Over the next several years , however , Ann McLean received an income yield that far exceeded 6 %, and the remaindermen witnessed a sharp decline in the market value of the portfolio . In October 1828 , the disagreement re-entered the courts when Francis Amory ( the only surviving trustee ) sought to tender his resignation from the trust and presented the account to the probate court for approval . The remaindermen demanded that Amory settle the account by paying the difference between the current and original market value of the insurance and manufacturing stocks , which they argued did not meet the investment guidelines . After several years , the case of Harvard College v . Amory reached the Supreme Court of the State of Massachusetts . Justice Samuel Putnam decided the case in favor of Amory and delivered the court ’ s final opinion . It included two sentences ( below ), which became known as the Prudent Man Rule .
“ All that can be required of a trustee to invest , is , that he shall conduct himself faithfully and exercise a sound discretion . He is to observe 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 .”
Justice Putnam ’ s ruling established an important legal precedent which was subsequently used to judge the prudence of trustees ’ decisions based on the soundness of the decision-making process , rather than discrete outcomes . This was a critical distinction , as it recognized the inherent uncertainty of investing . But the rule did not give trustees carte blanche on their decisions . On one hand , the ruling provided fair protection for trustees who cannot possibly predict investment outcomes with precision . On the other hand , it forced trustees to establish and prove adherence to a sound investment process .
Portrait of John McLean , the wealthy merchant whose last will and testament led to disagreements resulting in the Prudent Man Rule .
Contraction and Expansion of Trustee Flexibility
After the ruling by Justice Putnam , interpretations of the Prudent Man Rule slowly evolved as new precedents were established by case law . Throughout the remainder of the 1800s , precedents tended to restrict the types of investments in which trustees felt comfortable investing . For example , the 1869 case of Matter of King v . Talbot tilted trustees more toward the “ safety of capital ,” thus encouraging greater investment in government bonds and mortgages , rather than common stocks .
As case law continued to accumulate in the early 1900s , the American Law Institute set out to create a consolidated reference of key legal principles . This culminated in the publication of the American Law Institute ’ s Restatements of Law in 1935 . Among the first volumes was the first Restatement of Law Trusts , and the Prudent Man Rule served as an important guiding principle .
Soon after the United States exited the Depression and World War II , trustees pressured the American Law Institute to revise the Restatement of Law Trusts . At issue , once again , was the need for greater investment flexibility . Ironically , the problem was that “ legal lists ” that trustees used to determine allowable investments had limited their exposure to common stocks . While stocks had plummeted during the Great Depression , they had recovered over time . Non-government bonds also experienced massive losses during the Depression , but many never recovered . This strengthened trustees ’ interest in common stock investments .
The second Restatement of Law Trusts ( commonly referred to as Restatement of Law Trusts 2d ) was published in 1957 to address this problem . The first notable change was the creation of broader , approved “ investment categories ,” as well as the use of more ambiguous language on what constituted prudent investment decisions . Contrary to expectations , however , the revision continued to discourage risk taking . One problem was that by defining prudence in accordance with standard practices at the time , few trustees were willing to invest in non-conventional securities as markets evolved . A second problem was that the guidance on prohibited investments proved more restrictive than intended . Problematic language included restrictions on “ speculative stock ” and “ buying discounted bonds .” As a result of these issues , throughout the mid-1900s , most trustees continued investing primarily in low-risk government bonds and high quality , dividend paying stocks . In 1974 , their conservatism intensified even further after the passage of the Employee Retirement and Income Security Act ( ERISA ).
An Unanticipated Impact of ERISA
President Gerald Ford signed ERISA into law on September 2 , 1974 . The primary objective was to strengthen protections for employees covered by private pension plans . However , as is often the case with new regulations , ERISA produced several unexpected side effects . The impact on the nascent venture capital ( VC ) industry was especially troubling . Incorporation of the Prudent Man Rule into ERISA required trustees to discharge their duties “ by diversifying the investments of the plan so as to minimize the risk of large losses .” Many trustees interpreted this language as an implicit ban on VC investments , which routinely invested in multiple companies that were likely to produce large losses .
ERISA plan trustees responded by limiting exposure to VC investments , as well as traditional investment fund managers that ventured far beyond high-quality stocks and bonds . Non-ERISA plans , such as public pensions , foundations and endowments , adopted similar practices out of an
www . MoAF . org | Winter 2024 | FINANCIAL HISTORY 17