Editors' Synopsis: This Article reviews the history of trust doctrine and fiduciary duties, examines modern portfolio theory and analyzes the expansion of fiduciary duties and modern portfolio theory under the Restatement (Third). The author examines contemporary legal thought, case law, and fiduciary duties under the pension management requirements of the Employment Retirement Income Security Act of 1974. Finally, the Article explores plausible hedging strategies using financial derivatives or derivative-like products to maximize portfolio wealth. The author concludes that trust fiduciary duties require implementing and understanding modern hedging techniques.

TEXT:

 [*128]  I. INTRODUCTION

Trust fund management and fiduciary duties have long been an important part of Western civilization. These duties include the threat of personal liability of the fiduciary when trust assets underperform. In such cases, beneficiaries generally assume that a fiduciary's given investment decision was imprudent. Still, fiduciaries serve an important social function by managing trust assets. The importance of the trust is that it serves as a vehicle for the disposition of property. n1 Such disposition allows for the smooth passage of property and wealth from one generation to another. Moreover, trust funds are as important to estate planning as water is to the human body. Therefore, trust funds and fiduciary management, coupled with a keen understanding of the duties involved, play an important role in the preservation of a family's long-term wellbeing.

n1 RESTATEMENT (SECOND) OF TRUSTS introductory note (1959).

Fiduciary or trustee duties have evolved over many years in Western civilization. The old English common law system struggled with these duties, and eventually the struggle filtered into the American common law system. This migration set the stage for a perpetual evolutionary process of trust fund management and fiduciary duties that continues even today. Moreover, with the advent of modern financial thought and innovation, contemporary fiduciaries have an arsenal of financial management tools compared to their predecessors in the early nineteenth century.

 [*129]  The traditional fiduciary was limited to conservative financial management tools such as savings accounts, certificates of deposit, and government bonds. Additionally, negative deviation in corpus returns resulted in personal liability for a trustee, regardless of the overall success of the aggregate trust fund. This system mandated that fiduciaries were judged on an investment-by-investment basis. This standard required that no single investment in a pool of investments in the trust could fail. n2 Therefore, fiduciaries had no incentive to distribute trust corpus among an array of investments for fear that one poor result would subject them to liability. Fortunately, a modern expectation has replaced this antiquated and costly philosophy.

n2 For instance, if a fiduciary held ten investments in a fund and one out of the ten failed to be profitable, the trustee was held liable for the negative results of the one loser. Regardless of whether the remaining nine investments had stellar performances, only the loser would be focused upon.

In the early 1990s, the world of trust fund management and fiduciary law witnessed a significant change with the adoption of the prudent investor rule under the Restatement (Third) of Trusts ("Restatement (Third)"). n3 The ensuing changes have created increased flexibility for trust managers and have also increased trust managers' duties. Central to these duties is the prudent investor standard and that standard's adoption of modern portfolio theory. n4

n3 See RESTATEMENT (THIRD) OF TRUSTS ¿  227 general notes (1992) [hereinafter RESTATEMENT (THIRD)]. "The American Law Institute's prudent-investor project is the way in which the rule has previously been elaborated in Restatement commentary or other treatises and applied by courts in most of the states." Id.

n4 See Harry M. Markowitz, Portfolio Selection, 7 J. FIN. 77 (1952) (introducing the concept of portfolio theory for which Markowitz received the 1990 Nobel Prize in Economic Science). See generally RESTATEMENT (THIRD), supra note 3, ¿  227 introduction (mentioning fiduciaries' use of modern portfolio theory).

Under this contemporary theory, a trust fund's probability of success increases because of a balancing of risks and returns. The key factor of contemporary financial theory and fiduciary law is an expansion of fiduciary duties that, in certain instances, includes the use of financial derivatives and hedging strategies.

First, this Article briefly introduces and reviews the historical backdrop of trust doctrine and fiduciary duties. In addition, it briefly  [*130]  examines modern portfolio theory and analyzes the expansion of fiduciary duties and modern financial theory under the Restatement (Third). Risk and risk management are considered, and the corporate answers to risk management are examined. Then, this Article examines contemporary legal thought, case law, and fiduciary duties under the pension management requirements of the Employment Retirement Income Security Act of 1974 ("ERISA"), all of which evidence a shift of fiduciary responsibility that includes a duty to hedge risk. Next, this Article explores plausible hedging strategies using financial derivatives or derivative-like products to maximize portfolio wealth. Finally, this Article concludes that trust fiduciary duties require implementing and understanding modern hedging techniques.

II. THE DEVELOPMENT OF FIDUCIARY DUTIES: THE COMMON LAW PRUDENT MAN STANDARD

The original American prudent man standard evolved in the 19th century with the adoption of the old English standard. n5 This rule required prudent trustee investment approaches that were no more than ultra-conservative practices. n6 The English fiduciary doctrine for trust fund investment resulted from the financial collapse of the South Sea Company. n7 This doctrine protected trust corpus while creating a perpetual cash flow from consol bond investors for the English government which ensured the country's wealth would remain in England.

n5 See John H. Langbein, The Uniform Prudent Investor Act and the Future of Trust Investing, 81 IOWA L. REV. 641, 643-44 (1996).

n6 See id.

n7 See id.; Bubble Act of 1719, 6 Geo., ch. 18 (Eng.) (resulting from the collapse of the South Sea Company and restricting a fiduciary's ability to invest in anything but perpetual government-backed bonds known as consol bonds); BLACK'S LAW DICTIONARY 308 (6th ed. 1990) (defining "annuity bond" as one "without a maturity date," which is "perpetually paying interest").

Unfortunately, early America did not enjoy a mature financial market or a stable government that was capable of issuing and backing such bond  [*131]  instruments. n8 This forced the American common law system to construct its own version of trust doctrine and fiduciary duties. n9

n8 See Mayo Adams Shattuck, The Development of the Prudent Man Rule for Fiduciary Investment in the United States in the Twentieth Century, 12 OHIO ST. L.J. 491, 493 (1951) (explaining the different investment options in England and the United States that resulted from economic conditions in the United States after the Revolutionary War and the effects of these conditions).

n9 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. k.

Early development of the law governing trust investments in England and in this country was in the hands of the judiciary. Some courts attempted to define permissible types of investments. Others sought to judge a trustee's investments case by case, asset by asset, sometimes without articulated standards and sometimes with reference to a generally conservative standard of prudence.

Id.

In the seminal case of Harvard College v. Amory, n10 the Supreme Judicial Court of Massachusetts formulated the American version of the prudent man standard: n11

All that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested. n12

n10 26 Mass. (9 Pick.) 446 (1830).

n11 See id. at 461; RESTATEMENT (THIRD), supra note 3, ¿  227 general notes ("The prudent investor rule of this Section has its origins in the dictum of Harvard College v. Amory."). See also John A. Taylor, Massachuetts' Influence in Shaping the Prudent Investor Rule for Trusts, 78 MASS. L. REV. 51, 53 (1993) (analyzing the Harvard College case).

n12 Harvard Coll., 26 Mass. (9 Pick.) at 461.

The Harvard College standard was based upon the understanding that trust corpus was always subject to some risk regardless of the fiduciary's investment choices. n13 Therefore, a trustee only needed to exercise good judgment and the care of a prudent man in order for the courts to interpret even speculative investments such as common stocks as prudent. n14 The  [*132]  Harvard College decision afforded American fiduciaries a greater array of investment choices for investing trust fund corpus, which made a fiduciary's job much easier. n15

n13 See id.

n14 See id. at 460-61.

n15 See id.

Unfortunately, the mid-nineteenth century witnessed the deterioration of this broad-minded thinking as the courts redefined the Harvard College fiduciary standard. n16 In King v. Talbot, n17 the New York Court of Appeals held that fiduciaries who invested trust corpus in common stocks acted imprudently. n18 The King decision restricted fiduciaries to investments in government-backed bonds and mortgage-backed securities. n19 This wave of conservative thinking led to the creation of "legal lists," n20 which compiled acceptable fiduciary investments depending upon a given state's law. n21 The only exception regarding common stock investments occurred when a trust document gave specific instructions to the fiduciary to make such investments. n22

n16 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. k.

This was done in varying degrees of definiteness and, although usually accompanied by recognition of some general requirement of diversification, tended strongly to judge and classify investments in isolation. Broad categories of properties and techniques came to be branded as "speculative," or not of "investment quality," and to be viewed as per se or presumptively imprudent.

Id.

n17 40 N.Y. 76 (1869).

n18 See id.

n19 See id. at 77-78.

n20 See BLACK'S LAW DICTIONARY, supra note 7, at 895 (defining a "legal list" as a "list of investments selected by various states in which certain institutions and fiduciaries, such as insurance companies and banks, may invest. Legal lists are often restricted to high quality securities meeting certain specifications.").

n21 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. k.

Continuing into the twentieth century, statutes were widely adopted setting out so-called "legal lists" of permissible investments with varying degrees of specificity. In some other states an evolving "prudent man rule" prevailed in the courts, and through legislation this approach gradually spread to or was reaffirmed in most of the states.

Id.

n22 See id. "The terms of a trust or statute may. . . make [or break] a particular type of investment or course of action impermissible." Id.

Time itself evidences the impractical and restrictive nature of legal  [*133]  lists. n23 Consequently, the more flexible prudent man rule prevailed, and trust management, though still restrictive, was judicially handled on a case-by-case basis. n24

n23 See Austin Flemming, Prudent Investments: The Varying Standards of Prudence, 12 REAL PROP. PROB. & TR. J. 243, 244 (1977) (explaining that legal lists were restrictive due to their inflexibility, thus making it impossible for fiduciaries to adapt to changing economic environments). See also Robert J. Aalberts & Percy S. Poon, The New Prudent Investor Rule and the Modern Portfolio Theory: A New Direction for Fiduciaries, 34 AM. BUS. L.J. 39, 43 (1996) (comparing the legal list rule to the more vigorous Harvard College rule).

n24 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. k. "As generalizations were articulated and guidance was offered to trustees in dicta, opinions tended to transform what had been decided as a predominantly factual issue in one case into a legal precedent for application in others." Id.

Judicially created restrictions mandated that fiduciaries be judged on an individual investment basis while ignoring the overall results of well-diversified trust corpus. n25 This ideology severely limited the spectrum of potential returns because fiduciaries relied predominantly upon conservative, non-competitive investments that courts viewed as prudent. n26

n25 See id. "Through [judicial] processes and experiences, general standards were often crystallized into subrules specifying the permissible types . . . of trust investments. This was done in varying degrees of definiteness and . . . tended strongly to judge and classify investments in isolation." Id.

n26 See id.

Broad categories of properties and techniques came to be branded as "speculative," or not of "investment quality," and to be viewed as per se or presumptively imprudent. This was usually based on some perceived degree of risk that exceeded what the duty of caution would bear. The exercise of care, skill, and caution in establishing and implementing a suitable investment strategy usually was no defense in a surcharge action attacking a trustee's acquisition or retention of individual assets that were classified as "impermissible."

Id.

The historical view of prudence was inflexible and constrained a fiduciary's ability to implement competent financial management of trust corpus. n27 Moreover, under the historical standard, a fiduciary had to avoid  [*134]  innovative investment tools that would have been viewed as "speculative" in nature. n28 In summary, the restriction on managing trust corpus under the prudent man standard was an albatross--an inadequate, dead standard that cost trust beneficiaries both income and principal. n29

n27 See Robert A. Levy, The Prudent Investor Rule: Theories and Evidence, 1 GEO. MASON L. REV. 1, 3 (1994) (stating that the historical prudent man rule precludes a fiduciary from using innovative financial products such as futures, options, high-yield bonds, margin purchasing of securities or the purchase of collectibles, venture capital investments, or real estate purchases for future capital gain potential). But cf. RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. k (establishing that "there is no arbitrary barrier to the competent use, in proper roles and circumstances, of options and futures transactions or of programs for investing in foreign markets, real estate, or unestablished enterprises"). Id.

n28 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. k.

Beneficial objectives and the investment function may become so intertwined as to justify the purchase of financial products that might not ordinarily be thought of as investments. For example, an annuity may offer a reasonable means of seeking to assure that a trust's periodic distribution requirements can be met; or the acquisition and maintenance of a life insurance policy may fit within the trust purposes as an appropriate type of benefit or protection for one or more beneficiaries.

Id.

n29 See Stephen P. Johnson, Note, Trustee Investment: The Prudent Person Rule or Modern Portfolio Theory, You Make the Choice, 44 SYRACUSE L. REV. 1175, 1177 (1993) (stating that the inflexibility of the prudent person rule deters fiduciaries from doing an optimum job when managing a portfolio of investments).

III. MODERN PORTFOLIO THEORY

A. In the Beginning

In the early 1950s, Harry Markowitz published his landmark paper Portfolio Selection, which has become the generally accepted origin of modern portfolio theory within the financial and economic community. n30 The legal community's acceptance of modern portfolio theory came much slower, but following decades of empirical evidence, legal thought regarding contemporary trust doctrine has begun to join the mainstream. n31

n30 See Markowitz, supra note 4; CHARLES P. JONES, INVESTMENTS: ANALYSIS AND MANAGEMENT 566 (1994); WILLIAM F. SHARPE, ET AL., INVESTMENTS 167 (1995); Bruce Stone, The Prudent Investor Rule: Conflux of the Prudent Man Rule with Modern Portfolio Theory, EST. PLAN. & ADMIN. 9, 11-12 (1993).

n31 See RESTATEMENT (THIRD), supra note 3, ¿  227 general notes on cmts. e-h.

Investors have always known intuitively "not to put all their eggs in one basket." n32 Still, it was Markowitz who first conceived the idea of asset diversification. n33 Markowitz set himself apart from other economists by  [*135]  developing specific quantitative models to measure a portfolio's composite risk and expected return. n34 Through the use of his quantitative models, n35 Markowitz showed the world of finance how diversification n36 worked to reduce portfolio risk while maximizing return. n37

n32 JONES, supra note 30, at 36.

n33 See id.

n34 See id. at 566.

n35 See id. at 570.

E(Ri) = [SIGMA] (Pk) PRk (EXPECTED RETURN)

VAR(Ri) = [delta][i]<2> = [SIGMA] (PRk - E(Ri))<2> (VARIANCE)

SD(Ri) = [delta][I] = [[SIGMA] (PRk - E(Ri))<2>]<1/2> (RISK OR STANDARD DEVIATION)

n36 See id.

n37 See id. at 588 (explaining that risk reduction and return maximization are the keys to portfolio theory); RESTATEMENT (THIRD), supra note 3, ¿  227(b) cmt. f(3) (stating that "diversification is fundamental to the management of risk and is therefore a pervasive consideration in prudent investment management" and that "the duty to diversify ordinarily applies even within a portion of a trust portfolio that is limited to assets of a particular type or having special characteristics").

B. Diversification

Diversification is important because it dilutes the volatility of individual security prices and assists in prudent corpus management. n38 The specific risk of a single stock is generally higher than the risk of a group of stocks comprising a portfolio. n39 Additionally, a diversified portfolio generally is considered prudent because the expected rate of return  [*136]  increases without substantially increasing the portfolio's overall risk. n40

n38 See RESTATEMENT (THIRD), supra note 3, ¿  227 general notes on cmts. e-h. "The volatility of a portfolio, however, is reduced by increasing the number of securities held and by their tendencies to react differently to economic events (negative variance correlation). Yet, the portfolio's average return expectation is not affected by this reduction of diversifiable (or 'specific') risk." Id.

n39 See id.

Because all economic events do not affect the value of all investments in the same way, risk (or volatility . . .) is always greater with a single stock than it is with multiple stocks. At least this is true unless their returns are perfectly correlated--that is, unless they vary identically, as one could only hypothesize. To the extent their outcomes are opposed, so that variations in result would tend to cancel each other, the portfolio receives the benefit of reduced risk (that is, a reduction in the firm specific or diversifiable element of risk) with no impairment of the portfolio's average return expectation.

Id.

n40 See Baker Boyer Nat'l Bank v. Garver, 719 P.2d 583 (Wash. Ct. App. 1986).

[The court] . . . interpreted Washington's "total assets" approach to fiduciary investment as including a duty to diversify as a prudent investor would, noting that failure to do so would ordinarily result in liability that would include some approximation of the loss of appreciation in equity securities that a properly diversified portfolio would have produced.

Id. See also Nestle v. Nat'l Westminster Bank PLC, 1984 N. No. 1897 (Ch. June 29, 1988) (unreported case) ("Modern trustees acting within their investment powers are entitled to be judged by the standards of current portfolio theory, which emphasizes the risk level of the entire portfolio rather than the risk attaching to each investment taken in isolation.").

Diversification allows an investor to include more volatile investments without subjecting the portfolio to significantly higher risk. n41 For instance, a general stock mutual fund is the simplest example of a diversified portfolio. n42 The ultimate goal of modern portfolio theory is to balance portfolio risks and returns through diversification. n43 Therefore, by diversifying, trustees can fulfill their fiduciary duties to trust beneficiaries. n44

n41 See Nestle, 1984 N. No. 1897.

n42 See JONES, supra note 30, at 566-68. "[Stock funds are well-diversified portfolios;] less than 5 percent of stock mutual funds lost money in the five years following the crash of 1987." Id. at 566.

n43 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. e.

Despite variations and flexibility in all of these matters, one pervasive generalization prevails concerning the prudent investor's duty of caution: reasonably sound diversification is fundamental to the management of risk, regardless of the level of conservatism or risk appropriate to the trust in question. Therefore trustees ordinarily have a duty to diversify investments.

Id.

n44 See id. ¿  227 cmt. g. "The objective of prudent risk management imposes on the trustee a duty to diversify . . . unless special considerations make it prudent not to diversify in the particular trust situation." Id.

Diversification is fundamental to the optimal management of assets n45  [*137]  and is supported under section 227 of the Restatement (Third). n46 Diversification creates an advantage for fiduciary success because of the expanded universe of investment options available. n47 Conversely, a fiduciary is not mandated to use diversification when general economic conditions so dictate or if applicable statutes would be violated. n48

n45 See id. (stating that asset allocation determinations are fundamental to making investment strategy decisions and advancing the idea of diversification); Edward C. Halbach, Jr., Trust Investment Law in the Third Restatement, 27 REAL PROP. PROB. & TR. J. 407, 437 (1992) ("Sound diversification is fundamental to management of uncompensated risk."). Cf. Estate of Knipp, 414 A.2d 1007, 1009 (Pa. 1980) ("Although many financial authorities advocate diversity of investment as a desirable course for trust management, a judicial decision declaring non-diversification to be presumptively imprudent would arbitrarily foreclose executors and trustees from opportunities to retain beneficial holdings."). Id.

n46 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. g. The duty to diversify does not prohibit favoring a single investment class:

Given the variety of defensible investment strategies and the wide variations in trust purposes, terms, obligations, and other circumstances, diversification concerns do not necessarily preclude an asset allocation plan that emphasizes a single category of investments as long as the requirements of both caution and impartiality are accommodated in a manner suitable to the objectives of the particular trust.

Id. See also Halbach, supra note 45, at 438-39 (describing the adverse consequences from improper diversification, such as failure to examine tax considerations, inability to realize full value from real property sales and private bond placement illiquidity).

n47 See U.S. Nat'l Bank of Portland v. First Nat'l Bank of Portland, 142 P.2d 785, 792 (Or. 1943) ("The preservation of proper diversification and maintenance of adequate return, having in view the needs of the beneficiaries, are considerations of prime importance. It would be impossible to exercise any informed discretion on such an issue without a study of the entire portfolio.").

n48 See Levy, supra note 27, at 6 (highlighting the fact that Restatement (Third) section 228 exculpates a fiduciary who refrains from diversifying in compliance with trust instrument directions or applicable state statutes).

Overall, diversification makes taking advantage of pre-packaged diversified portfolios, such as mutual funds, which aid in increased returns without increasing corpus risk, easier for fiduciaries. n49 Diversification also increases fiduciaries' responsibilities to become significantly more knowledgeable about financial management as contemporary expectations of their performances continue to rise.

n49 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. g. "Broadened diversification may lead to additional transaction costs, at least initially, but the constraining effect of these costs can generally be dealt with quite effectively through pooled investing. . . . Hence, thorough diversification is practical for nearly all trustees." Id. But see John H. Langbein & Richard A. Posner, The Revolution in Trust Investment Law, 62 A.B.A.J. 887, 889 (1976) (calling into question the purported ease of diversifying assets). The vast selection of modern index funds available in the 1990s essentially negated this position.

 [*138]  C. Contemporary Duties: Restatement (Third) Section 227

1. The Prudent Investor Rule

The prudent investor rule sets an innovative standard for fiduciaries to follow when managing trust corpus. n50 The rule creates a fiduciary standard that essentially warns against exercising extreme conservatism; excessively conservative strategies literally can create liability for fiduciaries. n51 This standard came about in 1992 with the American Law Institute's ("ALI") adoption of the Restatement (Third). n52 Specifically, section 227 is rooted in contemporary financial thought, commonly known as modern portfolio theory. n53 Under section 227, trust fiduciary duties are commonly referred to as the "prudent investor rule." n54 This rule reverses years of restrictive judicial precedent in an effort to reflect modern asset management  [*139]  strategies. n55 Most importantly, section 227 merges contemporary portfolio theory and traditional trust doctrine. n56

n50 See RESTATEMENT (THIRD), supra note 3, ¿  227.

The trustee is under a duty to the beneficiaries to invest and manage the funds of the trust as a prudent investor would, in light of the purposes, terms, distribution requirements, and other circumstances of the trust.

(a) This standard requires the exercise of reasonable care, skill, and caution, and is to be applied to investments not in isolation but in the context of the trust portfolio and as a part of an overall investment strategy, which should incorporate risk and return objectives reasonably suitable to the trust.

Id.

n51 See id. ¿  227 cmt. e (stating that speculation can assist a fiduciary in complying with conservative trust requirement). See also Halbach, supra note 45, at 437 (stating that inordinate conservatism, like reckless speculation, can severely erode trust beneficiaries' entitlement).

n52 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. e (stating that the "general duty to invest conservatively is a traditional and accepted feature of trust law, [but] that duty is necessarily imprecise in its requirements").

n53 See id.

As a start, it is important that a trustee be reasonably knowledgeable or have professional advice in order to achieve the informed diversification normally required of trustees, because [it] will be beneficial in virtually all of the strategies the trustee might pursue. Beyond this, proper understanding and analysis of risk-reward relationships, associated strategies (such as those based on modern portfolio theory), and the means of their implementation are of considerable interest and importance to the trustee. . . . Because . . . [these decisions] undertaken to increase portfolio risk are the prudent investor's primary path to higher expected return.

Id. ¿  227 general notes on cmts. e-h.

n54 Id.

n55 See id.

n56 See RESTATEMENT (THIRD), supra note 3, ¿  227, introductory cmt. (explaining that modern portfolio theory is a responsible strategy for use with the changes in fiduciary trust management).

Presently, modern financial management theory has received wide acceptance throughout both the academic and practitioner communities of law and finance. n57 This wave of acceptance is evidenced by the wide statutory adoption of contemporary trust investment doctrine in several states. n58 Moreover, many states specifically have adopted the prudent investor rule or an investment management rule that is very similar. n59

n57 See Markowitz, supra note 4, at 77. See also RESTATEMENT (THIRD), supra note 3, ¿  227 introductory cmt. (encouraging the use of modern portfolio theory by fiduciaries).

n58 See ARIZ. REV. STAT. ANN. ¿  14-1041 (current version at ARIZ. REV. STAT. ANN. ¿ ¿  14-3715, 14-5424 (West 1956 & Supp. 2000)); ARK. CODE ANN. ¿ ¿  28-49-115 to 28-49-116 (Michie 1997 & Supp. 1999); COLO. REV. STAT. 1953, ¿ ¿  57-3-1 to 57-3-6 (current version at COLO. REV. STAT. ANN. ¿  15-1-304 (West 2000)); DEL. CODE ANN. tit. 12, ¿ ¿  3301-3308 (1993 & Supp. 2000); FLA. STAT. ANN. ¿ ¿  518.01, 518.06 to 518.14 (West 1997 & Supp. 2000) (¿ ¿  518.02-518.05 repealed by Laws 1953 ch. 28154 ¿  10), 660.02 (repealed by Laws 1976 ch. 76-168 ¿  3, Laws 1980 ch. 80-260); GA. CODE ANN. ¿ ¿  108-417 to 108-421 (repealed 1991); HAW. REV. STAT. ANN. ¿  554-6 (Michie 2000); IDAHO CODE ¿ ¿  68-501 to 68-505 (repealed and reenacted 1997) (Michie 1999); IND. CODE ANN. ¿ ¿  31-115 to 30-1-5-1 (Michie 2000); IOWA CODE ANN. ¿  636.23 (West 1992 & Supp. 2000); KY. REV. STAT. ¿  386.020 (Michie 1999); MICH. COMP. LAWS ANN. ¿  555.201 (West 1998 & Supp. 2000); MISS. CODE 1942, ¿  421.5 (Laws 1956, ch. 212) (current version at MISS. CODE ANN. ¿ ¿  91-13-1 to 91-13-3, 91-13-5 to 91-13-9 (1994 & Supp. 2000); MO. ANN. STAT. ¿  363.550 (West 1997 & Supp. 2001); NEB. REV. STAT. ¿  30-3201 (1995); NEV. REV. STAT. ANN. ¿  164.050 (Michie 1993 & Supp. 1999); N.H. REV. STAT. ANN. ¿  564:18 (1997 & Supp. 2000); N.Y. BANKING LAW ¿  100-b (McKinney 1990); N.Y. PERSONAL PROPERTY LAW ¿  21(1) (repealed 1967); N.D. CENT. CODE ¿ ¿  6-05-15, 7-04-09 (1987); OHIO REV. CODE ¿ ¿  2109.37, 2109.371 (Anderson 1998 & Supp. 1999); OKLA. STAT. ANN. tit. 60, ¿  161 (West 1994 & Supp. 2001); ORE. REV. STAT. ¿ ¿  128.021, 128.026, 128.031, 128.035, 128.065 (1990 & Supp. 2000); PA. STAT. ANN. tit. 20, ¿ ¿  7134, 7301-7319 (West 1975 & Supp. 2000); R.I. GEN. LAWS ¿  18-4-2 (2000); S.D. CODIFIED LAWS ¿  55-3-11 (Michie 1997); TENN. CODE ANN. ¿ ¿  35-302 to 35-324 (1996); UTAH CODE ANN. ¿  7-5-10 (1995); VA. CODE ANN. ¿  26-40 (Michie 1997 & Supp. 2000); WASH. REV. CODE ANN. ¿  11.100.020 (West 1998); W. VA. CODE ANN., ¿ ¿  44-6-1 to 44-6-5 (Michie 1997); WIS. STAT. ANN. ¿  881.01 (West 1991 & Supp. 2000).

n59 See supra note 58; RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. a.

The prudent investor rule stated in this Section is an extension and clarification of the traditional, so-called "prudent man rule" originally articulated by the Massachusetts Supreme Judicial Court and now followed by most states. In many jurisdictions the prudent investor rule or an earlier version of it has been adopted by statute.

In a few states, by statutory provision or otherwise, the investment authority of trustees remains considerably more restricted. See ¿  228.

Several bodies of state and federal legislation dealing with various types of charitable, pension, or public funds have incorporated rules more or less similar to the prudent investor rule.

RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. a.

 [*140]  Section 227 weaves modern investment strategies, fiduciary duties, and historical trust principles together to create a protective web for beneficiary interests. n60 Moreover, the Restatement (Third) clarifies trust fiduciary duties that require repeated balancing of risk and return multiples for a portfolio. n61

n60 See Halbach, supra note 45, at 435.

n61 See RESTATEMENT (THIRD), supra note 3, ¿  227 introductory cmt.

When balancing risk and returns for a trust portfolio, the prudent investor rule requires a fiduciary to make reasonable decisions. n62 In essence, the rule requires trustees to weigh the opportunity for higher expected returns against the inherent added risk that accompanies the higher expected returns. n63 Unfortunately, the prudent investor rule falls short in defining exactly what an appropriate portfolio balance should resemble. n64 Instead, the Restatement (Third) directs fiduciaries to evaluate the risk requirements of a particular trust by evaluating distribution requirements, specific documentation clauses, and the general purpose of the trust fund. n65 Therefore, fiduciaries are left to their own reasonable interpretation when evaluating the investment risk/return questions of a  [*141]  specific trust. n66

n62 See id. ¿  227 cmt. b. A trustee's duties include making investment decisions and periodically monitoring and reexamining investment strategies. The trustee should perform such duties in a reasonable manner, i.e., one that takes into consideration the given investments and stated course of instructions contained in the trust. See id.

n63 See id. ¿  227(a) ("This standard requires the exercise of reasonable care, skill, and caution, and is to be applied to investments not in isolation but in the context of the trust portfolio and as a part of an overall investment strategy, which should incorporate risk and return objectives reasonably suitable to the trust.").

n64 See id.

n65 See generally id. ¿  228 cmt. d ("As a general rule, a trustee can properly make investments in such properties and in such manner as expressly or impliedly authorized by the terms of the trust."); Halbach, supra note 45, at 436 (advising that a fiduciary's judgment should reflect the specific requirements and risk tolerances of a given trust fund).

n66 See id. ¿  228 cmt. d. "In the absence of contrary provision in the terms of the trust or in an applicable statute, ¿  227 describes the investment authority that is normally to be implied for the trustee." Id. "Decisions concerning a prudent or suitable level of market risk for a particular trust can be reached only after thoughtful consideration of its purposes and all of the relevant trust and beneficiary circumstances." Id. ¿  227 cmt. e.

Nonetheless, fiduciaries can fulfill their duties to protect beneficial interests and avoid liability if they understand the ramifications of including compensable risks in a trust portfolio. n67 This understanding requires a working knowledge of modern portfolio theory. Therefore, reasonable fiduciaries must possess a working knowledge of modern portfolio theory prior to applying the theory to trust fund management. Yet, even with a solid understanding of portfolio theory, fiduciary liability becomes more complicated when the fiduciary serves multiple masters.

n67 See id. ¿  227 cmt. e.

For purposes of understanding and applying the fiduciary duty of prudent investing, it is essential to recognize that compensated risk is not inherently bad. Therefore, no objective, general legal standard can be set for a degree of risk that is or is not prudent under the rule of this Section. Beneficiaries can be disserved by undue conservatism as well as by excessive risk-taking. . . . This process includes, for example, balancing the trust's return requirements with its tolerance for volatility.

Id. See Reporter's General Note on ¿  227, cmts. e-h.

2. The Conflict: Exercising Impartiality

A fiduciary has an obligation to treat each competing beneficial interest with impartiality. n68 The Restatement (Third) simplifies the duty to exercise impartiality by encouraging fiduciaries to continue to focus on the overall success of the portfolio. n69 This progressive thinking expands the concept of trust corpus preservation to include potential income  [*142]  production, but not at the expense of the future interests of the trust fund. n70 The key is in the drafting: professionals should specifically communicate their client's intent in the trust documentation, e.g., giving the client examples of how and why to phrase the objectives. n71 However, fiduciaries are still faced with the potential problem of balancing conflicting beneficial expectations. n72

n68 See id. ¿ ¿  170, 183, 227(c)(1) (noting that the ALI requires the trustee to conform to fundamental fiduciary duties of loyalty and impartiality." In cases involving multiple beneficiaries, the trustee has a duty to deal impartially with all of them. See id. See also In re Unisys Sav. Plan Litig., 74 F.3d 420, 434 (3d Cir. 1996) (stating a trustee must "have in view the preservation of the estate . . . and [the] regularity of income to be derived.")

n69 See id. ¿  227 cmt. i. "To whatever extent a requirement of income productivity exists, placing the trustee under a duty not to pursue an investment strategy unduly favorable to one beneficiary or group of beneficiaries at the expense of others, the requirement applies not investment by investment but to the portfolio as a whole." Id.

n70 See id.

The nature and significance of these productivity concerns vary with the trust's circumstances and terms. Usually, however, much is left to interpretation and inference. . . . Thus, for example, the extent to which the needs, or any particular needs, of a life income beneficiary are relevant to the productivity objectives of a trustee's investment program is a question of interpretation. See generally ¿  232, Comment c.

Id.

n71 See id. ¿  227 cmt. i. "Facts and circumstances of a case may offer some illumination. The terms of many trusts, however, simply direct that the beneficiary be paid the 'net income,' rather than, for example, 'such amounts as needed for support.'" Id.

n72 See id. ¿  227 cmt. c. "Conflicting fiduciary obligations result in a necessarily flexible and somewhat indefinite duty of impartiality. The duty requires the trustee to balance the competing interests of beneficiaries in a fair and reasonable manner." Id. See generally id. ¿ ¿  183, 227 cmt. i (noting that trustees have duties of fairness and impartiality to all beneficiaries). "It does [not] matter that particular assets are overproductive of income, as long as the remainder interests are reasonably protected by a balanced trust portfolio that is not overly productive overall." Id. ¿  227 cmt. i.

Section 227 provides a simple illustration of how a conservative investment strategy, designed purely to maximize income, can negatively impact the overall growth of trust corpus and simultaneously raise liability issues: n73

T is trustee of a trust to pay income to A for life, remainder to B if then living and if not then by right of representation to B's issue who are then living. T invests the trust funds in investments of a type that, despite the broad range of yields that might be appropriate to particular trusts, appear unduly to favor A's [present] interest in receiving a high income at the expense of the B family's [future] interest in having corpus protected against loss of purchasing power. This constitutes a breach of T's duty of  [*143]  impartiality in the absence of satisfactory explanation. n74

n73 See id. ¿  227 cmt. c illus. 7 (demonstrating that by maximizing income a fiduciary may minimize the long-term growth potential of trust corpus).

n74 Id. (citations omitted). See also Robert T. Willis, Jr., Prudent Investor Rule Gives Trustees New Guidelines, 19 EST. PLAN. 338, 340 (1992) (noting that the Restatement (Third) advises fiduciaries to understand that certain investment strategies with a primary focus of maximizing income may minimize growth potential).

Here, the present interest is adequately represented, but the duty of impartiality is breached because the remainderman interest is potentially subject to a future void of purchasing power. n75 Fiduciaries must always consider the concurrent beneficial interests involved when present interests demand the production of income and the future interests mandate corpus preservation. n76 When professionals understand and anticipate the probable risk issues involved, they enjoy a degree of liability protection because they arguably are exercising "reasonable care, skill, and caution." n77 Notwithstanding some liability exculpation, fiduciaries still must  [*144]  understand their personal limitations. n78 Fiduciaries are responsible for exploiting the best resources available to them in their management of trust corpus. n79

n75 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. i. "The trustee ... has a duty of fairness to all of the beneficiaries and of impartiality among them." Id. See also id. ¿  227 cmt. c (explaining that fiduciaries must recognize that inflation over long periods erodes corpus when high-yield and low-growth investment strategies are followed, thus posing a risk to the long-term future security of beneficiaries' needs); Willis, supra note 74, at 340 (suggesting that fiduciaries understand that strategies to maximize income at the expense of long-term growth may destroy trust corpus and cause the fiduciary inadvertently to violate the duty of impartiality). See generally RESTATEMENT (THIRD), supra note 3, ¿  232 (explaining the duties of trustees to successive beneficiaries); id. ¿  239 (explaining the duties of trustees regarding wasting and overproductive property); id. ¿  240 (explaining the trustees' duties regarding unproductive or underproductive property); id. ¿  183 (stating the duties of trustees to multiple beneficiaries).

n76 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. i.

In [some] trust situations there exists a fiduciary duty to make the trust estate productive of trust accounting income. The trustee then has a duty to consider two aspects of the productivity question. First, what is an appropriate level or range of income productivity for the particular trust? . . . This is a matter for interpretation and fiduciary judgment. Second, how should that productivity objective be incorporated into an overall portfolio strategy? In resolving the latter question the trustee is not governed by the productivity standard in the selection and retention of each individual investment. The standard applies to the portfolio as a whole.

Id. (citations omitted). "In short, only when beneficial rights do not turn on a distinction between income and principal is the trustee allowed to focus on total return without regard to the income component of that return." Id. (citation omitted).

n77 Id. ¿  227(a). See also id. ¿  227 cmt. e (noting that the rule recognizes that constantly maintaining positive returns is impossible because of business cycles, economic events, and general market fluctuations).

n78 See id. ¿  227 cmt. d. "The exercise of care alone is not sufficient . . . because a trustee is liable for losses resulting from failure to use the skill of an individual of ordinary intelligence." Id. "[When] the trustee possesses a degree of skill greater than that of an individual of ordinary intelligence, the trustee is liable for a loss that results from failure to make reasonably diligent use of that skill." Id.

n79 See id.

The duty to exercise both care and skill in investment management may require knowledge and experience greater than that of an individual of ordinary intelligence, depending on the investment strategy to be employed. This does not prevent an ordinarily intelligent person from serving as a trustee. . . . Such a person may have to take reasonable steps to obtain sufficient competent advice, guidance, and assistance in order to meet the standards of this Section and to formulate and implement a prudent investment strategy for the particular trust.

Id.

3. The Smart Decision: Delegating Authority

A fiduciary's ability to delegate managerial and investment duties was confined purely to ministerial duties under the Restatement (Second); however, the Restatement (Third) broadens a fiduciary's responsibility to include a duty to delegate investment decisions when appropriate. n80 This duty expands trust doctrine by enabling the trustee to secure the optimum risk/return opportunities available. Therefore, one can reasonably assume that a trustee of average intelligence has access to modern financial ideas,  [*145]  given the array of mutual funds and professional investment advice available to the general public. n81

n80 See id. ¿  227 cmt. j.

The trustee's authority to delegate is not confined to acts that might reasonably be described as "ministerial." Nor is delegation precluded because the act in question calls for the exercise of considerable judgment or discretion. The trustee's decisions with regard to delegation are themselves matters of fiduciary judgment and responsibility falling within the sound discretion of the trustee.

Id. See also id. ¿  227(c)(2) (stating that a trustee must "act with prudence in deciding whether and how to delegate authority and in the selection and supervision of agents").

A trustee has a duty personally to perform the responsibilities of the trusteeship except as a prudent person might delegate those responsibilities to others. In deciding whether, to whom and in what manner to delegate fiduciary authority in the administration of a trust, . . . the trustee is under a duty to the beneficiaries to exercise fiduciary discretion and to act as a prudent person would act in similar circumstances.

Id. ¿  171.

n81 See, e.g., CHARLES SCHWAB & CO., INC., at

https://www.investing.schwab.com/servlet/SchwabAccountApplication (last visited Jan. 20, 2001) (containing the electronic Charles Schwab brokerage account application for United States residents);

https://www.trading.etrade.com/cgi-bin/gx.cgi/AppLogic+OLAMasterpage 2(last visited Jan. 22, 2001) (containing the electronic E-trade brokerage account application for United States residents); SCHWAB RETIREMENT, at http://www.schwabretirement.com/home.asp (last visited Jan. 22, 2001) (containing Schwab's electronic retirement information); SCHWABFUNDS (R), at http://www.schwab.com/SchwabNOW/SNLibrary/SNLib122/SN122mainMiniHome/0,4525,504,00.html (last visited Jan. 22, 2001) (listing SchwabFunds (R) information for mutual funds traded through Charles Schwab & Co., Inc.). The Internet and contemporary advertising makes access to investment information relatively pain free for the average individual. Moreover, one needs only to watch a weekend sporting event to be exposed to a NASDAQ or Charles Schwab and Company's sponsored halftime report of e-trade online trading Television advertisements portrays ordinary people trading online and becoming rich. Lastly, remember the commercial, "When E.F. Hutton talks, people listen."

The duty to delegate does not eliminate the fiduciary responsibility of monitoring and supervising a trust's objectives. n82 When delegating investment authority to a third party, a trustee still must exercise care, skill, and caution. n83

n82 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. j (stating that a fiduciary has a duty to exercise care and prudence when selecting agents and supervising trust objectives).

n83 See id.

Whether pursuing modern portfolio strategies, exercising impartiality, or delegating the authority to make investment decisions, a fiduciary's personal liability also includes a duty to manage or oversee the management of corpus risk. n84

n84 See id. ¿  227 cmt. e. "Insofar as the term 'risk' is used ... to refer to volatility of return, risk management by a trustee requires that careful attention be given to the particular trust's risk tolerance, that is, to its tolerance for volatility." Id.

 [*146]  IV. MARKET VOLATILITY, INNOVATION, AND DERIVATIVES: EMPLOYING RISK MANAGEMENT TECHNIQUES

A. Risk And Reality

Risk is a pervasive adversary that challenges every fiduciary that manages money. n85 For example, multinational corporations face currency exchange rate and interest rate fluctuations, real estate developers' bottom lines rise and fall with interest rates and winding commodity prices, and airline and oil company profit margins move up and down with oil prices. n86 Additionally, trust fund and professional money managers struggle to avoid severe deviations from standard market index returns. n87 The prosperity of market participants is always subject to variations in the financial market and legal environment. n88 Moreover, market participants know that change is the only real constant in the financial markets. n89 This constant translates into market volatility, which subjects all market participants to the risk of potential loss. n90

n85 See Henry T.C. Hu, Hedging Expectations: "Derivative Reality" and the Law and Finance of the Corporate Objective, 73 TEX. L. REV. 985, 986 (1995).

n86 See id. at 986-87.

n87 See Interview with Andy Camega, Director of Quantitative Modeling, Calamos Asset Mgmt., in Naperville, Ill. (Dec. 1999). Professor Camega explained that substantial deviations from a benchmark financial index result in problems for asset management companies and money managers because customers want consistency from their professionals. If they cannot get that, they will move their money to one of the many other retail fund managers. See id.

n88 See Hu, supra note 85, at 986.

n89 See PHILIPPE JORION, VALUE AT RISK: THE NEW BENCHMARK FOR CONTROLLING MARKET RISK, 4-7 (1997). Examples proving that change is the only constant include the following: (a) the fixed currency exchange rate system was abrogated in 1971 "leading to flexible and volatile exchange rates;" (b) the early 1970s were permeated by high inflation and "oil-price shocks;" (c) on October 19, 1987, Black Monday brought a 23% collapse in United States stock prices; (d) the European Monetary System blew up in 1992 and stalled the monetary unification of Europe; and (e) the 1994 bond debacle saw the Federal Reserve Bank erase $ 1.5 trillion with a series of six consecutive interest rate hikes. Id.

n90 See id. at 3. "Risk can be defined as the volatility of unexpected outcomes, generally the value of assets or liabilities of interest." Id.

Analysts generally agree "that the financial environment is riskier  [*147]  today than . . . in the past." n91 The saving grace of this riskier financial environment has been the spawning of financial innovation. n92 "Financial innovation is a demand-driven phenomenon" that always has been fueled by market risk. n93 When financial markets are lackluster and generally nonvolatile, simple, conservative investments satisfy the market. n94 Yet, when such satisfaction deteriorates with price uncertainty, the market always responds with a proliferation of risk management instruments. n95

n91 CHARLES W. SMITHSON & CLIFFORD W. SMITH, JR., MANAGING FINANCIAL RISK: A GUIDE TO DERIVATIVE PRODUCTS, FINANCIAL ENGINEERING, AND VALUE MAXIMIZATION 2 (1995).

n92 See JORION, supra note 89, at 3.

n93 SMITHSON & SMITH, supra note 91, at 2. The volatility of the 1970s created an environment of price uncertainty with severe changes in foreign exchange rates, interest rates, and commodity prices. See id. at 28.

n94 See id. at 28.

n95 See id.

"Through [product] innovation, financial institutions [including professional fiduciaries] can better evaluate and manage . . . portfolios." n96 Offering customers products to manage risk has given fiduciaries and other financial intermediaries an opportunity to expand their businesses. n97 Risk managers regularly deal with price uncertainty, n98 and the onslaught of new financial management products affords fiduciaries the opportunity to come to grips with risk management techniques such as hedging. n99 Moreover, professional money managers and everyday investors accomplish hedging on a daily basis. n100 Therefore, the very existence of this regular use of hedging techniques suggests implicitly that trust fiduciaries have a similar standard to meet.

n96 Id.

n97 See id.

n98 See id. at 1.

n99 See JORION, supra note 89, at 3. "All of life is the management of risk, not its elimination." Id. (quoting Walter Wriston, former chairman of Citicorp).

n100 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. d ("[A] trustee is liable for losses resulting from failure to use the skill of an individual of ordinary intelligence.").

 [*148]  B. The Corporate Duty

1. Making Sense of Hedging

Amplified price uncertainty in the global financial markets has placed corporate fiduciaries under increasing pressure to implement hedging strategies. n101 Corporate fiduciaries regularly hedge corporate risk using derivative securities. n102 Prior to the 1980s, a corporate fiduciary could "blame . . . poor results on the movement of the dollar or unforeseen interest rate changes or commodity price shocks." n103 This was an acceptable response because financial managers and fiduciaries alike were limited in their ability to insure against price uncertainty. n104

n101 See SMITHSON & SMITH, supra note 91, at 65.

n102 See Kimberly D. Krawiec, Derivatives, Corporate Hedging, and Shareholder Wealth: Modigliani-Miller Forty Years Later, 1998 U. ILL. L. REV. 1039, 1045 (defining a derivative as "a bilateral contract or payment exchange agreement whose value is linked to, or derived from, an underlying asset"). See also Gerald A. Edwards, Jr. & Gregory E. Eller, Overview of Derivatives Disclosures by Major U.S. Banks, 81 FED. RESERVE BULL. 817, 818 (1995) (defining a derivative as "a financial contract whose market value is contingent upon the value of one or more underlying 'goods,'" which may include commodities, financial instruments, or financial indices).

n103 Edwards & Eller, supra note 102, at 1045.

n104 See SMITHSON & SMITH, supra note 91, at 65.

However, with the advent of financial derivative products, this response quickly became unacceptable because fiduciaries were now equipped with risk management tools. n105 Moreover, corporate stakeholders are sophisticated and expect management to protect company assets from negative price movements. n106 This reality has led both corporate and institutional stakeholders to hold their fiduciaries accountable for hedging against all forms of price uncertainty. n107

n105 See id.

n106 See id.

n107 See id.

The Indiana Court of Appeals decision in Brane v. Roth evidences such accountability. n108 In Brane, the shareholders of a commercial grain cooperative brought an action against the fiduciaries alleging liability for  [*149]  the directors' failure to hedge against commodity price risk. n109 The Brane court determined that the directors could have mitigated the losses by using grain futures contracts. n110

The court entered specific findings and conclusions determining that the directors breached their duties by retaining a manager inexperienced in hedging; failing to maintain reasonable supervision over him; and failing to attain knowledge of the basic fundamentals of hedging to be able to direct the hedging activities and supervise the manager properly. . . . n111

n108 590 N.E.2d 587 (Ind. Ct. App. 1992).

n109 See id. at 589.

n110 See id. at 591.

n111 Id. at 589-90.

Generally, when corporate executives make decisions based upon good faith and honest judgment, they avoid judicial scrutiny under the business judgment rule presumption. n112 The Brane court reasoned that the fiduciaries were not protected under the business judgment rule presumption because they failed to inform themselves of and implement the hedging tools commonly available to grain market participants. n113

n112 See id.

It is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, that judgment will be respected by the courts.

 Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) (citations omitted).

n113 See Brane, 590 N.E.2d at 592. "To invoke the [business judgment] rule's protection directors have a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them." Aronson, 473 A.2d at 812. See also W & W Equip. Co. v. Mink, 568 N.E.2d 564, 575 (Ind. Ct. App. 1991) (stating that "a director cannot take action blindly and later avoid the consequences by saying he was not aware of the effect of the action").

The Brane court further reasoned that these were material issues because the corporation derived ninety percent of its income from long n114 grain transactions and the directors failed to hedge under circumstances  [*150]  that warranted risk management. n115 The Brane court concluded that hedging was a reasonable business expectation in the grain co-op business and that reasonable managers would have protected against commodity price uncertainty. n116 This decision sets a precedent for those unique instances in which a fiduciary of average intelligence could have avoided the same losses by implementing the appropriate derivatives hedging transaction.

n114 The term "long" means to have ownership of the underlying commodity; thus, the commodity owner possesses the insurable property and a position in a futures contract or an option on a futures contract can be taken to shift the commodity price risk to another legal entity. This is no different from purchasing insurance on a house and shifting the liability to the insurance company.

n115 See Brane, 590 N.E.2d at 592.

n116 See id. at 591. "The record supports the court's findings and its conclusions that the directors breached their duty by their failure to . . . become aware of the essentials of hedging to be able to monitor the business which was a proximate cause of Co-op's losses." Id.

This decision also spurs the debate over the validity of permitting stakeholders and judges to circumvent management's judgment in handling a given corporate risk by alleging a duty to hedge. The importance of the Brane case is that the fiduciaries breached their duty to hedge when they failed to be reasonably informed about commonly used risk management strategies that were regularly implemented in the grain co-op business. Commentary on Brane stresses that the decision should not be applied as a blanket rule that removes the hedging decision from management, or one that supercedes the presumption under the business judgment rule. n117

n117 See Krawiec, supra note 102, at 1043 (stating that "the decision . . . to hedge should be protected by the business judgment rule, so long as that decision is done in good faith by fully informed" managers).

By interpreting the Brane decision as precedent for a fiduciary duty to hedge, the argument will be made that courts are interfering with the day-to-day operations of a company. Nonetheless, hedging is a business decision implemented by management, not unlike other business duties that affect stakeholder interests, so the important question is when does the decision not to hedge become a breach of duty? n118

n118 See id. at 1043.

2. Determining A Breach

When determining a breach of the duty to hedge, a court should ask whether the "information is material [and thus] there is a substantial  [*151]  likelihood that a reasonable shareholder would consider it important" in making an investment decision. n119 For corporate management, the fact that management fails to hedge an ordinarily hedgable risk appears on its face to be information that an investor would find material to the decision of whether or not to invest. Therefore, the Brane court's decision can be interpreted as a benchmark for setting a reasonable corporate fiduciary duty to hedge that protects shareholders from negligent managers who fail to stay reasonably informed about common industry risk management practices.

n119 See SMITHSON & SMITH, supra note 91, at 68-69.

For instance, would it be reasonable for a fiduciary to manage a principal's real estate business and not insure or hedge the buildings against damages? Certainly not! The buildings represent a substantial source of revenue for the business, and a fiduciary has an implicit duty to be informed as to the availability of commercial building insurance. Therefore, a reasonable principal would view a fiduciary's decision not to insure the buildings as a material breach of the duty to hedge against an insurable loss.

Moreover, the key to determining whether a breach has occurred, regardless of the business sector, is whether fiduciaries have fulfilled their duty to be informed about available hedging and risk management strategies. n120 This duty also includes a duty to delegate the hedging decision to knowledgeable individuals who can implement appropriate risk management strategies. n121

n120 See THE GROUP OF THIRTY GLOBAL STUDY GROUP, DERIVATIVES: PRACTICES & PRINCIPLES 1 (1993) [hereinafter GROUP OF THIRTY] (recommending that top management obtain an extensive understanding of hedging and derivatives use before agreeing to implement strategies for their use for risk management purposes).

n121 See id.

C. Implied Acceptance of Derivatives Use

The duty to utilize derivative strategies has become well established and is supported by the Federal Reserve Board and Financial Accounting  [*152]  Standards Board ("FASB"). n122 Moreover, the duty to hedge has become the standard rather than the exception in global markets. n123 "Alan Greenspan, the chairman of the Federal Reserve, estimated [in early 1999] that the financial derivatives market was worth some $ 80 trillion." n124 The sheer size of the derivatives market implies that hedging has become commonplace in corporate America. n125

n122 See FINANCIAL ACCOUNTING STANDARDS BOARD, SUMMARY OF STATEMENT NO. 133: ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, at http://www.rutgers.edu/Accounting/raw/fasb/public/index.html (last visited Jan. 22, 2001):

This Statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction.

. . . . Under this Statement, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity approach to managing risk.

Id. See Michael H. Moskow, The Regulation of Derivatives, Federal Reserve Bank of Chicago's Symposium on Derivatives and Public Policy (1996) at http://www.frbchi.org/pubs-speech/publications/conferences/derivatives/derivatives.html (last visited Jan. 22, 2001).

n123 See Jonathan Moules, Derivatives Exposed, TREASURY & RISK MGMT., May/June 1999, at 9 (quoting Warren Edwards, a financial consultant: "It is incumbent on the board of directors to understand and authorize appropriate derivatives. Shareholders have successfully sued when they have not been used.").

n124 Teresa Riordan, Patents, N.Y. TIMES, Aug. 16, 1999, at C15.

n125 See Saul Hansell, Diving into Derivatives Not as Dangerous as It's Portrayed, ORLANDO SENTINEL, Oct. 9, 1994, at H1 (stating that in a 1993 survey of annual reports by the Swaps Monitor, in excess of two-thirds of Fortune 500 companies regularly used derivatives). See also ENRON, 1999 ANNUAL REPORT 48 n.3 (1999) (explaining Enron's price risk management activities); SOUTHERN COMPANY AND SUBSIDIARIES, 1999 ANNUAL REPORT 48-49 (1999) (explaining Southern Company's financial instruments for nontrading activities).

The Financial Accounting Standard Number 133 ("FAS 133") further  [*153]  evidences not only the extensive use of derivatives, but also the importance of a more thorough disclosure of their use to the marketplace. n126 FAS 133 specifically requires that corporate fiduciaries include a note in their financial statements explaining the strategy behind their use of derivatives. n127 This disclosure requirement is designed to inform both present and future stakeholders of a corporation's strategies to utilize derivative securities. n128

n126 See Moules, supra note 123, at 9 ("Beginning June 15, [1999] the Federal Accounting Standards Board (FASB) will require every publicly traded U.S. company to publish information about its derivatives [use] in the annual report.").

n127 See FASB, supra note 122, at http://www.rutgers.edu/Accounting/raw/fasb/public/index.html (providing a nutshell perspective); Moules, supra note 123, at 10.

n128 See SMITHSON & SMITH, supra note 91, at 70 ("Firms should tell the market about their risk management policies--what the firm is doing and why--[because] . . . the market will reward firms for managing risk.").

A stigmatic contingency still remains among corporate fiduciaries that fear "the market would penalize them . . . [for] using derivatives." n129 Some of this concern is justifiable given historical media and governmental responses to past derivative abuses. n130

The mere mention of the word "derivatives" raises a red flag for federal bank regulators, Congress, the Securities Exchange Commission (the "SEC"), the Commodities Futures Trading Commission (the "CFTC"), . . . and various international agencies. Even newspapers warn the public to check for derivatives before investing, as if a derivative were some kind of an infectious disease. n131

Unfortunately, a "blame-the-product" attitude occurs when a specific financial instrument fails to fulfill an alleged purpose. n132 The problem is  [*154]  that when focusing solely on a specific financial instrument, and not on the implementation of that instrument, the possibility of misinterpreting the real problem exists; moreover, basing a regulation on the same potential misinterpretation lacks logic and reasoning. n133

n129 Id. See Moules, supra note 123, at 9.

n130 See George Crawford, A Fiduciary Duty to Use Derivatives, 1 STAN. J.L. BUS. & FIN. 307, 315 (1995).

n131 Id. (footnotes omitted).

n132 See Thomas A. Russo & Marlisa Vinciguerra, Regulation in the Wake of Long-Term Capital's Rescue, FUTURES AND DERIVATIVES L. REP., Feb. 1999, at 1, 4. "History demonstrates that 'blame-the-product' regulation proves futile at best and counterproductive at worst. For example, this type of approach failed miserably in the case of commodity options in the U.S., which, by the way, are no more inherently evil than any other option." Id.

n133 See id.

Notwithstanding, some regulation is needed to police numerous "problems that demand regulatory attention in financial markets." n134 But a blame-the-product mentality is as impractical as wanting to eliminate motor vehicles because they cause too much personal and property damage. Rarely is the product the problem; instead, regulatory requirements should focus on the implementation of the derivatives strategy. n135

n134 Moskow, supra note 122, at http://www.frbchi.org/pubs-speech/publications/conferences/derivatives/derivatives.html. Problems consist of fraud, insider trading, unfair barriers to credit access, systematic crises due to illiquidity or insolvency of individual financial institutions, the potential of anticompetitive monopolies, and the moral hazard concern stemming from deposit insurance. See id.

n135 See id. The Federal Reserve Bank of Chicago ("FRBC") has taken a modified approach to the regulation of fiduciary duties and derivatives usage because the FRBC explains that it understands the importance of distinguishing between implementation and the importance of an appropriate regulatory environment. See id.

The concept of risk management is more than a bank or corporation buying hedges; it is the idea of protecting the dollar value of the business. n136 Corporate fiduciaries have a general duty to understand how to protect the dollar value of the business. n137 The positive impact that risk management disclosure has had upon a company's net cash flows further evidences this point. n138 Therefore, implicit in a corporate fiduciary's duty to protect the dollar value of the business is the duty to hedge insurable  [*155]  risks. n139

n136 See SMITHSON & SMITH, supra note 91, at 72 (restating the ideas of David Feilder, Eastman Kodak's foreign exchange planning director, in Companies Learn to Live With Dollar's Volatility, N.Y. TIMES, Aug. 11, 1992).

n137 See id. at 65.

n138 See id. at 505. Theoretically, risk management increases a corporation's net cash flows by "decreasing taxes, . . . decreasing the expected costs associated with financial distress, . . . [and] avoiding the errors in the investment decision that are induced by conflicts between bondholders and shareholders." Id. at 505-06.

n139 See GROUP OF THIRTY, supra note 120.

Analogously, a trust fiduciary also has an implicit duty to hedge against insurable risks, especially given the availability of information regarding modern financial management techniques. n140 A trustee also has a duty to protect trust corpus and the beneficiaries' entitlements, n141 which is similar to a corporate duty to protect the dollar value of a business. n142 This duty implicitly requires that a trustee be informed of risk management tools and hedging techniques. n143

n140 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. b. "In managing investments . . . the trustee must adhere to fundamental fiduciary standards." Id.

n141 See id.

n142 See SMITHSON & SMITH, supra note 91, at 65.

n143 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. b (explaining that a trustee should monitor investment strategies and make reasonable decisions that conform to the stated instructions of the trust document).

V. THE MODERN TRUSTEE'S DUTIES

A. A Duty to Hedge: The Changing Landscape

Levy v. Bessemer Trust Co. n144 is a good example of a trustee's need to be informed of risk management tools and hedging techniques. In that case, Levy brought an action against Bessemer Trust Company ("BTC") seeking millions of dollars in compensatory damages "for negligence, gross negligence, negligent misrepresentation, breach of fiduciary duty, breach of the duty to supervise, breach of contract, and fraud." n145 The Levy court found that the plaintiff adequately pled all causes of action but breach of contract, dismissing that claim for lack of specificity in the pleadings but granting Levy leave to replead that allegation. n146

n144 No. 97 Civ. 1785, 1997 U.S. Dist. WL 431079 (S.D.N.Y. July 30, 1997).

n145 See id. at *2.

n146 See id. at *3-6.

Originally, Levy approached BTC with a large equity position he received in consideration for his business in a merger transaction with  [*156]  Corning Incorporated. n147 BTC specifically represented to Levy that the company had "special expertise in providing financial services and investment advice to high net-worth individuals" and managing equity positions. n148

n147 See id. at *1. "The stock certificate prohibited [Levy] from trading the Shares for a period of one year from issuance." Id. Levy informed BTC that his stock certificate contained a liquidation contingency. Id. at *1-2.

n148 Id. at *5.

In numerous conversations with BTC account representatives, Levy stressed the importance of protecting his position in Corning from price depreciation. n149 BTC explained to Levy that no immediate means were available for protecting against a downward move in the stock price. n150 Levy, unsatisfied with BTC's response, sought further advice and eventually closed his account with BTC and reopened it with Paine Webber. n151 Unfortunately, Corning stock had experienced substantial price depreciation by the time Levy's position was hedged. n152

n149 See id. at *1-2.

n150 See id. at *1 (noting that BTC employees and management claimed they were not aware of the option strategies available to hedge Levy's position).

n151 See id. (noting that Paine Webber account executives hedged Levy's investment against further price depreciation).

n152 See id. at *2.

The importance of the outcome in Levy is that the court found a material question of fact in the pleadings for breach of the fiduciary duty to hedge and breach of the duty to supervise the hedge. n153 The Levy court correctly found a material issue with BTC's alleged breach to Levy as an investment advisor. BTC provided "erroneous investment information . . . [and] made misrepresentations to induce [Levy] to maintain his account with BTC . . . ." n154 If BTC had properly advised Levy in the first place, Levy would have had the opportunity to take appropriate action and hedged the equity shares. The Levy court's decision that the trustee breached a duty to hedge is analogous to a corporate fiduciary's duty to protect a business. n155

n153 See id. at *4.

n154 Id.

n155 See SMITHSON & SMITH, supra note 91, at 65. See also, W & W Equip. Co., 568 N.E.2d at 575 (stating that "a director cannot blindly take action and later avoid the consequences by saying he was not aware of the effect of the action").

 [*157]  The Levy court determined that BTC had a duty properly to supervise Levy's account but breached that duty by failing to "maintain a proper system of supervision and control to prevent the account representatives from giving erroneous advice. . . ." n156 Similar to the Brane case, in which the court held that fiduciaries have a duty to be reasonably informed about the basics of hedging, n157 the Levy court also found that BTC had a duty to be reasonably informed of the basics of hedging. n158

n156 See Levy, 1997 U.S. Dist. WL 431079, at *4.

n157 See 590 N.E.2d at 589. "The [trial] court entered specific findings and conclusions determining that the directors breached their duties by retaining a manager inexperienced in hedging; failing to maintain reasonable supervision over him; and failing to attain knowledge of the basic fundamentals of hedging . . .," which were fundamental to their business. Id.

n158 See Levy, 1997 U.S. Dist. WL 431079, at *4.

Lastly, Levy could have argued that BTC had a duty to hedge because hedging is a prudent strategy under the Restatement (Third) section 227. n159 Section 227 merges modern financial innovation with the trust doctrine. n160 This reality will provide fiduciary litigators and trust fund managers with a wave of future challenges as they attempt to understand a trustee's duty to hedge. The Levy case should act as a benchmark standard that requires trust fiduciaries to conform to basic hedging standards, especially because of the accessibility of product information regarding derivatives strategies. n161

n159 See RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. f(2).

Specific investments or techniques are not per se prudent or imprudent. . . . The same is true of specific courses of action, such as the "defensive" use of options [or other derivatives] seeking to reduce the risk of an investment strategy and to do so at a lower "price" in terms of program goals than might be exacted by converting to a more conservative portfolio of assets.

Id.

n160 See id.

n161 See THE CHICAGO BOARD OF OPTIONS EXCHANGE, at http://www.cboe.com/education (last visited Jan. 22, 2001) (providing investors and fiduciaries with products to manage financial risk and education and implementation strategies).

B. ERISA Duty: One Model to Consider

A fascinating decision supporting the use of modern portfolio theory  [*158]  in pension fund management is Laborers National Pension Fund v. Northern Trust Quantitative Advisors ("ANB"). n162 In ANB, the Fifth Circuit reversed a district court determination that ANB's purchase of interest-only mortgage-backed securities ("IO") n163 was not a prudent investment and rendered a money judgment for the fund against the bank. n164

n162 173 F.3d 313 (5th Cir. 1999). "ANB" represents American National Bank, the primary defendant in this case.

n163 Interest-only mortgage-backed securities (IOs) [or STRIPS] were created in the late 1980s. An IO is a right to receive a portion of the interest only from payments on mortgage loans. Each IO is paid from the stream of interest payments made on mortgage loans by a pool of homeowners. . . . IOs can serve as a hedge to prevent significant losses in value due to interest rate changes because IOs generally increase as interest rates rise and mortgage-backed securities generally decline as interest rates rise.

 Id. at 316.

n164 See id.

The Laborers National Pension Fund ("Fund") sued ANB for breach of fiduciary duties alleging violations under ERISA. n165 The lower court determined that ANB ignored the Fund's investment requirements because IOs were inconsistent investments for the Fund, and a prudent fund manager would not invest in an IO under the Fund's requirements. n166 The lower court also found expert testimony supporting investment in IOs unpersuasive. n167

n165 See id. at 316-17.

ERISA was enacted to regulate employee benefit plans and protect the funds invested in such plans. 29 U.S.C. ¿  1302(a). ERISA assigns to plan fiduciaries "a number of detailed duties and responsibilities, which include 'the proper management, administration, and investment of [plan] assets, the maintenance of proper records, the disclosure of specified information, and the avoidance of conflicts of interest.'"

Id. See also 29 U.S.C. ¿ ¿  1001-1461 (1994 & Supp. 11995) (delineating fiduciaries' duties under ERISA). See generally ALAN P. WOODRUFF, ERISA LAW ANSWER BOOK (1998 & Supp. 2000).

n166 See ANB, 173 F.3d at 315.

n167 Id. at 322.

The Fifth Circuit held that the district court's decision was erroneous because modern portfolio theory under ERISA requires that investments  [*159]  not be viewed in isolation. n168 The Fifth Circuit found no reasonable basis for the lower court's decision when the applicable law was correctly applied to the present set of facts. n169

n168 See id.

n169 See id.

The court agreed with ANB's position that the IO purchase was a hedge designed to protect the portfolio n170 and that the investment was a reasonable portfolio addition, which acted as insurance against potential economic turmoil. n171 The court added that ANB provided adequate testimony that the IO investment was prudent n172 and that the ANB expert had properly analyzed the IO hedge "using the correct prudent man, modern portfolio ERISA principles." n173

n170 See id.

n171 See id. at 321.

n172 See id. at 323 (ANB's investment in IOs was reasonable "under the prudent investor [rule], modern portfolio principles of ERISA and the pertinent Department of Labor regulations and guidance.").

n173 Id.

The ERISA position further evidences the strong move towards modernization of the trust doctrine with the incorporation of portfolio theory and hedging techniques. n174 The ANB case evidences a strict view that pension fund managers must use the most modern money management strategies available. Therefore, ordinary trust fiduciaries should also be held to the same standard.

n174 See Employee Retirement Income Security Act of 1974, Pub. L. No. 93-406, 88 Stat. 829 (codified as amended at 29 U.S.C. ¿ ¿  1001-1461 (1994 & Supp. I 1995)). See also Howard v. Shay, 100 F.3d 1484 (9th Cir. 1996). "The business judgment rule is a creature of corporate, not trust, law" that is inapplicable to ERISA breach cases that rely on a prudent person standard. Id.

C. More on Trustee Liability

The principle that hedging is a good method for reducing risk in portfolios is well established. n175 In A Fiduciary Duty to Use Derivatives,  [*160]  George Crawford relates a fictional story in which the main character, an elderly woman who owns a substantial position in Phillip Morris stock, approaches a local bank and sets up a custodial trust account. n176 The main character's stock position has greatly appreciated over the years of her ownership, yet she refuses to sell her equity position. n177 This creates a dilemma for the trustee. First, selling the stock outright would create a taxable event that would eliminate the tax advantage of the "stepped-up basis" that would otherwise occur upon the death of the settlor. n178 Second, holding her position in the stock subjects the trust corpus to price uncertainty. Inevitably, the stock price declines and the portfolio is adversely affected. A few weeks before the decline in stock price, the settlor's guardian approached the trustee with questions regarding hedging the trust portfolio with options, and the trustee completely disregarded the idea of hedging. n179

n175 See SMITHSON & SMITH, supra note 91, at 2 (discussing the authors' focus on numerous contemporary methods of successful management of financial risks). See also RESTATEMENT (THIRD), supra note 3, ¿  227 cmt. f(2) (advocating using options in defensive risk management strategies); Ruth Simon, New Laws May Lift Trust-Fund Returns, WALL ST. J., July 22, 1999, at C1 ("Under the new rules, trustees are told, in essence, to invest the money under their care according to today's basic ideas about smart money management--and promised legal protection if they do.").

n176 See Crawford, supra note 130, at 307.

n177 See id.

n178 See id. "Property received by will or intestate succession, along with non-probate property included in the decedent's gross estate for federal tax purposes, acquires a new basis equal to the value of the property on the date of death." Id. See generally 26 U.S.C. ¿  1014 (2000).

n179 See id. at 313.

Crawford argues that the trustee should have used modern financial techniques to hedge the portfolio. n180 Crawford compares hedging strategies to the traditional trust doctrine choices of sell or hold, and illustrates the distinct advantages of hedging. n181 Crawford concludes that the trustee may be liable for breaching the duty of prudent investing by failing to hedge. n182 The importance of Crawford's article is that it further evidences the changing mindset within the legal community regarding fiduciary duties, trust funds, and hedging.

n180 See id.

n181 See id.

n182 See id. at 309.

 [*161]  VI. PLAUSIBLE STRATEGIES A FIDUCIARY May CONSIDER

A potential client approaches a trust company with 10,000 shares of company XYZ stock. n183 The client is concerned with price fluctuation yet does not wish to sell and diversify. The trust company's goal, which will be specified in the trust documentation, is to maintain the client's equity position. In this situation, the client expressly agrees in writing to allow the fiduciary to use whatever means available to insure against price risk.

n183 XYZ is a stable stock at its all-time high value.

Several possible strategies exist that protect both the settlor's intent and the beneficial interests. The strategies include implementing a protective put strategy, n184 implementing a combination of both puts and calls to create a protective collar, n185 or entering into a customized contractual agreement to shift the portfolio liability to a willing legal entity. Each strategy can be implemented through private negotiation with a derivatives broker/dealer; alternatively, the option strategies can be easily implemented on a public exchange such as the Chicago Board of Options Exchange ("CBOE"). n186 The above-mentioned strategies work essentially as follows.

n184 See CHICAGO BOARD OF OPTIONS EXCHANGE, EQUITY STRATEGY DISCUSSIONS, at http://www.cboe.com/education/strategy/eo-4.htm (last visited Jan. 22, 2001) ("Buying a protective put involves the purchase of one put contract for every 100 shares of stock already owned or purchased.").

n185 See CHICAGO BOARD OF OPTIONS EXCHANGE, PORTFOLIO MANAGEMENT STRATEGIES, at http://www.cboe.com/institutional/portfoli.htm (last visited Jan. 22, 2001) ("The protective collar strategy provides downside protection through the use of index put options but finances the purchase of the puts through the sale of index call options, in effect trading away some upside potential.").

n186 See CHICAGO BOARD OF OPTIONS EXCHANGE, at http://www.cboe.com/exchange/cboehistory.htm (last visited Jan. 22, 2001).

The Chicago Board Options Exchange (CBOE), founded in 1973, revolutionized options trading by creating standardized, listed stock options. Prior to that time, options were traded on an unregulated basis and did not have to adhere to the principle of "fair and orderly markets." The quick acceptance of listed options propelled CBOE to become the second largest securities exchange in the country and the world's largest options exchange. Today, CBOE accounts for more than 51 percent of all U.S. options trading and 91 percent of all index options trading.

Id.

 [*162]  The protective put strategy insures against price depreciation by limiting the risk potential while allowing for a theoretically unlimited upside potential for capital appreciation. n187 The purchaser buys one protective put contract for every 100 shares of stock that the purchaser owns. The put gives the purchaser the right, but not the obligation, to sell the underlying stock at the exercise price of the put option up to the date of expiration. This strategy is analogous to purchasing an insurance policy because it requires renewal premiums to be paid at a predetermined expiration date and is only cashed in when an emergency occurs. The purchaser pays a premium, which is the cost of the put option, and insures against depreciation in the stock price. Regardless of the depreciation in the price of the stock, the put option purchaser has the right to sell the stock at a predetermined price, the "strike price," any time prior to the date of expiration.

n187 See EQUITY STRATEGY DISCUSSIONS, supra note 184, at http://www.cboe.com/education/strategy/eo-4.htm.

An additional strategy is a protective collar, which consists of combining the purchase of put options while selling call options. n188 This strategy provides a benefit by creating a high/low range and ensures a fixed price within that range, whether the underlying asset price moves significantly in either direction. This strategy also reduces the overall premium cost because the premium income from the call option sale offsets the price of the put option purchase. n189 The opportunity cost of this strategy is that it nullifies full participation in price appreciation of the stock because of the increased liability in the call option position. n190 Collar strategies are also readily implemented using long-term options known as Long-term Equity Anticipation Securities, or LEAPS(R). n191 LEAPS(R) allow  [*163]  the fiduciary to structure long-term portfolio protection.

n188 See PORTFOLIO MANAGEMENT STRATEGIES, supra note 185, at http://www.cboe.com/institutional/portfoli.htm.

n189 See Michael Leon & Jonathan E. Kahn, Managing Equity Risk In Volatile Markets, TR. & EST., Jan. 1999, at 18 (noting that if the protective collar strategy is engineered properly, the trust fund can create "a zero premium collar to hedge a stock's price risk and defer taxes" while maintaining some upside potential in the stock).

n190 See id. "It is . . . important . . . to realize that the collar is not costless, rather its cost is the forfeited upside potential of the stock, which . . . has in effect been sold to the [counter party]." Id.

n191 See CHICAGO BOARD OF OPTIONS EXCHANGE, LEAPS(R), at http://www.cboe.com/education/glossary.htm#leaps (last visited Jan. 22, 2001) (Long-term Equity Anticipation Securities, or LEAPS(R), are long-term stock or index options. LEAPS(R), like all options, are available in two types, calls and puts, with expiration dates up to three years in the future, whereas, standard option contracts span over only nine months or less.).

Another advantage of the collar is that exercising the option positions, causing a sale of stock and creating a potential tax liability, is not required. Instead, the options can be cash settled by transacting the opposite position in the same options contract. For example, if a purchaser buys a put option, the purchaser can cash settle that position by selling the same put option prior to the expiration date. Therefore, the owner only deals with tax consequences of the options transaction.

An alternative to traditional exchange-traded options is a privately negotiated transaction with a derivatives broker/dealer or a bank. n192 This benefits a settlor because the parties can customize the option position so that the contract expires in up to five years and includes a renewal or rollover option. n193 Another possibility that may be experimented with in the future is a customized contract that is tied directly to the settlor's mortality. n194 Like any life insurance or options strategy, the cost of this contract would demand scrutiny by the fiduciary so that all parties involved could understand the expenses and risk exposures that would accompany the potential choices.

n192 See Too Much Money in Just One Stock? Get Rid of the Risk, Not the Stock, BARON'S, Aug. 1, 1994, at 7 (purporting this alternative as a fix for estate planning dilemmas of undiversified portfolios in a magazine advertisement by Banker's Trust Company).

n193 Interview with R. James French, Principal, French Capital Management, in Chicago, Ill. (May 12, 2000).

n194 As with any contractual agreement, this would be a particularly flexible contract because the parties would be free to agree to the specifics; therefore, the terms of the insurance or option contracts could be structured so that the exercise dates are directly tied to the settlor's date of death, providing a "floating exercise" date.

In addition, to meet the needs of the ultra tax sensitive settlor, a trust fiduciary could enter into a "debt exchange for common stock or a prepaid forward variable sale" to protect the trust corpus. n195 The prepaid  [*164]  forward variable sale has characteristics similar to a collar. Yet, this strategy enables the purchaser to borrow over the standard fifty percent margin requirement against the underlying equity position. n196 Furthermore, the purchasers do not have to exercise the contract at a future date because this instrument can be cash settled. n197 These products are designed so that purchasers contractually agree to sell their equity position at a predetermined date while receiving cash immediately. n198 The transaction settles when the purchasers deliver a variable number of shares equivalent to the stock's closing value at an agreed upon maturity date. n199 The number of shares at delivery will equal the economic equivalent to the full amount of down-side protection with the purchaser maintaining the capital appreciation of the position up to a capped amount. n200 This strategy enables the purchaser to avoid the immediate creation of a constructive sale of the stock because the shares are not due for delivery until the future exercise date. n201 Lastly, cash settling the contract can avert the sale, and it avoids the tax consequences of the sale of the stock. n202

n195 Leon & Kahn, supra note 189, at 20. A prepaid, forward variable sale is a structured product that allows an investor or a trust fund to hedge the equity value while retaining a portion of the potential capital appreciation, foregoing an immediate tax consequence. The investor retains all the voting rights and dividend payments during the term of the contract. See id.

n196 See French, supra note 193 (noting that the option purchaser can borrow up to 81% of the stock value with the collar or the put strategy).

n197 See Leon & Kahn, supra note 189, at 20.

n198 See id.

n199 See id.

n200 See id. (noting the cap creates the incentive for the counter party to participate in this transaction).

n201 See id.

n202 See id.

In summary, the foregoing examples are a sampling of potential derivative strategies that a fiduciary could consider when managing the risk associated with a trust holding large positions in a single equity. Each strategy lessens the price risk of the equity position while temporarily avoiding the tax consequences of an outright sale of the asset. Nevertheless, the opportunity costs of each strategy must also be analyzed carefully and then explained thoroughly to the client.

VII. CONCLUSION

Given the availability of risk management alternatives to financial  [*165]  management professionals, reasonably intelligent fiduciaries have a duty to integrate modern financial thought into their toolboxes of trust management skills. Moreover, fiduciary requirements and expectations will continue evolving to even more sophisticated levels for the modern trust manager. n203

n203 See RESTATEMENT (THIRD), supra note 3, ¿  227 general notes on cmts. e-h; Hansell, supra note 125, at H1; Markowitz, supra note 4, at 77-91; JONES, supra note 30, at 566; SHARPE, supra note 30, at 167.

Section 227 of the Restatement (Third) stresses the need for diversification through the use of contemporary financial innovation. Additionally, section 227 (c)(1) reminds the professional of the importance of showing impartiality toward beneficiaries, which translates into balancing portfolio risk and return. The legal community has begun to accept the idea of a fiduciary duty to hedge; therefore, a requirement that directors and money managers be knowledgeable and understand basic hedging strategies has evolved. n204

n204 See Brane, 590 N.E.2d at 592; Krawiec, supra note 102, at 1045; Moskow, supra note 122, at http://www.frbchi.org/pubs-speech/publications/conferences/derivatives/derivatives.html.

Additionally, direct legal challenges will arise against trust fiduciaries who fail to manage corpus risk with derivatives when appropriate. Legal professionals will argue that requiring trustees to hedge portfolio risk merely asks them to act as prudently as other financial professionals act on a daily basis. Under ERISA, fiduciary prudence includes the implementation of modern portfolio theory and appropriate hedging techniques to accomplish safe money management. n205

n205 See 29 U.S.C. ¿ ¿  1001-1461; ANB, 173 F.3d at 322 ("Since 1979, investment managers have been held to the standard of prudence of the modern portfolio theory by the Secretary's regulations. 29 C.F.R. ¿  2550.404a-1.").

Hedging strategies are no longer just an academic exercise or an innovative financial experiment. Hedging with derivative securities is as commonplace in the finance and banking industry as a homeowner's purchasing insurance on a home. The time has come for trust fiduciaries to embrace hedging and derivatives usage as part of their daily duties. Fiduciaries must develop the ability to implement hedging strategies under certain circumstances to meet their duty to exercise reasonable care, skill,  [*166]  and caution in their day-to-day management of trust corpus.