Tag: Prudent Investor Rule
In Tuesday’s blog, I scratched the surface of the recent battle between titans of Wall Street and a social media community over shares of GameStop, a brick-and-mortar video game retailer. The enormous volatility seen in GameStop’s share price, fluctuating between $20 and $350 in a matter of only a few weeks, led to some investors profiting handsomely, leaving others, including certain institutional investors, to foot the bill so to speak. Today’s blog discusses the obligations of a trustee to prudently invest trust capital and to generally avoid high-risk, high-reward strategies unless specifically instructed.
Section 27(1) of Ontario’s Trustee Act provides that a trustee investing trust assets “must exercise the care, skill, diligence and judgment that a prudent investor would in making investments” – colloquially known as the Prudent Investor rule. A further subsection of the Trustee Act, section 27(5), sets out a non-exhaustive list of criteria that a trustee is to consider when making investment decisions which include, among others, the expected total return on investment.
A savvy but risk-prone hypothetical trustee might have viewed the GameStop saga as an opportunity to earn significant returns for the benefit of the trust. Of course, had such a trustee “gotten in early” when the share price was still low and also correctly predicted the meteoric rise, the trust in question might well have enjoyed a capital return many times the size of their initial investment. Great!
However, the opposite consideration is relevant to any discussion of a trustee’s obligation as a prudent investor. What if the trustee took steps to invest in GameStop or any other volatile security, without reasonable justification for doing so, and suffers substantial losses? What recourse, if any, is available to the beneficiaries of a trust that suffers such losses?
In the ordinary course, a trustee may be personally liable for any investment losses as a result of imprudent investment decisions. Whether the trustee committed a breach of his fiduciary duty by choosing to invest in high-risk, high-reward securities is a nuanced question. In carrying out their obligation as a prudent investor, a trustee must consider several factors, including:
- The terms of the trust instrument or Will including any investment guidelines contemplated by the grantor or testator;
- The guidelines of any investment plan or strategy relied on by the trustee in making investment decisions, including any such plan prepared by a professional advisor; and
- The nature and extent of the investment made and the loss suffered.
A consideration of the factors above will determine whether a trustee’s actions constitute a breach of fiduciary duty. Hypothetically, a trustee may be directed by the terms of the governing instrument to invest a certain portion of the capital into specific types of assets, which could include volatile securities, with asset diversification as a main goal.
Although such investments might not ordinarily be viewed as “prudent”, section 27(9) of the Trustee Act provides that a trustee is not authorized to act in a manner that is inconsistent with the terms of the governing instrument. Although the trustee has some discretion in terms of the choice of investment, they may nonetheless be directed by the instrument to engage in risky transactions.
As such, the risk of personal liability to a trustee who was directed to invest a small share of the total capital of a trust into high-risk securities, as compared to a trustee who unilaterally decides to invest half of the trust capital into similar assets, will be considerably different. Provided the conduct of the trustee is in accordance with the directions and reasonable professional guidance offered to them, it is unlikely that a trustee will be personally liable for investment losses.
Thanks for reading.
Late last month, I and many of my colleagues of the Millennial age were treated to a flurry of headlines that many of us in that age bracket were able to piece together, but which might have left those of a more senior generation scratching their collective heads. The battle between Wall Street and an army of social media users over stock trading perhaps led to some new terminology entering the lexicon of those beyond the Millennial age group. No doubt the words ‘Reddit’, ‘subreddit’, and ‘GameStop’ caused a few crossed eyes. Allow me to explain.
GameStop Corporation is a publicly traded company that, for much of the 1990s and early 2000s, operated a slew of brick-and-mortar retail stores selling video games, consoles, and other associated merchandise worldwide. As a bright-eyed middle-schooler during the height of GameStop’s market control, many a Friday night was spent wandering the aisles with friends eagerly looking to spend my allowance on the next craze.
As a result of a shift in the direction of the video game industry towards digital and online fare, as well decreased engagement as a result of the pandemic, GameStop’s brick-and-mortar sales model, and retail models more generally, saw a historic decline in sales and revenue. As the demand for GameStop’s business model declined, so did its share price.
This decline did not go unnoticed by certain savvy Wall Street hedge funds and other institutional investors. Shares in GameStop were a popular purchase among “short sellers” looking to turn a profit as a result of the company’s misfortunes. Briefly summarized, short-selling occurs when an investor borrows a particular stock from a stockholder, then sells that stock to a third-party investor willing to pay current market price for the security, on the short-seller’s expectation that the share price will have decreased by the time the loan from the original stockholder is called. The short-seller would then repurchase the borrowed stock from the third-party investor at the now-lower share price before returning ownership to the original stockholder and earning a profit on the difference.
In the case of the GameStop saga, the short-selling attempts by some large hedge funds and institutional investors did not proceed as planned. Members of a specific community under the Reddit platform – individually, a ‘subreddit’ – discovered in late 2020 that GameStop stock had been ‘shorted’ to an unprecedented degree. In essence, hedge funds and investors had bet significant sums on the continued decline of GameStop, intending to turn a profit as the share price was expected to continue dropping.
Members of the ‘WallStreetBets’ subreddit saw an opportunity to ‘squeeze’ the investors by collectively purchasing a significant portion of the available stock in GameStop, driving up the price-per-share to historic highs and decimating the intended ‘short’. The price-per-share ballooned from around $20 in early 2021 to a staggering $350 per share by the end of January. Many of the investors and hedge funds who had bet on the price decreasing from $20 were now compelled by their loan obligations to repurchase shares at a price many times higher than their initial capital investment, incurring significant losses in the process.
Although the frenzy around GameStop and other publicly-traded companies such as AMC has died down in recent weeks, as of today’s date GameStop is still trading at around $51 per share, more than double the share price at the beginning of the year. The incident has also drawn the ire of securities regulators as well as the US Congress. Game over?
The next blog in this series will tie in the concepts of short-selling and the fundamentals at play in the GameStop incident to the obligations of fiduciaries to act as prudent investors.
Thanks for reading.
There is so much in flux right now due to COVID-19. In the area of estates and trusts though, the obligations that an estate trustee owes to beneficiaries remains stable. During this time, estate trustees need to consider how best to administer an estate, and what they should be doing to limit future claims against them. The purpose of today’s blog is to consider the estate trustee’s duty to invest.
According to section 27(1) of the Trustee Act, “In investing trust property, a trustee must exercise the care, skill, diligence and judgment that a prudent investor would exercise in making investments”. This is often referred to as the prudent investor rule. Section 27(5) sets out certain criteria the trustee is required to consider in investing trust property, including, amongst other things, the general economic conditions and the possibility of inflation or deflation.
Given the current market fluctuations, estate trustees need to give invested trust property considered attention. While they cannot be expected to produce resounding returns for the beneficiaries, they can take steps to make sure their investments are prudent in the circumstances and avoid future claims from beneficiaries. These could include claims that the estate trustee failed to properly invest trust assets or that they failed to exercise their discretion.
The estate trustee should consider doing at least four things. First, they should review the terms of the will as to whether there are any specific investment requirements. Second, they should contact their investment advisor to obtain professional advice and share any relevant terms of the will. Third, the estate trustee should ask the investment advisor to put their advice/comments in writing and the estate trustee should hold on to this. Fourth, if the trustee is afforded some sort of discretion (for instance, considering the interests of capital versus income beneficiaries), the trustee should prepare a memorandum to themselves. The memorandum should set out the reasons why they reached the investment decision that they did and the factors they considered, which should include the section 27(5) criteria.
Stay safe and wash your hands,
Please click on this link to see our COVID-19 related resources, as well as these related blogs:
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