial distinction between “prudent” and imprudent or “speculative” investments; |
| (e) | allowed “safe”, that is list style, low risk investing without scrutiny; and |
| (f) | prohibited the delegation of investment decisions. |
Academic writings about the law of trusts, both in
the United States – the work of Austin Wakeman Scott – and in
England
– the work of Underhill, Keeton and Pettit - also focussed on
voluntary family trusts and ignored the growing market for commercial
trusts.
These criticisms only emerged after the phenomenon of inflation
undermined the economic assumptions upon which financial theory had
relied
during the nineteenth and early twentieth centuries.
The Restatement
(Second) of Trusts, s 227 (1959) reflected and was in part responsible for
the approach of the courts. The section provided:
Investments Which a
Trustee Can Properly Make
In making investments of trust funds, the
trustee is under a duty to the beneficiary (a) in the absence of provisions in
the terms
of the trust or of a statute otherwise providing, to make such
investments and only such investments as a prudent man would make
of his own
property having in view the preservation of the estate and the amount and
regularity of the income to be derived.
The focus of this formulation
remained upon voluntary trusts requiring the separation of the capital and
income accounts and the needs
of beneficiaries having successive interests.
Spurred on by the revelations of investment theorists of the post-war,
inflationary era, American jurists secured adoption in 1992
of a new s 227 in
Restatement of Trusts (Third) the purpose of which was a change of focus.
It provides that the trustee is under a duty:
to invest and manage the
funds of the trust as a prudent investor would, in light of the purposes, terms,
distribution requirements
and other circumstances of the trust.
Of this
new formulation Edward C Halbach said:
Accordingly, the prudent investor
rule is intended to liberate expert trustees to pursue challenging, rewarding,
non-traditional strategies
when appropriate to a particular trust. It is also
designed to provide unsophisticated trustees with reasonably clear guidance to
practical courses of investment that are readily identifiable, expectedly
rewarding and broadly
adaptable.[5]
The distinction
between the old “prudent person” and the new “prudent
investor” is regarded as crucial.
In Australia and New Zealand the
“prudent person” test of the Restatement (Second) of Trusts,
s 227 of 1959 has been adopted and not the “prudent investor” test
of the Restatement (Third) of Trusts of 1992. To that extent the
legislation is backward looking.
The Australian and New Zealand
legislation also imposes on trustees:
(a) a duty to exercise the powers
of a trustee in the best interests of all present and future beneficiaries of
the trust;
(b) a duty to invest trust funds in investments that are not
speculative (or, in Western Australia, hazardous);
(c) a duty to act
impartially towards beneficiaries and between different classes of
beneficiaries; and
(d) a duty to take (in Queensland to obtain)
advice.[6]
These provisions,
too, are redolent of earlier law. They still evince concern with capital and
income accounting in trusts for successive
beneficial interests; and they
maintain an arguably artificial distinction between prudent and speculative
investments.
Despite the retention of the conservative prudent person test, there are
also to be found in the legislation significant allusions
to the findings of
modern investment theory that underlie the Third Restatement. Although these
allusions when coupled with the prudent
person test may be seen as
jurisprudentially ambiguous, they clearly empower trustees to take advantage of
the theoretical findings.
These allusions to modern investment theory are to be
found in provisions that require trustees to have regard to 15 specific matters
when investing.[7] They are as
follows:
| (a) | The purposes of the trust and the needs and circumstances of the beneficiaries; |
| (b) | The desirability of diversifying trust investments; |
| (c) | The nature of and risk associated with existing trust investments and other trust property; |
| (d) | The need to maintain the real value of the capital or income of the trust; |
| (e) | The risk of capital or income loss or depreciation; |
| (f) | The potential for capital appreciation; |
| (g) | The likely income return and the timing of income return; |
| (h) | The probable duration of the trust; |
| (i) | The liquidity and marketability of the proposed investment during, and on the determination of, the term of the proposed investment; |
| (j) | The aggregate value of the trust estate; |
| (k) | The effect of the proposed investment in relation to the tax liability of the trust; |
| (l) | The likelihood of inflation affecting the value of the proposed investment or other trust property; |
| (m) | (except in New Zealand) The costs (including commissions, fees, charges and duties payable) in making the proposed investment. |
It is within these highly significant provisions
that trustees can find justification for pursuing rewarding, non-traditional
investment
strategies, when appropriate to a particular trust.
One main purpose of this lecture is to consider whether the findings of
modern investment theory can assist trustees. A starting point
would seem to be
to consider two key phrases used by investment theorists. One is the
efficient market hypothesis and the other modern portfolio theory. Do
these phrases really mean anything?
The Efficient Market Hypothesis evolved in the 1960s from the Ph.D.
dissertation of Eugene Fama. Fama argued that in an active market
that includes
many well-informed and intelligent investors, securities will be appropriately
priced and reflect all available information.
To the extent that a market is
efficient, no amount of information or analysis can guarantee to the investor
returns better than
an average benchmark. Associated with the efficient market
hypothesis is the random walk theory. That theory asserts that price movements
will not follow any patterns or trends and that past price movements cannot be
used to predict future price
movements.[8] Consumer protection
laws now require some financial services providers to include this proposition
in advertisements soliciting
business.
The phrase efficient market is
usually left undefined in literature about the efficient market hypothesis: it
is taken for granted.
What it is that makes a market efficient? It is submitted
that indicia of an efficient market include the following:
| (a) | It provides easily accessible venues to vendors and purchasers for the transaction of business. |
| (b) | It enables vendors and purchasers to transact business quickly. |
| (c) | It is capable of handling small as well as large volumes of business. |
| (d) | It offers price transparency. |
| (e) | It offers low or at least transparent transaction costs. |
| (f) | It offers a minimum of intermediacy between vendor and purchaser. |
| (g) | It offers a minimum requirement of paperwork. |
| (h) | It is free of transfer taxes. |
There may be further indicia. Writings that discuss
the efficient market hypothesis seem to assume that it applies only to such
investments
as meet all or most of these indicia. In applying these indicia one
form of property most capable of efficient marketing would appear
to be
commercial choses in action, in particular shares in publicly listed companies.
The markets for trading in such forms of property
are more accessible than ever
before; price and transaction costs are transparent and they can handle
virtually all the business
required of them at immense speed, sometimes at the
speed of light. There is a minimum of intermediacy and paperwork and in
Australia
no transfer taxes. These characteristics attract large numbers of
investors, many of them well informed, to financial markets and
must inevitably
attract trustees.
Let us probe the efficient market theory further.
Consider what happens when an investor in an efficient market – for
instance
the share market – decides to act: that is, to buy or to sell.
First of all, however expert and informed the investor is, or however
foolish and ignorant, it is the market that dictates the day’s
price, not
the investor. A very large investor’s decision to buy or to sell may
affect the market price. But the ordinary investor
must accept the day’s
price or exit the market.
Secondly, pricing represents the combined
judgment of both sellers and buyers; and is sustained by volume trading. Since
one cannot
appraise the judgment of an investor according to the outcome of the
investment[9] one can never say that
either the investor who buys or the investor who sells, at the price set by the
market on the day, has made
a mistake. It is suggested that the vocabulary of
right and wrong, or smart or foolish, does not belong here. Price in an
efficient
market is skill neutral.
Thirdly, there are forms of price
sensitive information that can never be factored into the market analyst’s
calculations. For
instance the analyst can never know how many buyers and
sellers will want to deal on any given day; or whether there are far more
buyers
than sellers or vice versa. Nor can the analyst know for what reasons, other
than reasons based on objective market analysis,
an investor may decide to buy
or to sell. Many investors enter the market for purely personal reasons; and an
important, though not
exclusive, factor in a decision to buy is the hope of
gain; and an important factor in a decision to sell is the fear of loss. If
the
efficient market hypothesis includes such imponderables in its ratiocination, it
is not a hypothesis that can assist trustees
who wish to invest. But that is not
its raison d’être. Its raison d’être is to demonstrate
that making costly
enquiries when investing is not cost effective. Its value for
trustees is that they cannot be charged with negligence merely for
having bought
or sold an investment at a price supported by volume trading in an efficient
market.
Where a market is inefficient, however, knowledge and skill can
make all the difference. So extensive enquiries are justifiable. As
an example
of a less efficient market I would suggest the real estate market. Unlike
financial investments it is often impossible
to compare one piece of realty with
another, because usually each parcel of realty is unique. For vendors and
purchasers of realty,
knowledge of such things as future developments in
transport infra structure, in environmental and planning policy and in
demographics
will place the skilled investor at an advantage, as will civil
engineering expertise and a knowledge of the law. Without expertise
however, the
investor is hampered by lack of transparency as to prices which is clouded by a
real estate industry the reputability
of which has been compromised by rogue
elements and deterred by such matters as the impact of estate agents’
commission, and
high legal and transaction costs.
As another example one
might suggest that the art and antiques markets are relatively inefficient. The
ability to differentiate between
the paintings of a master and those of a
master’s school and even skilled forgeries is sometimes not available even
in the
world’s most prestigious auction houses; and very few people can
identify the provenance of unmarked antique porcelain, pottery
or glass. Those
who can are at an advantage.
Is our comprehension of the efficient market
hypothesis assisted by the expertise of the financial press and the
advertisements of
the finance management industry? It is worth considering what
substance there is in some of the phrases that crop up in financial
journalism.
One is: “profit takers were out in force today”. Another is:
“bargain hunters came into the market
today”; another is
“financial markets welcomed (or failed to respond to) the news” and
another is “the market
made a technical correction”. It is
difficult to find any illumination in such phrases. As for profit takers, that
is vendors,
one may well ask: who were the purchasers? And of bargain hunters,
that is purchasers, one may well ask: who were the vendors? The
financial press,
in using these expressions, seems sometimes to be making unjustifiable value
judgments. It seems to be suggesting
that the profit takers and the bargain
hunters are smarter than those they have dealt with. If this is so the phrases
endorse the
decisions of the vendors in the one case and the purchasers in the
other. Why should they? And as for news, for instance of take-overs
or mergers,
or management changes affecting prices, all one can say is that it is impossible
to know whether the news is good or
bad, or even what the outcome will be.
Furthermore, how can one tell that it is that news, and not other factors, that
made the difference,
or no difference, to the day’s price? It is to be
doubted whether this has any real meaning. If the phrase “the market
made
a technical correction” is redolent of a belief in some sort of mystical
omniscience of “the market”, it is
not illuminating. The efficient
market hypothesis counters the belief that some individuals can always
“beat the market”;
that is, it accepts the market as the ultimate
arbiter.
As for the finance management industry we do know that financial
services providers accumulate wealth by using other people’s
money rather
than their own. Other people’s money is their business. Self-interest
dictates that financial services providers
reject the all-inclusive view
embraced by the efficient market hypothesis. Financial services providers
necessarily take a narrower,
self-determined view. In doing so the industry
utters some strange pronouncements. For example a very large financial services
provider,
in a half page advertisement in The Australian newspaper for 23
August 2000, in a series described as ‘Insights for Investors’,
informed the investing public that Mount
Kosciusko is not Australia’s
highest mountain: Big Ben is. Big Ben, if you read the rest of the long
advertisement, is in Heard
Island, part of Australia’s Antarctic
Territories; and a picture of it can be viewed on a web site. The site reveals
that very
few people have ever seen the summit of Big Ben because it is always
shrouded in clouds. It is also Australia’s only active
volcano. One
wonders whether Big Ben is a metaphor for the fund management
industry.
The advertisement having pronounced that Equity markets reveal
“truths with ruthless efficiency”- doffing its cap to the
efficient
market hypothesis - goes on to say:
And there’s always the odd
market truth, as remote and clouded as Big Ben, waiting to be revealed. Once it
is True Value’s
assigned, and the stock’s marked up or marked down
before the average investor can say boo.
One wonders whether True Value
is an attempt at a Platonic hypostasis or an allusion to a chain of hardware
outlets. It can hardly
be the former because True Value, in the share market,
itself changes before you can say boo. The advertisement also advises us
to
note the con in conventional wisdom. Our financial services provider has teams
of experts “working in a collegiate style
that fosters cross pollination
and encourages critique.” One can commend the advertisement as a
masterpiece of persuasion.
But one may legitimately ask whether the exercise is
cost effective for the investing clients of the financial services provider.
One should affirm, however, that in the case of efficient markets, the
valuable contribution of a portfolio manager consists of analysing
and investing
appropriately, based on the personal profile of the investor and having regard
to such factors such as age, tax bracket,
risk aversion, employment pension
eligibility and so on. It is in this context that expert financial advice can be
crucial. The role
of the portfolio manager in an efficient market is to tailor a
portfolio to those needs, rather than to beat the market.
Associated with the efficient market hypothesis is the random walk
theory. That theory asserts that price movements do not follow
any patterns or
trends and that past price movements cannot be used to predict future price
movements. Consumer protection laws now
require some financial service providers
to include this proposition in advertisements soliciting business.
In essence modern portfolio theory demonstrates the advantages of
diversification. The advantages include the minimisation of risk
and
administrative costs. Risk is minimised because diversification averages profits
and losses. Administrative costs are minimised
because the efficient market
hypothesis demonstrates that trustees cannot obtain better than average returns
by making expensive
enquiries in an attempt to forecast price movements.
Trustees who decide to invest an appropriate proportion of the trust fund in
a
diversified portfolio of, say, shares may be referred to the findings of the
United States author R A Brearley in his work An Introduction
to Risk and Return
from Common Stocks.[10] He
estimated[11] that as few as ten
well selected stocks can achieve 87% diversification; 20 such stocks, 93%; 50
such, 97% and 100 such, 98%.[12] A
portfolio that attempts to mirror the market as a whole is called index linked,
or an index tracker. It reflects rises and falls
in the market it tracks but it
cannot avoid systemic variations of value. Systemic variations are flattened by
following a policy
of holding the portfolio and of investing
regularly.
Modern portfolio theory is highly persuasive and many
financial services providers index link. This is not to say that trustees must
index link rigidly. It is not appropriate for trustees to set a policy, in
advance, that if changes in share prices have the effect
that a portfolio in
management ceases to reflect the list precisely, shares that have fallen in
value must be sold, and shares that
have risen in value purchased, although some
financial services providers do that. It is a policy that bucks the random walk
theory
and is usually commission driven. It might also have the effect of
fettering the future exercise of the trustees’ discretion
in investing. It
is arguable that modern portfolio theory justifies investors to respond to
volatility storms, sometimes caused by
fraudulent price manipulation, in the
same way as to systemic price fluctuations, that is, to ride them out.
The answer to this is YES – IF that is the purpose of the trust, or
if the needs and circumstances of the beneficiaries require
it. But there is a
fundamental objection to trustees playing the market – that is buying and
selling - as a matter of general
administration of every trust. Although trustee
legislation now permits trustees to invest in any form of investment and to vary
investments at any time, except in the case where the trustees wish to buy or
sell a residence, it is submitted that it is difficult
for trustees to justify
selling an investment solely for the purpose of purchasing some other
investment, that is for the purpose
of adding value to the trust fund. One
reason for this is that playing the markets is an inherently speculative or
hazardous activity.
It stands to reason that if trustees sell asset A for
$20,000 for the purpose of acquiring asset B and the $20,000 is then used to
acquire asset B, the value of the trust fund has not changed - asset B is worth
the same as asset A. The trustees may well believe
that asset A will fall in
value and asset B will rise in value, but it is unlikely that that belief is
shared by the purchaser of
asset A or the vendor of asset B. Trustees cannot
assume that their belief is always right. In any case the costs of the sale and
purchase have been irretrievably lost. A practice of swapping investments,
marketed as good practice by some financial services
providers, is usually
commission-driven. Known as “churning” in the United States and
Canada, it is incompatible with
efficient financial management. Another reason
limiting the extent to which trustees can justify playing the markets is that if
they
have regard to the matters they are required to have regard to in
investing, they will usually find that there is no justification
for trading.
For example the author heard of a case where a testator left his estate to a
trustee to pay the income of the estate
to his widow for life and at her death
to distribute the capital amongst their children. The trouble was that the
entire income of
the trust was being absorbed as trustees’ fees and
expenses. The trustees argued that they were benefiting the capital of the
fund
by their expertise in investing and their fees were deserved. They were in
breach of trust. In the first place they were ignoring
the main purpose of the
trust, which was to secure a reasonable income for the life tenant. Playing the
market was inconsistent with
that purpose. Secondly in appropriating
remuneration and management expenses from the income account they were in breach
of trust
because remuneration for activities directed to improving the capital
of the fund should have been charged to capital. Thirdly, if
indeed the value of
the capital account had risen as a result of the trustees’ efforts, a
portion of the capital should have
been set aside to meet the needs of the
widow. If their efforts had not resulted in benefit to the capital account, they
might properly
be required to repay remuneration appropriated from the fund on
the grounds that it had not been properly earned.
The conclusion is that
when trustees buy or sell, they must do so for a reason connected with the
conduct of the trust as such, not
because of some imagined benefit to be gained
from trading.
On the other hand, sometimes a trustee is expected to play
the markets. Suppose that an investor, diffident about trading in the market
personally, decides to employ a financial services provider to invest as it
thinks fit. The investor admires the financial expertise
of the provider and
believes that it will ensure an above average return for the investment. The
provider maintains a trust account
as part of its investing structure. Aside
from any statutory provisions governing how financial services providers must
operate,
the contract between the investor and the provider expressly authorises
the provider to buy and sell investments. It is the purpose
of the contract and
of the trust envisaged by if not embedded in it. But the investor is a competent
adult with contractual rights,
who authorises the provider to take risks. Like
any beneficiary who authorises a trustee to act in a certain manner, the
investor
cannot complain of the outcome of the provider’s investing
activities.
The new legislation specifically authorises trustees to purchase
residences for beneficiaries. This is not a rejection of diversification
theory.
It recognises a particular feature of the Australian tax system that confers
benefits on homeowners. A trust estate that
consists solely of four residences
for four beneficiaries could not be described as pursuing a goal of
diversification; but it might
well be far more advantageous to each of the
beneficiaries than investment in a diversified portfolio producing only taxable
income;
and it can be justified by the specific power conferred on trustees by
the legislation.
As for hedge funds, trustees will be entirely justified
in using them occasionally for the purpose for which they are intended. For
instance a trustee with an obligation to pay a large sum in a nominated overseas
currency at a future date may well decide to insure
the obligation against a
fall in value of the Australian dollar vis-à-vis the nominated currency.
Out of such context, however,
a trustee would be justified in investing in a
hedge fund only an appropriate fraction of the fund under investment, that is a
fraction
justified by a disciplined diversification policy. Similar remarks
would apply to other investment markets such as the futures or
derivatives
markets.
Trustees of large funds must be constantly on their guard against
criminal intrusion. Sophisticated misconduct has not been absent
from the
Australian financial scene and trustees of large funds should assume that they
will be targeted by criminal elements and
that legislation designed to protect
investors is ineffective. The lack of financial experience of elected trustees
and the sense
of power that control of huge sums of money imparts may make some
trustees of large funds vulnerable to commit fraud. There are warning
signs.
There are strategies that can deter the criminal. There follow some very
elementary, but by no means always followed, prudential
safeguards to protect
against fraud.
A common indication of negligent and dishonest trust management is that
the trustee fails to keep trust property separate from the
trustee’s own
property.
The advantages of diversification in terms of risk and cost minimisation
have been briefly described. Except where the purposes of
the trust or the needs
of the beneficiaries justify the maintenance of an under-diversified portfolio,
failure to diversify is a
first sign of mismanagement. Serious criminals will
not attempt to suborn trustees of a $100m pension fund who, in pursuance of a
disciplined policy of diversification, usually do not acquire any investment
costing more than $500,000. The prize would not be large
enough.
The advantages of investing in an efficient market have been
described.
Decisions to buy are governed by principles very different from decisions
to sell. In the case of a pension fund trust where contributions
are being
received regularly the trustees must adopt an investment strategy that will
ensure immediate short-term investment of contributions.
This can be achieved by
placing contributions in interest-bearing deposit accounts at a bank. In the
case of more sophisticated longer
term investing, trustees who cannot achieve a
high level of diversification must ensure that they obtain proper advice in
investing.
Selling an investment requires justification. For instance if
an investment consists of an older building a decision to sell or renovate
may
have to be made. Making that decision will involve a consideration not only of
the profitability implications of the decision
but also of the availability of
other investments, the balance of the portfolio, any need for liquidity and so
on. Another reason
for selling might be that there is a purchaser willing to pay
what is clearly an above market price, for instance a purchaser whose
ownership
of adjacent property gives access to development potential not accessible to the
trustees or anyone else. Another reason
for selling is that the purposes of the
trust and the needs and circumstances of the beneficiaries require it. Selling
in a difficult
market to meet a liquidity need should rarely be necessary for
trustees of large funds because they should anticipate the need and
have
sufficient investments in an easily realisable form.
The value of
playing the market has already been considered.
When trustees agree to acquire an investment, they must not part with the
purchase moneys without at the same time receiving the title,
or the means of
acquiring the title, to the property purchased. When they sell trust property
they must not part with the title deeds
and transfer documents without at the
same time receiving the purchase moneys.
The reliability and the genuineness of documentation supporting an
investment proposal should always be carefully checked and, if
in doubt,
professional and independent advice obtained. For example, according to a press
report on page 38 of The Australian newspaper dated 12 July 2000, a $100
million dollar loan fraud which was successfully perpetrated against three major
banks had just
been revealed. The loans were supposedly secured by the sale of a
non-existent cargo of prawns, to be transported from Brisbane to
Japan on a
non-existent ship. Several vital documents produced to secure the loans were
forged. These included falsified supplier
invoices, invalid bills of lading,
bogus purchaser invoices, discrepancies in letters of credit making them invalid
and phoney export
insurance policies. Some of the forgeries were obvious. The
perpetrator of the fraud was said to be bankrupt and the liquidator was
reported
as having failed to trace any of the moneys lent. But it is submitted that the
criminal intent of the borrower is not the
really important issue. It is the
failure of bank officers to check the documentation. One must not make
inferences from a mere press
report, but every case of this kind constitutes a
warning to all to check documentation when buying or selling and to refrain from
assuming that large financial institutions are immune from infiltration by
organised crime.
It is elementary safeguards such as these that are
routinely ignored by negligent or fraudulent trustees.
There is no doubt that trustees may employ financial advisers to assist
them in investing. Indeed the new legislation specifically
authorises them to do
so. If one considers how trustees should approach a financial adviser many
thoughts come to mind. The trustees
would indicate to the adviser that they are
trustees, what the extent of the fund is, what its purposes are and the needs
and circumstances
of the beneficiaries. They could hardly do less. The financial
adviser would then be circumscribed by the trustees’ duties
because the
trustees are not investing on their own account. The trustees should also
indicate to the adviser those matters which
trustee legislation requires them to
take into consideration, and if appropriate invite the adviser to maintain the
relationship
prescribed as an ongoing responsibility, and to advise the trustees
should circumstances require reconsideration of policy or investment.
It is not
a far step from that to allow the adviser to take over the actual management of
the trust assets or part of them.
In England the Trustee Act 2000
has addressed the question of trustees employing persons to manage trust funds.
It provides, in s 15, that the contract between
the trustees and the manager
must be in writing and that the trustees must prepare “a statement that
gives guidance as to how
the functions should be exercised (‘a policy
statement’)”. “The trustees must formulate the guidance given
in the policy statement with a view to ensuring that the functions will be
exercised in the best interests of the trust.” (s
15(3)). They must keep
these arrangements under review (s 22).
The law of Quebec, a jurisdiction which has experience in both common and
civil law concepts, provides illumination in our attempt
to clarify the
relationship which the law should allow trustees to enter into with financial
experts. In the recent case of Placements Armand Laflamme Inc. v
Prudential-Bache Commodities Canada Ltd
[13] Armand Laflamme, a person with
little or no knowledge of financial affairs, entrusted a fund to the management
of Roy, a securities
broker. The broker indulged in risky adventures, ignored
the needs and circumstances of the beneficiaries, as well as certain
instructions
of his client and lost the fund. The Supreme Court of Canada
described the nature and scope of the Quebec institution of the fiduciary
mandate.
23 A securities dealer may perform a variety of functions.
First, in his most common role, the dealer is an intermediary. He buys
and sells
securities on behalf of his client, in accordance with the client’s
instructions. The dealer is in no way involved
in the management of his
client’s portfolio and has no discretion regarding its content and the
transactions to be carried
out. In this situation, the client’s account is
sometimes referred to as ‘non-discretionary’.
24 Second, a
dealer may also be responsible for managing the portfolio. In addition to his
function as a dealer, he is also a portfolio
manager with responsibility for
making decisions with respect to the management and make up of the
portfolio...This kind of account
is referred to as a ‘discretionary
account’. While in the case at the bar Roy was both dealer and manager,
these functions
may sometimes be performed by different persons...
25 The
functions of a manager and the powers granted to the manager may be quite
extensive. Lise Beaudoin, (Le contrat de gestion de portefeuille de valeurs
mobilières (1994) describes them as follows at pp
25-26:
‘Authorised management of a portfolio results from
delegation by the client of his decision-making authority. The task covers
the
intellectual, tactical and strategic activities performed in respect of a
portfolio. The manager acts in accordance with the
investments objectives set
with the client. His decisions are essentially guided by the concept of
maximising return on the portfolio,
having regard to the risks that this
involves. The manager determines the portfolio’s make up and the
investments to make...’
26 Thus the manager makes most of the
decisions relating to the portfolio and the make up of the portfolio. The scope
of his management
authority and the exercise of his discretion will, however,
depend on any restrictions that are imposed by law or agreement. In particular,
the agreement may expressly circumscribe the manager’s authority and
discretion, for instance by giving the client the option
of confirming certain
transactions. Such limitations may also be implicit in the client’s
investment objectives or circumstances...
28 As in the case of any
mandate, the mandate between a manager and his client is imbued with the concept
of trust, since the client
places trust in the manager - the mandatory - to
manage his affairs... This element of trust explains, for instance the
mandator’s
authority to revoke the mandate at any time (art. 1756 Civil
Code of Lower Canada; art 2176 Civil Code of Quebec). This spirit of
trust is
reflected in the weight of the obligations that rest on the manager, which will
be heavier where the mandator is vulnerable,
lacks a specialised knowledge, is
dependent on the mandatory, and where the mandate is important. The
corresponding requirements
of fair dealing, good faith and diligence on the part
of the manager in relation to his client will thus be more
stringent.
These remarks might well be regarded as pertinent to trustees
who employ a financial adviser, but they are also pertinent to a person
contracting with a trustee in the creation of an inter vivos trust. Increasingly
the relationship between the settlor and the trustees
arises in the context of a
legal contract. In that case it is the contract that governs the relationship.
It is unwise, particularly
in Australia, to assume that financial advisers
undertake fiduciary duties unless they are prescribed within the context of an
enforceable
relationship. This is because whereas the Canadian perception of the
fiduciary allows the courts sometimes to impose prescriptive duties on
fiduciaries, in Australia the courts limit themselves to the imposition of
proscriptive duties.[14]
So in employing financial advisers to advise them or financial services
providers to invest for them trustees must take great care
in framing the terms
of the contract between them.
Where trustees employ financial advisers,
it is for the trustees to decide what action to take having considered the
advice received.
Investments undertaken following advice will be made in the
names of the trustees.
But where trustees consider employing a financial
services provider to invest trust funds in the provider’s name, leaving
the
trustees with only a contract binding them to the provider, different
considerations arise. In particular there arises the question
of whether the
trustees may be seen as delegating to the services provider decisions that only
the trustees may take.
The law has failed to make a clear distinction between matters that
trustees may not delegate and matters for which they may employ
agents.
It is arguable that the no delegation rule has been assumed to be much
broader than it should be and that is has imposed an unjustifiable
fetter on the
law that has always given trustees a wide general power to employ agents.
Professor John Langbein has described the
rule as “murky” and
“overbroad”.[15] It is
time for the courts to give consideration to the boundary between the
restrictive rule preventing delegation and the broad
power to employ
agents.
There are, of course, provisions in trustee legislation to enable
a delegate to attend meetings where a trustee
cannot.[16] In England amendments
to s 25 of the 1925 Trustee Act (the original version of which still
makes better sense than its amendments) have brought confusion to this
distinction that has not
necessarily been exorcised by the Trustee Act
2000, s 11(2) of which provides:
In the case of a trust other than a
charitable trust, the trustees’ delegable functions consist of any
function other than –
| (a) | any function relating to whether or in what way any assets of the trust should be distributed, |
| (b) | any power to decide whether any fees or other payment due to be made out of the trust funds should be made out of income or capital, |
| (c) | any power to appoint a person to be a trustee of the trust, or |
| (d) | any power conferred by any other enactment or the trust instrument which permits the trustees to delegate any of their functions or to appoint a person to act as a nominee or custodian. |
With respect it is clear that this provision does
not have as its purpose to distinguish between those powers that trustees cannot
delegate and those that they can. For instance it is hard to say that this
provision could enable trustees to delegate to others
such practical matters as
when and where the next meeting of the trustees should take place, or what
matters should be placed on
the agenda papers. Neither, it should seem, could it
enable trustees to delegate to others the composition of guidance leading to
a
“policy statement” in the context of employing agents to manage
trust property.
To address the more general issue it is submitted that
the only decisions of trustees that cannot be delegated, or entrusted to agents,
are decisions that relate to the conduct of the trust as such. As an
obvious starting place it is clear, for example, that only the trustees can
decide upon the time and place of meetings of
trustees or what items should be
placed on the agenda for such a meeting. Until recently no general guidance has
been furnished by
case law as to what are matters concerning the conduct of the
trust as such. Surprisingly, however, it is submitted that the new
investment
legislation, almost providentially, gives that guidance in requiring trustees,
when investing, to have regard to the matters
listed in the statute and detailed
earlier in this article. Most if not all of these matters undoubtedly appertain
to the conduct
of the trust as such. At the top of the list are the purposes of
the trust and the needs and circumstances of the beneficiaries and
the
desirability of diversifying trust investments. In any case, apart from the
question of whether these matters appertain to the
conduct of the trust as such,
agents cannot be employed to “have regard” to these matters because
the statute requires
the trustees to do that. Trustees may need to employ
advisers to advise them with respect to these matters in which case their duty
is to consider that when having regard to the matters. They cannot leave it to
their advisers or follow their advice blindly.
On the other hand, if it
is prudent for investors to use the services of financial service providers, it
is arguable that trustees
should not be excluded from acting prudently by a
doubtful doctrine of the law of trusts dating from long before the recent
revelations
of financial theory.[17]
In Jones v AMP Perpetual Trustee Co NZ
Ltd[18] trustees invested in a
life insurance policy the premiums of which were invested in a unit style trust
fund that fell in value.
The Court of Appeal rejected an argument that the
trustee had improperly delegated its investment power, because investment in
insurance
policies was specifically authorised by the trust instrument
saying:
Express authorisation of this kind means that Perpetual was doing
what it was entitled to do, and that cannot be an improper delegation
of
authority.[19]
After quoting
these words Professor Philip Manns observes:
Further, the court
reiterated its conclusions when the trustee’s actions were measured
against the “prudent person”
rule of s 13B; consequently a decision
to invest in managed funds is not a wrongful delegation under either pre-1988
law or the post
1988 prudent person
law.[20]
In addition it may
be argued that by authorising trustees to invest in “any form of
investment”, investment in the “products”
of financial
services providers are within the meaning of the legislation; and that it is
unduly restrictive to deny trustees access
to the very expertise, in financial
services providers, the availability of which has generated law
reform.
It is submitted that the problem is not that trustees may not
invest in products offered by financial services providers but that
it may be
difficult for them to find products that are suitable to the purposes of the
particular trust and the needs and circumstances
of the particular
beneficiaries. Not all financial services providers’ products are
appropriate as vehicles for the investment
of trust funds. Some products appeal
to the owner investor rather than to trustees. A product that requires
commitment by the investor
to a long-term contract and to reinvestment of income
for the duration of the contract may be unsuitable for a trustee who has a
duty
to distribute the income or capital of the trust on a regular basis, or who has
a power, often found these days, to terminate
the trust. A product that does not
offer transparency to the investor with respect to such matters as the
realisable capital value
of the product from time to time or its annual
realisable income return may also be more suitable for the owner investor than
the
trustee. Furthermore it is submitted, for reasons already given, that a
trustee cannot impose fiduciary duties with respect to the
conduct of the trust
as such upon a manager, even if a manager could be persuaded to assume them.
Efficiencies of scale require financial
services providers to offer a
generalised product to a great number of owner investors, rather than a product
tailored to the needs
of a trust. To put it another way, using the language of
the English Trustee Act 2000, a fund manager might not wish to enter into
a contract with trustees who furnish it with a “policy statement”
for
guidance, the purpose of which is to protect the trust.
On the other
hand, there is one type of trust that does have a long temporal reach and
requires the reinvestment of income, namely
the superannuation trust fund.
Trustees of such funds may find products of financial services providers
suitable for their needs,
subject to the juggernaut of Australian superannuation
fund legislation.
But other concerns must deter the trustee minded to
invest trust funds with commercial financial services providers. Clearly
financial
services providers are in business to make money for themselves. To a
certain extent this purpose places them in conflict with their
clients.
Financial services providers must engage in risk taking activities if they are
to secure better than average returns to
their clients having remunerated
themselves appropriately and met all their administrative expenses.
Administration expenses can
themselves be enormous. For instance the Bankers
Trust website, in a report in 1998 indicated that updating its computer systems
for the new millennium would cost as much as $260m. Advertising expenses that
managers must assume to keep their products in the
public eye must also be very
considerable. Whilst such considerations may be insignificant to trustees of
very large funds minded
to acquire financial services providers’ products,
they may be a deterrent to trustees of small funds.
In some ways the new investment powers, while freeing trustees of the
tyranny of the old list of authorised trustee investments, place
a greater
burden upon them. They are now obliged to take responsibility themselves for
their conduct in investing. It is not surprising
in this context that trustees
nowadays ordinarily expect to be indemnified from loss caused by negligence, and
that the Courts have
expressed willingness to give full effect to indemnifying
provisions in trust instruments and
contracts.[21] This development in
the law substantially diminishes the reliance that can be placed on the trust as
a property management device.
In the last fifty years trusteeship has become highly remunerated.
Trustees no longer act gratuitously or for very low fees, as family
solicitors
used to. The level of remuneration to which trustees are entitled may eventually
be seen as a deterrent to the creation
of small trusts. For example s 21(1) of
the Victorian Trustee Companies Act 1968 provides as follows:
In
respect of an estate committed (whether before or after the commencement of this
section) to the administration of a trustee company
as executor, administrator,
trustee or as a sole guarantor or surety or as guardian of any minor or in any
other capacity, the trustee
company shall be entitled to receive out of the
estate, in addition to all moneys properly expended by the trustee company and
chargeable
against the estate, a commission to be fixed from time to time by the
directors of the trustee company but not in any case exceeding
–
| (a) | $5 for every $100 of the gross value of the estate; and |
| (b) | $6 for every $100 of income received by the trustee company on account of the estate. |
In
New South Wales the Trustee Companies Regulation 2000 came into effect on
the 1st September 2000. It details the services for which management
fees may be charged by trustee companies. But the law must be the same
for other
trustees. It is an exhaustive list and includes such matters as keeping books of
accounts, forming and restructuring companies,
and carrying on a business as
well as attending to the usual duties of managing trust
property.
Concerns about levels of trustees’ remuneration and
disbursements may also be expressed in relation to the management of some
charitable trusts. The Industries Commission Report on Charitable
Organisations[22] revealed that some
high profile Australian charities admitted that administration expenses absorbed
over 48% of their income. The
problem seems to be insoluble. Concern is
justifiable where the purpose of the charity is the relief of poverty, but the
officers
and employees of the charity enjoy large commission style remuneration
and substantial expense accounts. Members of the public are
often unaware of
this, and their immense generosity to these charities could be at risk, which
would be a national disaster. The
States and the Commonwealth, which makes a
huge contribution to these charities through tax exemptions, should address this
issue.
In particular, all charities that enjoy any form of taxation relief
should be required to make all their accounts available to the
relevant
Attorney-General who should be empowered to publish them on the Internet.
Many trusts these days empower trustees to make discretionary payments to
beneficiaries. Indeed such trusts are usually called discretionary
trusts. The
law of discretionary trusts is that the discretions are conferred upon the
trustees and no one else. Ordinarily this
means that neither the courts nor any
beneficiaries can interfere with their proper exercise. Discretions conferred
upon trustees
vary enormously not only as to the extent of their operation, but
also as to the kind of consideration the trustees should give to
their exercise.
It is when trustees exceed their powers or fail to give the required
consideration to their exercise that the courts
will intervene. Since these
cases are decided largely on questions of fact, namely the intention of the
settlor and the circumstances
and manner of exercise of the discretion, their
value as precedents can be limited.
The discretionary nature of
trustees’ powers often inhibits the courts from using the word
“must”. Nevertheless
a discretion given to trustees cannot be
entirely unfettered. That would be inconsistent with the trustees’
fiduciary duty
to exercise an active and informed discretion, and would
jeopardise the supervisory jurisdiction of the courts.
The trouble is
that some trustees may believe that the discretions conferred upon them
virtually relieve them of accountability for
their actions and manage the trust
as if it were a private fiefdom. In Attorney-General v
Breckler[23] Gleeson CJ,
Gaudron, McHugh, Gummow, Haynes and Callinan JJ said:
Where a trustee
exercises a discretion, it may be impugned on a number of different bases such
as that it was exercised in bad faith,
arbitrarily, capriciously, wantonly,
irresponsibly, mischievously or irrelevantly to any sensible expectation of the
settlor, or
without giving real or genuine consideration to the exercise of the
discretion. [24]
So
trustees’ discretions are never unfettered. But judicial pronouncements,
such as that quoted, are usually expressed in negative
terms. Many trustees do
not know whether they are giving adequate consideration to the exercise of their
discretions. Because this
poses a perennial practical difficulty for trustees,
the following submission is made that it is hoped will assist them in practice.
When trustees meet to decide to allocate payments of trust funds to
discretionary beneficiaries, they should ensure that they are
fully informed as
to the intention of the settlor in conferring the discretion and as to the
circumstances prevailing at the time
of exercise of the discretion. One way of
doing this is by imagining that the creator of the trust is present at the
meeting when
the discretion is being exercised. The trustees should ask
themselves whether that ghostly personage would whole-heartedly and
unequivocally
endorse their decisions. If they feel unanimously that that is the
case, it is unlikely that they will make decisions that anyone
will subsequently
wish to contest. It is their duty to seek relevant information and they may do
so from sources outside the trust
instrument.[25]
The law of
trusts has changed enormously in the last fifty years. The high cost of managing
a trust fund, and ensuring that trustees
perform their duties, means that in
some ways it is less able to deal with what is required of it. Nevertheless if
the law can continue
to ensure accountability in trustees, the institution will
remain a significant achievement of our jurisprudence.
[*] BA, LLB, formerly Reader in
Law, University of Queensland, Adjunct Professor of Law, QUT and Bond
University; Commissioner for Law
Reform, Queensland. This is a revised and
updated version of the Inaugural W A Lee Equity Lecture given at the Queensland
University
of Technology on Thursday 2 November
2000.
[1] Australian Capital
Territory (Trustee Amendment Act No 28 of 1999); New South Wales
(Trustee Amendment (Discretionary Investments) Act No 102 of 1997); the
Northern Territory (Trustee Amendment (No 2) Act No 60 of 1995);
Queensland (Trustee (Investments) Amendment Act No 69 of 1999); South
Australia (Trustee (Investment Powers) Act 1995); Tasmania: Trustee
Amendment (Investment Powers) Act 1997; Victoria: Trustee and Trustee
Companies (Amendment) Act 1995 (No 104/1995); and Western Australia:
Trustees Amendment Act 1997; New Zealand Trustee Amendment Act 1988,
No 119.
[2] ACT s 14E; NSW s 14DA; NT s
10A Qld s 28; Tas s 5; Vic s 11; WA s
4.
[3] ACT s 14A; NSW s 14A; NT s
6; Qld s 22; Tas s 7; Vic s 6; WA s18; NZ s 13B.
[4] 26 Mass (9 Pick)
446.
[5] E C Halbach, ‘Trust
Investment Law in the Third Restatement’ [1992] 77 Iowa Law Review
at 1155.
[6] ACT s 14B; NSW s 14B; NT s 7; Qld s 23; SA s 8; Tas s 9; Vic s 7; WA s 19; NZ s 13F.
[7] ACT s 14C; NSW s 14C;
NT s 8; Qld s 24; SA s 9; Tas s 8; Vic s 8; WA s 20; NZ s
13E.
[8] E F Fama, ‘Random
Walks in Stock Market Prices’ (1965) Financial Analysts
Journal.
[9]
Nestlé v National Westminster Bank Plc [1992] EWCA Civ 12; [1993] 1 WLR 1260 (CA) per
Staughton LJ at 1276.
[10] R A
Brearley, An Introduction to Risk and Return from Common Stocks,
2nd edn 1983.
[11]
Ibid at 112.
[12] Cited
in Langbein, The Uniform Prudent Investor Act and the Future of Trust
Investing [1996] 81 Iowa LR
641-669.
[13] (2000) SCC 26
(Supreme Court of Canada 3 May 2000).
[14] Breen v Williams [1996] HCA 57; (1996) 186 CLR 71 per Gaudron and McHugh JJ at 113; National Mutual Property Services (Australia) Pty Limited v Citibank Savings Limited (1998) (unrep) FCA No NG 765 of 1994 (Lindgren J).
[15] J Langbein, ‘The
Uniform Prudent Investor Act and the Future of Trust Investing’ [1996] 81
Iowa LR at 650-651.
[16]
ACT s 64; NSW s 64; NT s 3; Qld s 56; SA s 17; Tas s 25AA; Vic s 30 and
Instruments (Powers of Attorney) Act No 9421 (1980) ss 2, 5; WA s 54; NZ
s 31.
[17] See Restatement
(Third) of Trusts s 227, comment
j.
[18] [1994] 1 NZLR
690.
[19] Ibid at
705.
[20] P Manns, ‘New Zealand Trustee Investing: Reflecting on Modern Portfolio Practice and the Ancient Distinction of Capital and Income’ (1998) Victoria University of Wellington Law Review 611 at 625.
[21] Armitage v Nurse
[1997] EWCA Civ 1279; [1997] 3 WLR 1046.
[22]
September 1995.
[23] (1999) 197
CLR 83.
[24] Ibid at para
7.
[25] Hitch v Leworthy
[1842] EngR 1143; (1842) 2 Hare 200; 67 ER 83 per Sir James Wigram V-C at 207; Maciejewski v
Telstra Super P/L (1998) 44 NSWLR 601.
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