The Supreme Judicial Court of Massachusetts has held that a trustee holding a fund to provide long-term income to a charity must invest with an eye toward growth of the fund so that the value of the income is not eroded by inflation over time.  It has ruled that a trustee that invested funds almost entirely in fixed income assets for more than 50 years and failed to grow the value of the fund has breached its fiduciary duty because the value of the income has not kept pace with inflation.  (The Woodward School for Girls v. City of Quincy,  Sup. Jud. Ct., MA, No. SJC-11390, 7/23/14.) 

The fund was originally created in 1822 by John Adams, second President of the United States, and augmented in 1886 by a bequest from his grandson, Charles Francis Adams.  By two pieces of state legislation, the City of Quincy became trustee and in 1953 the Woodward School for Girls was designated as the sole income beneficiary.  The trust was required to pay the income from the trust to the school.  The trust would terminate only upon the “gross corruption or mismanagement” or knowing waste by the trustee, in which case the principal would go to the oldest living male descendant of President Adams. 

In 1953, the combined assets of the fund were about $383,000, including real estate valued at about $102,000.  In 2005, the value of the fund, after sale of the real estate, was about $345,000.  It had generated more than $700,000 in income over those years, which had been distributed to the school or used to pay costs of administration.

In 2005, the school began to question the distributions and sought information about the fund.  When it did not receive satisfactory answers, in July 2007, it filed a court request for an accounting.  A special master concluded that Quincy had breached its fiduciary duty to the school by failing to maintain adequate books and records and by selling the real estate at less than fair market value. 

Following a 13-day trial, the Probate Court agreed with the special master and further held that Quincy had breached its fiduciary duty by employing inappropriate investment strategies between 1953 and 1973 and then by disregarding professional investment advice to diversify its investment mix that it received in 1973.  The Probate Court awarded the school almost $3 million in damages, including $1.6 million in pretrial interest and about $1.1 million in unrealized gains in the portfolio.

On appeal by the trustee, the Supreme Judicial Court looked primarily to the state’s Prudent Investor Act for the standards for investing.  The Act requires a trustee to invest “solely in the interest of the beneficiaries” with “reasonable care, skill, and caution” while “considering the purposes, terms, and other circumstances of the trust.”  Among those considerations are “the possible effect of inflation or deflation” and “the expected total return from income and the appreciation of capital.”  Citing the Restatement (Third) of Trusts, a compendium and distillation of common law reasoning, the Court said that natural conservatism must be balanced with “a degree of risk in order to obtain income for the trust and protect the principal against inflation.”

Having set out the standards, the Court first considered the Probate Court’s decision that the trustee’s 1973 failure to follow advice from a bank was per se a breach of fiduciary duty.  The bank had recommended that the trustee diversify the fund’s allocation to 60% stocks, 35% bonds and 5% cash instead of 90% bonds and only 10% stocks. 

First, the Court said that the recommendation was only one of several possible alternatives advanced by the bank.  But more importantly, it said that the trustee did not have any obligation to accept the recommendation.  While considering investment advice from professionals “may be a part of acting prudently and exercising care,” the Court wrote, a trustee is required to exercise independent judgment.  “Were we to require a trustee to follow investment advice it receives, we would in effect mandate delegation of a trustee’s fiduciary duties,” it said, and it refused to do so.

The Court essentially agreed with the Probate Court on the basic question of breach of duty on the investment scheme, however.  The trustee cited a series of cases involving trusts to provide life income to individuals, with the remainder to others upon the death of the income beneficiary.  In those cases, an emphasis on current income was not deemed a breach of duty to the subsequent beneficiaries.

But “the Adams Fund’s status as a charitable trust and Woodward’s institutional status makes this case distinctly different from those involving trusts with a lifetime beneficiary,” the Court said.  A charitable trust is designed to support an income beneficiary in perpetuity and the trustee “must necessarily consider both the generation of income and the growth and maintenance of the principal in order to provide income funds to the beneficiary indefinitely,” it held.  “At a minimum, a trustee must consider how best to guard the principal against inflation, if not how to grow the principal while simultaneously generating income to support the beneficiary.”

“A prudent investor would have realized at some point, long before 2008, that a fund value that is unchanged for decades after 1953 has not kept up with inflation, and, given the potential perpetuity of the income beneficiary’s needs, would have taken steps to protect the principal in order to preserve future income opportunities.  If Quincy recognized that the Adams Fund was vulnerable to inflation, likely attributable to its lack of diversification, it had a duty to determine which of its assets could be invested in a manner that would guard against this vulnerability.”

The trustees argued that the original gift required investments in bonds, but the Court said that one of the state statutes provided that the proceeds of the sale of real estate could be invested in any investments that trustees were authorized to hold in the Commonwealth.

It concluded that Quincy had “failed to invest with the long-term needs and best interests of the income beneficiary in mind, creating a portfolio that consistently provided income but that left the principal vulnerable to inflation and, as a result, depreciation.”

The Court rejected the trial court’s determination of damages, which was based on a calculation of the gain the portfolio would have obtained if the trustees had followed the bank’s advice to switch to a 60-35-5 investment allocation in 1973.  The award must be based on more than the unheeded advice, the Court wrote, “and should instead consider the totality of the circumstances as they would have informed prudent investment decisions over the relevant time period.”  It remanded the case for determination of those damages.

YOU NEED TO KNOW

This case shows the value of the Uniform Management of Institutional Funds Act (UMIFA) (See Ready Reference Page: “UMIFA Sets Rules for Charitable Endowments”) and the revised Uniform Prudent Management of Institutional Funds Act (UPMIFA) (See Ready Reference Page:  “New UPMIFA Sets Rules for Management of Charitable Funds”).  Charity trustees would be highly unlikely to invest solely for income as the trustee did here because those acts strongly encourage investment for total return and allow the trustees to distribute a reasonable amount without regard to whether it comes from “income” in the traditional definitional sense or from capital gain.  Those acts, however, apply only to funds held by charities for the exclusive use of charities.  They do not apply to trusts held by banks or other trustees, as is the case here, or to trusts with a non-charitable beneficiary, as is possible, though highly unlikely, here.