Prudent Man Rule

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21 Aug, 2024

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Prudent Man Rule Definition

Prudent man rule refers to a legally guiding principle which states that a fiduciary or trustee should manage the entrusted assets, investments, or cases (of another individual) with the same degree of care, intelligence, and diligence as a reasonable person would have taken to administer their assets or matters.

A prudent man is often desired to behave rationally without risking the capital or asset of the grantor. Thus, the assets should be cautiously and sensibly invested in reasonable investment opportunities after proper analysis of potential returns and risks associated with it. Hence, this rule widely applies to pension funds, insurance, finance, investment, business, healthcare, etc.

Prudent Man Rule Definition

Prudent man rule is a legitimate principle that governs the actions of a fiduciary or trustee in administering the trust assets, estate, funds, investments, or cases with the same level of diligence, care, and sensibility as they would have considered for handling their personal assets, funds or issues.
According to this rule, as a prudent man, a fiduciary must fulfill four duties. They include duty of care, impartiality, loyalty, and diversification while managing the entrusted assets or matters.
This rule was framed in 1830 by Samuel Putnam, who was then a Massachusetts Supreme Court Judge.

Prudent Man Rule Explained

The prudent man rule applies to a fiduciary who holds and controls the assets, funds, or cases under the trust management and they must be extremely careful and vigilant in investing or employing the entrusted assets or funds or managing the undertaken case or affair (of other individuals or grantors) in the same way a reasonable person should have done in such circumstances. The federal Prudent man rule under the Employment Retirement Income Security Act (ERISA) of 1974 safeguards the retirement security and pension rights of millions of workers across the US.

Given below are the essential duties or responsibilities of a fiduciary under the prudent man rule:

1. Care: The fiduciary must be very careful and rational. Specifically, during investing the entrusted assets or funds, providing healthcare facilities, or handling organizational data to avoid loss.

2. Loyalty: A prudent person is desired to direct all their conduct toward the best of the beneficiary's interest and good faith. They should not aim to take personal advantage.

3. Impartiality: A fiduciary must treat all the trust beneficiaries equally without providing undue advantage to any particular individual or firm.

4. Diversification: In the case of investments of entrusted pension funds or other assets, the trustee should diversify the same in different asset classes to ensure that they don't expose the assets to unreasonable risk for high returns.

A fiduciary can avoid legal consequences and punishments for failure to manage trust assets carefully when they know the prudent man rule. It aims to discourage any speculative practices by the trustee. These principles have been developed to witness their application in the pension fund, insurance, investment, finance, healthcare, cybersecurity, information technology, and various other sectors. However, some experts debate that this rule is not suitable for all types of circumstances.

Examples

The prudent man rule was an initial version of the principle that requires ethical and careful management of the trust assets by the fiduciary. Let us go through some instances of its violation in various situations:

Example #1

Suppose Mr. A works at a private factory in the US, and a portion of his income goes to the private pension and welfare plans. These funds are managed by the trustees of ABC Pension Fund Co. Now, after 17 years, Mr. A retired from his post and became eligible to receive retirement benefits. However, he finds out that the money deposited in the pension fund has lost value due to the trustees' wrong investment decisions. In such a case, Mr. A can legally sue the trustees at ABC Pension Fund company for violating the ERISA prudent man rule.

Example #2

A recent class action lawsuit against Johnson & Johnson (J&J) alleges breaches of fiduciary duties regarding the mismanagement of employee drug benefits, leading to substantial overpayments for certain medications. Due to evolving transparency regulations, this legal action underscores a broader trend of heightened scrutiny on ERISA health benefits. Employers are encouraged to establish oversight committees, carefully review service provider contracts, ensure cost-effectiveness, and monitor overall expenses. This case emphasizes the significance of fulfilling ERISA fiduciary obligations and implementing proactive measures to mitigate potential risks.

Prudent Man Rule vs Prudent Investor Rule

The prudent man and prudent investor rules are the legal principles. They govern the ethical management of entrusted assets, funds, or investments. However, they differ in their legal framework and application as follows:

Basis	Prudent Man Rule	Prudent Investor Rule
Definition	It is the governing law applicable to a fiduciary or trustee for carefully, diligently, and rationally handling a case, asset, or investment under trust management in the way a rational or reasonable person would do.	It is a development of prudent man rule, necessitating a fiduciary to take due care and vigilance while investing the trust funds or assets in the same way as they would have for their assets.
Formed in	1830	1992
Purpose	Rational decision-making while handling the entrusted case, assets, funds, etc.	Discouraging speculative or high-risk investments of the entrusted funds while rationally evaluating the risk and returns of potential opportunities
Scope	Applicable in investment, pension fund, financial market, healthcare, law, information technology, cyber security, etc.	Applicable in portfolio management, investment trust, and financial markets
Emphasizes	Thinking and decision-making like a reasonable person	Emphasizes diversifying and efficiently managing the trust funds or assets in the best interest of the trust's investment strategy and risk appetite.
Legal Framework	General law principle	Governed by the Uniform Prudent Investor Act (UPIA)
Flexibility	More conservative or rigid principle	More flexibility to fulfill the trust's objectives

Frequently Asked Questions (FAQs)

1. Who established the prudent man rule?

Massachusetts Supreme Court Judge Samuel Putnam formed the prudent man rule in 1830. It happened as a result of the decision in the Harvard College vs. Amory case. The college claimed that the trustees managing John McLean's estate had deliberately made high-risk investments to generate exceptional income for McLean's widow. They could have instead created a steady source of income for her.

2. What is the difference between due care and the prudent man rule?

Due care is the desired caution in performing an action, exercising control, or imposing a policy. Meanwhile, the prudent man rule is the duty of a fiduciary to follow due care, diligence, and intelligence. Also, handling the entrusted assets or cases as they would have done for their assets or matters.

3. What is the importance of prudent man rule in information security?

The prudent man rule CISSP (Certified Information Systems Security Professional) is important. It checks whether the senior officials have taken proper care and security measures to protect the organization's data.