John Langbein accepting the Frankel Prize from Deborah DeMott, a professor of law at Duke University and a member of the selection committee.
John Langbein may not be a familiar name to financial advisors, but he has had a significant and lasting impact on our profession. On September 16, he was awarded the Frankel Fiduciary Prize.
Langbein is an emeritus professor of law at Yale, specializing in trust law. To appreciate the impact of his work, consider that, prior to the 1990s, bank trust portfolios were routinely allocated to what were then considered safe assets – bonds. Langbein, through his scholarship and changes he spearheaded in trust law, transformed this practice to use modern portfolio theory (MPT).
Langbein provided the intellectual foundation for the prudent investor rule to use MPT in fiduciary investments. He introduced this concept in 1992, and by 2006 it was adopted by every state. Data shows that this led to greater allocations to stocks starting in 1992 by banks, based on pension and charitable endowment holdings.
“The asset allocation of trillions of fiduciary assets has been altered in a beneficial way due to the scholarship and legislation led by Langbein,” said Robert H. Sitkoff, a professor of law at Harvard Law School, who also spoke at the presentation.
The Institute for the Fiduciary Standard established the Frankel Fiduciary Prize to honor individuals who advance fiduciary principles. The Frankel Fiduciary Prize is awarded annually to a person who has made significant contributions to the preservation and advancement of fiduciary principles in public life.
The prize is named in honor of Tamar Frankel, a pioneer in fiduciary law scholarship and advocacy for fiduciary principles and a professor emeritus of law at Boston University.
Langbein delivered a talk about the two core principles of trust law, how those principles are routinely compromised and what can be done to prevent abuse.
The first principle of trust law is the “duty of loyalty” – to administer a trust solely in the interests of the beneficiary. A trustee cannot take into account their own self-interest when making decisions about a trust.
It is the most fundamental rule of trust law, Langbein said. You cannot engage in self-dealing and must avoid conflicts of interest. If you violate that rule you are subject to the second principle, the “no further inquiry” rule. It says that the law will not entertain a defense based on the merits. You are not allowed to explain why whatever action you took may have benefitted the beneficiary.
Any action which might have benefitted the beneficiary but also helped the trustee is subject to the “no further action” rule. Langbein called this a “very harsh” standard.
The purpose, he said, is prophylactic – to deter abuses by trustees before they happen.
In practice, he said, there is an enormous amount of conflicted activity. The reason is that the duty of loyalty and no further inquiry can be altered when the trust is created. For example, by naming a child as a trustee of a family trust, where that person is also a beneficiary, creates a “hopelessly conflicted” situation. All investment decisions will be conflicted, he said, because they will affect the payout to the income bearers (the parents) and beneficiaries (the children). “The trustee cannot observe the duty of loyalty to avoid self-dealing,” Langbein said.
When the trustee is a bank or corporation, Langbein said that legislation allows certain conflicts. For example, a bank can deposit funds in its own accounts. The thought is that the gain of such actions outweighs the danger of abuse.
Legislation also allows a trust to use mutual funds and other investment products offered by a subsidiary of the trust company. The trust company will get fee income from the trust, but this is allowed.
As a result, bank trustees regularly use pooled devices like mutual funds as investment vehicles.
Careful drafting can often cause these problems to be diminished or eliminated, according to Langbein. For example, a trust can provide guidance that someone is the primary beneficiary and only if anything is left over can someone else benefit. In the case of a family trust, for example, the parents are the primary beneficiary and the children benefit only if funds remain upon their death.
Langbein cited another example of conflicts of interest. In pension law, under ERISA, health plans often don’t cover experimental treatments. The decision as to what is experimental is made by the employer, who is also funding the plan. Conflicted decision making is incessant in pensions, he said.
“Rule one of conflicted trusteeship is to recognize that the duty of loyalty still exists,” he said, “but the trustee cannot be prevented from taking certain steps.” When the structure of the trust creates conflict, the duty of loyalty cannot be followed and “no further inquiry” cannot apply.
What steps can be taken to mitigate the risk of abuse in a trust? Langbein cited three areas. Greater disclosure is helpful. Conflicted trustees should inform parties, especially beneficiaries, of conflicts in advance. Trustees can also ask for clarification by seeking judicial instruction (i.e., asking a judge about the propriety of an action), rather than acting in one’s peril. The third path is to try to delegate decisions to a court-appointed substitute person who is un-conflicted. The trouble, he said, is that it is rarely done because the choice of a particular substitute may be open to criticism. If someone merely asks the court to appoint someone, then the trustee can be accused of “dumping” his or her responsibilities. But if you delegate the decision, you have a duty to find a competent, appropriate person.
I asked Langbein whether bank trustees have migrated to the use of index funds as a way to mitigate the concern with choosing an inferior investment product. He said two concerns have impeded the adoption of index funds. One is the fear that indexing would overwhelm the capital markets, destroy price discovery and cause inferior or unpredictable performance. The other is a belief that bank trust departments can outperform indexes by investing in, for example, small-cap stocks, which he said have been a source of alpha.
I disagree with Langbein’s concerns about index funds, but his overall impact on investing has been remarkable and positive for fiduciaries.
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