Publications

Publication Date: August 24, 1999

On June 25, 1999, Governor Ridge signed into law a new "Prudent Investor Rule" ("New Prudent Investor Rule" or "New Rule") to govern fiduciary investments in Pennsylvania. This bulletin will focus on the responsibilities of fiduciaries of nonprofit corporations and charitable trusts.

The new Prudent Investor Rule codifies fundamental changes in the investment duties of those responsible for the investments made by Pennsylvania charities. The most dramatic change involves a shift from an outdated "Prudent Man" standard, where each investment would individually be judged to be prudent or imprudent, to a modern "Prudent Investor" standard where:

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Thus, the new Prudent Investor Rule embraces the key elements of academic Modern Portfolio Theory and fundamentally changes the manner in which Pennsylvania charities are permitted to invest. It is now the total portfolio which is reviewed and not any investment in isolation.

The investment principles embraced by the new Prudent Investor Rule may be summarized as follows.

• The Donor’s Intent Controls. The New Rule is consistent with existing Pennsylvania law which states that any or all statutory investment duties may be modified by the person creating the trust or fund. In short, the New Rule applies to trusts only as a default rule which may be altered by the Donor of a particular fund. (§ 7202)

• The Overall Investment Strategy Must Be Prudent. The New Rule provides that, in general, "a fiduciary shall invest and manage property held in a trust as a prudent investor would, by considering the purposes, terms and other circumstances of the trust and by pursuing an overall investment strategy reasonably suited to the trust". (§ 7203(a)) For this purpose, a nonprofit corporation is treated as a trust.

• Permissible Investments. Under the Act there is no individual investment that is per se imprudent. (§ 7203(b)) Each investment is analyzed in the context of the entire trust portfolio. This provides comfort to charities who desire to diversify their portfolios by investing a portion of the trust in investments which involve a higher degree of individual volatility and risk, such as hedge funds and venture capital funds.

• Investing Considerations. In making investment management decisions Pennsylvania charities should now consider, among other things, the following factors:

• The size of the trust;

• Any restriction on investments specified by the Donor;

• The liquidity and distribution requirements of the charity;

• The expected tax consequences of investment decisions or strategies and of distributions of income and principal;

• The role that each investment or course of action plays in the charity’s overall investment strategy;

• An asset’s special relationship or special value, if any, to the purposes of the trust or to any one or more of the beneficiaries; and

• Any known needs for present and future distributions. (§ 7203(c))

The appropriate investment considerations may differ depending on whether the fund is wholly charitable or is a split-interest trust, having both charitable and noncharitable beneficiaries. Thus, for example, the trustee of a charitable lead trust may take into account the tax consequences to the remainder beneficiaries of a sale of low basis stock.

Under the New Rule, Pennsylvania charities are under a duty to "reasonably diversify investments" unless the fiduciary reasonably determines that it is in best interests of the beneficiaries not to diversify…." (§ 7204) This change represents a fundamental departure from prior Pennsylvania law which previously allowed a fiduciary to follow the admonition of Andrew Carnegie to: "Put all your eggs in one basket and watch the basket"(fn1). This requirement of reasonable diversification apparently does not apply, however, to (i) assets received directly from the Donor, so long as the decision to retain a concentration of assets is made in the exercise of reasonable care, skill and caution (§ 7206) and (ii) trusts which were irrevocable prior to December 25, 1999 or, were created under documents signed prior to December 25, 1999 and not amended thereafter. Certain charities, such as private foundations, must also comply, however, with additional investment rules imposed by the Internal Revenue Code which may impose more stringent diversification requirements than the New Prudent Investor Rule.

The New Prudent Investor Rule also modernizes Pennsylvania trust investment law in that it expressly authorizes the delegation of fiduciary investment authority. Heretofore, existing case law had indicated that delegation of discretionary investment authority by Pennsylvania fiduciaries was prohibited.(fn2)  The new express authority to delegate investment authority, however, is not absolute. The New Rule requires that the scope of delegated authority must be clearly articulated and that the performance of investment managers must be periodically reviewed. For its part, any investment agent undertaking to act for a Pennsylvania charity may be held accountable for its actions in a Pennsylvania court. Investment authority may also be delegated to a co-fiduciary who has greater investment skills (e.g., a corporate fiduciary). (§ 7206)

While most advisors assumed a Pennsylvania court would apply modern investment concepts in cases where investment actions were challenged, the new Pennsylvania Prudent Investor Rule codifies the modernization of Pennsylvania trust investment law and provides greater assurance of uniformity of application by Pennsylvania Courts. The New Prudent Investor Rule, however, does not fully embrace all aspects of Modern Portfolio Theory or even the Model Prudent Investor Act upon which it is based. Unlike the Model Act and most academic statements of Model Portfolio Theory, the Pennsylvania Prudent Investor Rule requires only "reasonable" rather than the complete diversification of investments and has no requirement that inception assets must be diversified within a reasonable period of time. This and other aspects of the New Rule will be fully understood only after the New Rule has been tested in the Courts. The differences from the Model Act, however, tend to favor and grant more flexibility to Pennsylvania directors and trustees.

(fn1) Saeger Estate, 340 Pa. 73 (1940).

(fn2) Kohler's Estate, 348 Pa. 55 (1943).