Modern Investment Management and the Prudent Man Rule

292 Pages·1987·21.03 MB·English

by  Bevis Longstreth

Modern Investment Management
and the Prudent Man Rule
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Modern Investment
Management and the
Prudent Man Rule
BEVIS LONGSTRETH
New York Oxford
OXFORD UNIVERSITY PRESS
1986
Oxford University Press
Oxford New York Toronto
Delhi Bombay Calcutta Madras Karachi
Petaling Jaya Singapore Hong Kong Tokyo
Nairobi Dar es Salaam Cape Town
Melbourne Auckland
and associated companies in
Beirut Berlin Ibadan Nicosia
Copyright © 1986 by Bevis Longstreth
Published by Oxford University Press, Inc.,
200 Madison Avenue, New York, New York 10016
Oxford is a registered trademark of Oxford University Press
All rights reserved. No part of this publication may be reproduced,
stored in a retrieval system, or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording, or otherwise,
without the prior permission of Oxford University Press.
Library of Congress Cataloging-in-Publication Data
Longstreth, Bevis.
Modern investment management
and the prudent man rule.
Includes index.
1. Legal investments—United States.
2. Portfolio management—United States. I. Title.
KF1083.L66 1986 346.73'07 86-16294
ISBN 0-19-504196-8 347.3067
2 4 68 10 9 7 5 31
Printed in the United States of America
on acid-free paper
Statement of Advisers
We have examined the study entitled Modern Investment Management and the
Prudent Man Rule directed by Bevis Longstreth in collaboration with the Salo-
mon Brothers Center for the Study of Financial Institutions at New York Uni-
versity's Graduate School of Business Administration. In our opinion this study
identifies and thoroughly explores the gap that exists between legal notions of pru-
dence in investment management by fiduciaries, on one hand, and the teachings
of financial economics and sound practices of investment professionals, on the
other. The development of a modern legal standard of prudence contained in
Chapter 4 is generally sound. It deserves serious consideration by fiduciaries sub-
ject to some form of prudent man rule and by others, including judges, lawyers,
and investment managers, who are called upon to interpret and apply that legal
standard.
Francis H. Burr, Esq. Hilda Ochoa-Brillembourg, C.F.A.
Ropes & Gray Chief, Pension Investment Division
World Bank
Professor Robert Charles Clark
Harvard Law School Professor Myron S. Scholes
Graduate School of Business
Judge Frank H. Easterbrook
School of Law
United States Court of Appeals
Stanford University
7th Circuit
Dean Richard R. West
Nicholas deB. Katzenbach, Esq.
Graduate School of Business
Riker, Danzig, Scherer,
Administration
Hyland & Perretti
New York University
Dean LeBaron
James D. Wolfensohn
Trustee
President
Batterymarch Financial Management
James D. Wolfensohn Incorporated
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Foreword
It is axiomatic that fiduciaries must be prudent in the investment of funds for
which they are responsible. Defining prudence may always have been a challeng-
ing matter, but in a time of rapidly changing investment markets, with new
investment opportunities, new financial products, and proliferating investment
methods and strategies, the task is even more difficult.
Finding an appropriate legal framework in which to manage funds has become
particularly important to today's manager of endowment funds, especially those
devoted to charitable, educational, and other eleemosynary purposes. Faced by
increasing financial pressures, institutions have looked to their endowment man-
agers to use energy and imagination to increase total return. Excessive caution
and failure to take advantage of new financial products and new investment
opportunities, methods, and strategies can adversely affect the charitable or edu-
cational enterprise's ability to accomplish its purposes as surely as can excessive
risk taking. Responsive legal guidance that permits active management and
timely decision-making is a necessity for many institutions.
However, legal counsel for many charitable institutions have too often found
themselves unable to respond adequately to questions posed by their officers and
trustees in this new and evolving investment environment. The innovative
approaches to endowment management are sophisticated and complex, and exist-
ing statutes and case law do not provide clear guidance.
In the course of discussing this matter, the four of us, in our capacities as legal
counsel respectively for Columbia, Harvard, Princeton, and Stanford Universi-
ties, with encouragement from colleagues at other institutions, came to the view
that a study of this subject had the possibility of providing clarification and better
understanding of the issues. We believed that a thorough legal analysis of the law
of prudence and a review of current economic theory on the subject of risk man-
agement, supplemented by a "real world" survey of investment activities by insti-
tutional investors, could point the way to more solid ground. Bevis Longstreth's
familiarity with the relevant legal principles and his experience as a legal adviser
to several kinds of charitable institutions, together with his recent service as a
Commissioner of the Securities and Exchange Commission, fitted him well for
viii FOREWORD
the role of directing such a study. We were pleased to find that the foundations to
which we took our proposal agreed about the importance and promise of such a
study.
We have been influenced from the beginning, in our vision of this study, by the
contribution of William Cary and Craig Bright in their creative work, The Law
and Lore of Endowment Funds (and The Law and Lore Revisited). These studies
changed in important ways the manner in which certain legal principles applica-
ble to the management of institutional endowments are viewed. Those changes
have, of course, now been largely codified and adopted in many states, in the
Uniform Management of Institutional Funds Act. But it was changes in percep-
tions of lawyers, judges, legislators, and fiduciaries that made possible the recod-
ifications that occurred.
We do not, of course, know exactly what effects this study will have. We believe
that the study squarely addresses the central issues and consequently considerably
advances the reader's understanding of the law of prudence and provides a useful
analytic framework for considering and answering the legal questions posed by
the fiduciary in today's world. We are optimistic that this thoughtful work will
lead to a substantial clarification in what seems to us now to be an unnecessarily
vague and outdated understanding of the meaning of "prudence" with regard to
the responsibilities of fiduciaries and in particular their management of educa-
tional and charitable endowments.
May 1986 John Mason Harding
Columbia University
Daniel Steiner
Harvard University
Thomas H. Wright
Princeton University
John J. Schwartz
Stanford University
Acknowledgments
There are many deserving of thanks for helping to bring this book into being.
Thomas H. Wright, General Counsel of Princeton University, and Daniel Steiner,
General Counsel of Harvard University, share parentage of the idea that the pru-
dence standard be addressed. They, together with their counterparts at Columbia
and Stanford Universities, John Mason Harding and John J. Schwartz, initiated
early planning for the study, selected the author as study director, and advanced
funds to support the preparation of a "prospectus" to test the idea's utility against
the opinions of possible users and funding sources.
The five foundations supporting the study, and those at the foundations whose
special interest led to support, include the Alfred P. Sloan Foundation and its
President, Albert Rees, the Carnegie Corporation of New York and its Vice Pres-
ident, David Z. Robinson, The Ford Foundation and its Vice President, Louis
Winnick, The William and Flora Hewlett Foundation and its President, Roger
W. Heyns, and The Rockefeller Foundation and its Treasurer and Chief Invest-
ment Officer, Jack R. Meyer, and its Vice President, Alberta B. Arthurs. Sloan
provided 50 percent of the budget and the others 121/2A percent each.
While acknowledging the generous support of these universities and founda-
tions, I should emphasize that they bear no responsibility for the book's analysis
and conclusions.
New York University's Graduate School of Business Administration and, in
particular, its Salomon Brothers Center for the Study of Financial Institutions,
administered the study. The Center's Director, Dr. Arnold W. Sametz, became
the study's associate director, lending his important support and that of the Cen-
ter to the effort. In addition to assuring the interest in the project of several econ-
omists at the Center, including Professors Edwin J. Elton and Martin J. Gruber,
the authors of Appendix A, and Professor Kose John, who wrote a research paper,
Dr. Sametz provided able advice and reassuring support throughout the study.
In Professor Jeffrey N. Gordon, I enjoyed not only a contributor, whose essay
appears in Appendix B, but an adviser as well, who interested himself in all
aspects of the study and provided important guidance along the way.
Over the course of writing this book, I was fortunate to have the advice of a