Investment risks and solicitor trustees

While the world of finance turns in a state of unrest, Ian Muirhead advises solicitor trustees on compliance with the Trustee Act 2000

The investment world is in ferment.

Market indices have fallen for two successive years and may yet fall for an unprecedented third year.

Some insurance companies are reputed to have been forced sellers of equities, and in danger of breaching their solvency requirements.

Final salary pension schemes are being abandoned because employers cannot afford the risk of having to shore up their funds.

Some pension funds (notably Boots) have abandoned equity investment altogether, in favour of fixed-interest securities.

The doom-mongers are again calling the end of the equity cult; and even the optimists are signalling a major shift from equity to fixed-interest investment.

So what are solicitor trustees to make of all this? How many have reviewed their investment portfolios and reconsidered their investment strategy? How many stand to be accused by disappointed beneficiaries of benign neglect?

The pressure is upon those who undertake responsibility for others' investments.

Only last year, Merrill Lynch was sued in a high-profile case for an alleged failure to exercise proper diligence in looking after the investments of the Unilever pension fund.

It made a substantial out-of-court settlement.

The warning for trustees is the benchmark case of Nestle v NatWest [1993] 1 WLR 1260.

However, the criteria are less demanding than for professional investment advisers.

Section 1 of the Trustee Act 2000 requires a trustee to exercise 'such skill and care as is reasonable in the circumstances having regard in particular: (a) to any special knowledge or experience that he has or holds himself out as having, and (b) if he acts as trustee in the course of a business or profession, to any special knowledge or experience that it is reasonable to expect of a person acting in the course of that kind of business or profession'.

Exercising such skill and care in investment matters as it might be reasonable to expect of a solicitor who does not hold himself out as an investment professional would not appear to be an unduly onerous requirement.

However, account must also be taken of section 5 of the Act, which provides that a trustee must take advice on investment matters except where 'he reasonably concludes that in all the circumstances it is unnecessary or inappropriate to do so'.

The commentary on the Trustee Bill suggested that the exception would apply 'if the investment is small, so that the cost of advice would be disproportionate to the benefit to be gained...

or where the trustees themselves possess skills and knowledge making such separate advice unnecessary'.

The authority for solicitor trustees who are not authorised by the Financial Services Authority to provide investment services is derived from the Solicitors Financial Services (Scope) Rules 2001 and part XX of the Financial Services and Markets Act 2000.

The relevant exemptions permit them to provide discretionary investment management services insofar as these are incidental and complementary to their legal work, but not to advise on the acquisition of investments.

However, they need to be conscious that inadvertently stepping outside the terms of the exemption constitutes a criminal offence.

It may be possible, in some cases, for unauthorised solicitors to navigate between part XX and beneficiaries' expectations.

However, one would expect that in the case of most significantly sized trusts, they would opt for prudence and seek external advice.

Section 5 defines advice for this purpose as meaning 'the advice of a person who is reasonably believed by the trustee to be qualified to give it by his ability in and practical experience of financial and other matters relating to the proposed investment'.

Two other important obligations under the new Trustee Act are to ensure that investments are 'suitable' and that they are properly diversified.

In this respect, while undertaking periodic reviews of trust investments - another obligation under the Act - trustees should question their traditional dependence on direct equity investment, particularly in the case of smaller trust funds.

The Financial Times (8 June 2002) ran an interesting article reviewing research by an investment bank which questioned the assumption that investment markets had become more volatile in recent years.

The research indicated that markets in the UK, US, Europe and even Japan are no more volatile now than they were a decade ago, and that it is in fact individual shares which have become more volatile.

Indeed, between 1990 and 2000 the risk associated with individual shares almost doubled.

Two main reasons for this situation were suggested.

First, companies' activities are in general less diversified than they used to be.

The drive for efficiency and economy has caused businesses to specialise on particular activities or sectors, which makes their earnings more volatile.

Secondly, companies are coming to the market at an earlier stage of their development, when their viability is less well established.

The result of this increased volatility is that investors with portfolios of individual shares need a larger and more widely diversified spread of investments to compensate.

The research suggested that in order to achieve the same level of diversification as could be achieved with a portfolio of 15 shares in the 1960s, one would now need around 30-35 stocks.

The conclusion is clear.

Given the size of the parcels in which it is economic to buy individual shares, few investors or small trust funds can afford a properly diversified stockbroker portfolio.

In the words of The Financial Times from July 2001, 'for most investors, collective funds are the most sensible option'.

Collective funds enable trustees to satisfy the requirements for diversification and suitability.

The typical collective fund has between 60 and 100 underlying holdings, and a multi-manager fund may have several hundred.

Furthermore, such funds offer valuable tax advantages and major savings in the cost of accounting for tax - both important ingredients in determining suitability.

Recent market events have highlighted the vulnerability of solicitor trustees who fail to recognise the requirements of the new Trustee Act; and professional indemnity insurers are becoming increasingly conscious of the risks associated with investment advice.

The writing is on the wall.

Ian Muirhead is a member of the Law Society's finance and investment services working party and director of Solicitors for Independent Financial Advice