What is the 'Prudent-Person Rule'

The prudent-person rule (also known as the "prudent man rule") is a legal maxim restricting the discretion allowed in managing a client's account to the types of investments that a prudent person seeking reasonable income and preservation of capital might buy for his or her own portfolio.

BREAKING DOWN 'Prudent-Person Rule'

This rule is intended to protect investors using the services of an investment advisor from shady, risky, or otherwise questionable investments, such as penny stocks.

The precedence set with the prudent-person rule does not require the trustee, who has been given the fiduciary responsibility to oversee securities, to have extraordinary expertise in this field. However, there is a reasonable expectation that they will make rational, intelligent decisions when making investment choices on behalf of their client.

How the Prudent-Person Rule Is Used

This rule can also apply to an individual who has been granted stewardship or guardianship of someone’s estate, who may be otherwise separated, restricted from, or incapable of administering their own affairs. For example, if an individual were to administer a pension fund or other form of trust on behalf of employees at a company, they would be required to make investments with the fund that have a reasonable possibility of turning profit. The funds could not, for instance, be directed entirely toward high-risk investments with a low expectation for a positive return. The assets could not be willfully diverted to investments that would intentionally impair the income of the account holder, regardless if it enriched a third party.

For instance, if a fiduciary were given control of an estate during a period that their client was unavailable to direct their own investments, this rule would prohibit them from putting the funds towards money-losing endeavors that have no plausible way of making good on the investment. In addition to securities, this might include real estate purchases, the funding of businesses, the acquisition of collectibles or other assets that present no means to generate any capital or will knowingly lead to losses and liability. This rule does not require that all investments be lucrative, consistently generate profits, or correct.

However, the investment decisions must be made in line with what a person of average intelligence would deem as an appropriate action. Some of the language in the Employee Retirement Income Security Act is comparable to the prudent-person rule, by directing managers of retirement funds and comparable assets to reduce the risk in the portfolio and avoid large losses on the overall return.

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