The Madoff Madness and the Banking Crisis: At one extreme, trustees must dodge sociopathic fraudsters; on the other, they must avoid the hubris of "the smartest guys in the room."
Modern Portfolio Theory and the legal thinking it's influenced address the problem by means of risk analysis and diversification. This approach has limits, as Investments & Pensions Europe reported recently: "Dutch pension funds have lost €166m to the Ponzi scheme run by Bernard Madoff, Wouter Bos, the Dutch finance minister has claimed."
The Age Before the "Prudent Man"
In other times, courts have taken different views of how a trustee should deal with risk.
Harvard College v. Amory, 9 Pick. (26 Mass.) 446, 461 (Mass. 1830) was the case that first stated the Prudent Man Rule. The Massachusetts Supreme Judicial Court said that trustees should model their stewardship "on 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."
The Court rejected Harvard's argument that the trustees should have invested in an annuity which would have been less risky than common stocks, but would have provided the beneficiary a much lower income. Harvard's position seems ludicrous today. It wasn't in 1830.
In rejecting Harvard's position, the Court quoted critically an English case (Trafford v. Boehm, 3 Atk. 440, 444, 26 Eng. Rep. 1054, 1056) decided 86 years earlier:
"Neither South-sea stock nor Bank stock[s] are considered as a good security, because it depends upon the management of the governors and directors, and [both] are subject to losses; for instance, it is in the power of the South-sea company to trade away their whole stock while they keep within the terms of their charter…. "But South-sea annuities and Bank annuities are of a different consideration; the directors have nothing to do with the principal, and are only to pay the dividends and interest till such time as the government pay off the capital, and it is not in their power to bring any loss upon them, and therefore are only and properly good securities."
Two things one should note here. First, the court held that annuities backed by government debt were appropriate trust investments. But stock shares issued by the same entities that sponsored the annuities weren't. It's this very limited scope of trust investing the Prudent Man Rule overturns.
The Lessons of the 18th Century's Bubble Economy
Second, note how the court contrasts the relative investment merits of "South-sea stock" and "South-sea annuities." Here one sees the aftershocks of probably the greatest financial and political crisis in Anglo-American history between the English Civil Wars and today.
The collapse of the South Sea Company in 1720 shook the British state to its core. The South Sea Bubble combined a completely fraudulent investment scheme with political intrigue and mad speculation in everything from real estate to trading voyages. (See generally Malcolm Balen, The Secret History of the South Sea Bubble (New York: Fourth Estate, 2002) and James Macdonald, A Free Nation Deep in Debt (New York: Farrar, Straus & Giroux, 2003), pp. 206-219, 223-29.)
It would be hard to identify an area of commercial law or of political and social history that the Bubble did not affect. Trust law certainly changed.
In 1723 the South Sea Company shareholders began receiving perpetual annuities backed by government debt (the Company's only asset) in exchange for their devalued shares. The "Bank" mentioned in Trafford is the Bank of England, then still a private institution but, from the South Sea Bubble onward, the unquestioned central bank for the Empire. It too issued annuities backed by government debt. But even its stock, the Trafford court held, was not a proper trust investment.
I can't imagine a swing in the law back to Trafford. But the devastation of pensions and other trusts, such as the Harvard University endowment (see Richard Bradley, "Drew Gilpin Faust and the Incredible Shrinking Harvard", Boston Magazine, June 2009) – whether caused by fraud, hubris or faith in failing models – will lead to changes in trustees' fiduciary duties.
It is a mess, regardless. The worst of it may still be; policy makers and global corporates have sold the everyday US citizen down the river to serve themselves for their piece of the 'pie' with regard to other G19 countries. This is what has been the driver for 'free' trade and off-shoring big US corporates into other economies. Meanwhile with the 'free' trade and off-shoring, many economic sectors' players, large and small and in the case of large have killed their top line, resulting in their problems with funding their pension, and/or healthcare and 401(k) responsibilities. Where between the US and the remainder of the world there isn't a level playing field because here the individuals and corporates have paid healthcare and retirement, while around the world those governments foot to costs for both of those. The case against the US investor however while the rest of the masses around the world, even in developed Europe, very little investment comes out of the 'middle class' in Europe and elsewhere except for perhaps Japan. So here now with off-shoring, further economic burden and upheaval health or otherwise on the wallet of the voters, little investible/discretionary means for investing will be available unless this administration wakes up and boards stop giving a pass to managements who will off-shore to skinny labor/healthcare and retirement costs in turn pretending it's done its job better. Prudent man I don't think would have allowed management, especially the self interests of professional management to disrupt the commercial ripple effect back through local and broader commercial environments. For board directors to somnolently aid and abet professional management to trash US production and employment, making it a more dicey commercial environment and more difficult to even fund green R&D, which every firm could start, occurs when virtually all in positions of responsibility in corporate America have lived self-serving, vain interests that have contributed to the current problem labeled as the 'financial' crisis, but it's really a larger one - how was it that aggressive greed and conceit had the abusive power that it has? A single regulator isn't the answer. Holding accountable the ones that laid down on the job is what we need to do. Commodities Modernization Act (1999 or 2000) needs to be repealed and make illegal all over the counter derivatives and financial engineering that was contrived and needed that legislation to exist. I also suggest taking away the power of the fed to be the only or final approver of bank mergers. The House and Senate and SEC also need to review and reject mergers that make these shops abusive and too Big which grew that way to operate above the law, access executive privilege, and pay themselves a great deal more than they deserve. Perhaps repealing Gramm Leach Bliley (GLB) which reinstates Glass Steagall. Also repealing or resinding all 'free' trade agreements and eliminating some of the federalization of corporate law. Production will re-shore very quickly and immediately spur domestic production and employment. Also repealing the 'net capital'rule with Paulsen heckled the SEC to have and then went to the Treasury Department and avoided filling the role in his department that coordinates with the banking regulators. Also reinstate aggressive fed oversight and examination of government agency/security dealers which Corrigan eliminated in 1993 before he went to work for Goldman. Eliminating the Net CApital rule will force investment banks to run with more capital and shed assets that they never needed and are generally worthless. Also repealing or removing BHC status from Goldman and Morgan Stanley , which do not have banks' balance sheets, have units that are commercial and/or engage in comemrce and breach teh separation of banking and commerce. There is the Financial Holding Company Charter under GLB; why did the investment banks seek shield under the BHC charter other than to feed from the Fed discount window and perhaps other fed largess. That's yet another thing to repeal, the Federal Reserve act passed in 1913. WE don't need the system and we do need to require banks to have stronger capital ie, tangible equity ratios. The reigning in of activities that are not prudent banking, that are not permissible under safe and sound banking practices, these too would be ceased & Desisted as well as calling regulators stupid because they probably figured out that virtually all of teh financial engineering after the CMA was worthless and bogus and fraud, and when they called all of that for what it is, were told they were stupid, like Fastow screaming at analysts when they questioned him and Enron's model. Same.