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.