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Should a Fiduciary Tiptoe in the Crypto? Rules & Risks

Stephen J. Olsen
Stephen J. Olsen – Trusts & Estates, Taxation

By Stephen J. Olsen, Esq.

Over the last few years, Gawthrop Greenwood’s tax, trusts and estate practice has seen a significant increase in questions and issues related to cryptocurrencies and non-fungible tokens (“NFT”). (It is only a matter of time before someone asks about the best way to pass their Metaverse digital land holdings to their children!) While increased tax reporting for crypto is on the horizon, I’d like to focus on the most relevant questions of whether cryptocurrencies, NFTs and other digital assets are acceptable assets to be held and invested in by executors and trustees. I’ll also outline planning steps that should be taken for clients that may want their future fiduciaries to significantly invest in these asset classes.

Determining Legal Acceptability of Digital Assets

Should fiduciaries be investing in digital assets? Cryptocurrencies are not actually legal tender like other currencies under United States law, and, while outside of the purview of this article, almost all cryptocurrencies and other NFTs currently circulating are not securities under United States law. (Although NFTs could be structured as securities and subject to securities laws.) Although not fitting in these classifications, digital assets absolutely are transferable assets that trusts can invest in, and there is nothing illegal or inherently wrong with investing in the asset class.

Since there is no strict prohibition on investments in these digital assets, fiduciaries will need to look to their state’s Prudent Investor Rule to determine the extent to which an investment in a digital asset is acceptable. Pennsylvania’s statute is found in 20 Pa.C.S.A. § 7203, and states generally that the fiduciary shall invest the property as a prudent investor would by considering the purpose, terms and other circumstances of the trust. The governing instrument can expand or constrict this rule, but the default is that a fiduciary may invest in every kind of lawful investment. The statute also enumerates eight factors a fiduciary must consider in making investments. The factors are: 1) the size of the trust; 2) nature and duration of the fiduciary relationship; 3) liquidity and distribution needs of the trust; 4) tax consequences of the investment; 5) role of investment in overall investment strategy; 6) an assets special relationship or value to the purpose of the trust or a beneficiary; 7) needs of current and future beneficiaries; and 8) the income and resources of the beneficiaries and any related trusts. As is clear from these factors, the trustee generally has a dual obligation to the current and future beneficiaries.

Prudent Investor Rule & Risks

The Prudent Investor Rule is largely based on modern portfolio theory. One of the pillars of modern portfolio theory is that diversification of assets across asset classes is viewed as necessary to reduce the overall investment risk of the portfolio, and this is incorporated into Pennsylvania’s Prudent Investor Rule at 23 Pa.C.S.A. § 7204. As stated above, a fiduciary can invest a portion of the portfolio in any legal investment, which is stated in 23 Pa.C.S.A. § 7203(b). The comments to the law make clear, this includes investments that may have previously been considered too speculative if they are now appropriate. If a court is reviewing whether one or more investments were prudent, it will not review each individual investment to determine whether it was prudent or too speculative, and instead the fiduciary is judged on the results of the total portfolio. This is stated in the uniform law that the Pennsylvania Prudent Investor rule is largely based on and in case law.

In addition to the factors above, in determining whether the investment in digital assets is prudent, the specific risks of digital assets must be considered. Currently, cryptocurrencies are viewed as having regulatory risk that could devalue the asset. For instance, many countries around the world prevent investment and ownership in multiple cryptocurrencies. There could also be a move toward cryptocurrencies that are pegged to certain tangible currencies, which are referred to as stable coins, and that could in theory reduce demand for non-stable coins. There is also some taxation and compliance risk, which would need to be considered. Some NFTs may have a liquidity risk, since they are not traded frequently. One of the primary risks receiving significant coverage for investing in the asset class is volatility risk. None of these makes an investment inappropriate, but are considerations for a fiduciary.

Overall, the Prudent Investor Rule and the underlying modern portfolio theory should allow a fiduciary to invest a portion of an entire portfolio in digital assets without subjecting the fiduciary to liability if the digital asset fails to perform. On the one hand, a fiduciary over a modest trust with significant current distribution would likely face scrutiny if he or she invested a significant portion of the portfolio in cryptocurrencies or NFTs. On the other hand, the fiduciary holding a substantial trust fund that elected to invest two or three percent in digital assets would likely be viewed as investing prudently.

Overall, digital assets are clearly an acceptable part of a diversified portfolio. A fiduciary currently would not be at risk if they decided to wait to add the class to the portfolio at this time. Most fiduciaries who decide to invest in the class will be best protected by, when appropriate, tiptoeing in the crypto, by investing only a small portion in a diversified portfolio in this class.

Attorney Stephen J. Olsen is the head of the Tax, Trusts and Estates practice at Gawthrop Greenwood, PC, and is a member of its Business Law Group. Contact Stephen at solsen@gawthrop.com or 610-696-8225. https://gawthrop.com

Reprinted with permission from the March 22, 2022 issue of The Legal Intelligencer. © 2022 ALM Media Properties, LLC. Further duplication without permission is prohibited.  All rights reserved.

 

Stephen J. Olsen is a member of Gawthrop Greenwood’s Estates and Trusts Department, practicing in the areas of Estate & Trust Administration, Estate Planning Taxation, and Business Transactions.

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