JUNE 30, 1997 VOLUME 4, NUMBER 52
When New York State Senator Rodney B. Janes died in 1973, he had managed to accumulate an estate of about $3.5 million. About half of his estate consisted of Eastman Kodak stock.
Janes left his estate in trust with Lincoln First Bank, which later became a part of Chase Manhattan Bank. The Trust’s income was to be paid to Janes’ widow, and the ultimate beneficiaries of most of his estate were a number of charitable organizations.
When Janes died, his Eastman Kodak stock was trading at $139 per share. Over the next eight years, Lincoln First Bank continued to hold the Eastman Kodak stock, even as its value slid to $47. By the time the stock was liquidated, the trust had experienced a loss of more than $1.2 million.
Janes’ charitable beneficiaries complained about the stock losses. They pointed to well-accepted principals of financial management which call for investments to be diversified to minimize risk. In fact, they argued, the precipitous loss of Eastman Kodak stock value was precisely the kind of danger that diversification is meant to avoid. Lincoln First Bank should have heeded the old adage about too many eggs in one basket, argued the charities.
Lincoln First Bank, defending its actions, argued that a trustee should not be required to change the original investments of a trust unless there are specific, identifiable “elements of hazard.” In other words, unless there was evidence of a fundamental problem with Eastman Kodak stock, the bank should not be charged with knowledge of what might be coming. In fact, said Lincoln First, Eastman Kodak remained a recognized blue chip stock throughout the eight-year period, and reasonably prudent investors could have made responsible decisions to buy or hold the stock.
The New York Court of Appeals disagreed. Saying that reliance on a “restrictive list of hazards” would be a rigid limitation on investment obligations for trustees, the Court instead chose to focus on the failure to diversify. “Failure to diversify can itself constitute imprudent investment,” said the Court. Furthermore, noted the Court, Lincoln First had failed to ever consider the propriety of continuing the Eastman Kodak investment, failed to consider the needs of Janes’ widow, and failed to follow its own policies for investment review.
Lincoln First was ordered to pay a surcharge to the Trust’s beneficiaries. The remaining question for the Court to resolve was how much that surcharge should be. A lower court had imposed a penalty of $1.2 million, representing the loss in value of Eastman Kodak stock. The trial court, on the other hand, had adopted another approach to calculating the damages: if the Eastman Kodak stock had been sold and invested in an appropriately diversified mutual fund, said the trial judge, the Trust would have received another $6.1 million, and that is how much the bank should now repay.
The Court of Appeals decided that Lincoln First’s penalty should be limited to the loss in Eastman Kodak’s value, and so set the surcharge amount at $1.2 million. The Court’s decision was based partly on the fact that the failure of the Bank was in its “negligent retention” of the stock, rather than in affirmative investment mistakes. Lincoln First Bank, NY Court of Appeals, May 2, 1997.
Arizona law would likely yield a similar result, though for different reasons. New York continues to employ the “prudent person” standard for fiduciary investments. That standard requires a Trustee to consider what a reasonable person would do with the money of another. Arizona, on the other hand, has recently adopted the “Prudent Investor” standard, which requires a review of the entire investment portfolio. That review must include a consideration of the need for diversification to protect against this type of loss.