49SCCO EVI 00DBSCH INQ 9325 1 A21307 AnthonyMolloy

EXTRACT FROM SEPTEMBER 2009 ISSUE
Trusts & Trustees, Vol. 15, No. 7, September 2009
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Trusts & Trustees, Vol. 15, No. 7, September 2009 1
Contents
Three months in prospect . . . . . . . . . . . 519 Negligent investment: claims against trustees
and agents . . . . . . . . . . . . . . . . . . . . . . . . . . . 602
David Halpern
Editorial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
Lord Hoffmann Investment—can private trustees learn
anything from pension scheme trustees? . . 611
In brief . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522 James Clifford
Crunch! When the worlds of trusts and
Articles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524 insolvency collide . . . . . . . . . . . . . . . . . . . . . 619
I am a trustee. I can’t make head or tail of Will Richmond-Coggan
P0 ¼ S0 Nðd1 Þ Xert Nðd2 Þ The importance for trustees to understand

S0 2 their tolerance to investment risk . . . . . . . . 626
Ln þ rþ t
X 2 pffiffi
where d1 ¼ pffiffi and d2 ¼ d1 t James Martineau
t
Am I at risk? . . . . . . . . . . . . . . . . . . . . . . . . 524 Taxing times for trustees . . . . . . . . . . . . . . . 633
Tony Molloy Anita Gatehouse
The worried trustee . . . . . . . . . . . . . . . . . . . 596
Trust Register . . . . . . . . . . . . . . . . . . . . . . . . 640
Nicholas Le Poidevin
Trusts & Trustees, Vol. 15, No. 7, September 2009 521
Editorial
Lord Hoffmann*
On 31 July 1987, I made an order giving the trustees except as wall paper’’: (Nesle v National Westminster
of the Wellcome charitable trust freedom to invest in Bank [1993] 1 WLR 160, 1275). But one question in
equities and ventured the observation that, on past particular which is bound to arise is the extent to
form, equities had been a safer form of investment which trustees, charged with a breach of their duty
than gilts: see Steel v Wellcome Custodian Trustees under section 1 of the 2000 Act to exercise ‘‘such care
[1988] 1 WLR 167, 173. I do not know how quickly and skill as is reasonable in the circumstances’’, to rely
the Wellcome trustees made use of this new power. A upon what is known in tort law as the Bolam princi-
little dilatoriness would have been in order, because ple, namely, that they were acting in accordance with
on 19 October 1987 the equity market collapsed. The a practice followed by a respectable body of expert
Dow Jones index fell 20 per cent in a single day—till opinion. Can they say that a large number of reputa-
recent events, the largest fall since 1929. It just goes to ble investors also entrusted their clients’ funds to Mr
show. Perhaps that was the reason why it took Madoff? As Keynes said after the 1929 crash: ‘‘a sound
another 13 years before Parliament, for much the banker, alas, is not one who foresees danger and
same reasons as those that persuaded me in the avoids it, but one who, when he is ruined, is ruined
Wellcome case, finally passed the Trustee Act 2000 in a conventional and orthodox way with his fellows,
to abolish the obsolete concept of an authorized so that no-one can really blame him.’’ In the law of
investment and allow the conduct of trustees to be torts, especially medical negligence, there are limits to
judged by reference to the portfolio as a whole. this doctrine. The views of the respectable body of
The 1987 crash does not seem to have produced opinion are subject to a rationality test that the invest-
much litigation but that of 2008 is likely to be a ment with Mr Madoff might not pass. But following
different matter. I hope that judges will not show the herd is part of the expertise of investment: as
the magnificent hindsight of Staughton LJ, who, look- Keynes also said, it is an exercise in forecasting what
ing back at securities that had lost their value as a average opinion will forecast average opinion to be.
result of political changes during and after the The question therefore remains an open and,
Second World War, was able to say that they like others discussed in these essays, a highly
‘‘sooner or later must have become of little value topical one.
*Lord Hoffmann is a retired Law Lord who accepts appointments as an arbitrator and mediator. He was an advocate of the Supreme Court of South Africa
1958–60, called to English Bar by Gray’s Inn in 1964 and appointed Queen’s Counsel in 1977. He was appointed a judge of the High Court (Chancery Division)
1985–1992, elevated to the of the Court of Appeal 1992–1995 and appointed a Lord of Appeal in Ordinary 1995–2009. From 1980 to 1985 he was a (part-time)
member of the Courts of Appeal of Jersey and Guernsey. Since 1998 he has been a non-permanent judge of the Court of Final Appeal of Hong Kong. In his career at
the Bar he undertook a wide range of commercial and property disputes, including ICC and Swedish Chamber of Commerce arbitrations. His recent leading
judgments on arbitration have included Fiona Trust v Privalov (2007), Premium Nafta Products Ltd v. Fili Shipping Company Ltd [2007] UKHL 40 and West Tankers
Inc v RAS Riunione Adriatica (2007).
ß The Author (2009). Published by Oxford University Press. All rights reserved. doi:10.1093/tandt/ttp087
524 Trusts & Trustees, Vol. 15, No. 7, September 2009
Articles
I am a trustee. I can’t make head or tail of

S0 2
Ln þ rþ t
rt X 2 pffiffi
P0 ¼ S0 Nðd1 Þ Xe Nðd2 Þ where d1 ¼ pffiffi and d2 ¼ d1 t
t
Am I at risk?1
Tony Molloy QC*
Abstract Nuns, Lord Nicholls, Pope John XXXIII, Lord

Millett, Playboy, the Gospel According to
Co-editor Tony Molloy QC’s keynote address to Matthew, Norman Mailer, the Book of Isaiah, the
this year’s Trusts and Estates Litigation Forum, Prime Ministers of Iceland and Australia,
at Terre Blanche, confronted the problems of alcoholic Telomian Hounds and the personal
financial investments so complex as to preclude habits of Mongolian Gerbils: to name but a few.
any meaningful assessment of the risks associated
with them; and of a financial system so lacking
in transparency as to have been compounding The word ‘investment’ has no very precise legal
investment risk under cover of its claims to have meaning, but its natural meaning, in a financial con-
been dissipating it. To break open some of the text, is the acquisition of an asset to be held as a source
potential consequential trustee investment litiga- of income: see for instance Jenkins J in Re Power
tion issues, he found it necessary to traverse [1947] Ch 572, 575.
finance, economics, sociology, politics and philo-
sophy, as well as to reconsider the leading cases Dominicia Social Security Board v Nature Island
from a number of jurisdictions. As appears from Investment Company Limited & Anor (Dominica)
this revised version of his paper, this led to [2008] UKPC 19 (2 April 2009) 8 (PC).
Bernard Madov, lap dancers, centrefold models
and the South Sea Bubble jostling with Lord
Walker, St Thomas Aquinas, Lord Lindley, Sir
Anthony Kenny, Lord Hoffmann (who, having Part 1: Before the meltdown
reviewed it in writing his editorial, wrote that he Scope
had ‘‘very much enjoyed Molloy’s article’’), Sister
Catherine Crowley, Lord Jacobs, the Carmelite Professor Langbein’s famous paper on ‘The
Uniform Prudent Investor Act and the Future
*Tony Molloy QC, Shortland Chambers, 70 Shortland Street, Auckland, New Zealand. Tel: +6493091769; E-mail: [email protected]
1. In the theorem set out in this title, P0 is the option price; S0 the current market price of the share; X the agreed future price at which the option could be
exercised; t the time to maturity—i.e. the expiration date of the option; is the annualized volatility—i.e. the foreseeable potential variation in the price of the share
between the date of payment of the option price and the expiration date of the option; r is the risk free rate of return in the economy; e the exponential;
and Ln the natural logarithm. See ‘A world of algorithms, computer trading and black boxes,’ at p 550 below.
ß The Author (2009). Published by Oxford University Press. All rights reserved. doi:10.1093/tandt/ttp081
Trusts & Trustees, Vol. 15, No. 7, September 2009 Articles 525
of Trust Investing’2 articulated what he called the ‘Investment’ not authorized

‘fractionation’ of trusteeship:3
Although Prof. Waters QC has shown clearly that it
Trusteeship entails three relatively distinct func- was not always so,6 trust investment powers these
tions: investment, administration, and distribution. days are very wide. Nonetheless, a trustee who man-
Investment includes not only the initial selection ages to dissipate the trust estate on an unauthorized
of securities or other assets, but also the tasks investment commits a breach of trust.
of monitoring the investments for continuing It will avail nothing that, in investing without
suitability, investing new funds, and voting the authority, the trustee acted in good faith. Thus, in
shares. Webb v Jonas,7 Kekewich, J. began his judgment in
this way:
As the then Chancellor Kent Professor of Law
at Yale University proceeded to note, each of these I cannot help regretting that I am obliged to decide
functions imposes its own special demands:4 this point, and still more so because I think it is my
duty to decide it against the trustees. Personally, if I
As financial assets have become the characteristic may say so, I am extremely unwilling to treat trustees
asset of the modern managerial trust, there is otherwise than with the greatest leniency which the
ever less reason for these three relatively dispa- law permits when they have acted honestly; and I
rate functions—investment, administration, and have not the slightest doubt that in this case they
distribution—to remain consolidated in a single pair acted honestly, that is to say, with an anxious desire
of hands. No deep connection exists between, to do their best for their cestuis que trust, and to invest
for example, being good at working with benefi- the money on what they believed to be a sufficient and
ciaries on the distribution side, and being expert prudent security. But I have not to consider in this
at investing trust funds or preparing fiduciary case any question of prudence, exercise of discretion,
tax returns. or honesty in the usual and proper sense of the word.
I have only to consider whether the trustees, as agents
Neither administration nor distribution is going to of their cestuis que trust, have fulfilled the terms
get any easier for trustees in the present volatile of their authority or gone beyond their authority. I
market. But trustee risk in respect of those functions have already said, and I repeat, that it is no answer for
pales alongside investment-related risks incubating an agent, who is blamed for having omitted to do that
amid ‘financial assets’5 that would make John which he was told to do, or done something in excess
Langbein’s hair curl if he had to review his article of that which he was told to do, to say: ‘What I have
today. Apart from their obvious oxymoronic aspect, done has been done in good faith, and is beneficial
these ‘assets’ might well engage not so much the trust to my principal.’ The agent is bound to keep himself
lawyer in him as the lawyer whose acclaimed scholar- within the terms of his authority.
ship includes books on the Adversary Criminal Trial,
Torture and the Law of Proof, and Prosecuting Crime Because ‘the most important duty of the trustee is
in the Renaissance. to obey the terms of the trust’,8 the trustee is not
2. 81 Iowa L Rev 641 (1966).

3. Ibid 665.
4. Idem.
5. See Guy Patterson: ‘Key issues for trustees on asset management and the credit crunch’, and Janette Rutterford: ‘The financial crisis and its impact on trusts
and trustees’, 15 Trusts & Trustees (2009), at 89 and 104 respectively.
6. Waters et al., Waters Law of Trusts in Canada (Carswell, 2005), 3rd edn, pp. 940–950.
7. (1888) 39 Ch D 660.
8. Youyang Pty Ltd v Minter Ellison Morris Fletcher (2003) 212 CLR 484, 498.
526 Articles Trusts & Trustees, Vol. 15, No. 7, September 2009
permitted to debit the cost of that unauthorized compensatory relief in the form of damages, based on
investment to the account of the trust estate.9 As negligence15 shown to have been an operative cause
will be suggested below,10 his account will be falsified, of the loss.
and, in equity’s exclusive jurisdiction,11 he will be
subjected, if necessary, to an order for compensation Prudence
by way of substitutive performance: to restore to the
trust estate the amount lost—calculated, with At a recent seminar,16 the Archbishop of Canterbury,
hindsight, as at the date of judgment against him. Dr Rowan Williams:
called for an enlisting of the classical virtues into the

Investment within power but careless
economic system. . . . The archbishop said that the
The existence of a power to invest in a particular cardinal virtues—prudence, temperance, fortitude
asset will rule out substitutive compensatory relief. and justice—would be a start.
Nonetheless, as also will be suggested below,12 while
an unauthorized investment also is a breach of trust, Professor Orbach wasn’t so keen, suggesting that they
the power authorising investments is an administra- ‘sounded a bit like Gordon Brown’. Dr Williams,
tive power only. It is not part of the trusts on which while admitting they did sound a bit ‘Scots’,
the trust estate is held.13 rallied to their defence. Prudence, he said, was
Intra vires, but improvident, investment accord- ‘Good judgement’, temperance was ‘emotional
ingly is not a breach of fiduciary duty. The trustee’s intelligence’ . . . understanding our desires and bring-
accountability for it is on the basis of ‘wilful ing them into self-critical awareness’, fortitude was
default’—for what she might have received given ‘courage . . . without being deflected by circumstance’
due diligence on her part. If an account is sought, and justice ‘was what it said on the can . . . it’s doing
equity will surcharge the trustee by reference to the what is due to the individual, society and environ-
loss caused by his want of care and skill. The remedy ment’. This, he said, ‘was not a bad definition of
therefore falls, not within the exclusive jurisdiction of what a growing, learning humanity should look
equity, but within its concurrent jurisdiction,14 like’. . . . Dr Williams . . . said . . . that humanity had
where, following the law, equity dispenses reparative an ‘abiding dignity’ and that virtues rest on the
9. Hayton et al., Underhill & Hayton: Law Relating to Trusts and Trustees (Butterworths, London, 2006) 17th edn 89.1(1), 89.3 say that his account must be
falsified to delete the unauthorized payment.
10. Under ‘Consequences of unauthorized investment but for which the trust estate would not have suffered,’ at p. 564 below.
11. The jurisdiction exercised by the Court of Chancery, prior to the Judicature Act, in a case in which no other court could have given relief: Browne,
Ashburner’s Principles of Equity (2nd edn, Butterworths, London 1933; reprinted by Legal Books Pty Ltd, Sydney, 1983) 1933, 2nd edn, pp. 3–4.
12. Under ‘Consequences of authorized, but negligent, investment,’ at p. 557 below.
13. See ‘Consequences of authorized, but negligent, investment,’ at p. 557 below.
14. Where, prior to the Judicature Act, equity gave the like remedy by following the common law, and so rested content for the cause to be tried in either
court save only where ‘the court of equity was able to give a more perfect remedy or the nature of the case admitted of its being better tried by the procedure of
a court of equity than by a court of law’: Browne, Ashburner’s Principles of Equity (2nd edn, Butterworths, London 1933; reprinted by Legal Books Pty Ltd, Sydney,
1983) 1933, 2nd edn, p. 4.
15. Hayton et al., Underhill & Hayton: Law Relating to Trusts and Trustees (Butterworths, London, 2006) 17th edn 89.38 say:
In Target Holdings Ltd v Redferns [[1994] AC 421 (HL)] the court endorsed Lord Cottenham’s views in Clough v Bond [(1838) 3 My & Cr 490 at
496–497] that if a trustee or personal representative invests funds in unauthorized securities or puts them within the control of persons who are not
authorised to be entrusted with them and a loss be sustained, then such trustee or personal representative will be liable to make it good, however
unexpected the result, however little likely to arise from the course adopted and however free such conduct may have been from any improper motive.
On this basis if trustees delegated management of their investment portfolio to a discretionary manager where not authorised to do so, then the
trustees would be automatically liable even if the loss in value of the portfolio was caused by an unforeseeable market crash. The beneficiaries could
therefore derive a significant advantage from framing their claim as a substitutive performance claim rather than as a reparation claim, in a case where
the trustee’s decision to delegate management of the trust portfolio is negligent as well as unauthorized. In such a case, their reparation claim for
breach of the trustee’s equitable duty of care would be subject to principles relating to causation, foreseeability and remoteness that would not apply
to their substitutive performance claim.
16. Reported by Christopher Lamb as ‘Beyond Capitalism’, The Tablet, 4 April 2009, 4–5.
something that is greater than ourselves; they are Put another way, it is ‘the quality of an integrated
‘transcendental’. . . . ‘We all start from self-love, as personality’,23 and is the virtue ‘most necessary for
St Augustine said. But what changes is not self-love, human life’,24 in the sense that it helps us to lead
it’s the self that we’re loving, and if the self that a good life and not merely become a good person.25
we love is expanding into relation, expanding into A distinction made his own by St Robert Megarry,26
maturity, recognizing its dependence and its limits, who held that the requirement of prudence ‘is not
then what is in the interest of that self, what shows discharged merely by showing that the trustee has
love for that self, is actually the same as the interest acted in good faith and with sincerity. Honesty and
of the human community and the other. That is sincerity are not the same as prudence and
the extraordinary work of human liberation, or, you reasonableness’.27
might say, salvation.’ The American Law Institute Restatement of
the Law Third: Trusts: Prudent Investor Rule
Of course, as Kekewich, J. held, in the passage already §227 provides a convenient statement of the
cited from his reasons in Webb v Jonas,17 all the principles:
prudence in the world will not save a trustee from
the consequences of his having made an unauthorized General Standard of Prudent Investment
investment. But where authorized investment is The trustee is under a duty to the beneficiaries to
concerned, it is the cultivation, and exercise, of the invest and manage the funds of the trust as a prudent
virtue of prudence which is the key to avoiding investor would, in light of the purposes, terms,
trustee risk. distribution requirements, and other circumstances
In the philosophy of St Thomas Aquinas, prudence of the trust.
is the virtue of ‘actions, choices, and means to ends.
Prudence is knowledge put to use.’18 It is ‘right reason (a) This standard requires the exercise of reasonable
about things to be done.’19 On the one hand, it is the care, skill, and caution, and is to be applied to
antithesis of impulsive or heat-of-the-moment deci- investments not in isolation but in the context of
sion making—‘non solum ex impetu aut passione’:20 the trust portfolio and as a part of an overall
something to bear in mind when considering later investment strategy, which should incorporate
suggestions21 that much recent investment activity risk and return objectives reasonably suitable to
may have been testosterone-driven. And on the the trust.
other hand, it is not to be confused with ‘over- (b) In making and implementing investment
cautious bean counting’.22 decisions, the trustee has a duty to diversify the
17. (1888) 39 Ch D 660.

18. Nemeth, Aquinas in the Courtroom: Lawyers, Judges, and Judicial Conduct (Greenwood Press, Connecticut, 2001) 95.
19. Summa Theologica I–II Q 57 a 4 c.
21. See ‘A world full of algorithms, computer trading, and black boxes,’ p. 564 below.
22. In her interview with Chris Blackhurst, ‘The nun who knew first’, The Tablet 11 April 2009, 12, 13, Sister Catherine Crowley, whose prescient book The Value
of Money: Ethics and the World of Finance (Continuum, London, 2006), is discussed under ‘Nun sense: Sister Catherine Crowley,’ p. 591 below, is reported
as having said:
‘There’s been a lack of certain virtues, for example, justice, and a lack of understanding of certain virtues, for example, prudence. . . . When Aristotle
wanted to give an examp1e of the prudent person, he chose a successful general, because prudence involves looking at all your options and working
out what the most effective means are to achieving what one wants to achieve. So the good general will deploy troops in an effective way. It’s got
nothing to do with over-cautious bean counting. That is not prudence. I think the way we have lost sight of what prudence originally meant means we
can’t develop prudence very easily.’ She chuckles again. ‘Which is why it’s simple to use another term which is practical wisdom.’
23. Nemeth, Aquinas in the Courtroom: Lawyers, Judges, and Judicial Conduct (Greenwood Press, Connecticut, 2001), p. 91, citing Eschmann, The Ethics of
St Thomas Aquinas, 1997, p. 179.
24. ‘Maxime necessaria ad vitam humanam’: Summa Theologica I–II Q 58 a 2.
25. Summa Theologica I–II Q 57 a 5, ad 1.
26. Not to forget St Arthur Kekewich J in Webb v Jonas (1888) 39 Ch D 660, 665-666.
27. Cowan v Scargill [1985] Ch 270, 289.
investments of the trust unless, under the They are, however, required to recognize where
circumstances, it is prudent not to do so. special knowledge is required.
(c) In addition, the trustee must: Where special knowledge is required, the trustees
(1) conform to fundamental fiduciary duties of must seek it from appropriate experts.
loyalty (§170) and impartiality (§183); When they have obtained specialist advice—as they
(2) act with prudence in deciding whether and had done in that case, in the form of a report from
how to delegate authority and in the selection a valuer—the trustees were not free to accept that
and supervision of agents (§171); and advice, that the property is good security for
(3) incur only costs that are reasonable in a certain sum, without first having subjected to
amount and appropriate to the investment critical analysis its reasons and its underlying
responsibilities of the trusteeship (§188). assumptions.
(d) The trustee’s duties under this Section are The trustees had failed in that regard.
subject to the rule of §228, dealing primarily
with contrary investment provisions of a trust Lindley LJ famously restated the trustees’ obligation:30
or statute.
The principle applicable to cases of this description
The judgments in the classic case on prudent was stated by the late Master of the Rolls in Speight
investment, Re Whiteley, Whiteley v Learoyd,28 retain v. Gaunt31 to be that a trustee ought to conduct the
high topicality in the current financial maelstrom. business of the trust in the same manner that an
The terms of the relevant trusts expressly permitted ordinary prudent man of business would conduct
investment in ‘real securities in England and Wales’. his own, and that beyond that there is no liability or
The trustees invested by taking title—as mortgagees— obligation on the trustee. I accept this principle; but in
to the legal estate, subject to the right of the mortga- applying it care must be taken not to lose sight of the
gors to redeem. The mortgagors became insolvent, fact that the business of the trustee, and the business
and failed to redeem. The trustees attempted to which the ordinary prudent man is supposed to be
exercise their power of sale. They found that the conducting for himself, is the business of investing
property was unsaleable. money for the benefit of persons who are to enjoy
In the Court of Appeal, Cotton LJ discussed the it at some future time, and not for the sole benefit
matter29 on the footing that: of the person entitled to the present income. The duty
of a trustee is not to take such care only as a prudent
The mortgage was technically within the invest- man would take if he had only himself to consider;
ment power. the duty rather is to take such care as an ordinary
It did not follow that the trustees were free from prudent man would take if he were minded to make
liability in respect of the loss revealed when the an investment for the benefit of other people for whom
trustees tried to sell up. he felt morally bound to provide. That is the kind
Trustees are not required to have special of business the ordinary prudent man is supposed
knowledge. to be engaged in; and unless this is borne in
28. (1886) 33 Ch D 347 (CA); affd (1887) 12 App Cas 727 (HL).
29. Ibid 350–352.
30. Ibid 355; 357. See also Lopes LJ at 358. See further Re Partington (1888) 57 LT 654, 657; Bartlett v Barclays Bank Trust Co Ltd (No 1) [1980] Ch 515, 531–534;
Cowan v Scargill [1985] Ch 270, 289; Steel v Wellcome Custodian Trustees Ltd [1988] 1 WLR 167, 171; Nestle v National Westminster Bank plc [1993] 1 WLR 1260;
and Getzler, ‘Duty of Care’, in Birks and Pretto, Breach of Trust (Hart Publishing, Oxford, 2002), pp. 41–74. A ‘‘higher duty of care is plainly due from someone like
a trust corporation which carries on a specialised business of trust management’’: Bartlett v Barclays Trust Co (No 1) [1980] 1 Ch 515, 534 (Brightman J).
31. 22 Ch D 739. When Speight v Gaunt came before the House of Lords, Lord Blackburn held that a trustee ‘sufficiently discharges his duty if he
takes in managing trust affairs all those precautions which an ordinary prudent man of business would take in managing similar affairs of his own’: (1883)
9 App Cas 1, 19.
mind the standard of a trustee’s duty will be fixed In referring—in the above passage from his reasons
too low . . . . for judgment in Re Whiteley, Whiteley v Learoyd34—to
the investment having been intended for the benefit
... of the persons to take on the death of the life tenant,
Lindley LJ. appears to have intended to do nothing
Whilst on the one hand the Court ought not to more than emphasize the importance of the long-
encourage laxity and want of care, on the other term safety of the capital. The same can be said of
hand the Court ought not to prevent people from Cotton LJ,35 and, particularly of Lopes LJ,36 each of
becoming trustees by converting honest trustees into whom made similar remarks.37 There was a life
insurers of the moneys committed to their care. I have tenant in the case. The asset in which the trustees
endeavoured to avoid both errors. had invested was a brickwork. The land on which
it stood was being wasted in the production of
Of the passage I have italicized, Hoffmann, J. has the bricks—which, as Cotton LJ had observed
held32 that: in the Court of Appeal,38 was ‘constantly exhaust-
ing the security’. The rate of diminution may
This was an extremely flexible standard, capable of not have been so rapid as to have been a threat to
adaptation to current economic conditions and con- the security of the interest of the life tenant, but
temporary understanding of markets and investments. Lindley LJ clearly was awake to the possibility
Modern trustees acting within their investment of disadvantage to the remaindermen on the life
powers were entitled to be judged by the standards tenant’s death.
of current portfolio theory, which emphasises the On appeal, Lord Halsbury LC declared himself:39
risk level of the entire portfolio, rather than the risk
attaching to each investment taken in isolation.33 But unable to follow or adopt some observations of the
care must be taken not to endow the prudent trustee Court of Appeal which seem to point to a different
with prophetic vision or expect him to have ignored degree of care in regard to the conduct of the business
the received wisdom of his time. A trustee must have of a trust according to whether there are persons to
regard to the interests of those entitled in the future to take in the future, or whether the trust fund is to be
capital, and such regard will require them to take into held for one beneficiary absolutely. The question must
consideration the potential effects of inflation, but be the due care of the capital sum. Whether that
a rule that real capital values must be maintained capital sum is one in which there is a life estate
would be unfair to both income beneficiaries and only, or absolutely for the use of the beneficiary,
trustees. seems to me to bear no relation to the question of
32. Nestle v National Westminster Bank plc [2000] WTLR 795, 797; affd [1993] 1 WLR 1260 (CA).
33. In Dominicia Social Security Board v Nature Island Investment Company Limited & Anor (Dominica) [2008] UKPC 19 (2 April 2009), their Lordships
(pp. 10–11) said that:
It may well be that investing in a telecommunications and broadcasting business operating in Dominica is a relatively high-risk investment, and DSSB
is in a position of stewardship for the people of Dominica. But the law recognises that when very large investment funds are available, the degree of
risk acceptable to fiduciaries should to some extent be judged by reference to the entirety of the holdings in a diversified portfolio, rather than by
reference to individual holdings (see Sir Robert Megarry V-C in British Museum Trustees v Attorney-General [1984] 1 WLR 418, 425 and the extra-
curial observations of Lord Nicholls of Birkenhead in (1995) 9 Tru LI 71, quoted in Lewin on Trusts, 18th ed (2008) p. 1285). Those are all matters
which the DSSB, and in particular its Investment Committee, must be supposed to have taken into account in deciding on the joint venture with
WRB; and they go to prudence, not to vires.
34. (1886) 33 Ch D 347, 355.

35. (1886) 33 Ch D 347, 350.
36. (1886) 33 Ch D 347, 358.
37. (1886) 33 Ch D 347, 350 (Cotton LJ), 358 (Lopes LJ).
38. (1886) 33 Ch D 347, 352.
39. Learoyd v Whiteley (1887) 12 App Cas 727, 732.
the due caution which a trustee is bound to exercise in could for their cestui que trust. But the goodness
respect of the investment of the trust fund. of their motives cannot justify the propriety of the
investment.
The learned Lord Chancellor, like Lord Fitzgerald—
who made similar remarks40—may have failed to get . . . I do not think it is true to say that one is entitled to
properly to grips with the basis on which Lindley LJ consider the special qualities or degree of intelligence
had found that the trustees had failed to get properly of the particular trustee. Persons who accept
to grips with their expert’s advice. Lindley LJ’s that office must be supposed to accept it with the
remarks are expressive of, and they are consistent responsibility at all events for the possession of
with, ‘due care of the capital sum’ being the upper- ordinary care and prudence.
most consideration.
There is nothing in the judgment of the third In this, Lord Halsbury was of one mind, and also,
Law Lord, Lord Watson, to indicate that the judg- with Bowen LJ who—a mere four years earlier—had
ments of the Court of Appeal had struck him in the held that the standard of ‘honesty’ is that of a sane
way they seem to have struck Lord Halsbury LC and and rational person:43
Lord Fitzgerald.
In any event, the House of Lords upheld the Bona fides cannot be the sole test, otherwise you
judgment of the Court of Appeal. might have a lunatic conducting the affairs of the
company, and paying away its money with both
hands in a manner perfectly bona fide yet perfectly
Trustees’ responsibility for ‘right reason’
irrational.
Their Lordships did not expressly cite St Thomas’s
view that prudence is ‘right reason about things to Bowen LJ said this in the context of his famous
be done’.41 An important consideration against dictum that the bona fides of the provision of gratu-
ascribing this omission to Protestant malice was ities to directors and staff of a company are to be
that Lord Fitzgerald was sitting with the Lord considered in the light of the principle that there
Chancellor and Lord Watson on this appeal. As well can be ‘no cakes and ale except such as are required
as hinting at, at least, bedroom Catholicism, his for the benefit of the company’44—an admonition
Lordship’s thirteen children suggest that, when it seldom mentioned by directors who vote bonuses in
came to recognizing a deficiency of prudence and the tens of millions to the chief executives to whom
due care in others, it took one to know one. they owe their own appointments to the Board.
But if he did not cite the Angelic Doctor, Lord
Halsbury LC was at least of like mind with him:42 Their duty not only to obtain competent and
skilled advice, but to ‘test the soundness’of
No one either at the Bar or in either of the Courts in
that advice: a trustee must understand
which this matter has been litigated has doubted that
the trustees intended to do what was right, and no To bring the trustee to ‘right reason’ about the ‘things
imputation can certainly be made against them that to be done’ in order to make such an investment
they were actuated by any other motive than that of as the ordinary prudent person would make for the
procuring the highest amount of interest that they benefit of other people for whom she felt morally bound
40. Learoyd v Whiteley (1887) 12 App Cas 727, 736.

42. Learoyd v Whiteley (1887) 12 App Cas 727,731.
43. Hutton v West Cork Railway Co (1883) 23 Ch D 654, 672–673.
44. Hutton v West Cork Railway Co (1883) 23 Ch D 654, 671.
to provide, ‘it is quite clear’, held the Lord Chancellor In Olsen v Hegarty,47 it was argued by the plaintiffs
in Learoyd v Whiteley:45 before the US District Court for New Jersey that:
that a trustee is entitled to rely upon skilled persons in The decision-making process that justified this
matters in which he cannot be expected to be experi- makeup, according to the Plaintiff, was marked by
enced. He may perhaps rely upon a lawyer on some uneducated assumptions, a lack of independent inves-
matters of law, and in this case I do not deny that he tigation, and a failure to obtain needed expertise as to
would be entitled to rely on a valuer upon a pure the best way to meet the Plan’s goals. The Plaintiff
question of valuation. But unless one examines with argues that the overall investment strategy was the
reference to what question the skilled person gives result of the majority of Trustees merely attending
advice it is possible to confuse the reliance which monthly meetings and rubber stamping the judgment
may be properly placed upon the skill of a skilled of Defendants Hegarty and Campbell, along with
person with the judgment which the trustee himself Mr. Foley, thereby abdicating their duty to make
is bound to form on the subject of the performance informed and independently investigated investment
of his trust. decisions.
The valuers’ instructions appear to have been vague, Rejecting the defendant trustees’ summary judgment
and the issue they addressed—the value of the land, application, the Court held that:
plant and business—was not the relevant issue of
the value of the land alone. Lord Watson gave the Whether the Defendants have violated their fiduciary
tenor of their Lordships’ reasoning:46 duty of prudence cannot be decided solely based on a
comparison of the Plan’s performance in light of the
If they employ a person of competent skill to value a ideal return of a portfolio with a similar purpose over
real security, they may, so long as they act in good the same time period. It is not within the province of
faith, safely rely upon the correctness of his valuation. this Court to create an artificial standard of return,
But the ordinary course of business does not justify against which all portfolios are measured to determine
the employment of a valuator for any other purpose whether a violation of fiduciary duty has occurred.
than obtaining the data necessary in order to enable Rather, this Court must examine and analyze the
the trustees to judge of the sufficiency of the security particular behavior and decision-making processes
offered. They are not in safety to rely upon his bare that account for these investments and determine
assurance that the security is sufficient, in the absence whether these actions or omissions were so imprudent
of detailed information which would enable them to as to constitute a violation of [their duty], regardless
form, and without forming, an opinion for themselves. of the outcome of the investment.
At all events if they choose to place reliance upon his
opinion without the means of testing its soundness they Even with the assistance of outside consultants
cannot, should the security prove defective, escape from making up for their lack of investment experience,
personal liability, unless they prove that the security the Trustees still were required to maintain an
was such as would have been accepted by a trustee of independent and critical eye toward the decisions
ordinary prudence, fully informed of its character, that they approved. . . . The investment making
and having in view the principles to which I have process revealed in the record illustrates an approach
already adverted. wherein Defendants Hegarty and Campbell, along with
45. (1887) 12 App Cas 727, 731. See also Cotton LJ, in the Court of Appeal, (1886) 33 Ch D 347, 350–352.
46. (1887) 12 App Cas 727, 734. Being ‘‘fully informed’’ requires sound advice, see footnote 52; and an aversion to doing that which one does not understand,
see text attached to note 318.
47. 180 F Supp 2d 552 (2001).
Mr. Foley, were in total control of the Fund’s invest- have done due diligence, what could I have done?
ments, while the other Defendants passively looked on, I knew several people that had been in the fund for
moving only to blindly participate when their official more than 15 years’.
approval was called for under the terms of the Trust.
At the very least, the Plaintiff here has raised a genuine ‘The only joke is my friends in England who are quite
issue of material fact as to whether the Trustees, for the savvy said, ‘‘What return are you getting?’’. I said,
most part not competent enough to rely on their ‘‘9%–11%’’. They said they were in hedge funds that
own expertise, exercised this level of independent were producing 25%. I went for the lower return
scrutiny when approving the Fund’s investments. because I am risk-averse, which makes me out to be
a total idiot.’
The passages I have italicized in the Learoyd v
Whiteley48 and Olsen v Hegarty49 judgments under Trustees cannot be so reticent. They have to under-
this heading of this article relate to matters likely to stand. They must seek advice.52 They must be
feature in any arguments about, say, investments prepared to ask, and they must ask, the hard
in hedge funds, collateralized debt obligations and questions. They cannot possibly invest ‘prudently’
other such ‘securities’ of the current era. otherwise. Trustees must be prepared and able
I refer later 50 to the Emperor’s New Clothes, and to to point to a diversified investment strategy; must
the questions the US Secretary of the Treasury and the be able to explain how it was developed for
Chairman of the Federal Reserve should have asked, this Trust, and why they considered it to be prudent
but did not. Lord Jacobs is in the same boat: under the circumstances; and, where those circum-
although, it seems, fortunately for him, not as a trus- stances have changed from time to time, how they
tee. He is said to have blown £30 million of his £128 adjusted the strategy to meet those new circum-
million fortune by placing it with Mr Madoff. stances, or why they considered that no adjustments
According to the Sunday Times:51 were necessary on the particular occasion.
‘Prudence is knowledge put to use’53—not ignor-
Madoff’s ‘Ponzi’ fraud used cash from new investors ance, and impulse, run amok. Yet, as will appear,
to pay high returns to those who had already com- hedge funds that are not Ponzi schemes may turn
mitted money, giving the illusion of genuine profits. out to be run by companies, the managers of which
Jacobs said: ‘Ponzi schemes typically fold after two cannot begin to explain what they are doing—apart
to three years but this went on for 20 years and it from making an unconscionable lot of money
was paying out 10% a year and 21/2% a quarter.’ irrespective of the damage they may be in the course
of inflicting on their clients and on the world
... economy.54 If, like Lord Jacobs, the trustees cannot
understand, but—in desperation—are hell bent on
Asked what he had done to look into Madoff before investing ‘solum ex impetu aut passione’,55 they are
injecting funds, he said: ‘When people say you should going to be vulnerable to impressive ‘names’.
48. (1887) 12 App Cas 727, 731: cited in the text to footnotes 45 and 46 above.
49. 180 F Supp 2d 552 (2001).
50. See ‘The committee to save the world’ thinks ‘something’ is happening in the economy, to which ‘time-honoured rules of thumb might not apply, at p. 575
below.
51. Waples, Sunday Times 15 February 2009.
52. In Cowan v Scargill [1985] Ch 270, 289, Sir Robert Megarry refers to the duty of trustees to ‘seek advice on matters which the trustee does not understand,
such as the making [and reviewing] of investments.’ See also footnotes 46 and 318.
53. Nemeth, Aquinas in the Courtroom: Lawyers, Judges, and Judicial Conduct (Greenwood Press, Connecticut, 2001) 95.
54. See, for example, Cowley, The Value of Money: Ethics and the World of Finance (Continuum, London, 2006), 145, ‘if market practitioners cannot be sure of
the risk, how are others to know?’; and Tavakoli, ‘Risk and valuation issues’, Ch 5, Structured Finance & Collateralized Debt Obligations: New Developments in Cash
& Synthetic Securitization (Wiley, New Jersey, 2008), 2nd edn.
55. St Thomas Aquinas, Summa Theologica I-II Q 57 a 5 c.
Being interrogated in cross-examination:

The relevance of a ‘good name’
We have just been living in an era during which ‘(Q) What other inquiries did you make about
investment has been occurring in funds that are the brick properties?
being invested on the strength of doubtful and (A) I instructed our solicitor to make inquiries
opaque security, of ‘names’, of rating agencies,56 respecting the respectability of the parties.’
and of the ‘respectability of the parties’.
Unhappily, at times, medical students without It plainly appears from these answers that the
bank accounts, and wine merchants with ‘very appellants had no information regarding the subjects
small’ businesses, can become trustees. They certainly mortgaged except what was contained in the report
did in Robinson v Harkin.57 The medical student left of their valuators.
the investment decision entirely in the hands of the
wine merchant. In his turn, the latter left it all up to The ‘parties’ on whose ‘respectability’ the trustees
a broker who was not a member of the Stock staked the trust estate had been identified in the
Exchange. The small-time wine merchant had selected Court of Appeal as the proprietors of the ‘speculative
him on the basis that the broker was ‘regarded as and fluctuating brick-making business’: ‘a business
a good customer by a firm of wine merchants in a largely dependent on the energy and solvency of
small way of business’. Judgment was given against those working in it . . . and which cannot be carried
both trustees for the mess that they made of the trust on without such an excavation and destruction of
estate. the soil as must eventually leave what remains
Lord Watson saw similar features in Learoyd v nearly useless’.60
Whitely when it was before the Lords:58 If they had been convicted fraudsters, or serial
bankrupts, the check would have been useful, and
The course which was followed by the appellants might have put the trustees off. But to have plunged
in entering into the transaction of January 1878 is in just because the solicitors had not been able to
very compendiously stated by Mr Learoyd [one of impugn the proprietors’ ‘respectability’ in some
the trustees: an accountant—see the eighth rule of such way was hardly prudent. Prof. J. K. Galbraith
thumb59], in whose evidence, so far as it related to repeatedly advised the need for taking great care
matters within his personal knowledge, Mr Carter when dealing with big names. Thus:61
[the other trustee: a schoolmaster] generally con-
curred. In his examination in chief Mr Learoyd was The world of high finance can be understood only
referred to a report by Messrs Uttley & Gray [the when it is recognized that the greatest admiration
‘valuators], dated the 8th of October 1877, and is accorded those who are paving the way for the
interrogated: greatest catastrophe.
‘(Q) Did you and Mr Carter on that report And thus:62

form an opinion that it was a proper
security for the investment? It must be recognized that from few matters has
(A) We did after further inquiries.’ modern society more suffered than from the excesses
56. See ‘But I relied on a rating agency,’ p. 595 below.

57. [1897] 2 Ch 415, 416.
58. (1887) 12 App Cas 727, 735.
59. Under ‘Ten rules of thumb,’ p. 582 below.
60. (1886) 33 Ch D 347, 359 per Lopes LJ; adopted as having stated the position accurately in (1887) 12 App Cas 727, 737 per Lord Fitzgerald.
61. The World Economy Since the Wars (Sinclair Stevenson, London, 1994), 73.
62. The Good Society: The Humane Agenda (Sinclair Stevenson, London, 1996), 79–80.
and errors of what is now called the financial com- indifferent to legal constraints and may, in modern
munity, although it once had the more luminous times, be a potential resident of a minimum-security
sobriquet of high finance. prison.
Lord Kylsant almost certainly would have passed A risk which Lord Walker, also, has stressed:66
a ‘respectability’ check by a provincial solicitor
before he went to jail because the prospectus for A director who is also controlling shareholder of
which—as a director—he bore legal responsibility a company may need a lot of persuasion that he is
failed the test stated by the Court of Criminal not fully entitled to feather his own nest at the expense
Appeal in Rex v Kylsant:63 of ‘his’ company. Indeed he may find himself serving
a custodial sentence before he begins to believe it.
The falsehood in this case consisted in putting before
intending investors, as material on which they could
Reconciling prudence and risk
exercise their judgment as to the position of the
company, figures which apparently disclosed the An ordinary prudent person might well invest
existing position but in fact hid it. more expansively for herself than she would invest
as trustee for the benefit of other people for whom she
The prospectus Lord Kylsant had signed represented felt morally bound to provide. As Lord Watson
that the company had paid a dividend in every year explained, in Learoyd v Whiteley, the trustee is
since the end of World War I. It had, too. Hence, one denied:67
might have thought that its business was prospering.
But it failed to mention that, for the last seven years, the same discretion in investing the moneys of the
the company had been making large trading losses. trust as if he were a person sui juris dealing with his
The dividends had been possible only because the own estate. Business men of ordinary prudence may,
company had made large profits in a brief artificial and frequently do, select investments which are more
shipping ‘boom’ attributable to the ending of the or less of a speculative character; but it is the duty of
war, and because it had been the beneficiary of a trustee to confine himself to the class of investments
a number of non-recurring items such as refunds which are permitted by the trust, and likewise to
by the Revenue authorities of wartime excess profits avoid all investments of that class which are attended
taxes. with hazard.
Trustees accordingly need to wash investment
proposals in ‘cynical acid’,64 for, as Professor In Estate of Rodney B Janes,68 the Surrogate Judge
Galbraith has also noted:65 held that the prudential obligation entailed that the
trustee ‘does not have a license to speculate.’
Having money may mean, as often in the past and None of this means that the trustee is forbidden
frequently in the present, that the person is foolishly all risk. He is not an insurer of the trust estate.69
63. [1932] 1 KB 442, 448.

64. Holmes, ‘The Path of the Law’ 10 Harvard L Rev 457 (1897).
65. A Short history of Financial Euphoria (Penguin, New York, 1994), 14.
66. ‘Fraud, fault, and fiduciary Liability’, Vol 10 No 2 Jersey & Guernsey L Rev (2006) para 14.
67. (1887) 12 App Cas 727, 733.
68. 214 NYLJ (5 July 1995) para 11. Affd In re Janes 90 NY 2d 41; 681 NE 2d 232; 659 NYS 2d 165 (1997).
69. Re Mulligan [1998] 1 NZLR 481, 501, ‘I accept that a trustee is neither a surety, nor an insurer of the fund for which he is responsible. Loss of trust money,
or . . . diminution in the real value of a trust fund, does not of itself render a trustee liable. It must be shown that the loss of diminution arose from some failing on
the part of the trustee, which can be properly characterized as a breach of trust.’ See also Re Whiteley, Whiteley v Learoyd, (1886) 33 Ch D 347, 357 per Lindley LJ:
Whilst on the one hand the Court ought not to encourage laxity and want of care, on the other hand the Court ought not to prevent people from
becoming trustees by converting honest trustees into insurers of the moneys committed to their care.
Life presents many dangers. Not the least of them is expressed must not be strained beyond their meaning.
safety. As the faithless servant in Matthew’s Parable of Prudent businessmen in their dealings incur risk.
the Talents70 discovered, totally risk-free investment That may and must happen in almost all human
is an oxymoron. Not even burying the trust estate affairs.
affords protection against loss,71 and, as Geoffrey
Shindler has put it:72 Reconciling Lord Watson’s deprecation of hazard
with Bacon V-C’s recognition and acceptance of the
Keeping the money under the bed is not risk-free; inevitability of risk, Brightman J has held that ‘the
you are subject both to inflation and burglars distinction is between a prudent degree of risk on
(though not necessarily in that order). Even if the one hand, and hazard on the other’.74
money at the bank ought probably to remove the
burglar risk, it will not remove the inflation risk.
Where the settlor wants all the trust eggs in
one basket, the trustee had better watch
Indeed, at the beginning of his reasons for judgment the basket closely
in Re Godfrey, Bacon V-C held that:73
That reconciliation can be hardest where the terms of
No doubt it is the duty of a trustee, in administering the trust fetter what otherwise might be trustee’s
the trusts of a will, to deal with property intrusted into better judgment. The ‘prototypical trust asset’ of old
his care exactly as any prudent man would deal with was ancestral land.75 Today, it is more likely to
his own property. But the words in which the rule is be a family company. In either situation, sentiment
See, too, Bartlett v Barclays Bank Trust Co Ltd (No 1) [1980] Ch 515, 531–534 (Brightman J); Re Partington (1888) 57 LT 654, 657; Cowan v Scargill [1985] Ch 270,
289; Steel v Wellcome Custodian Trustees Ltd [1988] 1 WLR 167, 171; Nestle v National Westminster Bank plc [1993] 1 WLR 1260; and Getzler, ‘Duty of Care’,
in Birks and Pretto, Breach of Trust (Hart Publishing, Oxford, 2002), 41–74.
70. Mt 25: 14–30:
Again, [the ‘Kingdom of Heaven’] will be like a man going on a journey, who called his servants and entrusted his property to them. To one he gave
five talents of money, to another two talents, and to another one talent, each according to his ability. Then he went on his journey. The man who had
received the five talents went at once and put his money to work and gained five more. So also, the one with the two talents gained two more. But the
man who had received the one talent went off, dug a hole in the ground and hid his master’s money.
After a long time the master of those servants returned and settled accounts with them.
The man who had received the five talents brought the other five. ‘Master,’ he said, ‘you entrusted me with five talents. See, I have gained five
more.’ [These early wealth managers hadn’t yet learned about charging up-front fees, success fees, flat fees, and commissions.] His master
replied, ‘Well done, good and faithful servant! You have been faithful with a few things; I will put you in charge of many things. Come and share
your master’s happiness!’
The man with the two talents also came. ‘Master,’ he said, ‘you entrusted me with two talents; see, I have gained two more.’ His master replied, ‘Well
done, good and faithful servant! You have been faithful with a few things; I will put you in charge of many things. Come and share your master’s
happiness!’
Then the man who had received the one talent came. ‘Master,’ he said, ‘I know that you are a hard man, harvesting where you have not sown
and gathering where you have not scattered seed. So I was afraid and went out and hid your talent in the ground. See, here is what belongs to you’
His master replied, ‘You wicked, lazy servant! So you knew that I harvest where I have not sown and gather where I have not scattered seed? Well then,
you should have put my money on deposit with the bankers, so that when I returned I would have received it back with interest. Take the talent from him
and give it to the one who has the ten talents. For everyone who has will be given more, and he will have an abundance. Whoever does not have, even
what he has will be taken from him. And throw that worthless servant outside, into the darkness, where there will be weeping and gnashing of teeth.’
71. Under the headline ‘Exec loses buried treasure’ the Singapore Straits Times for 29 January 2009 reported that ‘An elderly Japanese businessman buried US$4
million (S$6 million) in his garden for safekeeping only to find it dug up by a thief, police said on Thursday. The man in his 1980s discovered the theft in October
and died two months later. As he left no records, it took time for investigators to piece together the details. The man, who was still serving on a corporate board
when he died, had put cash into a container over four decades, repeatedly digging it up and then placing it back in the ground in his yard in southern Saga
prefecture. On October 10, he noticed at around 6.00 a.m that something was amiss. ‘‘He noticed that there are signs that parts of his yard were dug up. Then he
learned that the container in which he kept the money was gone’’, a local police official said. Police were searching for the culprit behind the theft of the cash,
estimated at 360 million yen (S$6 million). ‘‘He buried the money because financial institutions are offering only low interest rates, and he thought it was better to
keep his cash himself’’, the official said. ‘‘He chose to bury the cash in his garden to avoid damage from possible house fires or earthquakes’’, he said. The
businessman had recollected that the last time he had checked the money was in the middle of 2007, the official said—AFP.
72. ‘Should we be devoted followers of investment fashion?’ Trusts and Estates Law & Tax Journal (Oct 2003) 3.
73. (1883) 23 Ch D 483, 493.
74. Bartlett v Barclays Bank Trust Co Ltd (No 1) [1980] Ch 515, 531.
75. Langbein, ‘The Uniform Prudent Investor Act and the Future of Trust Investing’ 81 Iowa L Rev 641, 665 (1966).
is a fetter on the trustee—who is more on her mettle continue as a prudent investor, and do what has
than ever. to be done.
In the family company context, Cross, J. held, in This is just what the trustee in In the Matter of
Re Lucking’s Will Trust,76 and, in Bartlett v Barclays Repus Trust and Trustcorp Ltd79 had set out to do in
Trust Co (No 1),77 Brightman, J. repeated and elabo- respect of a trust estate the sole asset of which was the
rated, that a trustee of a controlling shareholding illiquid 744 acre Barne Estate in Tipperary, Ireland,
in a family company must keep a close eye on the on which stood a period house and other buildings,
company’s activities. The trustee must not rest con- all in a state of decay and disrepair. The estate had
tent with receiving no more than the statutory been in the family for more than three centuries.
accounts. Without having to go so far as to monitor Confirming the trustee’s decision to sell up, against
the directors’ every move, the trustee nonetheless beneficiary opposition, the Bailiff, Sir Philip
must not just turn a blind eye. Rather, he must Bailhache, exercised the jurisdiction which Robert
secure the regular supply of all the information that Walker, J. had confirmed in these terms in an
an ordinary prudent investor would require, so as to unnamed, undated and unreported judgment in
enable him to act timeously for the protection of the Chancery Division:80
the trust estate. Their Lordships said that this
could involve the trustee in, for example, all or The second category is where the issue is whether the
some of: proposed course of action is a proper exercise of the
trustees’ power where there is no real doubt as to
running the business himself, the nature of the trustees’ powers and the trustees
becoming a non-executive director, have decided how they want to exercise them but,
appointing a nominee to the board to report to because the decision is particularly momentous, the
him, trustees wish to obtain the blessing of the court for
overseeing the company’s affairs by studying the action on which they have resolved and which is
the agenda and minutes of board meetings, the within their powers. Obvious examples of that which
management accounts, and the quarterly or other are very familiar in the Chancery Division are a
periodical reports to the board. decision by the trustees to sell a family estate or to
sell a controlling holding in a family company. In such
The same principle applies whenever the share parcel circumstances there is no doubt at all as to the extent
included in the trust estate is big enough to empower of the trustees’ powers nor is there any doubt as to
the trustees to insist on such, or similar, rights in what the trustees want to do, but they think it prudent
respect of the company’s business.78 and the court will give them their costs of doing so,
If the information so secured begins to show that to obtain the court’s blessing on a momentous
drastic action is called for, including even selling the decision. In a case like that there is no question of
underlying business or property, the trustee must surrender of discretion and indeed it is most unlikely
76. [1968] 1 WLR 866, 874.

77. [1980] Ch 515, 533.
78. Thus, in Dominicia Social Security Board v Nature Island Investment Company Limited & Anor (Dominica) [2008] UKPC 19 (2 April 2009), their Lordships
[at page 10] denied the possibility of viewing the interposition of a company, to manage the assets in question,
as a mere matter of form. They would add (to avoid any misunderstanding) that trustees or other fiduciaries cannot of course use a limited liability
company as a means of insulating themselves from responsibility for recklessness in the conduct of a business (see Bartlett v Barclays Bank Trust
Company Ltd [1980] Ch 515). DSSB, and in particular its Director and its Investment Committee, will have a heavy and continuing responsibility for
monitoring the way in which the new company’s board of directors carry on its business. So, in a rather more remote way, will the Minister. But in
doing so they will be taking care of an investment, not running a business.
79. Jersey Royal Court, Samedi Division, [2005] JRC 081, 15 June 2005.
80. Jersey Royal Court, Samedi Division, [2005] JRC 081, 15 June 2005, para 11.
that the court will be persuaded in the absence of possibility of a disposal of Courts or its business
special circumstances to accept the surrender of dis- during 2004, all of which they say were good reasons
cretion on a question of that sort, where the trustees not to diversify. They also allege that the claimant,
are prima facie in a much better position than the with full knowledge, consented to and concurred in
court to know what is in the best interests of the the retention by HAE of the Courts shares. It is
beneficiaries. common ground that I cannot deal with these issues
on the present applications, and that the application is
On the other hand, the beneficiaries in Gregson v HAE restricted to the two narrow points I have already
Trustees81 claimed their trustee had failed to take the identified. However, this brief survey shows that if
steps it ought to have taken in respect of the old, this case is to continue there will be a reasonably
established family furniture business which—like the substantial trial.
trustee, whose directors were being sued in a ‘dog-leg’
claim—had become insolvent. The estimated Irrespective of the outcome of the dog-leg claim, the
deficiency for shareholders was £70 million. parties fully argued, and asked the court to decide,
The court ruled that the directors of the corporate whether the trustee had been dispensed from any
trustee owed fiduciary duties to that company alone, duty to act as the trustee of the Repus Trust had
and not to the beneficiaries of the trust which it had done. Although expressed in terms of provisions
been administering. Nonetheless, the court noted of the Trustee Act 2000, the decision accords with
what would have been in issue had it ruled against the general prudential trustee obligation:83
the directors:82
Fifth, the imposition of the duty to review diversifica-
I should also say what is not in issue on these application of the trust investments under section 4(3) of the
tions. The defendants say that they did in fact consider 2000 Act is not, in my view, inconsistent with, or
the question of diversification of the Courts [Bros inimical to, the . . . notion that this was a trust of
(Furnishers) Limited] shares from time to time and shares in a family company, or the settlor’s letters of
had good grounds for concluding that the shares wishes, or any other indications that the settlor wished
should be retained. They say it was always the wish HAE, if possible, to retain the Courts shares. I reach
of the Cohen family, including the claimant and the this view for several reasons.
other appointees of the Settlement, that Courts should
remain substantially a family owned and managed In the first place, the settlor did not, as he could have
company. They rely on letters of wishes by which done, insist that the Courts shares never be sold.
the settlor stated in 1988 that the shares should not He gave the Trustees a power to sell them and, as
be sold except in the case of a takeover. They point out already explained, this meant that they were always
that the holdings of the various family members in ‘available for investment’.
Courts, which together comprised a majority holding,
continued until late 2004, and that diversification The second reason is that section 4(3)(b), which deals
would have risked eliminating the family’s controlling with diversification, contains the qualification ‘in so
holding. They also refer to the terms of shareholders far as is appropriate to the circumstances of the trust’.
agreements affecting the shares, to potential tax This important qualification is echoed also in section
liabilities from a sale of the shares and to the 5(3), where the exception to the need to obtain advice
81. [2008] WTLR 999.

82. [2008] WTLR 999 at para 21.
83. [2008] WTLR 999 at paras 87–91.
refers to ‘all the circumstances’. In my view, the nature keep a close watch on the basket.86 And at some
and purposes of the Settlement, the existence of cl 2, point, her vigilant discharge of these duties shall
the letters of wishes, and, indeed such matters as the have brought her to the point at which she must
shareholdings of other members of the family or make a decision to bail out, then she must do so—
family trusts in Courts, are all ‘circumstances of the first applying to the court for confirmation where
trust’ for the purposes of section 4(3)(b) capable of beneficiary dismay makes that wise.
qualifying the appropriateness of diversification.
Hence, all the arguments that the settlor intended
When failing to diversify is inexcusable failure
HAE to hold the Courts shares and reflected this in
to balance the portfolio
cl 2 of the Settlement come into play in the exercise
of the section 4(3) duty. This approach appears to Save for cases like these—where the trustee has
me to be far more consonant with the statutory undertaken the trust on the basis that all or most of
purpose of requiring trustees to review the trust its eggs are intended to be in the one basket—the
investments and to consider diversification than the tension between hazard and prudent risk must
argument that these factors serve to oust the duty be resolved by balancing diverse investments.87
altogether. Prof. Langbein identifies:88
The third reason is that the section 4(3) duty is a two situations in which resisting diversification might
duty to review and consider diversification of the be appropriate: first, when the tax cost of selling
investments of the trust, it is not a duty to diversify. low-basis securities would outweigh the gain from
In my view, it is not inimical to or inconsistent with diversification; and second, when the settlor mandates
the terms or purposes of the Settlement to require that the trust retain a family business.
HAE to review the diversification of the invest-
ments of the trust from time to time, where the But, he quickly adds:89
circumstances relevant to their review might well
justify deciding to retain the entire block of Courts When, however, the trust investor starts with cash in
shares. hand, failing to diversify is inexcuseable [sic].
That approach must be right. Of course the sentimen- Loring J. certainly thought so in the Massachusetts
tal attachments to the particular enterprise must be case, Warren v Pazolt.90 The trustees had managed
weighed in the balance. The identity of the family may to tie up 92% of the trust estate in a single investment.
be closely entwined with the business of the estate, The learned judge held that:91
and that is not to be ignored. But that does not
absolve the trustee from her Re Lucking’s Will The fundamental objection to the erection of the
Trust84 Bartlett v Barclays Trust Co (No 1)85 duties. Carney Building being an act in the exercise of
If you have all your eggs in one basket, you need to a sound discretion lies in the large proportion which
84. [1968] 1 WLR 866, 874.

85. [1980] Ch 515, 533.
86. Cf Dominicia Social Security Board v Nature Island Investment Company Limited & Anor (Dominica) [2008] UKPC 19 (2 April 2008), where, at p. 10, their
Lordships refer to the trustees’ ‘heavy and continuing responsibility for monitoring the way in which the new company’s board of directors carry on its business.’
87. In ‘English Fiduciary Standards and Trust Law (The Rise of the International Trust)’ 32 Vanderbilt Journal of Transnational Law 555, 558 (1999), Professor
David Hayton pointed out that ‘the need to diversify arises from the duty to act as a prudent person would in investing for others’.
88. ‘The Uniform Prudent Investor Act and the Future of Trust Investing,’ 81 Iowa L Rev 641, 646 (1966).
89. ‘The Uniform Prudent Investor Act and the Future of Trust Investing,’ 81 Iowa L Rev 641, 646 (1966).
90. 89 NE 381 (1909).
91. 89 NE 381, 388 (1909).
that investment bears to the whole trust estate. . . . The which resulted in a monumental and precipitous
value of the land when the new building was decline in the stock market during the 1973–74
determined upon was therefore $403,000. The new period, the bank’s position continued to be one to
building cost about $450,000 all of which was retain the Eastman Kodak stock in its concentrated
borrowed on mortgage. This single investment was form. In that one year the EK stock dropped from
an investment of $850,000 out of a trust principal of approximately $115 a share to about $60 a share.
a little over $920,000. We do not see how this can be In summary, the Bank’s position in demonstrating
justified as the exercise of a sound discretion . . . . prudence is that the retention of the EK was part of
a conscious and studied investment plan. In reality,
. . . The error made by the trustees was adding to the Bank’s responsiveness to the admittedly turbulent
this land then worth $375,000 another lot worth and precipitous tenor of the times (1973) was to
$28,000 and erecting upon it a $450,000 building, do nothing. To assert that mere review, analysis, and
when the whole trust amounted to no more than monitoring satisfies the standard of due care by a
$920,000, in place of selling the land valued at prudent person where action and activity are indicated,
$375,000 with the old buildings then on it as they tests the Court’s sense of reason and logic and more
stood. importantly flies in the face of the surcharge cases
heretofore cited.
92
Taking a like view in Estate of Rodney B. Janes, the
New York Surrogate Judge found against a trustee The decision of the learned Surrogate Court judge
bank which had maintained 71% of the trust estate on liability was affirmed by the Court of Appeals,
in a single blue chip stock (Eastman Kodak) which New York:93 That Court held that:
had long been experiencing a decline in value. The
witness for the trustee, Mr Patterson, testified that First, petitioner failed to consider the investment
the testator’s widow had told the bank that she in Kodak stock in relation to the entire portfolio
‘loved’ Kodak. of the estate . . ., ie, whether the Kodak concentra-
tion itself created or added to investment risk. The
Patterson testified that Mrs Janes agreed with each of objectants’ experts testified that even high quality
the Patterson recommendations to the extent that she growth stocks, such as Kodak, possess some degree
‘loved Kodak’ and her husband ‘loved’ Kodak. As of volatility because their market value is tied so
appears later, the bank’s reliance on these expressions closely to earnings projections . . . . They further
was part of the basis to retain a concentration in EK. opined that the investment risk arising from that
The loose statements made by Mrs Janes can hardly be volatility is significantly exacerbated when a port-
equalled [sic] with a consent to the retention. folio is heavily concentrated in one such growth
The record is devoid of any signed consent, further stock.
communications [sic] by her, acknowledged or
otherwise. Second, the evidence revealed that, in maintaining
an investment portfolio in which Kodak represented
The Surrogate Judge said: 71% of the estate’s stock holdings, and the balance was
largely in other growth stocks, petitioner paid
Notwithstanding turbulent worldwide economic insufficient attention to the needs and interests of
conditions including an OPEC oil embargo, all of the testator’s 72-year-old widow, the life beneficiary
92. 214 NYLJ 31 (5 July 1995).

93. In re Janes 681 NE 2d 332, 338–339 (1997).
of three quarters of his estate, for whose omfort, Senator Janes’s widow might have been a sweet
support and anticipated increased medical expenses and complaisant little old lady who could live on
the testamentary trusts were evidently created. the smell of an oily rag, but the court was not going
Testimony by petitioner’s investment manager, and to condone the bank treating her that way. Referring
by the objectants’ experts, disclosed that the annual again to the hapless bank witness, the learned
yield on Kodak stock in 1973 was approximately Surrogate judge had said:94
l.06%, and that the aggregate annual income from
all estate stockholdings was $43,961, a scant l.7% of That the EK stock in 1973 had a yield of 1.1% is again
the $2.5 million estate securities portfolio. Thus, uncontroverted. The Patterson testimony and indeed
retention of a high concentration of Kodak jeopar- the thrust of the bank’s position vis-a-vis this income
dized the interests of the primary income beneficiary level is that yield in its broader form involves not only
of the estate and led to the eventual need to substan- the actual dividend ratio to the price but also involves
tially invade the principal of the marital testamentary the growth nature of the stock and the probabilities
trust. Lastly, there was evidence in the record to for future appreciation. . . . With this position, the
support the findings below that, in managing the Court does not agree. Given the age, health and
estate’s investments, petitioner failed to exercise due status of Mrs Janes in 1973 and the fact that the
care and the skill it held itself out as possessing ultimate beneficiaries were charities, the income
as a corporate fiduciary . . . . yield was insufficient and unacceptable.
Notably, there was proof that petitioner: Sweetness and complaisance may well have been
lurking somewhere deep in the character of the
(1) failed initially to undertake a formal analysis widow in Re Mulligan,95 but she seems to have
of the estate and establish an investment plan suppressed any urge to reveal those qualities. She
consistent with the testator’s primary objectives; was the life tenant. She was one of the trustees. The
(2) failed to follow petitioner’s own internal trustee other trustee was a trustee corporation. Although her
review protocol during the administration of personal solicitor gave evidence—the relevance of
the estate, which advised special caution and which is unclear—that she ‘was not obdurate or
attention in cases of portfolio concentration of unreasonable in his experience’,96 the officers of that
as little as 20%; and corporation seem to have seen her as something
(3) failed to conduct more than routine reviews of of a Madame Lash. The court found that ‘she was
the Kodak holdings in this estate, without con- a person of some business acumen’, that she had
sidering alternative investment choices, over a been ‘alive to the wisdom that a share portfolio his-
seven-year period of steady decline in the value torically and into the future would provide a measure
of the stock. of protection against inflation’, but that ‘she was quite
hostile to any suggestion of diversification when that
Since, thus, there was evidence in the record to sup- issue was raised’ by officers of the trust company.97
port the foregoing affirmed findings of imprudence on She turned her income situation into the reverse of
the part of petitioner, the determination of liability that from which the New York courts rescued the
must be affirmed . . . . widow in Janes.
94. 214 NYLJ 31 (5 July 1995).

95. [1998] 1 NZLR 481.
96. [1998] 1 NZLR 481, 505.
97. [1998] 1 NZLR 481, 507.
She outlived her farmer husband by 41 years. The whereas the options would have been limited with any
farm was sold after 16 of those years, and she then appreciably lower level of investment. A reasonable
received the balance of a substantial legacy, which spread would have comprised about ten shares,
enabled her to buy a home, a rental apartment, and selected on the basis of performance and with long-
(although the trustee knew nothing of this) to make term retention in mind. Other considerations would
significant investments in shares. also have been at play. In 1972 the rate of inflation was
The $108,000 balance remaining in the hands of the of the order of 10 per cent and the trend in relation to
trustees would have sufficed to purchase 14 average mortgage interest rates was upwards. These factors
residential properties in the city of Christchurch in would have underscored the need for a decisive
1965. From that year, until the widow’s death 25 move into the sharemarket.
years later, the trustees invested it entirely in fixed
interest securities such as mortgages and central and A fund of only $43,000 was never going to be enough
local government stock. to construct and manage a fully index-matched port-
The life-tenant-widow-trustee had a very good folio. The trustees would have to have made
income as a result. The realty and shares on which choices:101
she spent her legacy were worth $686,000 when she
died in 1990. Turning to the question of whether the assumed estate
Thanks to the investment policy, the trust capital portfolio would have increased in value in line with
was then worth only $102,000: $10,000 short of the the Barclays Index, the Court was again confronted
average price of a single residential property in with conflicting evidence. On the one hand
Christchurch at that date. Mr Nisbet ventured the confident opinion that a
The question identified by the court was ‘whether suitable mix of blue-chip shares would have outper-
exclusive investment in fixed-interest securities to the formed the index. He justified this opinion on the
exclusion of equities constituted a breach of trust in basis that the estate would have been advised to pick
the circumstances of this case’. On behalf of the the six to ten best stocks out of the 40 that comprised
defendant trustees, expert evidence was given that the then Barclays Index. At the other end of the
their investment policy had been ‘in line with the spectrum was the final witness Mr Irvine called for
then current thinking and practice’.98 That evidence the second defendants. He considered that although
may have evoked in the mind of the court the the index was probably the most suitable available
celebrated comment by Bowen LJ99 that ‘Bona fides benchmark, it did not provide a valid base for
cannot be the sole test, otherwise you might have measuring the performance of a fairly modest
a lunatic conducting the affairs of the company, and portfolio of a private trust. He supported this conten-
paying away its money with both hands in a manner tion by reference to various factors. The index
perfectly bona fide yet perfectly irrational’. At all comprises a basket of shares. An estate could not
events, the court found the trustees to have been in hope to ‘buy the Index’. The spread of investment
breach of duty by not having ensured that, by 1972, over 40 shares would provide, he considered, a
the estate had been invested in equities to the extent lower risk profile than investment in a limited
of 40% [or $43,200] of the fund:100 number of shares. In addition, he characterised the
index as a ‘winners’ measure. By this Mr Irvine
Investment at that level would have enabled the meant that profitable growing companies become
purchase of a reasonable spread of blue-chip shares, part of the index, while declining companies
98. [1998] 1 NZLR 481, 497.
99. Hutton v West Cork Railway Co (1883) 23 Ch D 654, 672–673.
100. [1998] 1 NZLR 481, 509.
101. [1998] 1 NZLR 481, 510.
drop out. Accordingly for an estate to match the This is not to say that the Trustees can, or must,
index, would require a considerable level of trading; adopt fixed percentages, or rules of thumb. As the
conduct inconsistent with that to be expected of trus- US District Court, Maryland, in Meyer v Berkshire
tees committed to the purchase of blue-chip shares Life Insurance Company103 held:
on a long-term basis. He pointed as well to the costs
involved in acquiring and selling shares, namely com- the duty to diversify investments cannot be stated as
mission and duty. It was therefore Mr Irvine’s view a fixed percentage, because a prudent fiduciary must
that in using the index as a benchmark in the present consider the facts and circumstances of each case.
context, a discount factor of 50 per cent should be
applied.
Balance mediates between risk and return:

I considered Mr Irvine to be an impressive witness.
portfolio theory104
Largely on the basis of his evidence it is my view that
the identified contingencies do require the application As Hoffmann J. has put it,105 trustees now are to ‘be
of a discount factor, but not at the level suggested. judged by the standards of current portfolio theory’.
I consider a discount of one-quarter would be appro- And in the United States, the Association for
priate. Mr Irvine’s views were expressed on the footing Investment Management and Research has declared
that the estate would hold a narrow portfolio of that:106
two or three shares. I regard that as unlikely. With
an investment of $43,200 in 1972 a portfolio of The investment profession has long recognized that
perhaps ten shares would have been obtained. the combination of several different investments
I consider this holding would have been retained is likely to provide a more acceptable level of risk
intact and would, on the probabilities, have increased exposure than having all funds in a single investment.
in value to the extent of 75 per cent of the growth
in the index. For the larger trust estate, ‘buying the index’ may be
feasible and desirable. For the smaller estate, as in
From there, as will appear,102 the court was driven Re Mulligan,107 as few as ten stocks may suffice. The
to conclude that the $43,200 would have increased important thing is that they are truly diverse in the
to $170,640, and effectively to surcharge the sense of being minimally correlated. Stocks are not
trust company with the difference between these relevantly diverse if they are ‘co-variant’—all likely
figures. to go belly-up at once.
102. Under ‘Consequences of authorized, but negligent, investment,’ p. 557 below.

103. 250 F Supp 2d 544, 565 (2003).
104. See Ian Shipway’s clear explanation in ‘Modern Portfolio Theory’, and Christopher Mc Call’s ‘A Fine Romance: the Union of Prudence and Risk’ 15 Trusts
& Trustees (2009), at 60 and 66.
As for pension fund investment, see Clifford, ‘Investment—can private trustees learn anything from pension scheme trustees?’ 15 Trusts & Trustees
(2009) 611; Lee, ‘Modern Portfolio Theory and the Investment of Pension Funds’ in Finn (ed.) Equity and Commercial Relationships (Law Book Company,
1987), 284, and Ellison, Pension Fund Investment Law (Tottel, 2008), bearing in mind what Staughton LJ said in the Court of Appeal in Nestle v National
Westminster Bank plc [1993] 1 WLR 1260, 1277 (CA):
There is in my opinion a better answer to this comparison. Life assurance companies and pension funds have as their primary duty an obligation
to pay at some future date a sum that is fixed in monetary terms. No doubt they offer profits, or an increase on the promised pension; and it may
be that even in 1959 there was competition between companies by reference to their past records of success. But I am convinced that they could
be expected to follow a policy of considerable caution in order to ensure that, come what may, their minimum obligations in monetary terms were
fulfilled. I do not regard them as a reliable guide to what would have been done by private investors, or should have been done by trustees of a private
family trust.
105. Nestle v National Westminster Bank plc [2000] WTLR 795, 797; affd [1993] 1 WLR 1260.
106. The Standards of Practice Handbook, 1999, 8th edn.
107. [1998] 1 NZLR 481, 510.
Justice Richard Posner of the US Court of The prevalence of risk aversion in investing is
Appeals for the Seventh Circuit, writes extensively illustrated by the normally lower rate of return on
of portfolio design in his Economic Analysis of bonds compared to the common stock of the same
Law.108 His comments include these basics [for company. Suppose that the expected return
ease of reference, I have inserted subheadings, (dividends plus appreciation) on a company’s
and have incorporated the footnotes into the common stock is 10 percent. Risk-neutral investors
text]: would demand 10 percent interest on the company’s
bonds as well. Although there is less risk to being
[Risk and expected return] a bondholder, since he has the cushion of the equity
A security has two dimensions: risk and expected shareholders, who would have to be wiped out com-
return. The expected return is constructed by multi- pletely before he could lose his interest, his additional
plying every possible return by the probability of its safety is offset in an expected-return sense by the
being the actual return, and then adding the results fact that he cannot earn more than the interest rate
of the multiplication. Thus, if there is a 50 percent specified in the bond. The difference between a
probability that a particular stock that sells for $10 company’s bond interest rate and the (higher)
today will be worth $12 one year from now, a 40 expected return to owners of the common stock is
percent probability that it will be worth $15, and compensation to the stockholders for the extra risk
a 10 percent probability that it will be worth nothing, they bear. [(There) is one risk that bondholders bear
its expected return is $2 [(.5 $2) þ (.4 $5) that shareholders do not (to the same extent). (It is,
(.1 $0)] [The expected value is $12 [(.5 of course, inflation.)]
$12) þ (.4 $15) þ (.1 $0)], and the current price
is $10. To simplify analysis, it is assumed that no [Negatively correlated risks can cancel each other out]
dividends will be paid. The expected return of a It follows that there should also be a systematic
stock includes, of course, both appreciation and difference among the expected returns of common
dividends.] stocks that differ in their riskiness; but this point is
subject to an important qualification. Suppose the
[Usual preference is for the lower risk for the same expected per-share returns of two stocks (A and B)
return] are the same, $2, but the expected return of A com-
Although the expected return of a 100 percent chance bines a 50 percent probability of no return with a
of obtaining $10 is the same ($10) as the expected 50 percent probability of a $4 return, while that of
return of a 50 percent chance of obtaining $20 or B combines a 50 percent probability of a –$6 return
a 1 percent chance of obtaining $1,000, we know with an equal probability of a $10 return. B is the
that people are not indifferent to the various ways of riskier stock. Let there be a third stock (C) that, like
combining uncertainty and outcomes to yield the B, has an expected return of $2 resulting from a com-
same expected return. In choosing among securities bination of a 50 percent probability of a –$6 return
that have identical expected returns, the risk-averse with the same probability of a $10 return—only the
investor will choose the one having the least uncer- fortunes of C and B are reciprocal, so that when B
tainty unless the prices of the others fall, thereby does well C does poorly and vice versa. [That is, there
increasing their expected returns, to the point where is a 50 percent probability that B will yield a –$6
he feels adequately compensated for bearing greater return and C a $10 return, and a 50 percent probabil-
risk. ity that B will yield a $10 return and C a –$6 return.]
108. 7th edn (2007) 465–466.

Then a portfolio composed of B and C will be less securities. The other component is risk that is nega-
risky than one composed solely of A, even though A, tively correlated, or uncorrelated, with the risk of the
considered in isolation, is less risky than either B or C. market as a whole, and therefore can be diversified
The investor will not insist on a risk premium for away. Diversification is an important goal of portfolio
holding B and C in his portfolio. Their risks cancel; design because it allows the investor to get rid of a
the portfolio itself is risk free.109 form of risk that is uncompensated (precisely because
it can be eliminated at slight cost, through diversifica-
[Portfolio design proceeds accordingly] tion) and is therefore a deadweight loss to the investor
This illustrates the fundamental point that portfolio who is risk averse. But diversification does not
design can alter the risk characteristics of securities eliminate all risk; some risk, as we have seen, is
considered individually. And in a world in which the undiversifiable, and to bear that risk the risk averse
risks of different common stocks were negatively investor will insist on compensation. Because systema-
correlated, as in the preceding example, there would tic risk—the risk component that is positively corre-
be few if any differential risk premiums among lated with the risk of the market as a whole—is also
common stocks. Less obviously, this would also be compensated risk, the portfolio manager who wants to
true if the risks of common stocks, instead of being reduce it must be prepared to pay a price in the form
negatively correlated, were uncorrelated, ie, random; of a lower expected return. [Stocks that differ in
for in a portfolio consisting of many different systematic risk have been found empirically to differ
common stocks, the randomly distributed risks of in expected return, and the correlation between
the securities in the portfolio would tend to cancel systematic risk and return has been found to be posi-
out. By way of analogy, observe that while the tive as expected. The evidence is summarized in
riskiness of every individual life in this country is James H Lorie & Mary T Hamilton, The Stock
nonnegligible, the country’s death rate—the Market: Theories and Evidence, chs 11-12 (1973), but
performance of the ‘portfolio’ of all individuals—is remains controversial. Compare Eugene F Fama &
extremely stable. It is, in fact, much more stable Kenneth R. French, Common Risk Factors in the
than the stock market. This suggests that the risks of Returns on Stocks and Bonds, 33 J Fin Econ 3
different common stocks are neither negatively (1993), with Fischer Black, Beta and Return, J
correlated nor random but in fact have a strong Portfolio Mgmt, (1993), p 8.]’’
positive correlation. This in turn makes it necessary
in portfolio design to distinguish between two
components of risk. One is the component that is
Trustee reliance on funds110
positively correlated with the risk of the whole flock
of securities, the market, and therefore cannot be To that end—following the discussion of basic port-
eliminated simply by adding more and more folio theory, in his Economic Analysis of Law111 cited
109. Grinblatt and Titman, Financial Markets and Corporate Strategy 106–107 (1998) add a vital qualification as to co-variance:
Diversification, the holding of many securities to lessen risk, is the most important concept introduced in this chapter. It means that portfolio
managers or individual investors balance their investments among several securities to lessen risk. As a portfolio manager or individual investor adds
more stocks to his portfolio, the additional stocks diversify the portfolio if they do not covary (ie, move together) too much in concordance with other
stocks in the portfolio. Because stocks from similar geographic regions and industries tend to move together, a portfolio is diversified if it contains
stocks from a variety of regions and industries.
...
While the principle of diversification is well known, even by students new to finance, implementing mean-variance analysis—for example, coming up
with the weights of portfolios with desirable properties, such as a portfolio with the lowest variance—requires some work.
110. See Martin Day and Fiona Duggan ‘Common Investment Funds’ 15 Trusts & Trustees (2009) 116.
111. 7th edn (2007).
above, and a discussion of leverage as a, risky, means analysts in general115 when it comes to beating the
of increasing portfolio returns—112Justice Posner market:116
canvasses the considerations bearing on whether this
duty to balance risk and return requires the trustees to . . . empirical studies have found that mutual funds,
engage in constant attempts to ‘beat the market’ by despite their employment of security analysts and
identifying and purchasing undervalued shares, and portfolio managers for the purpose of outperforming
by identifying and selling overvalued shares, and the market, fail to do [The early studies are summar-
thus maximizing the return to the trust estate.113 ized in Lorie & Hamilton, The Stock Market: Theories
His view is that the game is not worth the candle. and Evidence at ch 4. See also Burton G Malkiel,
Research is expensive. Transaction costs are high. ‘‘Reflections on the Efficient Market Hypothesis: 30
Much expensive trustee time is consumed. Above Years Later,’’ 40 Fin. Rev 1 (2005); RA Brealey, An
all, the public availability of the information, on Introduction to Risk and Return from Common Stocks,
which assessments of under and overvaluation fall ch 3 (2d ed 1983); Richard A Ippolito, Efficiency with
to be made, entails a sufficient degree of market Costly Information: A Study of Mutual Fund
efficiency to frustrate the attempt to beat it.114 Performance, 1965–1984, 104 QJ Econ 1 (1989). The
So what about managed funds? The trustee think- empirical research has concentrated on mutual funds
ing in that direction would need, also, to heed because they are required by federal law to report in
Justice Posner’s pessimism whether fund managers, detail on their performance; but all indications are
and their specialist analysts, are any better than that common trust funds, pension funds, and other
112. 7th edn (2007) pp. 468–469.

113. 7th edn (2007) pp. 471–473.
114. Economic Analysis of Law 7th edn (Aspen, New York, 7th edn, 2007), 472.
It may seem virtually self-evident that a skilled investor, who conducts careful research into the conditions and prospects of particular companies and
of the economy as a whole, will earn a higher return (always correcting for differences in systematic risk) than the investor who simply buys the
market, blindly investing in the entire stock market list and never selling a stock when its prospects begin to sour. But since the value of a stock is a
function of its anticipated earnings and therefore depends largely on events occurring in the future, it will often be impossible to determine whether a
stock is undervalued at its current price without knowledge of what the future holds, and very few people are good at predicting the future. Although
a stock may be undervalued because of some characteristic of the company (or of its competitors, suppliers, customers, political environment, etc)
that exists today but is not widely known or correctly understood, the problem here is that the underlying information is in the public
domain, meaning that it is equally available to all security analysts. The only way to make money from such information is to interpret it better
than other analysts do. This is not a promising method of outperforming the market. It requires both that the analyst interpret publicly available
information differently from the average opinion of the analyst community and that his deviant interpretations be correct substantially more
often than they are incorrect . . . .
115. Langbein The Uniform Prudent Investor Act and the Future of Trust Investing,’ 81 Iowa L Rev 641, 656–658 (1966) points out why:
Why have the professional investment managers performed so poorly? Modern Portfolio Theory supplies a crisp answer to that question. In a nutshell,
the insight is that the professional portfolio managers are not incompetent bunglers, indeed, just the opposite. They are so good at what they do that
they effectively cancel each other out.
To understand why, start with the basics. The price of a security represents the present discounted value of its future earnings. Furthermore, for every
buyer there must be a seller—someone who has formed an opposite judgement about the value of that future earnings stream at the security’s current
price. If all investors agreed that a particular security was a bargain at its current price, no one who owned the security would sell it at that price.
Only an increase in price would induce sellers to sell. This is why we can say that, presumptively, any security is correctly priced at its current
trading level.
To outperform the market—that is, consistently to identify undervalued or overvalued securities in advance of other investors—an investor must
predict future earnings with superior speed and accuracy. But here the task becomes daunting. New information about individual companies is
disseminated rapidly as a result of modern communications systems. The securities laws have largely choked off inside information as a source of
advantage in trading. Economic developments, technological innovation, foreign affairs, political events, social changes—all profoundly affect the
prices of securities, yet these phenomena are notoriously difficult to foresee.
Professional securities analysts are thus largely limited to interpreting information already in the public domain and available to other analysts. In
order to outperform the market the portfolio manager has to be consistently better at making such interpretations than the thousands of competing
professionals who are interpreting the same data. The theory of efficient markets posits that everything that is known or knowable about the price of a
publicly traded security is already fully reflected in its price. The securities markets are so efficient in discounting information and pricing securities
that not even the professionals can consistently identify undervalued and overvalued securities before other investors get there. The indifferent
performance record of professional investment managers is, therefore, ‘exactly what we should expect in an efficient market.’
116. Economic Analysis of Law 7th edn (Aspen, New York, 7th edn, 2007), 472–473.
institutional investors likewise fail to systematically comparison was long derided on the ground that the
outperform the market portfolio.] They do no better S&P 500 is a hypothetical fund and hence has no
than the blind market portfolio. administrative costs. Now that there are, and indeed
for some years have been, real market-matching funds
Although it has been argued that the proper compar- in operation . . ., it is possible to evaluate—and
ison is not between all mutual funds and the market reject—this criticism. The administrative costs of a
but between the most successful mutual funds and the market fund turn out to be so low (on a $500 million
market, the studies suggest that there are no cons- portfolio, perhaps 10 percent of the costs of conven-
istently successful mutual funds. Some enjoy shorter tional management) that the expected return of
or longer runs of success, but generally the degree of a market fund is only trivially different from that
success observed is no greater than one would expect of the S&P 500.
if luck, not skill, is indeed the only factor determining
the fund’s performance. ...
In Nestle v National Westminster Bank117 Dillon LJ In a dramatic sign of the changing legal environment,
noted in the Court of Appeal that: trustees will now even invest portions of the funds
entrusted to them in index funds. A typical index
118
as Hoffmann J pointed out, that the evidence fund buys and holds a 200 to 500 stock portfolio
showed that if the BZW Equity Index was applied designed to match the performance of the New York
over the period from July 1974 to December 1986 Stock Exchange (or perhaps some weighted average of
to ‘growth’ unit trusts (as opposed to ‘income’ domestic and foreign securities markets), performing
unit trusts) it appeared that 12 of the ‘growth’ trusts no securities analysis and trading only insofar as
had done better than the index, but 21 had done necessary to maintain diversification, handle redemp-
worse. tions, and invest its shareholders’ cash. It epitomizes
passive investment—thus raising such questions as
So is the solution for the hapless trustee to go passive; what if every investor adopted the passive strategy
to run with Underhill and Hayton’s advice on the implied by the concept? Then the market would
alternative to the Re Mulligan119 approach, and120 cease to be efficient . . . . But long before this hap-
‘bear in mind the possibility of investing small trust pened, some investors would abandon the passive
estates in ‘‘tracker finds’’ which track and reflect the strategy to take advantage of the opportunities,
index, so obviating the need for a discount based on which today are rare, for obtaining positive profits
the size of the fund in question’? Here Justice from securities analysis and active trading. How
Posner is more positive:121 many active traders are necessary to keep the market
efficient is a difficult question (need it be answered?).
The studies support an even stronger conclusion: But observation of other markets, for example the
When brokerage costs and management fees are housing market, where transactions are relatively
taken into account, the average mutual or common infrequent and the products traded are heterogeneous
trust fund yields a lower net return than a broadly (no two houses are as alike as two shares of the same
based market index such as the S&P 500. This class of the same company’s stock), suggests that the
117. Nestle v National Westminster Bank plc [1993] 1 WLR 1260, 1267 (CA).
118. Nestle v National Westminster Bank plc [2000] WTLR 795.
119. [1998] 1 NZLR 481, 510.
120. Hayton et al, Underhill & Hayton: Law Relating to Trusts and Trustees (Butterworths, London 2006), 17th edn 89.42.
121. Economic Analysis of Law, (Aspen, New York, 7th edn, 2007), 473, 479.
stock market would remain efficient even if most and essentially costless gains that are to be had from
investors were passive. maximizing diversification. These twin insights point
the fiduciary investor—that is, the prudent investor—
Prof. Langbein adds his weight to this:122 strongly toward the use of pooled investment vehicles
that are large enough to achieve high levels of
One response to the lesson that you cannot beat the diversification at reasonable cost. The investment
market is that you might make a considered judgment path of the future for trusts, especially smaller
to cease attempting it, especially if you can pocket the trusts, is the mutual fund or the bank common
savings from not trying. A vast proportion of all trust fund.
fiduciary investing is now conducted ‘passively,’ in
so-called index or market funds. These funds under- But while an investor of another person’s money
take simply to replicate the performance of the broad could prudently invest in a tracker fund in theory,
market indexes. In the mid-1970s when market funds it is clear that such an investment might not automa-
first appeared, they attracted only a few hundred tically be prudent in practice.123
million dollars, most of it from the AT&T pension Apart from anything else, a prudent trustee would
funds. Today, hundreds of billions of dollars in not simply hand the relevant part of the fund over to
American equities are indexed. the tracker fund manager, without considering, and
regularly verifying, for example, the basis on which
Modern Portfolio Theory has taught us that the game it proposed to maintain diversification.
of stock picking is costly and futile for most investors, Nor would a prudent trustee necessarily and always
especially small investors, while emphasizing the large concentrate on stocks and bonds, but ignore land124
122. Langbein ‘‘The Uniform Prudent Investor Act and the Future of Trust Investing,’’ 81 Iowa L Rev 641, 656-658 (1966).
123. Cf Womack, ‘When tracker funds go off the rails,’ Mail on Sunday, 14 January 2008:
Tracker funds are supposed to take the guesswork out of investing. But a saver who five years ago picked the wrong UK tracker for their £10,000
investment would today be more than £8,000 worse off than someone who chose the top tracker.
These funds aim to reproduce the gains, or losses, of a stock market index by holding a representative mix of the shares that make up the index.
The process is largely automated, with no room for the human judgement calls made by the high-earning fund managers who run active funds.
In theory, savers can invest in a tracker and expect it to give them returns in line with their target index. But in reality the funds deliver widely
varying returns with differences in charges and management styles leaving investors in some funds 17% behind others who were aiming for the
same target.
Someone who invested five years ago in both St James’s Place Tracker and Fidelity Moneybuilder UK Index would expect the same return from both
funds. This is because both track the FTSE All-Share Index. But while Fidelity Moneybuilder has generated a return of 101.1%, St James’s
Place Tracker has delivered just 83.8%.
Worryingly for savers, no tracker fund was able to keep pace with its target index over the past five years. All were index laggers rather than index
trackers.
Charges and fees explain most of the differences in performance between funds tracking the same index. The cheapest trackers, such as Fidelity’s
Moneybuilder, have annual charges of just 0.1%. But others-such as St James’s Place Tracker, charge 1.25% a year—12 and a half times as much.
Ben Willis, head of research at financial adviser Whitechurch Securities in Bristol who compiled the figures for Financial Mail, says:
‘Over time initial charges and annual management fees will eat away at returns and it is only to be expected that most trackers will lag some
way behind the index.’
124. For example, the American Law Institute’s authoritative Restatement of the Law, Trusts—Prudent Investor Rule (1992) 54–55 lays down that:
Because of its importance as a part of the country’s capital markets, real estate is a potentially valuable ingredient of a diversification strategy,
especially in light of its limited covariance with publicly traded equity and debt securities. Historically, land has also tended to provide long-term
protection against inflation. In addition, diversified real estate holdings have tended to offer, with less apparent volatility, returns comparable to those
of a diversified portfolio of marketable securities. Furthermore, with thoughtful selection of properties or structuring of ownership positions, a trustee
can organize the elements of the return toward the enhancement of either income productivity or principal appreciation, as might be desired for
a particular trust portfolio.
Despite the potential advantages of investing in real estate, it would not be prudent for a trustee to disregard the complexities, burdens, and special
risks associated with a decision to commit a portion of the trust estate to such investments. High transaction costs are to be expected. In addition, the
absence of regulated and efficient central markets that deal in largely uniform assets creates specialized problems and significant extra risks.
as a harbour in which to invest some of the trust or fund year is ipso facto imprudent—far from it.
estate. The point is that the growing comparability of fund
types provides a more precise and objective
benchmark for evaluating claims that a certain fund
Retaining an investment is ‘investing’: the
necessity for review is so manifestly inferior to competitors that investing
in it, or retaining it, is imprudent.
The ready comparability of funds can burden the
trustee who has not been diligent with the uncom- Trustees must always be prepared and able to
fortable onus of proving that his actions had been point to a diversified investment strategy; must
prudent:125 be able to explain how it was developed for this
Trust, and why they considered it to be prudent
Consider, therefore, a simple case. Suppose that a under the circumstances; and, where those circum-
trustee determines to invest twenty percent of the stances have changed from time to time, how they
trust in an intermediate-term bond fund. Suppose, adjusted the strategy to meet those new circum-
further, that the particular intermediate bond fund stances, or why they considered that no adjust-
that the trustee chooses persistently underperforms ments were necessary on the particular occasion.
other intermediate term bond funds on account of It is challenging enough to find an answer to the
drastically higher expense ratios. In view of the question ‘what would be a properly balanced portfo-
trustee’s duty to monitor, the burden will more lio in the light of, among other things, the state of the
easily shift to the trustee to explain why the trustee domestic and international economies; inflation or
chose that particular fund. Under the prudence stan- deflation prospects; the taxation matrix; the balance
dard, the comparability of increasingly standardized of special beneficiary income needs; and capital
fund types will allow trustees (and the courts who appreciation or at least capital protection?’126 But
oversee trustees when beneficiaries are unhappy) finding an answer is only the beginning, not an end,
greater precision in examining investment perfor- of the challenge. The answer will require constant
mance. The point is not that a disappointing fund review.127
Inefficiencies in pricing inevitably cut both ways. This is especially so given the hazards of appraisal. Also, risk as well as opportunity for gain results
from the array of uncertainties that relate to location, such as demography and land-use patterns, trends, and regulation.
Furthermore, important differences in the potential for gain enhancement and risk exposure turn on the specifics of the structure, terms, and
circumstances of each real estate investment. Variations may involve matters ranging from financing arrangements to operating form to tax
consequences of the diverse interests potentially involved. Some trust investments in real estate are likely to present challenging, ongoing management
requirements. In addition, efforts to achieve diversification within the affected portion of the trust estate will be complicated by the combination of
high unit costs typically associated with land and the general desirability of diversifying real estate investments by both geography and property type
when practical.
Thus, problems are likely to be presented by the concern many trustees will have, especially trustees of smaller trusts, over diversification objectives;
problems are also likely to be presented by a need for the technical competence that is so vital to success in a specialized field. These problems invite
cautious, informed consideration of the opportunities of acquiring real estate limited partnership interests or publicly traded shares of real
estate investment trusts and other real estate pooling devices.
Investing through real estate pools may also alleviate liquidity problems, transaction costs, and inefficient pricing that are normally associated with
investments in land.
...
In brief, a trustee contemplating the investment of trust funds in real estate has the usual fiduciary duty to make, with care, skill, and caution, an
analysis of the role the property is to play in the trust’s overall portfolio and strategy, and also an analysis of the risk-reward tradeoffs involved.
In addition, the trustee must recognize that special sensitivity and attention will be required either in selecting shares of suitable real estate investment
pools or in dealing with the competence and delegation issues that are virtually inherent in holding real estate directly as a part of the trust corpus.
Accordingly, special care is required in making the choice between these two divergent approaches to a program of real estate investment.
125. Langbein, ‘The Uniform Prudent Investor Act and the Future of Trust Investing,’ 81 Iowa L Rev 641, 662–663 (1966).
126. Cf Hayton, ‘English Fiduciary Standards and Trust Law (The Rise of the International Trust)’ 32 Vanderbilt Journal of Transnational Law (1999)
p. 555, 558.
127. Nestle v National Westminster Bank plc [1993] 1 WLR 1260; [2000] WTLR 795; Clarke v Clarke’s Trusts 1925 SC 693, 711.
In Estate of Rodney B. Janes,128 the New York decline in the stock market during the 1973-74
Surrogate Judge held that, as well as keeping under period, the bank’s position continued to be one to
surveillance ‘the risks of a portfolio, the marketability retain the Eastman Kodak stock in its concentrated
of the holdings, its volatility, and the market form. In that one year the EK stock dropped from
conditions then and there prevailing’, a trustee must approximately $115 a share to about $60 a share. In
consider whether, in the circumstances, he has: summary, the Bank’s position in demonstrating pru-
dence is that the retention of the EK was part of a
invested in or maintained an unusually large conscious and studied investment plan. In reality,
proportion of the fund in a single type of the Bank’s responsiveness to the admittedly turbulent
security. . . . Generally allied with the consideration of and precipitous tenor of the times (1973) was to
an unusually large portion retained in a single security do nothing. To assert that mere review, analysis, and
which may be termed a concentration (to be devel- monitoring satisfies the standard of due care by a
oped later in this decision) is the issue of diversi- prudent person where action and activity are indicated,
fication. In that respect it is clear that the failure to tests the Court’s sense of reason and logic and more
diversify by itself is not an act of imprudence. . . . importantly flies in the face of the surcharge cases
Courts have tended to apply a different (more relaxed) heretofore cited.
standard when the fiduciary retains assets owned by
the decedent as distinct from those that the fiduciary Writing extra-curially,132 Lord Nicholls of
has acquired. . . . Such retention, however, does not Birkenhead came down firmly against the con-
exempt the fiduciary from the Prudent Man Rule, venience of inertia:
so where a fiduciary retains assets it must exercise
prudence in doing so. Trustees’ problems with investments are not over once
they have formulated their strategy and acquired their
Where the trust estate does include assets derived portfolio. Shares carry rights, and part of the duty of
from the settlor, the ‘more relaxed’ attitude will trustees is to decide how to exercise the voting and
extend only so far as to treating them as authorized. other rights attached to the trust fund securities.
There will be no relaxation in the standard of The proper discharge of this duty today by trustees
vigilance required to ensure that their retention of large funds must require more than deciding how
does not become imprudent.129 to vote on routine resolutions put before shareholders
Because, as Berry V-C held, in the Court of at annual general meetings by the directors. Inertia
Chancery of New Jersey, in Dickerson v Camden is a comfortable pillow, but it is not available to trustees.
Trust Co,130 ‘retaining investments is in effect
making them’, review is not an end in itself.
Thus, in Estate of Rodney B. Janes,131 the New York Each trustee carries full responsibility
Surrogate Judge held also that:
Each trustee must consider the matter and make up
Notwithstanding turbulent worldwide economic his or her mind. ‘A fiduciary’s independent investi-
conditions including an OPEC oil, embargo, all of gation of the merits of a particular investment is
which resulted in a monumental and precipitous at the heart of the prudent person standard.’133
128. 214 NYLJ 31 (5 July 1995).

129. See the discussion under ‘Where the settlor wants all the trust eggs in one basket, the trustee had better watch the basket closely,’ p. 535 above.
130. 140 NJ Eq 34, 42; A 2d 225, 231 (1947).
131. 214 NYLJ 31 (5 July 1995).
132. ‘Trustees and their Broader Community: Where Duty, Morality and Ethics Converge’ (1996) Australian LJ 205, 214,
133. Meyer v Berkshire Life Insurance Company 250 F Supp 2d 544, 566 (2003).
So, in Re Mulligan,134 the New Zealand High Court The safer course for the Trustees, or for those of
held that: them on either side of the disagreement, is to apply
to the court for directions as in In the Matter of
upon entering office each individual trustee has a Repus Trust and Trustcorp Ltd.136
separate responsibility to ensure that the terms of the
trust are carried out. It is not open for one trustee to
Consequences of unauthorized investment
defer to the wishes of another trustee in the absence of
but for which the trust estate would not have
proper reasons for doing so.
suffered
As the decision in that case compellingly illustrates, Within the ‘limits of what was committed’137 to her,
there cannot be a ‘proper reason’ for minority trustees no exercise of a trustee’s power will be set aside just
to permit the majority to make decisions ‘at which no because the court would have done it differently
reasonable body of trustees could arrive’. Just as itself,138 or even just because of ‘gross negligence
‘getting along, by going along’ is fiduciary anathema, [or] honest blundering or carelessness’ on her part.139
resignation to clear a path for a breach of trust is However, those limits are critical. The common law
itself a breach of trust.135 It is not an option for the requires power holders to exercise their powers for
minority. the purposes for which they were conferred.140
134. [1998] 1 NZLR 481, 502.

135. Retirement is itself an act done as trustee. If it is done without due regard to the safety of the trust estate, the resigning trustee is liable: cf Head v Gould
[1898] Ch 250, 268–269 (Kekewich J). See also Professor Waters’ ‘The Protector: New Wine in Old Bottles’, in Oakley (ed) Trends in Contemporary Trust Law
(Clarendon Press, Oxford, 1996) 63, 84–85.
136. Jersey Royal Court, Samedi Division, [2005] JRC 081,15 June 2005. Considered under ‘Where the settlor wants all the trust eggs in one basket, the trustee
had better watch the basket closely,’ p. 535 above.
Waters, ‘The Protector: New Wine in Old Bottles?’, in Oakley (ed) Trends in Contemporary Trust Law (Clarendon Press, Oxford, 1996) 63, 84–85 states
the relevant principles with characteristic insight:
If under the terms of the trust the opinion of a majority of the trustees, or of one particular trustee (for instance, the spouse of the testator or settlor),
is to prevail in the event of a difference between the trustees, the minority or the cotrustees in the case of the particular trustee have a duty to bring the
matter before the court if they reasonably entertain the view that the contemplated action or inaction of the majority, or of the particular trustee,
constitutes a breach of trust. At this point, of course, we are essentially concerned with administrative powers, but breach will not always exist. If the
minority trustees merely cannot agree with a decision that is both authorized by the instrument and is within the range of what is reasonable, they are
required to lend their formal approval to necessary documentation and other procedural requirements for the carrying out of the decision. In any
minutes of meetings they may also have their dissent recorded.
It is in this way that the case law introduces a balance between the stalemate in decision-making that might otherwise occur, possibly to the injury of
the beneficiaries, and the danger that the substance of the disagreement involves action or inaction that in fact constitutes breach. Again, breach may
cause injury and loss to the trust beneficiaries. The role of the minority or of the co-trustees when it is a particular trustee who has the exclusive power
is to ensure that decisions dictated to them are those which a court would permit trustees to take, whatever the court itself might have decided in
the circumstances.
...
The paramount duty of the trustee remains that, if he cannot prevent by his vote what he understands to be breach or possible breach, he applies to the
court for advice and directions. If conduct is about to be perpetrated that will imperil the beneficiaries’ best interests, he does not think first how
he can avoid any blame.
137. Dundee General Hospitals Board of Management v Walker [1952] 1 All ER 896, 901G per Lord Normand (HL, Sc).
138. See, e.g., Re Londonderry’s Settlement [1965] Ch 918, 936G where Salmon LJ said ‘Whether or not the court, if it knew all the facts known to the trustees,
would have acted as they did, again I do not know—nor is it material.’ See also Karger v Paul [1984] VR 161, 165 (McGarvie J).
139. Karger v Paul [1984] VLR 161, 164 (McGarvie J).
140. In Equitable Life Assurance Society v Hyman, [2000] 3 WLR 529, 540–541, Lord Cooke made his speech ‘starting from the principle that no legal discretion,
however widely worded . . . , can be exercised for purposes contrary to those of the instrument by which it is conferred.
As Lord Woolf MR pointed out in his judgment in the Court of Appeal in this case [2000] 2 WLR 798, 806, this principle is common to administrative law
(eg Padfield v Minister of Agriculture, Fisheries and Food [1968] AC 997) and sundry fields of private law (eg Howard Smith Ltd v Ampol Petroleum Ltd [1974]
AC 821). In an administrative law context, violation of the principle may result in no more than invalidity; in a contractual context, it may result in a breach
of contract, which should be rectified.’
His Lordship’s chosen private law illustration involved a fiduciary power. In Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821, 834, the Privy
Council was concerned with the directors’ power to issue company shares:
Thus, and this is not disputed, the issue was clearly intra vires the directors. But, intra vires though the issue may have been, the directors’ power
under this article is a fiduciary power: and it remains the case that an exercise of such a power though formally valid, may be attacked on the ground
that it was not exercised for the purpose for which it was granted.
‘Equity follows the law, but not slavishly nor Writing extra-curially, Millett LJ has explained the
always’,141 and requires trustees to act ‘honestly’142 position with characteristic force:
[also the requirement of the statutory relief provi-
sion143] and within the limits set by the terms in It is misleading to speak of breach of trust as if it
which the power was created. were the equitable counterpart of breach of contract
So, a trustee who pays the trust estate away on at common law; or to speak of equitable compensa-
an unauthorized investment, is in breach of trust. tion for breach of fiduciary duty as if it were common
Because ‘the most important duty of the trustee is law damages masquerading under a fancy name. Forty
to obey the terms of the trust’,144 that trustee is not years ago, the Chancery Judges bore down heavily on
permitted to debit that payment to the account of the such solecisms. Woe betide a Chancery Junior who
trust estate.145 But for his unauthorized payment, the spoke of ‘damages for breach of trust’ or ‘damages
trust estate would have continued to reflect its value: for breach of fiduciary duty’. The judges knew that
which he therefore must restore fully as at the date misuse of language often conceals a confusion of
of the restoration. thought. Nowadays these misleading expressions
141. Graf v Hope Building Corp 254 NY 1, 9 (1930) per Cardozo J (dissenting: New York Court of Appeals).
In Canson Enterprises Ltd v Broughton & Co [1991] 3 SCR 534, 543, McLachlin J, in the Supreme Court of Canada, pointed out that ‘the
basis of the fiduciary obligation and the rationale for equitable compensation are distinct from the tort of negligence and contract. In negligence and
contract the parties are taken to be independent and equal actors, concerned primarily with their own self-interest. Consequently the law seeks a balance
between enforcing obligations by awarding compensation and preserving optimum freedom for those involved in the relationship in question, communal or
otherwise. The essence of a fiduciary relationship, by contrast, is that one party pledges itself to act in the best interest of the other. The fiduciary
relationship has trust, not self-interest, at its core, and when breach occurs, the balance favours the person wronged.’ The High Court of Australia cited
this approvingly in Youyang Pty Ltd v Minter Ellison Morris Fletcher (2003) 212 CLR 484, 501.
In Norberg v Wynrib [1992] 2 SCR 226, 272, her Honour repeated that ‘the foundation and ambit of the fiduciary obligation are conceptually distinct
from the foundation and ambit of contract and tort. Sometimes the doctrines may overlap in their application, but that does not destroy their conceptual
and functional uniqueness. In negligence and contract the parties are taken to be independent and equal actors, concerned primarily with their own self-
interest. Consequently, the law seeks a balance between enforcing obligations by awarding compensation when those obligations are breached, and
preserving optimum freedom for those involved in the relationship in question. The essence of a fiduciary relationship, by contrast, is that one party
exercises power on behalf of another and pledges himself or herself to act in the best interests of the other.’
But in Day v Mead [1987] 2 NZLR 443, 462, the New Zealand Court of Appeal reduced an award against a fiduciary to reflect a ‘want of care for his
own property’ [Somers J] on the part of the beneficiary.
On the other hand, again in Norberg v Wynrib [1992] 2 SCR 226, 295, McLachlin J, in the Supreme Court of Canada, held that, in awarding
compensation, ‘the same generous, restorative remedial approach, which stems from the nature of the obligation in equity, applies. The fiduciary, being the
person with the advantage of power, assumes full responsibility and cannot be heard to complain that the victim of his or her abuse cooperated in his or
her defalcation or failed to take reasonable care for his or her own interests.’
In like vein, in Pilmer v Duke Group Ltd (2001) 207 CLR 165, 201 McHugh, Gummow, Hayne, and Callinan JJ noted that ‘contributory negligence
focuses on the conduct of the plaintiff, fiduciary law upon the obligation by the defendant to act in the interests of the plaintiff.’
142. ‘Honesty’ and ‘bona fide’ are synonymous: Karger v Paul [1984] VR 161, 164 (McGarvie J). Haydon and Leeming Jacobs’ Law of Trusts in Australia, 2006,
7th edn, para 1608.
The standard of ‘honesty’ is that of a sane and rational person: cf Hutton v West Cork Railway Co (1883) 23 Ch D 654, 671, 672–673,
where, in considering the bona fides of the provision of gratuities to directors and staff of a company—‘no cakes and ale except such as are
required for the benefit of the company’, as he famously held—Bowen LJ observed that ‘Bona fides cannot be the sole test, otherwise you might
have a lunatic conducting the affairs of the company, and paying away its money with both hands in a manner perfectly bona fide yet perfectly
irrational.
Cf Millett LJ in Armitage v Nurse [1998] Ch 241, 251, holding that ‘a deliberate breach of trust is not necessarily fraudulent. Hence the remark famously
attributed to Selwyn LJ by Sir Nathaniel Lindley MR in the course of argument in Perrins v Bellamy [1899] 1 Ch 797, 798:
My old master, the late Selwyn LJ, used to say, ‘The main duty of a trustee is to commit judicious breaches of trust’. The expression ‘actual fraud’ in
clause 15 is not used to describe the common law tort of deceit. As the judge appreciated it simply means dishonesty. I accept the formulation put
forward by Mr Hill on behalf of the respondents which (as I have slightly modified it) is that it: ‘. . . connotes at the minimum an intention on the part
of the trustee to pursue a particular course of action, either knowing that it is contrary to the interests of the beneficiaries or being recklessly
indifferent whether it is contrary to their interests or not.’ It is the duty of a trustee to manage the trust property and deal with it in the interests of the
beneficiaries. If he acts in a way which he does not honestly believe is in their interests then he is acting dishonestly. It does not matter whether
he stands or thinks he stands to gain personally from his actions. A trustee who acts with the intention of benefiting persons who are not the objects
of the trust is not the less dishonest because he does not intend to benefit himself.
143. Trustee Act 1925 s 61.

145. Hayton et al, Underhill & Hayton: Law Relating to Trusts and Trustees (Butterworths, London, 2006), 17th edn 89.1(1), 89.3 say that his account must be
falsified to delete the unauthorized payment.
are in common use. It is time that the usage was complains that the trustee has misapplied trust
146
stamped out. money, he falsifies the account, that is to say, he
asks for the disbursement to be disallowed. If, for
Lord Diplock has said that a contracting party is example, the trustee lays out trust money in an
under a primary obligation to perform his contract unauthorized investment which falls in value, the ben-
and a secondary obligation to pay damages if he eficiary will falsify the account by asking the court to
does not [Moschi v Lep Air Services Ltd [1973] AC disallow both the disbursement and the corresponding
331]. It is tempting, but wrong, to assume that a trus- asset on the other side of the account. The unauthor-
tee is likewise under a primary obligation to perform ized investment will then be treated as having been
the trust and a secondary obligation to pay equitable bought with the trustee’s own money and on his
compensation if he does not. The primary obligation own behalf. He will be required to account to the
of a trustee is to account for his stewardship. The trust estate for the full amount of the disbursement—
primary remedy of the beneficiary—any beneficiary not for the amount of the loss. That is what is meant by
no matter how limited his interest—is to have the saying that the trustee is liable to restore the trust
account taken, to surcharge and falsify the account, property; and why common law rules of causation
and to require the trustee to restore to the trust estate and remoteness of damage are out of place.
any deficiency which may appear when the account is
taken. The liability is strict. The account must he If the unauthorized investment has appreciated in
taken down to the date on which it is rendered. value, then the beneficiary will be content with it.
That is why there is no question of ‘stopping the He is not obliged to falsify the account which the
clock’.147 trustee renders; he can always accept it. . . . Where
the beneficiary accepts the unauthorized investment,
... he is often said to affirm or adopt the transaction.
That is not wholly accurate. The beneficiary has a
148
Target Holdings Ltd v Redferns was concerned with right to elect, but it is merely a right to decide whether
the other side of the account. Where the beneficiary to complain or not.
146. Cf Rickett, ‘Equitable Compensation: Towards a Blueprint?’ [2003] Sydney Law Review 3: ‘Professor Michael Tilbury has written that ‘‘[e]quitable
compensation seems to have a secure function in modern law due to the absence of an alternative for the compensation of breaches of equitable rights’’.
[Michael Tilbury, ‘Equitable Compensation’ in Patrick Parkinson (ed), Principles of Equity (1996) at 814.] He further suggested that:
[T]here will be a tendency, wherever possible, to equate the principles applicable to equitable compensation . . . with the rules relating to damages
which have been well developed at law. This is a natural development in a post-judicature world. Its danger is that it may lead to a failure to appreciate
the operation, in appropriate contexts, of traditional equitable principles which, in the circumstances of the particular case, more appropriately
mirror the equitable right breached.’ [Ibid]
In the first flush of innocence and excitement, there was something of a rush in Canada and New Zealand towards wholesale integration of equitable
compensation with the common law of damages by simple adoption of common law principles and rules. . . . England and Australia were much more
measured, as befits the much keener awareness in those jurisdictions of the doctrinal and historical dimensions of the core of equity jurisprudence.
‘Compensation’ was understood to be limited and plaintiff-friendly because it was essentially ‘restitutionary’.
Gradually, however, it has come to be appreciated that, although in general terms the peculiarity of equity must not be overlooked, the fundamental
point is to examine carefully the type and content of any equitable duty allegedly breached, and the nature of that breach. From that examination
should flow the answer to how equity will compensate in any case. And so, custodial fiduciary duties can be enforced by performance orders, including
in some cases orders for money payments, and their breach can be remedied by a range of orders, including in some cases orders for reparative
compensation for loss caused to the estate. The process of compensating is girded by strict rules that cohere with the nature of the duties. Loss caused
by breaches of non-custodial fiduciary duties is also compensable, but only by reparation. Strict compensation rules also apply here, not because
equitable compensation is automatically strict, but because coherence of response with the nature of the duties breached requires those strict rules.
That equitable compensation is not per se automatically strict is most clearly seen in the case of compensation for breaches of duties of care and skill,
where there simply would be no coherence between duty and response if a strict regime were adopted. Compensating in equity for loss caused by
breach of obligations originating in equity is a process, as is compensating at common law for loss caused by breach of obligations originating in the
common law. How can it possibly be otherwise? The consequence is that the rules that equity develops for dealing with compensating for loss caused
by breaches of the other equitable duties identified in Part 1 of this paper will be sensitive to the need for coherence between the duty and
the reparative compensatory response.
147. Cf Target Holdings Ltd v Redfern [1996] AC 421, 437 per Lord Browne-Wilkinson.
148. [1996] AC 421 (HL)
Where the beneficiary accepts the unauthorized would have been avoided, but for the trustee’s
investment, the account must he taken as if the invest- breach. As long as they can do that, it is not open
ment were fully authorised in every respect. The to the trustee to claim that the loss really had been
investment is shown as a trust asset and the cost of caused by some unforeseeable intervening factor such
acquisition as an authorised disbursement. But the as the value of the Australian currency dropping
converse is equally true. Where the beneficiary elects below that of the New Zealand currency, as in
to falsify the account, the unauthorized investment is Re Dawson (deceased); Union Fidelity Trustee Co Ltd
not shown as an asset, the disbursement is disallowed, v Perpetual Trustee Co Ltd.154 In that case it sufficed
and the trustee is accountable in every respect as if he that, but for the trustee’s breach, the New Zealand
had not disbursed the money. He is liable to restore estate would not have been deprived of the funds.
the money to the trust estate; as notionally restored it As Professor Rickett has described it:155
remains subject to all the trusts powers and provisions
of the trust as if it had never been disbursed; and the defendant was a defaulting custodial fiduciary who
149
the account is taken accordingly. had control over assets that formed a trust estate,
ie, the equitable obligations of the trustee to the plain-
Thus, where the beneficiaries do not elect to accept tiff beneficiaries related to an estate. Thus, the relief
the unauthorized investment, and the trustee’s sought was substitutive compensation. The primary
account is falsified, her expenditure on the investment liability of the defaulting fiduciary was to restore the
is treated as having been from her own funds.150 The property in specie. If that were not possible, then the
proceeds of any resale are to her credit.151 Equity then monetary compensation payable in lieu (which might
awards against her such sum of compensation as may be termed equitable compensation) must reflect the
be required to fully restore the trust estate to the economic position had restoration in specie been
condition in which it would have stood but for possible. This was not a case where reparative
her breach.152 compensation was being sought, no matter the loose
references to ‘breach’ or ‘loss’.
The principles embodied in this approach do not
appear to involve any inquiry as to whether the loss Street J held that:156
was caused by or flowed from the breach. Rather the
inquiry in each instance would appear to be whether The form of relief is couched in terms appropriate to
the loss would have happened if there had been require the defaulting trustee to restore to the estate
no breach.153 the assets of which he deprived it. Increases in market
values between the date of breach and the date of
Of course, that assumes that the beneficiaries can recoupment are for the trustee’s account: the effect
show a loss that would not have occurred, or that of such increases would, at common law, be excluded
149. ‘Equity’s Place in the Law of Commerce’ (1998) 114 LQR 214, 225–227. See also Lord Millett’s ‘Proprietary Restitution’’ in Degeling and Edelman (eds)
Equity in Commercial Law (Lawbook Co, Sydney, 2005), 309, 310–311.
150. Millett LJ, ‘Equity’s Place in the Law of Commerce’ (1998) 114 LQR 214, 226; Hayton et al, Underhill & Hayton: Law Relating to Trusts and Trustees
(Butterworths, London, 2006), 17th edn 89.2–89.6; 89.36.
151. This follows from Millett LJ, ‘Equity’s Place in the Law of Commerce’ (1998) 114 LQR 214, 226. See also Hayton et al, Underhill & Hayton: Law Relating to
Trusts and Trustees (Butterworths, London, 2006), 17th edn 89.2–89.6; 89.35, and Street J in Re Dawson (deceased); Union Fidelity Trustee Co Ltd v Perpetual Trustee
Co Ltd [1966] 2 NSWLR 211, 216: ‘Increases in market values between the date of breach and the date of recoupment are for the trustee’s account: the effect of such
increases would, at common law, be excluded from the computation of damages; but in equity a defaulting trustee must make good the loss by restoring to the
estate the assets of which he deprived it notwithstanding that market values may have increased in the meantime.
152. Norberg v Wynrib [1992] 2 SCR 226, 295 per McLachlin J (Supreme Court, Canada).
153. Re Dawson (deceased); Union Fidelity Trustee Co Ltd v Perpetual Trustee Co Ltd [1966] 2 NSWLR 211, 215.
154. [1966] 2 NSWLR 211.
155. ‘Equitable Compensation: Towards a Blueprint?’ [2003] Sydney Law Review 3.
156. [1966] 2 NSWLR 211, 216.
from the computation of damages; but in equity representative, acting strictly within the line of his
a defaulting trustee must make good the loss by duty, and exercising reasonable care and diligence,
restoring to the estate the assets of which he deprived will not be responsible for the failure or depreciation
it notwithstanding that market values may have of the fund in which any part of he estate may he
increased in the meantime. The obligation to restore invested, . . . yet, if that line of duty be not strictly
to the estate the assets of which he deprived it pursued, and any part of the property be invested by
necessarily connotes that, where a monetary compen- such personal representative in funds or upon securi-
sation is to be paid in lieu of restoring assets, that ties not authorised, or be put within the control of
compensation is to be assessed by reference to the persons who ought not to be intrusted with it, and a
value of the assets at the date of restoration and not loss be thereby eventually sustained, such personal
at the date of deprivation. In this sense the obligation representative will be liable to make it good, however
is a continuing one and ordinarily, if the assets are for unexpected the result, however little likely to arise
some reason not restored in specie, it will fall for from the course adopted, and however free such conduct
quantification at the date when recoupment is to may have been from any improper motive. Thus, if he
be effected, and not before. omit to sell property when it ought to be sold, and it be
afterwards lost without any fault of his, he is liable;
157
The award is one of substitutive performance: . . . or if he leave money due upon personal security,
i.e. the payment of money, including interest,158 as which, though good at the time, afterwards fails . . . .
a substitute for performance of the trustee’s core And the case is stronger if he be himself the author of
duty159 of staying within the terms of the trust:160 the improper investment, as upon personal security, or
an unauthorized fund.
As against a trustee who, on the accounts being taken,
is shewn to have improperly applied part of the trust The strict approach of equity to substitutive compen-
estate, the right of a cestui que trust is to have those sation is necessary to protect the trust estate from
accounts set straight—that is, to compel the trustee dealings in breach of trust. It reflects the exclusive
to pay such a sum as will make them balance.161 jurisdiction of equity to enforce:
Compensation under this head effects restoration of those duties which are special to fiduciaries and which
the trust estate: making not only the ‘common law attract those remedies which are peculiar to the equi-
rules of causation and remoteness of damage’— table jurisdiction and are primarily restitutionary or
mentioned by Millett LJ in the passage just cited— restorative rather than compensatory. A fiduciary is
out of place, but also rendering irrelevant negligence, someone who has undertaken to act for or on behalf
contributory negligence, and dishonesty.162 of another in a particular matter in circumstances
Thus, as Lord Lyndhurst LC put it in Clough v which give rise to a relationship of trust and confi-
Bond163 dence. The distinguishing obligation of a fiduciary is
the obligation of loyalty. The principal is entitled to
It will be found to be the result of all the best autho- the single-minded loyalty of his fiduciary. This core
rities upon the subject, that, although a personal liability has several facets. A fiduciary must act in
157. Rickett, ‘Equitable Compensation: Towards a Blueprint?’ [2003] Sydney Law Review 3, citing Dr Steven Elliott’s Oxford D Phil thesis Compensation Claims
Against Trustees.
158. Hayton et al, Underhill & Hayton: Law Relating to Trusts and Trustees (2006) 17th edn 89.37.
159. Hayton et al, Underhill & Hayton: Law Relating to Trusts and Trustees (2006) 17th edn 89.8ff.
161. Head v Gould [1898] 2 Ch 250, 266 (Kekewich J)
162. Hayton et al, Underhill & Hayton: Law Relating to Trusts and Trustees (Butterworths, London, 2006), 17th edn 89.10.
163. (1838) 3 My & Cr 490, 496; 40 ER 1016.
good faith; he must not make a profit out of his trust; It is inherent in what I have already written that the
he must not place himself in a position where his existence of the same relationship between the parties
duty and his interest may conflict; he may not act ie trustee and beneficiary, does not mandate that the
for his own benefit or the benefit of a third person same approach to causation and remoteness should
without the informed consent of his principal. This be taken in all cases irrespective of the nature of the
is not intended to be an exhaustive list, but it is breach. In the first kind of case the allegation is that
sufficient to indicate the nature of fiduciary obliga- a breach of duty by a trustee has directly caused loss of
tions. They are the defining characteristics of the or damage to the trust property. The relief sought by
fiduciary. . . . the beneficiary is usually in such circumstances of
a restitutionary kind. The trustee is asked to restore
... the trust estate, either in specie or by value. The policy
of the law in these circumstances is generally to hold
The nature of the obligation determines the nature of the trustee responsible if, but for the breach, the loss
the breach. The various obligations of a fiduciary or damage would not have occurred. This approach is
merely reflect different aspects of his core duties of designed to encourage trustees to observe to the full
loyalty and fidelity. Breach of fiduciary obligation, their duties in relation to the trust property by
therefore, connotes disloyalty or infidelity. Mere imposing upon them a stringent concept of causation.
incompetence is not enough. A servant who loyally Questions of foreseeability and remoteness do not
does his incompetent best for his master is not unfaithful come into such an assessment.
and is not guilty of a breach of fiduciary duty.164
In the second kind of case, the trustee or other fidu-
As Tipping J held in the New Zealand Court of ciary has committed a breach of duty which involves
Appeal in Bank of New Zealand v Guardian Trust an element of infidelity or disloyalty engaging the
Co Ltd:165 fiduciary’s conscience—what might be called a true
breach of fiduciary duty. In . . . such a case once the
Although the relationship between the parties can plaintiff has shown a loss arising out of a transaction
properly be described as one of trustee and benefi- to which the breach was material, the plaintiff is
ciary, that relationship does not in and of itself dictate entitled to recover unless the defendant fiduciary,
how the law should determine issues of causation and upon whom is the onus, shows that the loss or
remoteness. Breaches of duty by trustees and other damage would have occurred in any event, ie without
fiduciaries may broadly be of three different kinds. any breach on the fiduciary’s part. Questions of fore-
First, there are breaches leading directly to damage seeability and remoteness do not arise in this kind of
to or loss of the trust property; second, there are case either. Policy dictates that fiduciaries be allowed
breaches involving an element of infidelity or disloy- only a narrow escape route from liability based on
alty which engage the conscience of the fiduciary; proof that the loss or damage would have occurred
third, there are breaches involving a lack of appropri- even if there had been no breach.
ate skill or care. It is implicit in this analysis that
breaches of the second kind do not involve loss or In the third kind of case, the relationship of trustee
damage to the trust property, and breaches of the (or fiduciary) and beneficiary is, in a sense, incidental.
third kind involve neither loss to the trust property, It provides the setting in which the breach of duty
nor infidelity or disloyalty. occurs, and with it such tortious proximity or
164. Bristol & West Building Society v Mothew [1998] Ch 1, 16–18 (CA). Emphases added.
165. [1999] 1 NZLR 664, 686–687.
contractual privity as may be necessary. The duty to solicitors held the plaintiff’s money in trust to pay it
take care is one which arises as an incident of the out—in exchange for a mortgage charging a particu-
relationship, but for the purpose of determining the lar property—to enable the payee to buy the property.
proper approach to causation and remoteness, it is In June 1989, the solicitors paid it out without
the failure to take care which is the material dimen- having arranged the execution of the mortgage.
sion, not the fact that the relationship also creates At that stage, the solicitor had made ‘an unauthorized
duties of a fiduciary kind. Those duties are not rele- application of trust money which entitled the plaintiff
vantly engaged. It is unnecessary for me to cite the to falsify the account. The disbursement must be dis-
various authorities which support this analysis; they allowed and the solicitor treated as accountable as
are identified in Gault J’s judgment. The approach of if the money were still in his client account and
the law to the linked questions of causation and available to be laid out in the manner directed.’167
remoteness is influenced by the nature of the wrong ‘The payment was a breach of trust; the solicitor
which the defendant has committed. If it is a wrong was strictly liable in equity to restore the trust prop-
engaging the conscience of the wrongdoer, what has erty; and he could not invoke common law rules
sometimes been called fraud in equity, a stricter about causation and remoteness of damage to limit
approach is justified. That corresponds with the posi- his liability.’168 In particular, the solicitors would not
tion when there is fraud in the common law sense, at have been able to claim that they should not be fully
least as far as some of the more recent authorities are liable because, even if they had secured the mortgage,
concerned. In such cases the greater moral turpitude the plaintiff’s recovery would have been reduced by
of the wrongdoer supports a restitutionary ‘but for’ the impact of the recession that began in 1991
approach, at least on a prima facie basis. But where the and afflicted the UK economy, and property market,
wrong amounts in substance to carelessness or breach until the autumn of 1992.
of contract, the policy considerations underpinning However, the mortgage was executed the following
the stricter approach are absent. Hence, whatever the month. Only with that event was the ‘underlying
classification of the relationship, the law approaches commercial transaction completed’.169 With that
the questions of causation and remoteness on a completion, the plaintiff:170
different and generally less onerous basis; namely
whether there is a sufficient causal nexus and also had obtained exactly what it would have obtained if
foreseeability or reasonable contemplation of loss no breach of trust had occurred, viz, a valid security
or damage of the kind in suit. for the sum advanced. In the absence of fraud, there
was no warrant for awarding equitable compensation
for the loss occasioned by the inadequacy of the
security, let alone the fall in the property market,
Losses coinciding with unauthorized investment
since neither loss was attributable to the relevant
but which would have occurred independently
breach of duty.
of the trustee’s breach
If he would have incurred the loss even if the trustee This was eminently satisfactory. It put right the error
had not transgressed the limits of what had been which the Court of Appeal had made in failing to
committed to her, a beneficiary’s claim will fail. In identify the relevant breach of trust, which was not
Target Holdings Ltd v Redferns,166 the defendant in parting with the money but in failing to obtain
166. [1996] AC 421 (HL)

167. Millett LJ, ‘Equity’s Place in the Law of Commerce’ (1998) 114 LQR 214, 227.
169. Target Holdings v Redfern [1996] AC 421, 436.
170. Millett LJ, ‘Equity’s Place in the Law of Commerce’ (1998) 114 LQR 214, 223–224.
the title deeds in return. This put the trust fund at trust money is held.’174 While competence is the duty
risk—but the risk did not materialise. of a fiduciary, it is not a fiduciary duty. On
Prof. Finn’s acclaimed analysis:
From being still notionally in the defendant solicitors’
‘client account and available to be laid out in the It is not the case that the pure negligence of a lawyer,
manner directed,’171 the sum advanced by the an agent’s excess of authority, a partner’s breach of the
plaintiff had become: partnership contract or a trustee’s improvident invest-
ment is, as such, a breach of fiduciary duty, no matter
so laid out. The plaintiff could not object to the how harmful to the interests of the client, the princi-
acquisition of the mortgage or the disbursement by pal, etc. If no issue of disloyalty is involved, such
which it was obtained; it was an authorised applica- matters will be actionable through those primary
tion of what must be treated as trust money notionally bodies of law which constitute or govern the ordinary
restored to the trust estate on the taking of the incidents of the relationship in question—negligence,
account. To put the point another way; the trustee’s breach of contract or breach of trust.175
obligation to restore the trust property is not an
obligation to restore it in the very form in which he Equity, therefore, has no exclusive interest in ‘malad-
disbursed it, but an obligation to restore it in any ministration’ such as the authorized but ‘imprudent
form authorised by the trust.172 exercise of a power . . . of investment by failure to
employ the care and diligence which equity
Consequences of authorized, but negligent, requires.’176 Accordingly, it follows the law. In that
investment173 case, the position is as Millett LJ describes it here:177
Although ‘an unauthorized investment of trust If the beneficiary is dissatisfied with the way in which
money is still a breach of trust’, nonetheless ‘trustee the trustee has carried out his trust—if, for example,
investment powers are not part of the trusts on which he considers that the trustee has negligently failed to
173. See Getzler, ‘Duty of Care’, in Birks and Pretto, Breach of Trust (Hart Publishing, Oxford, 2002), 41–74.
175. ‘The Fiduciary Principle’ in Youdan (ed) Equity, Fiduciaries and Trusts (Carswell, Toronto, 1989) 1, 27–28. See also Getzler, ‘Duty of Care’ in Birks and
Pretto (eds) Breach of Trust (Hart Publishing, Oxford, 2002), 41, 71; Millett LJ, ‘Equity’s Place in the Law of Commerce’ (1998) 114 LQR 214, 226 (‘Although he is a
fiduciary, [the trustee’s] duty of care is not a fiduciary duty.’]; and the New Zealand Court of Appeal in Bank of New Zealand v New Zealand Guardian Trust Co Ltd
[1999] 1 NZLR 664, 686–687.
177. ‘Equity’s Place in the Law of Commerce’ (1998) 114 LQR 214, 225–227.
See also Millett LJ in Bristol & West Building Society v Mothew [1998] Ch 1, 17 (CA) [Cited approvingly by the High Court of Australia in Youyang Pty
Ltd v Minter Ellison Morris Fletcher (2003) 212 CLR 484, 500]:
Although the remedy which equity makes available for breach of the equitable duty of skill and care is equitable compensation rather than damages,
this is merely the product of history and in this context is in my opinion a distinction without a difference. Equitable compensation for breach of the
duty of skill and care resembles common law damages in that it is awarded by way of compensation to the plaintiff for his loss. There is no reason in
principle why the common law rules of causation, remoteness of damage and measure of damages should not be applied by analogy in such a case.
It should not be confused with equitable compensation for breach of fiduciary duty, which may be awarded in lieu of rescission or specific restitution.
Furthermore, Lord Millett’s ‘Proprietary Restitution’ in Degeling and Edelman (eds) Equity in Commercial Law (Lawbook Co, Sydney, 2005), 309, 310-311, and
McInnes’ ‘Account of Profits for Common Law Wrongs’ in the same volume at 405ff.
And see Rickett, ‘Equitable Compensation: Towards a Blueprint’ [2003] Sydney Law Review 3, referring to the text to which note 165 above is attached:
As Tipping J stated in Bank of New Zealand v New Zealand Guardian Trust Co Ltd [[1999] 1 NZLR 664 at 687], breaches of duty of care and skill
‘involve neither loss to the trust property, nor infidelity or disloyalty’. Where a failure to take care is the material dimension in an alleged breach of
duty, trust and fiduciary duties are ‘not relevantly engaged’. [Ibid 688] Gault J said that the ‘but for’ test of causation and remoteness was not
appropriate where there was a breach of a duty in equity of equivalent scope to duties owed in contract or tort, unless the breach was dishonest or
fraudulent. He stated:
That the liability arises in equity is no sufficient reason. Surely the stage has been reached in the development of the law where something
more substantial than historical origin is needed to justify disparate treatment in the law of those in breach of the obligation to exercise
reasonable care.
obtain all that he should have done for the benefit of the party who has breached the contract is liable to
178
the trust estate, then he may surcharge the account. compensate the injured party for all the loss which
He does this by requiring the account to be taken on that latter party has sustained, and even in the law
the footing of wilful default. In this context ‘wilful of torts the general principle is to make good the
default’ bears a special and unusual meaning; it loss to the injured party.
means merely lack of ordinary prudence or due
diligence [see, eg, Re Chapman [1896] 2 Ch 763]. The question, therefore, is what is meant in trust,
The trustee is made to account, not only for what contract, and tort law by compensation for loss or
he has in fact received, but also for what he might damage. The injured party in a contract action is
with due diligence have received. Since the trustee is, entitled to restitutio in integrum, and the integrum is
in effect, charged with negligence, and the amount by made up of those items of damage which at the time
which the account is surcharged is measured by of the breach were foreseeable, either in the nature of
the loss occasioned by his want of skill and care, the things or in the special circumstances of the parties.
analogy with common law damages for negligence is The injured party in a tort action is also entitled to
almost exact [see Henderson v Merrett Syndicates Ltd recover for all those items of damage which were fore-
[1995] 2 AC, 205 per Lord Browne-Wilkinson]. seeable at the time of the commission of the tort.
Although he is a fiduciary, his duty of care is not Items which were not foreseeable are said to be too
a fiduciary duty [see Permanent Building Society v remote. In both contract and tort, damages may be
Wheeler (1994) 14 ACSR 109, 157-158 per Ipp J reduced on the basis that the plaintiff did not act
approved in Bristol & West Building Society v reasonably to mitigate his loss. And in negligence,
Mothew [1997] 2 WLR 436, 448-449]. In this context damages may also be reduced on the ground that
it must be right to adopt the common law rules of the plaintiff was contributorily negligent.
causation and remoteness of damage to their fullest
extent. The trustee’s liability is enforced in the course In the law of trusts, however, remoteness of damage
of taking the trust account rather than by an action issues have not been canvassed. Following a practice
for damages, but the obligation of skill and care is begun in the old courts of equity, Equity was content
identical to the common law duty of care. to leave the liability of the breaching trustee on the
broad basis of liability to compensate for loss. There
The common law obligations are put in a nutshell was never any inquiry into mitigation, nor into
in Waters’ Law of Trusts in Canada:179 contributory negligence.
The principle of compensation for loss caused is not None of the common law rules relating to causation,
peculiar to the law of trusts. In the law of contract remoteness of damage, or—on the view in Day v
It followed, therefore, that an equivalent approach to causation and remoteness as applied in contract and tort ought to apply to the equitable
duty.
The rules for equitable compensation for loss in breach of duty of care cases will mirror to a considerable extent the rules developed for
damages awards at common law. Particular care may need to be exercised in determining whether the equitable duty of care has been assumed
in the circumstances or must be imposed. This distinction may itself determine whether a contract or tort model of damages is followed.
This subtlety was adverted to in Bank of New Zealand, but the Court of Appeal regarded it as unnecessary on the facts to draw a clear
distinction. Most of the central features of compensation awards at common law (eg, contributory negligence, duty to mitigate, exemplary
damages, aggravated damages) will be fundamental factors in compensation awards in equity. In the background, however, there will also be the
overriding discretion of the equitable jurisdiction, but this will very likely surface only in the rarest of cases. Indeed, the discretion ought
perhaps to wither away through disuse and a growing recognition that its retention simply perpetuates the historical jurisdictional divide
in a context where there are no legitimate policy or doctrinal grounds to do so. Any work that needs to be done to balance the position of
the plaintiff and the defendant, in pursuit of a just solution, can and ought to be done by the established principles, without appeal to
overriding discretion.
178. Hayton et al, Underhill & Hayton: Law Relating to Trusts and Trustees (Butterworths, London, 2006), 17th edn 89.3.
179. Waters et al, (Carswell, 2005), 3rd edn 1216–1217.
Mead180—contributory negligence, apply to substi- It would equally be an error for counsel to argue,
tutive performance claims in respect of breach of or for a court to decide, that a trustee who has
trust. invested in authorized investments, but who—by
It would therefore be an error, to the disadvantage failing to have regard to the necessity for maintaining
of the trust estate, for beneficiaries in a position to a balance between the income needs of a life tenant
assert a substitutive claim, for true breach of trust by and the interests of the remaindermen in at least
means of unauthorized investment, to bring it merely maintaining the capital—183has done so imprudently,
as a reparative claim based on negligence,181 when the was liable to the trust estate on the substitutive test
damages will lie only if the plaintiff can show that rather than on the tests for reparative compensation.
the breach of the duty of care was an operative Counsel in Re Mulligan (Deceased)184 appear to have
cause of the loss; and when the award will be subject made this error.
to contributory negligence, and failure to mitigate, The court, however, was not influenced by it.
and the claim itself will lie only for foreseeable It found the trustees to have been in breach of duty
loss—unlike the substitutive claim which is assessed by not having ensured that, by 1972, the estate had
speculatively, using hindsight, as at the time of been invested in equities to the extent of 40% [or
trial.182 $43,200] of the fund.185 On that basis, and making
180. [1987] 2 NZLR 443 (CA).

181. Hayton et al, Underhill & Hayton: Law Relating to Trusts and Trustees (Butterworths, London, 2006), 17th edn 89.38 say:
In Target Holdings Ltd v Redferns [[1994] AC 421, HL] the court endorsed Lord Cottenham’s views in Clough v Bond [(1838) 3 My & Cr 490 at
496-497] that if a trustee or personal representative invests funds in unauthorized securities or puts them within the control of persons who are not
authorised to be entrusted with them and a loss be sustained, then such trustee or personal representative will be liable to make it good, however
unexpected the result, however little likely to arise from the course adopted and however free such conduct may have been from any improper motive.
On this basis if trustees delegated management of their investment portfolio to a discretionary manager where not authorised to do so, then the
trustees would be automatically liable even if the loss in value of the portfolio was caused by an unforeseeable market crash. The beneficiaries could
therefore derive a significant advantage from framing their claim as a substitutive performance claim rather than as a reparation claim, in a case where
the trustee’s decision to delegate management of the trust portfolio is negligent as well as unauthorized. In such a case, their reparation claim
for breach of the trustee’s equitable duty of care would be subject to principles relating to causation, foreseeability and remoteness that would
not apply to their substitutive performance claim.
182. Re Dawson (deceased); Union Fidelity Trustee Co Ltd v Perpetual Trustee Co Ltd [1966] 2 NSWLR 211, 216; Canson Enterprises Ltd v Boughton & Co [1991]
3 SCR 534; Target Holdings Ltd v Redferns [1996] AC 421, 437 per Lord Browne-Williamson; Youyang Pty Ltd v Minter Ellison Morris Fletcher (2003) 212 CLR 484,
498–499.
183. Cf In re Pauling’s Settlement Trusts (No 2) [1963] Ch 576, 586, where Wilberforce J referred to the trustees’:
normal duty of preserving an equitable balance, and if at any time it was shown they were inclining one way or the other, it would not be a difficult
matter to bring them to account.
In Nestle v National Westminster Bank [1993] 1 WLR 1260, 1279, Staughton LJ cited that dictum and continued:
At times it will not be easy to decide what is an equitable balance. A life tenant may be anxious to receive the highest possible income, whilst the
remainderman will wish the real value of the trust fund to be preserved. If the life tenant is living in penury and the remainderman already has ample
wealth, common sense suggests that a trustee should be able to take that into account, not necessarily by seeking the highest possible income at
the expense of capital but by inclining in that direction. However, before adopting that course a trustee should, I think, require some verification
of the facts.
184. [1998] 1 NZLR 481, 507–508.

185. [1998] 1 NZLR 481, 509. Professors Thomas and Hudson, The Law of Trusts (Oxford, 2004) comment on this approach at paras 52.28, and say at 52.29 that:
A more appropriate approach would be to break the test down into two questions. The first question is to consider what form of investment strategy the
trustees should have adopted when compared to funds of a similar size and nature. The second further question then requires a mathematical measurement
of the return which would have been generated by a reasonable fund of the type identified in answer to the first question. The first question ensures that the
trustees’ investment decisions are being evaluated according to the nature of their trust before any finding of a breach of duty is made against them.
However, if the first question were taken to be whether or not the trustees measured up to an average return on investment, then it can be supposed
that something approaching half of the participants in the market place will necessarily appear to have failed to generate an average market return
(that is because an average will generally be greater than half the sample and less than the other half of the sample) and so be potentially liable to their
customers for breach of some duty of competence. A test which prioritizes mathematical matters over matters of strategy and context, as in this first
question, will necessarily increase the incidence of liability for trustees and so encourage those trustees always to invest more adventurously so as to
generate a return on capital which will place them in the top half of the market place’s league table. This, it is suggested, would be contrary to the
prudence which is typically expected from trustees, in balance with any duty to achieve a good return. In the first part, the question of size indicates
the number of investments which could be compiled into a portfolio and also how diverse those investments could be, given that a large fund permits
more investments to be acquired than a small fund; and the nature of the investment strategy covers matters such as the level of risk inherent in the
investments, whether the investors wish to invest for long- or short-term return, and how risk averse are the investors. The second part, informed by
the first, gives a better approximation, it is suggested, of the mean return of participants in the circumstances of the trustees at issue.
all the usual allowances for contingencies, and for plus compound interest from that date until the
such matters as transaction costs in respect of a date of judgment, less dividends and other income
certain level of periodic shuffling of the portfolio, attributable to the wrongly retained assets;192
the High Court held that it had been foreseeable less the proceeds of the sale of the stock (or the
that the $43,200 could have been increased at least value of any unsold stock at the date of the
to $170,640. Judgment accordingly was given against accounting);
the trustees personally: effectively surcharging186 plus post-judgment interest, and costs.
them with the difference between those sums, plus
six years’ interest at 8%. The court also falsified the $326,302.66 which the
In the other case of failure to diversify which trustee had charged as commission, and for legal
has been referred to above, Warren v Pazolt,187 the fees on the trial.
trustees in default escaped liability only because, in In Learoyd v Whiteley,193 the trustees had invested
the circumstances, they were not in ‘wilful default’ £3000 in a mortgage of what turned out to have been
and accordingly fell within an exoneration an unsaleable194 property. They were effectively
provision.188 surcharged with, and ordered to account for, the
There was no such backstop for the trustee whole sum.195
in In re Janes,189 where the life tenant ‘loved
Kodak’. The Court of Appeals, New York sur- Negligent investment not actionable without
charged the trustee bank with $4,065,029, repre- proof of damageçand mere failure to maintain
senting: parity with an index is not damage196
the value of the capital lost through the trustee’s To repeat Lindley LJ’s restatement, in that case, of
negligent retention of the overweight of Eastman the trustee’s obligation:197
Kodak shares, and failure to diversify the trust
investments,190 after the date191 by which it The duty of a trustee is not to take such care only as
should have been sold; a prudent man would take if he had only himself to
186. Hayton et al, Underhill & Hayton: Law Relating to Trusts and Trustees (2006) 17th edn 89.3.
187. 89 NE 381, 388 (1909), considered under ‘When failing to diversify is inexcusable failure to balance the portfolio,’ at p. 538 above.
188. 89 NE 381, 388 (1909).
189. 681 NE 2d 332, 339–340 (1997), considered under ‘Retaining an investment is ‘‘investing’: the necessity for review,’ p. 548 above.
190. 681 NE 2d 332, 339 (1997):
Where, as here, a fiduciary’s imprudence consists solely of negligent retention of assets it should have sold, the measure of damages is the value of the
lost capital. . . .
In imposing liability upon a fiduciary on the basis of the capital lost, the court should determine the value of the stock on the date it should have been
sold, and subtract from that figure the proceeds from the sale of the stock or, if the stock is still retained by the estate, the value of the stock at
the time of the accounting . . ..
191. The Surrogate Judge, which the Court of Appeals New York upheld [681 NE 2d 332, 339 (1997)], on this point, had held that ‘the asset, the EK [Eastman
Kodak] stock, should have been sold within a reasonable time. . . . In some instances the courts have held that date of death or as soon as a fiduciary qualifies and
has the authority, the securities should be sold. . . . Rodney B Janes died 26 May 1973 and letters testamentary were issued 6 June 1973. The investment officer
assigned to the Janes Estate who finalized the investment strategy as of 9 August 1973 was already aware that EK [Eastman Kodak] stock was at a high concentration
in the portfolio. EK, which enjoyed an historic high in the market, generated a 1% annual return. It is this Court’s view on the state of the record that the Bank
as co-executor was responsible and should have, as of 9 August 1973, sold that portion of the EK stock concentration bringing its presence in the portfolio to
the 5% level.
The disposition of the EK on 1 August 1973 would have resulted in proceeds of $1,687,647.30 (12,087 shares sold at $139 5/8).’ (214 NYLJ 31(5 July
1995).
192. 681 NE 2d 332, 339–340 (1997).
193. (1887) 12 App Cas 727 (HL) affirming (1886) 33 Ch D 347 (CA) upholding (1886) 32 Ch D 196 (Bacon V-C).
194. (1886) 32 Ch D 196, 204 (Bacon V-C).
195. (1886) 32 Ch D 196, 206.
196. Everything said about trustee negligence in this article must be read subject to the paper, at page 602 of this issue, by David Halpern QC, one of the learned
authors of Jackson and Powell on Professional Liability (Sweet & Maxwell, London, 6th revised edn, 2006).
197. Re Whiteley, Whiteley v Learoyd (1886) 33 Ch D 347, 357.
consider; the duty rather is to take such care maintained. At times that will be impossible, and at
as an ordinary prudent man would take if others it will require extraordinary skill or luck. The
he were minded to make an investment for the benefit highest that even the plaintiff puts her claim is that,
of other people for whom he felt morally bound to if the equity portion in the fund as it stood in 1922
provide. (74 per cent) had been invested so as to achieve no
more than the index, the fund as a whole would
And to repeat, also, Hoffmann J’s characterization have been worth over £18 m. in 1986.
of that test as:198
In the same case, Dillon LJ noted in the Court of
an extremely flexible standard, capable of adaptation Appeal that:201
to current economic conditions and contemporary
understanding of markets and investments. Modern as Hoffmann J pointed out,202 that the evidence
trustees acting within their investment powers were showed that if the BZW Equity Index was applied
entitled to be judged by the standards of current over the period from July 1974 to December 1986
portfolio theory, which emphasises the risk level of to ‘growth’ unit trusts (as opposed to ‘income’ unit
the entire portfolio, rather than the risk attaching trusts) it appeared that 12 of the ‘growth’ trusts had
to each investment taken in isolation. But care done better than the index, but 21 had done worse.
must be taken not to endow the prudent trustee with It is impossible to say that those 21 unit trusts must
prophetic vision or expect him to have ignored the have been managed with a degree of incompetence
received wisdom of his time. A trustee must have which, in a trustee like the bank, would have
regard to the interests of those entitled in the future amounted to a breach of trust. The BZW Equity
to capital, and such regard will require them to Index is calculated by reference to the performance of
take into consideration the potential effects of inflation, the leading equity shares, the composition of the list
but a rule that real capital values must be maintained being changed from time to time with, fluctuations
would be unfair to both income beneficiaries and of the companies’ fortunes. It is thus difficult to beat,
trustees. particularly for a fund which is not large enough
to include substantial holdings in all the leading
The trustee is not an insurer of the trust estate.199 equities. It cannot be the criterion for the degree of
In Nestle v National Westminster Bank, Staughton performance which is expected of the ordinary prudent
LJ agreed with Hoffmann J:200 trustee.
Of course it is not a breach of trust to invest the There was no doubt that the trustee had misunder-
trust fund in such a manner that its real value is not stood the investment clause, and that, over a long
198. Nestle v National Westminster Bank plc [2000] WTLR 795, 797; affd [1993] 1 WLR 1260 (CA).
199. Re Mulligan [1998] 1 NZLR 481, 501, ‘I accept that a trustee is neither a surety, nor an insurer of the fund for which he is responsible. Loss of trust money,
or . . . diminution in the real value of a trust fund, does not of itself render a trustee liable. It must be shown that the loss of diminution arose from some failing
on the part of the trustee, which can be properly characterized as a breach of trust.’ See also Re Whiteley, Whiteley v Learoyd, (1886) 33 Ch D 347, 357 per
Lindley LJ:
Whilst on the one hand the Court ought not to encourage laxity and want of care, on the other hand the Court ought not to prevent people from
becoming trustees by converting honest trustees into insurers of the moneys committed to their care.
See, too, Bartlett v Barclays Bank Trust Co Ltd (No 1) [1980] Ch 515, 531-534 (Brightman J). See further Re Partington (1888) 57 LT 654, 657; Cowan v Scargill
[1985] Ch 270, 289; Steel v Wellcome Custodian Trustees Ltd [1988] 1 WLR 167, 171; Nestle v National Westminster Bank plc [1993] 1 WLR 1260; and Getzler,
‘‘Duty of Care’, in Birks and Pretto, Breach of Trust (Hart Publishing, Oxford, 2002), 41–74.
202. Nestle v National Westminster Bank plc [2000] WTLR 795.
period, it failed to keep the investments under would have been better off if the equities had been
review.203 But, as Staughton LJ put it:204 properly diversified.
the misunderstanding of the investment clause and The starting point must, in my judgment, be that, as
the failure to conduct periodic reviews do not by the plaintiff is claiming compensation, the onus is on
themselves, whether separately or together, afford her to prove that she has suffered loss because from
the plaintiff a remedy. They were symptoms of incom- 1922 to 1960 the equities in the annuity fund were not
petence or idleness—not on the part of National diversified: see Hotson v East Berkshire Area Health
Westminster Bank but of their predecessors; they Authority [1987] AC 750 and Wilsher v Essex Area
were not, without more, breaches of trust. The plain- Health Authority [1988] AC 1074. In some cases,
tiff must show that, through one or other or both of it is sufficient to prove loss of a chance because in
those causes, the trustees made decisions which they such cases, as in Chaplin v Hicks [1911] 2 KB 786,
should not have made or failed to make decisions the outcome, if the plaintiff had not lost the chance,
which they should have made. If that were proved, can never be proved. But in the present case, if
and if at first sight loss resulted, it would be the annuity fund had been invested wholly in fixed
appropriate to order an inquiry as to the loss suffered interest securities, it would have been relatively easy
by the trust fund. to prove, even though the event never happened, that
the annuity fund would have been worth much more
It may be difficult to discharge that burden, and if a substantial part had been invested in equities.
particularly to show that decisions were not taken Consequently fair compensation could have been
when they should have been. But that does not absolve assessed. Equally it would have been possible, even
a plaintiff from discharging it, and I cannot find that it though more difficult and much more, expensive, to
was discharged in this case . . . . prove, if it be the fact, that the equities in the annuity
fund would have performed even better if diversified
But Dillon LJ pointed out that the appellant’s than they did as concentrated in bank and insurance
complaint was not that:205 shares. But the plaintiff has not provided any such
proof. She has not even provided any material which
of failure to invest any adequate part of the annuity would enable the court to assess the strength of, or
fund in equities. It is that the part invested in equities value, the chance which she claims she has lost.
was from 1922 to 1960 invested in bank and insurance Therefore her claim for compensation or damages in
shares (which were good equities) only and not in respect of the investment of the annuity fund from
a wider spread of equities. Since therefore, for the 1922 to 1960 must, in my judgement, fail.
reasons given above I would reject the suggested use
of the BZW Equity Index as proving loss as between Leggatt LJ was of the same mind:206
bank and insurance shares only and fully diversified
equities, the crucial question is whether the onus The essence of the bank’s duty was to take such steps
remains on the plaintiff to prove loss for which fair as a prudent businessman would have taken to main-
compensation should be paid, or whether it is enough tain and increase the value of the trust fund. Unless it
for her to claim compensation for loss of a chance failed to do so, it was not in breach of trust. A breach
[as in Chaplin v Hicks ([1911] 2 KB 786) that she of duty will not be actionable, and therefore will be
203. Nestle v National Westminster Bank plc [1993] 1 WLR 1260, 1275 per Staughton LJ.
204. Nestle v National Westminster Bank plc [1993] 1 WLR 1260, 1275–1276.
205. Nestle v National Westminster Bank plc [1993] 1 WLR 1260, 1269.
206. Nestle v National Westminster Bank plc [1993] 1 WLR 1260, 1283, 1283–1284.
immaterial, if it does not cause loss. In this context I inactivity. Until the 1950s active management of the
would endorse the concession of Mr. Nugee for portfolio might have been seen as speculative,
the bank that ‘loss’ will be incurred by a trust and even in these days such dealing would have to
fund when it makes a gain less than would have be notably successful before the expense would be
been made by a prudent businessman. A claimant justified. The very process of attempting to achieve a
will therefore fail who cannot prove a loss in this balance, or (if that be old-fashioned) fairness, as
sense caused by breach of duty. So here in order to between the interests of life-tenants and those of a
make a case for an inquiry, the plaintiff must show remainderman inevitably means that each can
that loss was caused by breach of duty on the part complain of being less well served than he or she
of the bank. ought to have been. But by the undemanding standard
of prudence the bank is not shown to have committed
... any breach of trust resulting in loss.
In my judgment either there was a loss in the present

case or there was not. Unless there was a loss, there
was no cause of action. It was for the plaintiff to prove
Part 2:The prudent investor in the
on balance of probabilities that there was, or must
time of the meltdown
have been, a loss. If proved, the court would then When I was young people called me a gambler. As the
have had to assess the amount of it, and for the scale of my operations increased I became known as
purpose of doing so might have had recourse to a speculator. Now I am called a banker. But I have
presumptions against the bank. In short, if it were been doing the same thing all the time.
shown that a loss was caused by breach of trust,
such a presumption might avail the plaintiff in Edward Chancellor, Devil Take the Hindmost
quantifying the loss. The plaintiff’s difficulty is in (Macmillan, London, 1999), ix, citing Sir Ernest Cassell,
reaching that stage. banker to Edward VII.
The plaintiff therefore had to prove that a prudent

Where we are now
trustee, knowing of the scope of the bank’s investment
power and conducting regular reviews, would so have The sombre state of the environment in which trus-
invested the trust funds as to make it worth more than tees now must discharge their onerous duties has been
it was worth when the plaintiff inherited it. That was well described by the Prime Minister of Australia:207
a matter for expert evidence. . . .
Financial markets have suffered the greatest disloca-
No testator, in the light of this example, would choose tion in our lifetime. Global equity markets have lost
this bank for the effective management of his invest- approximately US$ 32 trillion in value since their
ment. But the bank’s engagement was as a trustee; peak, which is equivalent to the combined GDP of
and as such, it is to be judged not so much by success the G7 countries in 2008. Credit markets have all
as by absence of proven default. The importance of but dried up, with credit growth at its lowest level
preservation of a trust fund will always outweigh suc- since World War II. And, at the core of the crisis,
cess in its advancement. Inevitably, a trustee in the house prices are plummeting in many countries,
bank’s position wears a complacent air, because the with American prices falling at their fastest rate
virtue of safety will in practice put a premium on since modern records began.
207. Kevin Rudd, ‘The Global Financial Crisis’, The Monthly, February 2009, 20, 21–22. See further, ‘The Rudd Essay & the Global Financial Crisis,’ The
Monthly, May 2009, 26: being a symposium on the Prime Minister’s essay involving economists, historians, and philosophers.
The real economy is facing one of its toughest periods what policy, what abuses made this possible?
on record, with the IMF predicting that advanced Were there any warnings? And if so, why were they
economies will contract for the first time in ignored?
60 years, causing the number of unemployed to rise
by 8 million across the OECD. In developing Adapting the prudent investor test to ‘current
countries, the International Labour Organization
economic conditions and contemporary
predicts that the financial and economic crisis could
understanding of markets and investments’208
push more than 100 million people into poverty.
As the world licks these wounds, it may not be long
Furthermore, the crisis is producing unprecedented before it becomes apparent to what extent trust funds
costs and debts for governments which will be felt have been entangled with the investment products
for decades to come. It is estimated that the 2009 and approaches which have brought the international
deficit in the United States will be as high as 12.5% economy to its knees, and which may keep it in
of GDP. And estimates of the combined (actual and that position for perhaps a decade or more.
contingent) liabilities from the array of bank bailouts What care then would Lindley LJ’s prudent trustee
and guarantees run to more than $13 trillion—more have taken if—with an understanding of markets and
than the cost of all the major wars the United States investments in the present era—he was to have been
has ever fought. What this means for future American minded to make an investment for the benefit of
international borrowing is equally unprecedented. other people for whom he felt morally bound to
provide?
Bewilderment, however, rapidly turns to anger when To begin with, in no era can a trustee invest
the economic crisis touches the lives of families prudently in that which he does not understand.
through rising unemployment, reduced wage growth He must ‘seek advice on matters which the trustee
and collapsing asset values—while executive does not understand, such as the making [and review-
remuneration in the financial sector continues to go ing] of investments’,209 and he might be imprudent to
through the roof, apparently disconnected from the take that advice unless he can understand it, also.
reality of recent events. In 2007, S&P 500 CEOs Otherwise he knows not what he does, and that is
averaged $10.5 million (some 344 times the pay of no way for him to behave with the funds allocated
typical American workers). The top 50 hedge-fund for the benefit of those for whom he has a moral
and private equity fund managers averaged $588 obligation to provide.
million each (19,000 times the pay of typical workers).
In 2007, the five biggest Wall Street firms paid A world full of algorithms, computer trading
bonuses of a staggering $39 billion—huge payments
and black boxes
to the executives whose investment banks have since
been bailed out by American taxpayers. Computer ‘stop-loss’ trading decisions, to dump
stock as soon as it reached its historical low, are said
These are epic numbers, generated by a greed of to have greatly exacerbated the 1987 crash. Within
epic proportions. For a bewildered and increasingly a few years another form of ‘trading on the basis of
enraged public, they raise the following questions: mathematical models’,210 as the then US Secretary
How was this allowed to happen? What ideology, of the Treasury, Robert Rubin, described it, was in
208. Nestle v National Westminster Bank plc [2000] WTLR 795, 797 (Hoffmann J); affd [1993] 1 WLR 1260 (CA).
209. Cowan v Scargill [1985] Ch 270, 289.
210. Rubin and Weisberg, In an Uncertain World (Random House, New York, 2003), 284.
full flight. Each form of trading appears to have been Yet, in 1994, when Scholes teamed up with other
a substitute for prudence and judgment in dealing geniuses—including John Meriwether formerly of
with the money of others. It would be difficult Salomon Brothers—to form a fund called Long-
to imagine an approach more deeply antithetical to Term Capital Management,215 investors were beating
trustee duty, let alone general social responsibility. down their doors. The perceived brainpower of the
In some of the mathematical models, as will team attracted huge investments from the likes of
appear,211 the allegedly significant variables have UBS Bank216 from Switzerland, and Merrill Lynch217
been quite diverting. Not so the Black–Scholes from Wall Street. For its first four years, returns of
formula, in the title to this article, which has been around 40% per annum seemed to vindicate the
at the eye of the recent financial storm.212 investment decision of each of those who had laid
It provides scant consolation for trustees to learn out at least the minimum investment of USD10
that this formula was created ‘to solve what had million.
previously been considered a difficult problem’,213 Just like the children’s toys that come ‘complete
and that it won Scholes a Nobel Prize in 1997. If with batteries’, this fund came complete with
that is what passes for investment clarity, then, were hubris. By 1998, Long-Term Capital Management
he still around, Lord Nottingham would be standing was to prove what the sub-prime mania has proved
by the comment he made 300 years ago in Uvedale v a decade later: that IQ is irrelevant when decisions are
Ettrick:214 driven by testosterone. One thinks of a two year old in
the bath, having his scrotum washed: ‘Are those
I like not that a Man should be ambitious of a Trust, my brains, Mama?’ ‘Not yet, darling.’
when he can get nothing but Trouble by it. Iceland’s new Prime Minister has declared the end
of the age of testosterone.218 The women are pushing
If nothing else is clear, there can be no doubt that the men aside in the investment industry, and they
trouble will attend a trustee who invests on the basis have declared the simple ground rule: ‘we won’t
of a black box, an Ouija board, or the entrails of invest in anything we don’t understand’. Certainly,
a goat; or who uncritically accepts the counsel of we ‘don’t want to lend to men, they take unnecessary
an adviser and invests in a fund which uses any risks, they get drunk and they don’t give back the
of these methods as a substitute for judgment and money’.
prudence. The women of Iceland are right to have understood
Uncritical acceptance of mathematical formulae to that, when the testosterone develops in the finance
‘indicate’ a good investment, or a good time to invest, industry, it causes merry hell.
would appear to be just as objectionable: both to First, it feeds on the fantasy that size matters.
St Thomas and to the law. As Norman Mailer put it, ‘quantity changes quality,
211. For example, the model considered under ‘Switching algorithms: the WHR and the BWR’ p. 566 below.
212. Ferguson, The Ascent of Money: a Financial History of the World (Allen Lane, London, 2008), pp. 320–332.
213. Bannock et al., The Penguin Dictionary of Economics (Penguin, London, 7th edn, 2003) commenting further that it is:
based on looking at the price of a basket of financial assets which carried the same risk and return as an option.
214. (1682) 2 Cas in Ch 130, 131; 22 ER 880, 881.

215. Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (Random House, 2000).
216. The same bank that, a decade later, reached a settlement with the United States Securities and Exchange Commission to refund US$22.7 billion to
customers to whom it had sold ‘risky auction-rate securities that regulators said [it] had marketed to customers as safe.’ US Securities and Exchange Commission,
Litigation Release No 20824 (11 December 2008) http://www.sec.gov/litigation/litreleases/2008/lr20824.htm. Site last accessed 29 July 2009.
217. The same firm that, a decade later, having ‘lost more than USD 45 billion on its mortgage investments, agreed to sell itself . . . to Bank of America for $50.3
billion in stock . . .. It is a remarkable fall from grace for the 94-year-old Merrill, whose corporate logo—a bull—has long symbolized the fundamental optimism of
Wall Street. . . . ‘‘It is an enormous shock,’’ said Steve Fraser, a Wall Street historian and author of Wall Street: America’s Dream Palace (Yale University Press, 2008).
‘‘Merrill was a kind of bedrock institution whose stability and longevity was taken for granted and was reassuring to people,’’ Mr. Fraser said. ‘‘Even in these very
highly erratic and speculative marketplaces like we’ve been living through, you didn’t think Merrill would be vulnerable’’.’
218. Boyes, ‘Age of Testosterone comes to an end in Iceland’, The Times, 7 February 2009.
Engels said once, and a hustler of dimensions is Switching algorithms: the WHR and the BWR
a financier.’219 Second, testosterone leads ineluctably
to leverage. A trader able to generate Long-Term The learned authors first set out their methodology:
Capital Management’s prodigious initial returns is
highly vulnerable to the aphrodisiac effect. The Facial features. High-quality photographs that
black-box, formulaic approach apparently dulls the captured a complete, front, facial view of each of the
brain to the harsh truth that maintenance of—let 41 Playboy Playmates of the Year from 1960 to 2000
alone an increase in—the value of an asset which were located. The majority of the images were down-
must be sold, if the ‘gain’ is to be realized, depends loaded from the Internet (www.playboy.com) and the
on the availability of a purchaser who is, both, able remaining photographs were found in magazines and
and willing to justify, and to fund, payment of books, scanned using a flatbed scanner, and saved
the necessary price. as graphic files.
Long-Term Capital Management’s algorithm was
to be about as useful as it would have been if ...
it was to have reflected the variables identified and
classified by Pettijohn and Jungeberg in their Eye width was the distance between corners of
paper to the 15th annual American Psychological the visible eye divided by the width of the face at
Conference in Atlanta in 2003.220 Dr Pettijohn is the cheekbones. Eye area was calculated as the product
a leading authority on Attachment and Separation of the eye height ratio and the eye width ratio. Chin
Distress in the Infant Guinea Pig,221 Alleviation and length was the distance from the top of the lower lip to
Separation Distress in 3 Breeds of Young Dogs,222 the bottom of the chin divided by the length of the
The Effect of Alcohol on Agonistic Behaviour in face. Chin width was the width of the face at the jaw
the Telomian Dog,223 and, in particular, on measured at the middle of the chin height, divided by
Reactions of Mongolian Gerbils in the Presence of the length of the face. Chin area was calculated as the
Urine Stimuli.224 If Dr Scholes could get one, product of the chin length ratio and the chin width
Dr Pettijohn’s hat surely must be in the ring for ratio. Cheek thinness was the inner corner where the
a Nobel of his own: if not for those studies, then lips meet to the outer edge of the cheek divided by
at least for the astonishing economic bellwether the length of the face.225
which he and his learned colleague presented
to that meeting of the American Psychological Each face in this study no doubt would have launched
Conference. a thousand quips. But the authors’ devotion to
219. The Fight (Penguin Classics, London 2000) 115–116, describing Don King’s promotion of the famed ‘rumble in the jungle’ between Ali and Foreman in
what is now the Democratic Republic of the Congo:
Say, it would be hard to prove King was not a genius. A former nightclub owner and numbers king of Cleveland with four years in jail for killing a man
in a street fight, he had approached Ali and Foreman with the splendid credentials of a fight manager whose two best fighters, Earnie Shavers and Jeff
Merritt, had just both been knocked out in the first round. Still, he offered to promote Ali–Foreman. Each fighter would get five million dollars, he
said. Those eyes of true love must have made the sum believable, for they glowed doubtless with the cool delights of lemonade, the fantasies of Pernod,
and the golden kernels of corn—somehow, those eyes took him through barriers—he convinced Herbert Muhammad that he could produce this fight.
‘I reminded him of the teaching of his father Elijah Muhammad that every qualified Black man should be given a chance by his fellow Black
men.’ . . . What skills. Quantity changes quality, Engels said once, and a hustler of dimensions is a financier.
220. ‘Playboy Playmate Curves: Changes in Facial and Body Feature Preferences Across Social and Economic Conditions’, Personality and Social Psychology
Bulletin Vol 30 (9), 2004, 1186.
221. 12 Developmental Psychobiology 1979, 73.
222. The dogs, by the way, were Shetland Sheepdogs, Telomians, and Beagles: see 44 Developmental Psychobiology, 2004, 373–381.
223. 60 Psychopharmacology, 1979, 295–301.
224. 5 Animal Learning & Behavior, 1977, 370–372.
225. See n 220 above, at 1190.
hard-nosed scientific scholarship prevented their just when times were bad and neotenous227 features and
looking at faces as if the rest of the person did not a more curvaceous body type were preferred when
exist: times were good.228
Bust, waist, hips, and height were measured in inches. There was no ducking of the really hard questions:
Weight was reported in pounds. Waist-to-hip ratio
(WHR) was calculated by dividing waist measurement Although there was overall support for the
by hip measurement. Larger WHRs would indicate Environmental Security Hypothesis predictions,
less difference between waist and hip measurements Playmate of the Year chin size and facial thinness
than smaller WHRs, hence lesser curvaceousness. did not follow the predicted pattern of relating
Bust-to-waist ratio (BWR) was calculated by dividing positively with hard social and economic conditions.
bust measurement by waist measurement. Larger The measures of facial thinness, chin length, chin
BWRs would indicate greater difference between width, and chin area showed no relationship with
bust and waist measurements than smaller BWRs, the General Hard Times Measure, whereas the eye
hence greater curvaceousness. Body mass index measures were significantly negatively related to
(BMI) was calculated as the product of weight in social and economic hard times.229
pounds and the constant 703, divided by height in
inches squared (http://www.cdc.gov/ nccdphp/dnpa/ From this crystalline thought came the amazing
226
bmi). Larger BMI values indicate greater body fat. answer:
The economic conclusions of Pettijohn and Jungeberg One way to explain this discrepancy may lie in the
were more rigorous than much of what evidently weighted importance of body features over facial
has been passing for investment analysis these past features for this particular sample. Nude models are
few years: selected for their beauty, but the significance of
physical attractiveness may be connected more with
Consistent with the Environmental Security body features than facial features for Playboy center-
Hypothesis predictions, when social and economic folds. Having a strong chin or a thin face may be
conditions were difficult, older, heavier, taller of smaller consequence for Playmates, whereas body
Playboy Playmates of the Year with larger waists, features . . . may be of larger consequence in determin-
smaller eyes, larger waist-to-hip ratios, smaller bust- ing attractiveness.230
to-waist ratios, and smaller body mass index values
were selected. Conversely, as indicated with the The data before them thus brought the authors full
prescribed correlations, as social and economic con- circle. They seem to have established, scientifically,
ditions improved, younger, lighter, shorter Playboy the existence of a type of woman who is defined
Playmates of the Year with smaller waists, larger from the neck down, and who, for all any male scien-
eyes, smaller waist-to-hip ratios, larger bust-to-waist tist notices, might as well be headless. Had they been
ratios, and larger body mass index values were aware of it, Pettijohn and Jungeberg might have
preferred. Mature features and a more tubular body attempted to invoke a certain Papal occasion to fortify
shape were preferred to a relatively greater extent this brilliant conclusion of their scientific endeavour.
226. Ibid.
227. ‘Neoteny’, of course, is synonymous with pedomorphosis.
228. See n 220 above, at 1193.
229. Ibid.
230. Ibid.
In his biography of Pope John XXIII,231 Thomas photos are airbrushed and ‘corrected’ in editing.
Cahill wrote that, for Cardinal Roncalli, then Papal To the extent that any alterations are made, we
Nuncio in Paris: would argue that they would be in the direction of
the current societal trends. Furthermore, if images are
His own, exceedingly simple engagement with always corrected in the same fashion, this practice
Parisians took the form of strolls around his could not account for the current pattern of changing
beauquartier and animated conversation with those preferences with social and economic conditions.232
he met . . . . For this he was upbraided by [Pope]
Pius, who judged it undignified for a papal nuncio As Brian Viner has shown, this analysis can be
to be seen walking the Paris streets and rubbing readily transposed to economies other than that of
shoulders with the unclean masses as if they were the United States—certainly to the UK:
all on the same level.
But I love the theory all the same, and it certainly
But the nuncio, now nearing seventy, was becoming holds particular resonance in Britain, where in 1979,
evermore easygoing and, in his own playful way, unequivocally a time of grave economic crisis, we
fearless. The fight against his weight was decisively embraced not Donna Michelle or Anna Nicole but
lost . . . and he was not infrequently seen at diplomatic the even more mature-looking Margaret Hilda.
receptions with a glass of champagne in one hand,
sometimes with a cigarette in the other. At one of Maybe there is more to the theory than even
these gatherings, so the story goes, he was approached Dr Pettijohn thinks. Maybe the kind of women that
by a woman of considerable dècolletage, who wore a men find attractive at any one time is not so much
large crucifix between her mountainous breasts. a reflection of economic conditions as an anticipation
‘Quelle Golgothe!’ (‘What a Calvary!’) exclaimed the of them. Thus the popularity of Jordan might mean
nuncio merrily. that we are in for a period of unnatural inflation.
Or the fleeting fame of David Beckham’s alleged
Finally, as well as having demonstrated that not even lover Rebecca Loos might suggest that the balance of
scientists read Playboy for the articles, Pettijohn and payments will shortly start swinging both ways. It’s
Jungeberg showed a thing or two to those trustees not as ridiculous as it sounds. After all, wasn’t the
who make a hash of their investment decisions tricky business of economic forecasting once defined
because of excessive credulity towards prospectus as trying to work out in which direction a car is
statements: heading by looking in the rear-view mirror? Far
easier to consult page three of The Sun.
We recognize the limitations of using the Playboy
Playmate of the Year competition as a source of I don’t mean to be disrespectful towards either
preferences for female attractiveness over time. Dr Pettijohn or his theory, into which a lot of think-
Playboy is in business to sell magazines. They would ing, and looking, has obviously gone. But at the same
not be able to sell magazines if they featured time, I can’t help thinking about Hugh Hefner holed
unattractive women who were not desirable to their up in the Playboy Mansion in Los Angeles, picking
subscribers. Therefore, it is in the company’s best his Playmate of the Year and labouring under the
interest to know what the public wants in order to delusion that for the last 40-odd years he has
be successful. Some have speculated that model been the embodiment of hedonism, when it now
231. (Viking, New York, 2002), 147–148.

232. See n 220 above, at 1193–1194.
emerges that he should have been fronting The Money

Nobel laureates create a bust beyond the
Programme.233
dreams of playboy
Unlike Scholes’ theorem, the Pettijohn/Jungeberg Important as it is, this last point should not be pushed
thesis is being constantly refined by further rigorous, too far. The fact remains that, if Scholes, Meriwether,
peer-reviewed, studies. Thus, Webster234 makes a and the rest of the brains trust at Long-Term Capital
number of important points. First—because women’s Management, had only kept abreast of the changing
hormones get in the way—reflecting that the eco- economic mood which Mr Hefner was capturing
nomic cycle should be regarded as men’s work.235 in his centrespreads, and the ‘weighted importance
Second, although Playmates of the Year: of body features’ so rigorously analysed by Dr
Pettijohn and his colleague, the word uppermost in
may reflect current popular preferences, the initial their minds would have been ‘bust’.
pool of playmates is probably far more homogeneous The fund soon commanded US$134 billion. It was
in their bodily characteristics than a random sample of ventured on leveraged betting involving in excess of
women. . . . Finally, the present study specifically USD1 trillion. As Rubin put it, the huge initial returns
focused on men’s preferences for women’s bodies encouraged the fund to ‘bet the ranch’ on those
rather than faces. Although both social and evolution- models:
ary psychologists have made great strides in
understanding what makes faces attractive and why Before founding LTCM, Meriwether had run a
(eg, Cunningham, 1986; Rhodes, 2006), to speculate massive trading operation at Salomon and had done
on whether distinguishing between economic and very well over a long period. He had some of the top
existential threats are important to shifts in men’s minds in finance—Nobel Prize winners Robert
preferences for women’s facial features remains prema- Merton and Myron Scholes—working with him at
ture and is beyond the scope of the present research.236 LTCM. I was amazed that they had done what it
seemed they had, betting the ranch on the basis
For whatever modest value it may have, it is my own of mathematical models, even ones built by such
view that this shift to facial features is unlikely to sophisticated people.
occur until, with aging of the male population,
Playboy does, indeed, become read for its articles. Models can be a useful way of looking at markets
Finally, and critically for trustee-investors, Webster and can provide useful input to making decisions.
opines that: But ultimately traders have to make judgments
because reality is always far messier and more compli-
As with any correlational investigation of archival cated than even the most sophisticated models can
data, this present study has a few potential limitations. capture.237
First and foremost, the critical-thinking mantra of
‘correlation does not imply causation’ cannot be Judgment—prudent judgment at that—is necessary
stressed enough. for the investing trustee at least as much as it is for
233. Playmates, curves, and the economic outlook The Independent 15 June 2004.
234. ‘Playboy Playmates, the Dow Jones, Consumer Sentiment, 9/11, and the Doomsday Clock: A Critical Examination of the Environmental Security
Hypothesis’, Journal of Social, Evolutionary, and Cultural Psychology 2004, 2(2): 23–41.
235. Although women’s preferences for men’s body types may exhibit shifts over the menstrual cycle (Thornhill, Gangestad, and Garver-Apgar, 2004), it appears
that men’s preferences for women’s body types may exhibit their own shifts as a function of changes in existential threats and the resource availability. Thus, the
ESH remains a viable theoretical perspective that deserves attention from evolutionary and social psychologists alike. It is hoped the present research will not only
expose evolutionary psychologists to the ESH, but also inspire them to examine its efficacy in novel contexts using a variety of innovative methods: ibid 37.
236. Idem.
237. Rubin and Weisberg, In an Uncertain World (Random House, New York, 2003), p. 285.
the trader. As Rubin points out, markets have the total at 7,601 funds with $1.9 trillion in assets.
an ‘inherent tendency to excess’.238 Since 1998 there has been a veritable stampede to
The bust for Long-Term Capital Management came invest in hedge funds (and in the ‘funds of funds’
when Russia defaulted on its debt obligations in that aggregate the performance of multiple firms).
August 1998. Panic, and a flight to quality, ensued. Where once they were the preserve of ‘high net
The geniuses at Long-Term Capital Management worth’ individuals and investment banks, hedge
were totally unprepared for it. It destroyed the fund. funds are now attracting growing numbers of pension
As Prof. Ferguson put it in The Ascent of Money: funds and university endowments.
a Financial History of the World,239 Long-Term
Capital Management’s: This enormous investment pool was created by a
small band of traders who had made massive returns
value at risk (VaR) models had implied that the loss by the arbitrage of inefficiencies in the currency and
Long Term suffered in August was so unlikely that it commodity markets. Because it was their own money,
ought never to have happened in the entire life of the money provided by friends and associates, or
universe. But that was because the models were advanced by banks, they escaped the discipline of
working with just five years’ worth of data. If the formal prospectus disclosure. As long as they kept
models had gone back even eleven years, they would making money, they could do what they liked, and
have captured the 1987 stock market crash. If they had charge what they liked, without having to explain
gone back eighty years they would have captured the or justify themselves.
last great Russian default, after the 1917 Revolution. The foundation of the structure was the leveraging
Meriwether himself, born in 1947, ruefully observed: of credit by way of financial engineering of deriva-
‘If I had lived through the Depression, I would have tives. These were priced according to formulae such as
been in a better position to understand events.’ To put that included in the title to this article. Mathematics
it bluntly, the Nobel prize winners had known plenty emits a comforting aura of certainty and predictabil-
of mathematics, but not enough history. . . . ity. A formula perceived to have made a lot of people
a lot of money is readily accepted as a black box
It might be assumed that after the catastrophic failure that ‘just works’.
of LTCM, quantitative hedge funds would have We do not have to understand how the microchip
vanished from the financial scene. After all, the failure, works before we turn on our iPods, or how the inter-
though spectacular in scale, was far from anomalous. nal combustion engine works before we drive our
Of 1,308 hedge funds that were formed between 1989 cars. So with derivatives: you do not have to think
and 1996, more than a third (36.7 per cent) had ceased about them. You just apply the formula. If it is
to exist by the end of the period. In that period the thought to ‘work’ in practice, why bother about
average life span of a hedge fund was just forty whether it works in theory? Why spoil the party by
months. Yet the very reverse has happened. Far from asking whether it accords with common sense?
declining, in the past ten years hedge funds of every Sooner or later in the cycle, as George Soros
type have exploded in number and in the volume of has pointed out, there are no longer any others to
assets they manage. In 1990, according to Hedge whom one can pass the parcel:
Fund Research, there were just over 600 hedge funds
managing some $39 billion in assets. By 2000 there The typical sequence of boom and bust has an
were 3,873 funds with $490 billion in assets. asymmetric shape. The boom develops slowly and
The latest figures (for the first quarter of 2008) put accelerates gradually. The bust, when it occurs, tends
238. Ibid. p. 196.

239. (Allen Lane, London, 2008), 328–329.
to be short and sharp. The asymmetry is due to the regulators are not only human but also bureaucratic
role that credit plays. As prices rise, the same collateral and subject to political influences.240
can support a greater amount of credit. Rising prices
also tend to generate optimism and encourage a Myopic regulation241 is a big trustee risk in this area.
greater use of leverage—borrowing for investment Virtual absence of regulation is much worse.
purposes. At the peak of the boom both the value of One reason for lack of regulation is easy to see.
the collateral and the degree of leverage reach a peak. The boom sequence described by Mr Soros puts an
When the price trend is reversed participants are economy on something like a cocaine high. While it is
vulnerable to margin calls and, as we’ve seen in that state, politicians come to be viewed more
in 2008, the forced liquidation of collateral leads to benignly. Recall again what Pettijohn and Jungeberg
catastrophic acceleration on the downside. found, about these good times:
Bubbles thus have two components: a trend that Consistent with the Environmental Security
prevails in reality and a misconception relating to Hypothesis predictions, . . . as social and economic
that trend. The simplest and most common example conditions improved, younger, lighter, shorter
is to be found in real estate. The trend consists of Playboy Playmates of the Year with smaller waists,
an increased willingness to lend and a rise in prices. larger eyes, smaller waist-to-hip ratios, larger bust-
The misconception is that the value of the real estate is to-waist ratios, and larger body mass index values
independent of the willingness to lend. The misconcep- were preferred. . . . neotenous features and a more
tion encourages bankers to become more lax in their curvaceous body type were preferred when times
lending practices as prices rise and defaults on were good.242
mortgage payments diminish. That is how real estate
bubbles, including the recent housing bubble, are So while the testosterone-charged market makers are
born. It is remarkable how the misconception basking in silicone, and the community is feeling
continues to recur in various guises in spite of a wealthy and optimistic, the politicians are on easy
long history of real estate bubbles bursting. street.
The market is providing the bread and circuses.
. . . Bubbles always involve the expansion and contrac- These ensure that there are no hard decisions that
tion of credit and they tend to have catastrophic cannot be postponed. If it is working, why snatch
consequences. Since financial markets are prone to the drug away and expose themselves to a possible
produce bubbles and bubbles cause trouble, financial unfavourable reaction from their constituencies?
markets have become regulated by the financial Another reason is doctrinaire abhorrence for
authorities. . . . regulation. The cover story243 for the 15 February
1999 issue of Time was the ‘Committee to Save the
It is important to recognize that regulators base their World’. The sceptical approach to doctrine of US
decisions on a distorted view of reality just as much as Treasury Secretary Robert Rubin, Federal Reserve
market participants—perhaps even more so because Board Chairman Alan Greenspan and Deputy US
240. ‘The Crisis & What to Do About It’, The New York Review of Books, 4 December 2008, 63.
241. Cf Yale Prof. Shiller’s comment—in The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do About It (Princeton,
New Jersey, 2008)—on his discussions with US regulators about the subprime problem:
I had the feeling that many of them viewed me, with my argument that the bubble would burst, as an extremist who deserved a skeptical response.
242. ‘Playboy Playmate Curves: Changes in Facial and Body Feature Preferences Across Social and Economic Conditions’, Personality and Social Psychology
Bulletin Vol 30 (9), September 2004, 1193.
243. Ramo, ‘The Three Marketeers’.
Treasury Secretary Larry Summers, was contrasted its battle to stem global turmoil. It was Rubin—via the
with its antithesis: 1993 deficit reduction plan—who navigated the
Clinton Administration into budgetary agreements
In the Reagan Administration economic policymaking that helped create the first surplus in 29 years. This
was guided not by analysis but by conclusions— fiscal responsibility helped lower interest rates, which
specifically a belief in so-called supplyside economics. kicked off a surge in business spending. Greenspan,
No matter what the data showed, the results among who dovetailed his own monetary policy with those
Reagan-era economists like Arthur Laffer were always goals, let the economy build up its present head
the same: tax cuts and less regulation were the of steam.245
solution.
The titles of Rubin’s 2003 book, In an Uncertain
Allied with that second reason is the understandable World, and of Greenspan’s 2007 book The Age of
desire, if regulation is being considered, to ensure Turbulence, suggest that this triumvirate was feeling
that it applies only to what might go wrong in the its way, and that the economy—which was ‘making
economy, and that it does not damage what is going investors deliriously, perhaps delusionally, happy’—
right. At the time that magazine story was written, the therefore was being run, without the comfort of
US economy appeared to have the wind in its sails, dogmatic certainty.
while a number of other economies were in the A diet of ‘bagels, orange juice and quiche’ might
doldrums or worse.244 The ‘Committee to Save the well lead to delusions: there could be another project
World’ was trying to do just that without spoiling for Pettijohn and Jungeberg in that. Nonetheless,
the party in the USA: to Rubin:
In late-night phone calls, in marathon meetings and One of the issues the three of us returned to again and
over bagels, orange juice and quiche, these three again was the strong performance of the American
men—Robert Rubin, Alan Greenspan and Larry economy. By mid-1996, the expansion was well estab-
Summers—are working to stop what has become a lished and was still going strong. The growth rate was
plague of economic panic. Their biggest shield is an higher, and unemployment lower, than prevailing
astonishingly robust US economy. Growth at year’s views would have said was possible without igniting
end was north of 5%—double what economists had inflation and putting upward pressure on wages and
expected—and unemployment is at a 28-year low. By prices. People were throwing around the phrase ‘new
fighting off one collapse after another—and defending economy,’ suggesting that advances in technology had
their economic policy from political meddling—the revised the familiar rules and limits. Some investors
three men have so far protected American growth, appeared to be falling prey to the timeless boom-era
making investors deliriously, perhaps delusionally, temptation to believe that the business cycle had been
happy in the process. tamed, that companies would never fail in their
earnings, and that the next economic slowdown
... would never come.
To help resolve the riddle of imperfect markets, Yet . . . real signs suggested that something had indeed
the committee has spent six years working on an changed for the better. With unemployment so low,
experiment. It’s called the US economy. The current a Fed chairman’s normal instinct would be to raise
boom is as much a part of the committee’s legacy as is rates to prevent inflation. But there were no signs of
244. E.g. Thailand (1997), Russia and Brazil (1998), were languishing.
245. Ramo, ‘The Three Marketeers’, Time, 15 February 1999.
increased inflation. The question was whether . . . the To suggest the global nature of the change, I alluded to
American economy could safely grow faster than a new phenomenon: inflation seemed to be ebbing
through the previous few decades. all over the world. My point was that monetary
policy might now be operating at the edge of knowledge
This apparent change in the so-called speed limit of where, at least for a while, time-honoured rules of
economic growth strongly suggested that productivity thumb might not apply.
growth—which had greatly slowed from the early
1970s through the early 1990s for reasons not fully ...
understood—had now picked up again. Productivity
increases work wonders on an economy, allowing The fast-paced high-tech boom is what finally gave
faster growth without inflation. . . . broad currency to Schumpeter’s idea of creative
destruction.248. . . . The reigning powers of technol-
. . . Greenspan was the first of the three of us to reach ogy—giants like AT&T, Hewlett-Packard, and
the tentative conclusion that productivity growth did IBM—had to scramble to catch up with the trend,
explain the absence of expected inflation.246 That and not all succeeded.
meant the speed limit on economic growth was
higher than we’d thought. Larry and I followed in ...
agreement somewhat later.
Business now had an enormous capacity to gather
... and disseminate information. This accelerated the
creative-destruction process as capital shifted from
But did these seemingly real changes in America’s stagnant or mediocre companies and industries to
productivity growth justify the tremendous rise in those at the cutting edge. . . .
stock prices that was taking place? Again, Alan,
Larry, and I reached a similar, tentative, conclusion: To take a more recent example, compare Google and
something real was happening in the economy, but at General Motors. In November 2005, GM announced
the same time the markets were probably overreacting plans to terminate up to thirty thousand employees
to that real thing.247 and close twelve plants by 2008. If you looked at the
company’s flows of cash, you could see GM was
For Greenspan: directing billions of dollars it historically might have
used to create products or build factories into funds to
My idea was that as the world absorbed infor- cover future pensions and health benefits for workers
mation technology and learned to put it to work, and retirees. Those funds, in turn, were investing the
we had entered what would prove to be a protracted capital where returns were most promising—in areas
period of lower inflation, lower interest rates, like high tech. At the same time Google, of course, was
increased productivity, and full employment. ‘I’ve growing at a tremendous rate. The company’s capital
been looking at business cycles since the later expenditures increased nearly threefold in 2005 to
1940’s,’ I said. ‘‘There has been nothing like this.’ more than $800 million. And in the expectation that
The depth and persistence of such technological the growth would continue, investors bid up the total
changes, I noted, ‘appear only once every fifty or market value of Google stock to eleven times that of
one hundred years.’ GM’s. In fact, the General Motors pension fund
246. For his account of this, see Greenspan, The Age of Turbulence: Adventures in a New World (Allen Lane, Australia, 2007), pp. 172–173.
247. Rubin and Weisberg, In an Uncertain World (Random House, New York, 2003), pp. 194–195, 196.
248. As to which see Nelson, The Sources of Economic Growth (Harvard University Press, Cambridge Massachusetts, 1996), 88ff.
owned Google shares—a textbook example of capital The swifter the spread of technological innovation,
shifting as a result of creative destruction. and the broader its impact, the more we economists
had to scramble to figure out which fundamentals
Why should information technology have such a vast had changed and which hadn’t. . . .
transforming effect? Much of corporate activity is
directed at reducing uncertainty. For most of the ...
twentieth century, corporate leaders lacked timely
knowledge of customers, needs. This has always Both the economy and the stock market continued
been costly to the bottom line. Decisions were to boom. Output as measured by GDP grew at a
made based on information that was days or even superhot pace of over 6 percent in the spring of
weeks old. 1966. . . . Something extraordinary was happening,
and the challenge in trying to figure it out as it was
Most companies hedged: they maintained extra inven- happening, in real time, was considerable.
tory and backup teams of employees ready to respond
to the unanticipated and the misjudged. This ...
insurance usually worked, but its price was always
high. Standby inventories and workers are all costs, Even rising productivity could not explain the
and standby ‘work’ hours produce no output. They looniness of stock prices. . . . Though economic
produce no revenue or added productivity. The real- growth was strong, we worried that investors were
time information supplied by the newer technologies getting carried away. Stock prices were beginning to
has markedly reduced the uncertainties associated embody expectations so exorbitant that they could never
with day-to-day business. Real-time communication be met. . . .
between the retail checkout counter and the factory
floor and between shippers and truckers hauling The concept of irrational exuberance came to
freight has led to shorter delivery times and fewer me in the bathtub one morning as I was writing
hours of work required to provide everything from a speech. . . .
books to factory gear, from stock quotes to software.
Information technology has released much of the On the podium that night I delivered the key
extra inventory and the ranks of backup workers to passage . . . :
productive and profitable uses.
But how do we know when irrational exuberance
. . . Overall, the tech boom also had a major positive has unduly escalated asset values, which then
effect on employment. Many more jobs were being become subject to unexpected and prolonged
created than were being lost. Indeed, our unemploy- contractions, as they have in Japan over the
ment rates fell, from over 6 percent in 1994 to pasty decade? And how do we factor that assess-
less than 4 percent in 2000, and in the process ment into monetary policy? We as central bankers
the economy spawned sixteen million new jobs. need not be concerned if a collapsing financial
Yet . . . millions of Americans found themselves asset bubble does not threaten to impair the real
exposed . . . to the dark side of creative destruction. economy, its production, jobs, and price stability.
Secretarial and clerical functions got absorbed into Indeed, the sharp stock market break of 1987 had
computer software, as did drafting jobs in architecture few negative consequences for the economy. But
and in automotive and industrial design. . . . we should not underestimate, or become com-
placent about, the complexity of the interactions
... of asset markets and the economy.
Given the limits on what could be accomplished

The ‘Committee to Save the World’ thinks
through disclosure requirements, I thought limiting
‘something’ is happening in the economy,
leverage was also necessary both to constrain market
to which ‘time-honoured rules of thumb might
excesses and to mitigate the harm they can create.
not apply’
For many years, banks and registered broker dealers
This is getting close to the heart of why life got had lived with capital requirements, and all investors
so hard for trustees. The serpent is whispering to were subject to margin requirements when they
them: borrowed against stocks. But other kinds of financial
institutions, including hedge funds, had no regulatory
come on, prudence is different nowadays. Rubin’s leverage constraints other than the margin require-
saying that ‘something real’s happening in the ments, if any, associated with the instruments they
economy.’ Greenspan’s telling anyone who’ll listen bought or sold short. My own view was that it
that ‘something so extraordinary’s happening, that the wasn’t necessary to impose special leverage rules on
time-honoured rules of thumb don’t apply any more.’ hedge funds as a class of investor. I still think [he is
They don’t know how it works. They just know that writing in 2003] that is right, though as they become
it ‘works’. If it’s good enough for them, it should be a larger and larger part of trading activity, policy
good enough for you. Do you know more than the makers may revisit that question, if some systemic
Committee to Save the World? Pile in or you’ll risk is thought to be at stake. I do think, however,
miss out. that derivatives, with leverage limits that vary from
little to none at all, should be subject to comprehen-
With the other ear, hopefully, the trustee is listening sive and higher margin requirements. But that will
to Thomas Aquinas telling her that prudence almost surely not happen, absent a crisis.
is the antithesis of impulsive or heat-of-the-
moment decision-making: ‘non solum ex impetu aut While economically useful under most circumstances
passione’.249 for more precise risk management, derivatives can
For all the intellect, brainpower and resources pose risks to the system when market conditions
represented by the ‘Committee to Save the World’, become very volatile. That occurs because of various
and its bottomless pit of advisers and resources, technical factors that can cause derivatives users to
they could not agree that leverage might be a problem suddenly need to buy or sell in the underlying markets
in respect of hedge funds. Recall that, after only four to maintain appropriate hedge positions. With the
years, Long-Term Capital Management commanded truly vast increase in the amount of derivatives
USD 134 billion in investment. This was ventured outstanding, it is at least conceivable that the effect on
on leveraged betting involving in excess of USD already disrupted markets could be vast. Some evidence
1 trillion. of that potential appeared in the third quarter of 2003,
Rubin was worried that this leverage might be when a rapid spike in interest rates changed the
troublesome:250 hedging requirements for mortgage-backed securities.
The result was substantial exacerbation of that spike.
All the disclosures in the world won’t help if investors Similarly, in 1987, some traders estimated that
don’t care about risks or valuation, The boom in ‘portfolio insurance’ selling of stock index futures
Internet stock prices in the late 1990s occurred despite added substantially to the October 19, 1987, stock
full disclosure by companies with no real earnings. market collapse. In a later speech at the Kennedy

250. Rubin and Weisberg, In an Uncertain World (Random House, New York, 2003), pp. 198–199, 287–288.
School at Harvard, Larry characterized my concerns Capital requirements and margin requirements—both
about derivatives as a preference for playing tennis leverage limits—help to do that, both by decreasing
with wooden racquets—as opposed to the more the size of positions and by increasing the amount of
powerful graphite and titanium ones used today. money backing each position.
Perhaps, but I would still reduce the leverage allowed
on derivatives substantially. . . . Larry thought I was overly concerned with the risks
of derivatives. His argument was characteristic of
The broader public policy question arising out of the many students of markets, who argue that derivatives
LTCM mess was whether anything could be done to serve an important purpose in allocating risk by
reduce the probability and severity of this kind of letting each person take as much of whatever kind
event in the future. This was a frequent topic of dis- of risk251 he wants. That is right in principle, but it
cussion among Larry [Summers], Alan [Greenspan], is not the whole story. Throughout my career, I had
and me, with some of the discussion taking place in seen situations where derivatives put additional
meetings of the Financial markets Working Group, pressure on volatile markets (for example, through
which also included Bill McDonough; SEC chairman the additional selling in the stock market that can
Arthur Levitt; Brooksley Born, the chair of the occur when portfolio managers sell calls to arbitra-
Commodity Futures Trading Commission; the heads geurs, who in turn hedge by shorting stock against
of the other principal financial market regulatory the calls for protection as the market falls). I also
bodies; and Gene Sperling from the NEC. Some thought that many people who used derivatives
members of this group thought that derivatives— didn’t fully understand the risks they were taking—the
instruments such as options, futures, and forwards situation we had found ourselves in at Goldman
whose value depends on the performance of an in 1986. Larry’s position held together under normal
underlying security, currency, or commodity and circumstances but seemed to me not to take into
whose value can change in complicated ways that is account what might happen under extraordinary
hard for even experienced traders to anticipate —by circumstances. Of course, Larry thought I just
their nature could pose a systemic risk. Others wanted to keep markets the way they were when I’d
thought the unrestricted leverage available to hedge learned the arbitrage business in the 1960s—his point
funds such as LTCM was a problem. Some thought about ‘playing tennis with wooden racquets’ again.
neither was a problem.
So the world was to be ‘saved’ by a Committee, one
I thought both derivatives and leverage could pose member of which had well-founded convictions, but
problems. I had been involved with derivatives from no courage to stand up for them; another member of
the pioneering days of the founding of the Chicago which seems to have been controlled by testosterone,
Board Options Exchange. Derivatives serve a useful and in turn exercised control over that uncourageous
purpose by providing a means to manage risk more first member with jibes that only sissies play tennis
effectively and precisely, but they can create additional with wooden racquets; and the third member of
problems when the system is stressed. One way to which knew all the rules of thumb, but thought that
contain those risks is by limiting the permissible maybe gravity had been repealed and that they no
leverage of buyers and sellers of derivatives. If you longer applied.
think periodic market excesses are inevitable because The ‘tailors’ in Hans Andersen’s tale of the
human nature is likely to lead to excess, you Emperor’s New Clothes convinced all and sundry
should try at least to limit the damage to the system. that their ‘magical cloth’ was invisible only to fools.
251. Risks being taken with the money of other people to whom the risk takers may have felt little or no moral obligation.
The people gathered to watch the emperor parade in The banking systems of the Western world have
his very costly ‘new suit’. None was prepared to back come close to collapse. Almost overnight, policy-
the evidence of her own eyes. To cover their chagrin makers and economists have torn up the neo-liberal
at finding the ‘cloth’ invisible, and their stupidity playbook and governments have made unprecedented
therefore proven, all expressed rapture at the magni- and extraordinary interventions to stop the panic and
ficence of its colour and texture. It took a single child, bring the global financial system back from the brink.
who had no concept of seeming foolish, to pipe up
that the Emperor was naked. Even the great neo-liberal ideological standard-bearer,
‘Fool!’ his father reprimanded, running after him. the longserving chairman of the US Federal Reserve
‘Don’t talk nonsense!’ He grabbed his child and took Alan Greenspan, recently conceded in testimony
him away. But the boy’s remark, which had been before Congress that his ideological viewpoint was
heard by the bystanders, was repeated over and over flawed, and that the ‘whole intellectual edifice’ of
again until everyone cried: ‘The boy is right! modern risk management had collapsed. Henry
The Emperor is naked! It’s true!’ Waxman, the chairman of the Congressional
By then, the tailors had decamped with their Committee on Oversight and Government Reform,
bonuses, and respect for the emperor had started to questioned Greenspan further: ‘In other words, you
melt down, although, no doubt, it was the closest found that your view of the world, your ideology,
acolytes who were the last to admit the evidence of was not right; it was not working?’ Greenspan replied,
their own eyes. ‘Absolutely, precisely.’This mea culpa by the man once
Mr Greenspan now has admitted—‘I screwed called ‘the Maestro’ has reverberated around the
up’252—that he had completely misconceived the world.
peril in which the system stood in the face of the
subprime mortgages and the bonds sold against As recently as 31 January 2008, Mr Rubin was denying
them. No wonder, the sadness in the tone of the arti- a meltdown:254 a denial from which he did not retreat
cle, already cited, by the Australian Prime Minister:253 until 9 January 2009 in his statement released by
Citigroup on his retirement:255
George Soros has said that ‘the salient feature of the
current financial crisis is that it was not caused by My great regret is that I and so many of us who have
some external shock . . . the crisis was generated by been involved in this industry for so long did
the system itself’. Soros is right. The current crisis is not recognize the serious possibility of the extreme
the culmination of a 30-year domination of economic circumstances that the financial system faces today.
policy by a free-market ideology that has been
variously called neo-liberalism, economic liberalism, His conclusion that ‘no systemic risk is thought to be
economic fundamentalism, Thatcherism or the at stake’ was extraordinary. There cannot have existed
Washington Consensus. The central thrust of this anywhere else on the face of the earth any better
ideology has been that government activity should be informed and resourced group than the ‘Committee
constrained, and ultimately replaced, by market forces. to Save the World’. If they did not understand
the problem, how could trustees have understood it?
In the past year, we have seen how unchecked market And if trustees could not understand it, but invested
forces have brought capitalism to the precipice. anyway, how stands their investment in the light of
252. Time, ‘Top 10 Scandals’ http://www.time.com/time/specials/2008/top10/article/0,30583,1855948_1863946,00.html. Site last accessed 29 July 2009.
253. Kevin Rudd, ‘The Global Financial Crisis’, The Monthly, February 2009, 20, 22.
254. Robert Rubin: What Meltdown? http://money.cnn.com/2008/01/31/news/economy/rubin_benner.fortune/. Site last accessed 29 July 2009.
255. See Eric Dash and Louise Story, Rubin Leaving Citigroup; Smith Barney for Sale, New York Times, 9 January 2009.
the duty Lindley LJ identified, ‘to take such care as an to emerge that naked gambling lay at the heart of the
ordinary prudent man would take if he were minded financial markets. We had a system in which:
to make an investment for the benefit of other people
for whom he felt morally bound to provide’? Loans which the borrowers had no chance of
repaying were sliced, diced, and packaged into
Investment and gambling ‘securities’.
Other financial products such as the scanda-
In a sense, all investments are bets. But much lously mismanaged258 $50 trillion259 synthetic
betting is off limits to a trustee. A bet on a race, for Collateralized Debt Obligations market. The
example, or on the outcome of a game of two-up. director of a leading litigation funder has described
As Rowlatt J noted in Graham v Green,256 that sort the lack of transparency that would be an absolute
of bet is: barrier to any prudent trustee dalliance in such
products: ‘No one has a clue around the world—
merely an irrational agreement that one person should including the banks or the regulators. No one has
pay another person something on the happening of an a clue what the amount in value of CDOs is, who’s
event. A agrees to pay B something if C’s horse runs got them, when they are due to mature, what
quicker than D’s, or if a coin comes one side up rather the terms of them are, and what will cause a total
than the other side up. There is no relevance at all loss. . . . God only knows—or maybe even he
between the event and the acquisition of property. doesn’t. I certainly don’t.’260
The event does not really produce it at all. It rests, as Funds were accepting money from investors and
I say, on a mere irrational agreement.257 placing them into further Funds, many of which
were feeder funds for the likes of Mr Madoff and
When the trust estate is invested in a portfolio his Ponzi scheme. Mr Picard, the liquidator of
of stocks, there is always a gamble, but not of the Madoff’s empire, said on 21 February 2009 that
sort described in the italicized text above. he had ‘found no evidence to indicate that securi-
Companies in the real economy make real products ties were purchased for customers’ accounts for
that real people need and will buy. Real money perhaps as much as 13 years. It was cash in and
can be made. cash out. Picard also said he found no separation
From the accounts Greenspan and Rubin have between the company’s broker–dealer division and
given of their ruminations and discussions, it seems its investment advisory unit, which prosecutors
256. [1925] 2 KB 37, 39–40.

257. See the discussion of betting income in Molloy on Income Tax (Butterworths, Wellington, 1976) pp. 30–36, 257–258, 516–518, and 520n; and in the review
of the book, and particularly of that discussion, by Mahon J (a keen punter) in [1976] NZLJ 546–547.
258. Tavakoli, Structured Finance & Collateralized Debt Obligations: New Developments in Cash & Synthetic Securitization 2nd edn (Wiley, New Jersey,
2008), xviii.
259. Douglas, ‘IMF expects ‘‘unprecedented’’ litigation from synthetic CDO fallout’ ALB, 17 December 2008: http://au.legalbusinessonline.com/site-search/imf-
expects-unprecedented-litigation-from-synthetic-cdo-fallout/31981?Keyword=CDO+fallout. Site last accessed 29 July 2009.
260. See Hugh McLernon’s Synthetic, Single-Tranche, Non Sub-Prime, Collateralized debt obligations referenced to multiple corporate defaults, 23 December
2008, http://www.imf.com.au/get_pdf.asp?docid=CDO_10. Site last accessed 29 July 2009.
7 Warren Buffett is best known for his description of derivatives as ‘weapons of mass financial destruction’ but, around the same time as he made that
comment, he also pointed to the circumlocution of derivative documentation—‘and CDO squareds—I figured out on a CDO squared you have to
read 750,000 pages to understand the instruments that were underneath it.’
8 Buffett seems to me to be a straight talker and the arch enemy of circumlocution. I think he arrived at his weapon of mass financial destruction
comment, in large part, because of their complication.
9 The best known sub prime CDO in Australia is the Federation CDO promoted by Lehman Brothers. I have tried to reverse engineer that CDO and I
can vouch for Buffett’s number. The federation CDO includes tranches from forty different residential mortgage backed securities which in turn sit
above tens of thousands of residential mortgages. No one in their right mind would try to carry out a full due diligence on such a structure.
10 As will become apparent from what follows, I believe that jargon has played its usual role in synthetic CDO’s ie to obfuscate and to leave the reader
in a position where he must rely, almost totally, upon the author.
have said was at the center of an alleged $50 billion him to believe that one did.’265 The learned judge
Ponzi scheme at Madoff’s New York-based firm. held that:
We have found nothing to suggest there was
any difference, any separateness, Picard said at a If our function on the appeal were to decide the facts
meeting yesterday with Madoff clients in US de novo, I would respectfully regard the approach that
Bankruptcy Court in Manhattan. It was all one’.261 treats as decisive the bogus nature of Mrs Pilmer’s
activities as rather narrow and unreal.
Trustees who were putting trust funds into this
market could not have known anything useful about I would see the undertaking as a somewhat unusual
the reality of these ‘securities’. one involving diverse investments, in which
It is remarkable how the best and brightest Mrs Pilmer’s personality and supposed abilities were
are attracted to schemes of this type. Calkin v a key feature but the appellant himself played an active
Commissioner of Inland Revenue262 is an example. part. He raised the money, partly by the sale of assets
The appellant had been the Chief Executive of a sub- and borrowing, and he made certain repayments of
stantial company at the material times. At the time, he loans; he supplied the money to her; he travelled to
no doubt considered himself a prudent business Wellington and Masterton from time to time for
person. Like many others of similar status, he soon consultations with her; he spoke with her solicitor
came to see that initial high ‘returns’ had sucked him from time to time; he inspected properties and
deep into a Ponzi scheme. The returns were the approved or disapproved proposed transactions. He
residue—after the promoter’s deductions to cover did all this with the undoubted intention of making
the lifestyle to which she had become accustomed— a profit. Indeed it was his sole motive. The fact that
of the contributions made by later gullible entrants. the profit was to come from investments made by
As in Rowlatt J’s dictum, the ‘returns’ had not been her on his behalf does not, as I see it, compel a
produced by the ‘investment’. They had more the finding that he had not commenced the undertaking.
quality of a gift or a finding. On the contrary, he had done a great deal in the
undertaking—everything in truth that was required
The efficacy of prayer of him.
Between the trial and the appeal, Mr Calkin became Similarly I would be at least disposed to regard the
a clergyman. Notwithstanding the cold water which various intended transactions, although relating to
the House of Lords has thrown on the justiciability263 different kinds of property, as sufficiently part of an
of the efficacy of prayer,264 this change of occupation organised and coherent plan, and sufficient in time,
may have had some effect. In the Court of Appeal, Sir scale, volume and the commitment of money and
Robin Cooke, as Lord Cooke then was, decried the effort, to warrant calling the whole an undertaking.
Revenue’s Berkeleian argument that the losses had not Considerations of this kind have been laid down
been tax deductible because the business ‘undertaking by this Court as relevant in determining whether a
did not exist; there was merely an accumulation taxpayer is in business in the ordinary sense of that
of data received by the taxpayer’s mind which led word . . . .266
261. Kolker et al., ‘Madoff Left No Sign of Trades Reported to Clients, Trustee Says’: http://www.bloomberg.com/apps/news?pid=20601087&sid=
aGCJqXiWWV4g. Site last accessed 29 July 2009.
262. [1984] 1 NZLR 440 (CA).
263. ‘[A] non-justiciable question . . . is a question which is not susceptible of determination by any legal yardstick.’ Curtis v Minister of Defence [2002] 2 NZLR
744, paragraph 28 (CA).
264. Gilmour v Coats [1949] AC 426, 446 per Lord Simonds—‘manifestly not susceptible of proof . . . the court can act only on proof’, not on belief.
265. Calkin v Commissioner of Inland Revenue [1984] 1 NZLR 440, 444–445.
266. Grieve v Commissioner of Inland Revenue [1984] 1 NZLR 101.
Regrettably for the Rev. Calkin, the function of the paupers with his $50 billion Ponzi scam, 82-year-
Court of Appeal of New Zealand not only was not to old Richard Picoli, having advertised to good effect
decide the facts de novo, but was to disturb a finding in the New York Catholic press, was doing the same—
of fact only if it was to have been clearly wrong. albeit to the more modest tune of $17 million—for
Invoking Lord Radcliffe in Edwards v Bairstow,267 Catholic priests and their parishioners.271
and deferring to the other members of the Court of Investment advisers presumably attracted trustee
Appeal, Cooke J agreed that the case was one of those clients because the latter would have taken it for
‘in which it could not be said to be wrong to arrive granted that the advisers would have done due
at a conclusion one way or the other.’268 diligence on Mr Madoff and all their other ‘invest-
It followed that the appellant had not been carrying ments’. A test for the efficacy of the advisers’ prayer
on an ‘undertaking’ within the extended definition of soon might come to pass:
‘business’. From that it followed, also, that the
New Zealand business theft-deduction provision269 UK investors are planning legal action against HSBC,
also was inapplicable. UBS, Barclays and Nicola Horlick’s Bramdean fund
Trustees who discover that they have been Ponzi over advice received before the Bernard Madoff
victims may have paid tax in previous years on the $50 billion (£36.8 billion) investment scandal.
‘income’ from their ‘investment’ of the trust estate.
Their ability to obtain refunds of the tax may depend One of the British victims had £36m invested in
on whether their taxing authority can be compelled to Madoff funds, according to a lawyer acting for the
reopen assessments to which objection may not have claimants.
been taken within a certain time from the making
of the assessments. Ten wealthy investors have approached the law
Former Pro Vice-Chancellor of Oxford University, firm Edwin Coe with a view to suing bankers, fund
and distinguished philosopher, Sir Anthony Kenny, managers and other intermediaries for the full value
retired from the Roman Catholic priesthood in 1963 of the money they have lost in the Madoff collapse.
when he found that he had become agnostic. A keen
mountaineer, he has been quoted as suggesting that, The 10 claimants are said to include some of Britain’s
were he to lose foothold on a steep face, he might, richest people, with combined losses of about £87m.
nonetheless, still find it natural to pray during his While their identities remain shrouded in secrecy, it is
rapid descent to the rocks below. understood that most are entrepreneurs who amassed
The trustee who, having failed to ask the hard their fortunes by selling their businesses. . . .
questions, discovers that he has landed the trust
estate, and himself, in a Ponzi scheme, also may An investment trust overseen by Bramdean recently
find that prayer comes naturally. But however natural announced that it had written off £12.4m invested
this might be, it is even less likely than the prayers of in two hedge funds run by Madoff.
enclosed nuns270 to evoke a benign judicial response.
God appears to be mercifully impartial here. While HSBC and Bramdean declined to comment yesterday.
Mr Madoff was busy converting wealthy Jews into Barclays Wealth said: ‘Barclays Wealth has a small
267. [1956] AC 14, 33 (HL).

268. Calkin v Commissioner of Inland Revenue [1984] 1 NZLR 440, 445.
269. Land and Income Tax Act 1954 s 129CF.
270. Gilmour v Coats [1949] AC 426 (HL).
271. Tom Bawden, ‘Two More Ponzi Schemes Uncovered,’ The Times, 10 January 2009: http://business.timesonline.co.uk/tol/business/industry_sectors/
banking_and_finance/article5485064.ece. Site last accessed 29 July 2009.
number of clients with exposure to the alleged fraud by Much of the SFO’s investigation will concentrate on
272
Bernard Madoff through a third-party hedge fund.’ the managers of so-called feeder funds responsible
for attracting many European investors to Madoff
One of the miracles that no doubt will be urged on Securities International, Madoff’s UK enterprise.
the Prayee will be the provision of a plausible way of
reconciling the advisers’ alleged due diligence with the Attracted by Madoff’s outstandingly consistent
recent revelation that Mr Madoff’s ‘auditors’ were the returns, these financiers had the global connections
one man ‘firm’ of Friehling & Horowitz, operating to introduce a fresh batch of money-hungry investors
out of a 13’ 18’ office in a small plaza 30 miles to the apparently infallible BMIS [Bernard Madoff
out of Manhattan. This ‘firm’ had not been reviewed Investment Securities]. . . .
by the American Institute of Certified Public
Accountants for the last 15 years. The reason for He consistently beat other fund managers with his
this lack of supervision was that, in each of those seemingly simple strategy of buying shares in large
years, the ‘firm’ had certified to the Institute that it companies and selling options on the same names to
did not perform audits.273 mitigate the risk. But as legend of his fund’s miracu-
Not even the regulators seem to have noticed. lous performance spread—and, it is alleged, his
The regulators’ failure to notice calls in question the friends and family network became inadequate to
value of the hue and cry for more regulation, and it satisfy investors’ craving—Madoff’s operations
suggests that not much has improved since the author looked farther afield for cash.
of Isaiah wrote, two and a half thousand years ago:
These included international investors such as Swiss
My watchmen are blind, all of them unaware; and Austrian private banks, hedge funds owned by
They are all dumb dogs, they cannot bark; large insurance companies such as MassMutual’s
Dreaming as they lie there, loving their sleep . . . Tremont Capital Management and several charitable
The shepherds also, they have no understanding; organisations.
They have all turned to their own way,
each to his own gain, one and all.274 Some of these groups, particularly the charities and
the prominent individual investors who now face
The lenders of the funds which were providing the ruin, accessed Madoff’s operations through the more
leverage, for the advisers’ schemes to put their clients traditional route of their longstanding financial
aboard the Madoff wealth wagon, likewise might be advisers. They will be keen to understand what due
installing prie dieux in their offices: diligence was undertaken on their behalf and why
these advisers appear to have relied upon paper
Some of Britain’s largest banks and financial proof of returns created by MSI itself. Were they
institutions are among several banks across Europe negligent?
that lent billions of dollars to funds that were feeding
Madoff’s operations, some even creating special notes The feeder funds’ returns were augmented by billions
to provide a guarantee. of dollars in loans from some UK banks—and the
bankers want to know why these advisers recom-
... mended Madoff in the first place. . . .
272. Watts, ‘Madoff’s UK investors set to sue’, The Sunday Times, 25 January 2009.
273. Abkowitz, ‘Madoff’s auditor . . . doesn’t audit?’: 19 December 2008, http://money.cnn.com/2008/12/17/news/companies/madoff.auditor.fortune/
?postversion=2008121808. Site last accessed 29 July 2009.
274. Is 36: 10–11.
Given the scale of the losses, the victims of the scheme diversified, blah-blah—but, my God, it had been
will be keen to explore every avenue in an attempt to going strong for so long and with such fantastic
minimise their exposure. This could lead to the returns, we had to get in.277
possibility of litigation against financial advisers and
others involved in the investment process, both in Mr Madoff’s playing hard-to-get made his ‘fantastic
America and in Britain. Without doubt, this case returns’ irresistible to many with money to invest.
will be one to watch in 2009.275 He would have approved the approach of the
female appellant as described by Ward LJ in Sutton
v Hutchinson.278
Ten rules of thumb She worked at the Spearmint Rhino Club. The
respondent was a businessman. He appears to have
An attempt to link Mr Madoff with The 10 thought that the Beatles’ ‘money can’t buy me love’
Commandments would be futile, but he has helped refrain was untrue. In search of distraction from the
to establish 10 useful rules of thumb. cares and tensions of his daily round, he visited the
club one evening. During his visit, he managed to
Rule ofthumb #1 obtain the telephone number of the appellant with
Of these, the first is: do not invest the trust estate a view to having dinner with her sometime.
in a fund that makes out it does not want to accept The learned Lord Justice thought this probably was
you, or to accept all you wish to invest: not going to be the traditional boy-meets-girl, ‘let us
have dinner, darling,’ kind of invitation. That was
When he added an investment arm to his broking firm purely obiter of course, but his Lordship might have
more than a decade ago, Madoff limited investors had a point. Certainly, like—but presumably better
to friends and acquaintances from the tightly knit looking than—Mr Madoff, the appellant knew a
circles of Manhattan’s Upper East Side synagogues thing or two about being hard-to-get. She suggested,
and charitable organisations and Palm Beach’s and the respondent paid, around £1000 per night for
exclusive Country Club.276 the pleasure of her company. In fact, it appears that
he did so night after night after night, until a
For one such investor: considerable sum of money had changed hands
between them.
All we knew was that my wife’s entire family had been Unhappy differences supervened. They seem to
in the fund for decades and lived well on the returns, have brought the respondent to the sad conclusion
which ranged from 15% to 22%. It was all very that the Beatles might have been right after all.
secretive and tough to get into, which, looking back, He claimed that the money which he had paid
was a brilliant strategy to lure suckers. . . . There were to the respondent had been by way of loan.
the usual warnings prior to investing—we all knew it He sought repayment. The respondent saw things
was a risk, we were told to make sure we were differently. She had rather thought that they had
275. Blundell, ‘Bernard Madoff: how will British investors be affected?’, The Times, 15 January 2009.
276. Ibid.
277. Chew, ‘How I Got Screwed by Bernie Madoff’, Time, 15 December 2008. See also Written Testimony of Harry Markopolos to the House of Representatives
Financial Services Subcommittee Hearing on reform of US financial services regulation, 4 February 2009, p. 12. He describes a trip to Europe during his
investigation of the scheme:
During that trip I met with 14 French and Swiss private client banks and hedge fund of funds (FOFs). All bragged about how BM had closed his hedge
fund to new investors but ‘they had special access to Madoff and he’d accept new money from them.’ . . . I also came to realize that several European
royal families were invested with BM. I met several counts and princes during my trip and it seemed they all were invested with BM or were marketing
BM’s strategies to noble families throughout Europe. BM had a marketing strategy that appeared to be based on false trust, not analysis.’’
278. [2005] EWCA Civ 1773.

been payments for the—what Mr Madoff’s above The [trial] judge tantalisingly tells us, at paragraph
investor might have called—‘fantastic returns’ he 21 in his judgment, that the purpose is ‘to tease but
had been deriving from her, presumably very active, not to satisfy’.
personal services.
Ward LJ set the scene with an opening to his As far as his Lordship was concerned, that was
reasons for judgment that stands alongside Lord the limit of judicial speculation:
Denning’s279 ‘it was bluebell time in Kent’:
Whether or not Rule 2 of the Spearmint Rhino Club
The appellant is a lap dancer. I would not, of course, had been breached, requiring that you could get no
begin to know exactly what that involves. One can satisfaction, we do not know and fortunately do
guess at it, but could not faithfully describe it. not have to decide.280
279. Hinz v. Berry [1970] 2 QB 40, 42.

280. There are occasions on which such judicial reticence is unfortunate. This may have been one. With a little more thought, their Lordships surely would have
seen the case for what it was: the canary in the mine for the global financial system—which was only three years away from the meltdown of 2008. The reasons
for this regret are obvious. First, as Justice Oliver Wendell Holmes said in ‘The Path of the Law’, 28110 Harvard L Rev 457 (1897).‘For the rational study of
the law the black letter man may be the man of the present, but the man of the future is the man of statistics and the master of economics.’ Second, there is
Eliot Spitzer:
In March, in the wake of revelations that Spitzer, 49, had met with a $1,000-an-hour call girl named Ashley Alexandra Dupré and patronized a high-
priced prostitution ring multiple times, the Democrat announced that he would resign his post as governor [of New York]. ‘I cannot allow for my
private failings to disrupt the people’s work,’ Spitzer said at a news conference in New York City, with his stricken-looking wife, Silda, by his side.
Months later Spitzer was working in his father’s real estate firm and Dupré was telling People magazine, ‘I think he’s been punished enough.’ To his
wife, Dupré said, ‘I’m sorry for your pain.’
[Time, ‘Top 10 Scandals’, http://www.time.com/time/specials/2008/top10/article/0,30583,1855948_1863946,00.html (last accessed 29 July 2009)] Third:
Until the 1960s, economists were happy to assume that economic agents were more or less perfectly informed. While this was obviously simplistic, it
was not appreciated that deviations from this assumption could make an enormous difference to the functioning of markets. In particular, asymmetric
information, in which one party has more knowledge than another, turns out to be crucial to market performance. . . . [I]t is possible to rewrite much
of Keynesian economics as a form of information deficiency in the functioning of a modern economy.
Bannock et al, Penguin Dictionary of Economics (Penguin, London, 7th edn, 2003), 191.
Thus, if only Holmes had not been ignored, there would have been at least one ‘master of economics’ on the Court of Appeal in Sutton v Hutchinson [2005] EWCA
Civ 1773. That member would have known of the collaboration between Professor Robert Seymour of University College London and Peter Sozou, of the London
School of Economics and Political Science. This collaboration has most recently given us their magisterial ‘Duration of courtship as a costly signal’: Journal of
Theoretical Biology 256 (2009) 1. They have found that:
During courtship, both the male and the female pay participation costs per unit time at fixed rates. A courtship process involving a sequence of small
gifts fits the assumptions of this model as long as the gifts are ‘costly but worthless’, ie the time-cost to the female in receiving the gifts exceeds her
intrinsic (ie noninformational) benefit from the gifts. But the model is more general than this in that it considers a courtship process which involves
participation costs but need not involve gifts as such.
A key feature of the model is asymmetric information arising from a binary variable, not completely observable by the female. The female will get a
positive payoff from mating only if the male is a ‘good’ male, with respect to his genetic quality, or ability or intention to provide paternal care. If the
female mates with a ‘bad’ male, ie one who is low quality or will not provide paternal care, she will get a negative payoff from mating with him.
We have found evolutionarily stable behaviour in which mating occurs after extended courtship. This has the following characteristic: a ‘bad’ male
should quit the courtship process at a certain positive rate, whereas a ‘good’ male should persist for longer (indefinitely for the specific assumptions in
our model).
To the male, the game has some similarity to a war of attrition, with the opportunity to mate with the female constituting the resource for which he is
waiting. A ‘good’ male has a higher ratio of fitness benefit from mating to fitness cost per unit time of courting than a ‘bad’ male.
From the female’s point of view, the strategic problem that she faces is one of decision-making under uncertainty (Dall et al, 2005). Whereas the
model of Sozou and Seymour (2005) leads to an equilibrium outcome in which the female never mates with a ‘bad’ male, in real mating systems
females may sometimes mate with the wrong male. This could be because of random errors in a female’s assessment of male quality (Luttbeg, 1996) or
limits on the processing capacity of her neural system (Krakauer and Johnston, 1995).
The extended courtship equilibria in the present study also do not completely eliminate the risk of a female mating with a ‘bad’ male. The female’s
strategy is a compromise solution in the face of a trade-off between the costs of mating too quickly (an increased risk of mating with a ‘bad’ male) and
the time-cost of delay. The female’s cost of delay can be interpreted as a cost of acquiring information.
Bad males quit at a finite rate; they do not quit immediately. This means that, whilst the courtship cost incurred by a bad male is on average less than
that incurred by a good male, it is nevertheless positive. It is therefore necessary for bad males to sometimes succeed in mating in order for an
extended courtship equilibrium to be sustained. Appendix C extends the analysis to an arbitrary number of discrete male types of increasing
‘goodness’. The extended model behaves in all essential respects like the binary model: the worst type of male that courts the female constitutes
the ‘bad’ male type and has a finite quitting rate, whilst all better male types never quit and collectively constituting the equivalent of the ‘good’ male
type. Ibid. pp. 9–10.
Like the lap dancer, Bernie Madoff certainly was a bit Cornfeld: ‘Anyone was fool enough to put their
of a tease. Because of his guilty plea, the jury will money with us,’ she said, ‘that was their problem’.284
never be empanelled to decide whether he managed
‘to tease but not to satisfy’. He may yet manage to Rule ofthumb #3
give great satisfaction—after all, former Enron CEO Which leads directly to, and vindicates, the third
and President, Jeffrey Skilling [the devotee of ‘mark to useful rule of thumb. As enunciated by J. K.
market’ accounting281], got a 24-year sentence. Even Galbraith, this rule is that neither prudence, nor
though his appeal has been allowed, the talk is that his even probity, is necessarily to be inferred from
resentencing will run somewhere around 15–19.282 apparent wealth. Indeed:
A comparable sentence for Mr Madoff undoubtedly
would give considerable satisfaction to those trustees Having money may mean, as often in the past and
who invested with him, lost their shirts as a result, frequently in the present, that the person is foolishly
and resisted the temptation to suicide. indifferent to legal constraints and may, in modern
times, be a potential resident of a minimum-security
Rule ofthumb #2 prison.285
This leads to the second useful rule of thumb: do not
invest in a name like Bernie. In 1968, Anthony Rule ofthumb #4
Sampson gave it as the opinion of ‘most financial The fourth rule of thumb is: do not invest in anything
people’ that Bernie Cornfeld ‘has come to stay’, and the accounts of which are audited by a tin-pot
that his Investors Overseas Services mutual fund was accounting firm, such as Mr Madoff’s above-
set fair to ‘challenge the old banking establish- mentioned Friehling & Horowitz:
ment’.283 Yet only three years later, in their brilliant
analysis of the Cornfeld scheme, Raw, Page and ‘If you’d seen a PriceWaterhouse [Coopers] or
Hodgson were to conclude that: Deloitte as the auditor, you would’ve trusted them,’
Mr Siegel [a lawyer who advises nonprofits at Charity
If you were in the Fund of Funds, you would have Governance Consulting in Chicago] said. ‘A $50
done better to keep your money in an old sock. billion fund is not going to be audited by a three-
Or better still, to have spent it yourself before IOS person firm.’286
got hold of it. . . .
Rule ofthumb #5
After all the promises, it seems that the best account From whence we immediately derive the fifth rule
of the IOS investment operation is the one we of thumb: never allow an outfit with a name like
were given by the young woman who worked for Charity Governance Consulting select your auditor.
When the sexist badinage about the limits on the processing capacity of the female neural system had died down, the general force of the Seymour/
Sozou, analysis—buttressed, as it is, by pages of mathematical formulae pitched at the same level as the Black–Scholes option-pricing formula in the title to
this article—would have left no doubt in the minds of the Court of Appeal that the acceptance, by the appellant in Sutton v Hutchinson [2005] EWCA Civ 1773, of
a mere £1000 per night, when she was only a trans-Atlantic flight away from being able to charge $1000 per hour, indicated that ‘market performance’ in the general
economy was already mortally impaired by ‘asymmetric information’ within the passage already cited from Bannock et al., Penguin Dictionary of Economics
(Penguin, London, 7th edn, 2003), 191.
Warned by a judgment to that effect, Gordon Brown then would have had three years in which to have taken measures that might have avoided the meltdown
altogether.
281. The taking of future projected profits immediately on settlement of the transaction designed to make them. He called this the ‘black box’ approach.
282. Clark, ‘US Court orders Enron fraudster Jeffrey Skilling to be resentenced’, The Guardian, 6 January 2009.
283. The New Europeans (Hodder & Staughton, London, 1968), 186.
284. Do You Sincerely Want to be Rich (Penguin, UK, 1971), 458, 460.
285. A Short history of Financial Euphoria (Penguin, New York, 1994), 14. See also his The Good Society: the Humane Agenda (Sinclair-Stevenson, London, 1996), 80.
286. Cordova, ‘A few investors spotted Madoff’s red flags’: http://www.crainsnewyork.com/apps/pbcs.dll/article?AID=/20090109/FREE/901099987. Site last
visited 30 July 2009.
The Court of Appeal has pointed out that an auditor With the SEC, the Justice Department and various
is to be a watchdog only. He is not required to be congressional committees now scrutinizing
a bloodhound.287 But while he may not have to be Andersen’s audit work on Enron, there is little
overly suspicious, an auditor does at least have to doubt efforts will be made to rein in the industry.
bark at the obviously worrying signs. Over the eight ‘The profession has always done just enough
years that it audited the accounts of the giant Indian to get out of a hole,’ says industry analyst Arthur
listed company, Satyam Computer Services Ltd, it has Bowman. The SEC and Congress are looking into
been claimed that PriceWaterhouseCoopers did Andersen’s interpretation of accounting rules that
not even ask to see bank statements, or any other allowed Enron to exclude losses at several partner-
verification, of its audit client’s reported, but ships from its balance sheets. But the larger issue
apparently totally fictitious, USD 1 billion ‘cash in will be the objectivity of the entire industry.
the bank’, yet: Enron paid Andersen $25 million for its audit
last year and $27 million for ‘consulting’ and other
‘This is the basics. When you are doing an audit and services. ‘How can any auditor be independent
a client says I’ve got a billion bucks in the bank, you when his client is paying this kind of money?’
check with the bank that it’s there,’ said Hugh Young, Bowman asks.
who oversees $30 billion in assets as the managing
director of Aberdeen Asset Management’s Asia Two of Enron’s senior financial executives had pre-
288
funds. viously worked for Andersen in Houston: Richard
Causey, Enron’s chief accounting officer, and Jeffrey
Satyam, and the market, appear to have been as McMahon, chief financial officer. Although it’s not
happy with PricewaterhouseCoopers as auditor as unusual for auditors to be subsequently hired by
Enron had been with Arthur Andersen—of which it their clients, Andersen has an unusual history—in
was said289 that: Waste Management’s case, supplying every CFO
from 1971 to 1997.
The incident further tars the name of venerable Arthur
Andersen, which in June settled allegations of fraud Nonetheless, when the truth emerged, ‘Satyam
stemming from its audit of Houston-based Waste said . . . they had appointed Deloitte and KPMG to
Management and paid a $7 million fine without assist the company in restating its accounts.’290
admitting any wrongdoing. Last year, again without Ernst & Young seems not to have made the cut.
admitting wrongdoing, Andersen agreed to pay $110 Maybe this was because US Federal prosecutors
million to settle a class action brought on behalf of recently had charged four of its partners with partici-
shareholders of another client, Sunbeam, which pation in a scam to deprive the US Government of
had misstated its financial results during the 1990s. hundreds of millions of tax dollars.291 Ernst & Young
These days, an Andersen competitor observes sardo- was accused of having helped wealthy clients create
nically, settling a fraud case appears to be good for phoney losses on fictional investments, and then
attracting business from other firms that want a soft offsetting the losses in the calculation of their taxable
touch for an auditor. income.292
287. Re Kingston Cotton Mill Co (No 2) [1896] 2 Ch 279, 288 (Lopes LJ). See also Moore Stephens (a firm) v Stone Rolls Ltd (In Liq) [2009] UKHL 39.
288. http://www.thejakartapost.com/news/2009/01/14/pricewaterhouse-says-satyam-audits-unreliable.html. Site last accessed 29 July 2009.
289. Kadlec, ‘Enron: Who’s Accountable?’, Time, 13 January 2002.
290. http://www.thejakartapost.com/news/2009/01/14/pricewaterhouse-says-satyam-audits-unreliable.html. Site last accessed 29 July 2009.
291. The Times, 20 June 2007.
292. It was alleged that, for this purpose, they used ‘false and fraudulent factual scenarios’ such as the World Trade Centre attacks, which sent the value of
investments plunging across the globe. Ernst & Young allegedly made USD 121.7 million in fees from the bogus tax shelter profits in the form of a cut of the savings
that it generated for its clients.
Rule ofthumb #6 ‘That’s Mr Morgan’s yacht on the right,’ the guide

The sixth rule of thumb is: when you find you have would declaim. ‘The one next to it belongs to
been let down, do not just go off on the rebound with Mr Rockefeller—that one is Mr Dillon’s.’ One day
any old sweet talker who happens to cross your path. an innocent tourist is said to have asked: ‘Where are
The first frog or two you are tempted to kiss may turn the customers’ yachts?’
out to be just another toad, rather than a prince of
auditors. In January 2007, it was reported that So what does a trustee make of it, if an investment
Deloitte—the first of Satyam’s replacements for adviser is not charging for his advice? James Hedges
PriceWaterhouse—had paid $149 million to settle a IV, of LJH Global Investments, ‘a boutique firm
lawsuit arising from its audit of a huge Italian dairy that invests in hedge funds and private equity for
company. The company, Parmalat, became bankrupt high-net-worth families,’ visited Mr Madoff in 1997
under E14 billion of debt, after discovering a E4 on behalf of a client investment trust with an interest
billion gap in its accounting.293 In September 2006, in possibly investing with Mr Madoff. Mr Hedges
the other replacement, KPMG, reportedly paid $456 saw red flags all over the place. Not the least of
million to settle an investigation into illegal tax them was:
shelters. Almost simultaneously, a German bank
admitted criminal wrongdoing. It had to pay the fact that Madoff was charging no fees other than
$29.6 million in fines for its crime of having used trading commissions: ‘The notion that something is
KPMG’s so-called ‘tax shelters’ to cheat the US fee-less—which is what they largely proffered—is too
government. good to be true.’296
Like investors in Satyam, and in Mr Madoff’s
scheme, trustees who spurn rules of thumb four, Mr Hedges was not the only one for whom this was
five and six are doomed to prove the adage that a warning:
‘recessions find what auditors miss.’294
Madoff took no management fees for his investment
Rule ofthumb #7 advisory services. They just earned commissions on
The seventh rule of thumb is that investment advisers the trades which they processed through the market-
who are in demand because of great talent will charge making side of the business. This amounted to leaving
you rapaciously. After all, they model themselves on the table a quarter billion dollars a year Barron’s
on the Bar. estimated back in 2001. Why would he do that?297
The trappings of wealth in advisers bring to mind
New York of the 1920s. The yacht harbour was a
Rule ofthumb #8
magnetic sightseeing attraction. There were moored
there the floating gin palaces of the bankers and The eighth rule of thumb is that fraudulent,
brokers. To quote again Raw, Page and Hodgson’s untalented, and otherwise useless, investment advi-
exposé of Bernie Cornfeld’s Investors Overseas sers, who are in demand only because ‘trustees are
Services swindle:295 often at best only accountants, and beneficiaries
293. http://www.faqs.org/abstracts/Business-international/Parmalat-auditor-was-told-of-fraud-suspicion-in-2001-Deloitte-Italy-was-alerted-to-possible-fraud-
at.html. Site last visited 29 July 2009. Wall Street Journal, Europe, 2004, Nisse, ‘Deloitte ‘‘bowed to pressure to stop Parmalat whistleblower’’ ’, Independent, 1 May
2005: http://www.independent.co.uk/news/business/news/deloitte-bowed-to-pressure-to-stop-parmalatwhistleblower-526739.html. Site last visited 29 July 2009.
294. Nixon, ‘From pinstripes to prison stripes’, The Tablet, 31 August 2002.
295. Do You Sincerely Want to be Rich (Penguin, UK, 1971), 461.
296. Varchaver, ‘Who isn’t a Madoff victim? The list is telling’, 19 December 2008: http://money.cnn.com/2008/12/16/news/madoff.hedges.fortune/. Site last
visited 29 July 2009.
297. ‘Madoff Investment Securities Revealed as ‘‘Stunning Fraud’’ ’, 12 December 2008: http://www.topgunfp.com/madoff-investment-securities-revealed-as
-stunning-fraud/. Site last visited 29 July 2009.
gaping rustics,’ will charge you rapaciously. After all, grave suspicion whether the adviser has done any
they, too, model themselves on the Bar. useful due diligence at all:
The phrase cited in this rule is taken from an earlier
edition of Jacobs Law of Trusts in Australia.298 The Spanish lawyers, who hope to reach agreements with
phrase is not repeated in the current edition,299 of banks without going to court, are working with the
Jacobs Law of Trusts in Australia. Neither the discus- US law firm Labaton Sucharow.
sion, in connexion with the second rule of thumb,
of Enron’s Jeffrey Skilling, nor the discussion— The American law firm cited Optimal as one of the
under the fourth, fifth and sixth rules of thumb—of ‘feeder funds’ who channelled funds into Madoff Secu-
Friehling & Horowitz, PriceWaterhouseCoopers, rities in return for what it calls ‘lucrative commissions’.
Deloitte, KPMG, Ernst & Young and Arthur
Andersen, leaves room for surmise that the omission It said, Labaton Sucharow is investigating whether
of that phrase could have been related to a marked these feeder funds conducted adequate due diligence
improvement in the fitness of accountants for their before investing in Madoff in light of the multiple red
professed purpose.300 flags that are now known to have been evident, includ-
While urbanization may have had some effect on ing the absence of a serious or reputable auditor, the
their overall rusticity, there can be no doubt that absence of an outside clearing agent, and the overly
beneficiaries may gape more than ever these days, consistent returns.
if only at the precipitous drop in value of their trust
estate and at the fees charged by the trustees for [Spanish bank, Banco] Santander faces loses of
having managed that drop. E17 million euros (GBP 16m), but its clients were
exposed to loses of E2.3 billion euros.
Rule ofthumb #9
The ninth rule of thumb: beware over-consistent The Spanish bank reportedly praised Mr Madoff
returns. weeks before the disgraced financier was accused of
the biggest fraud in corporate history.
Using a strategy called ‘‘split strike conversion’’ which
involved selling calls and buying puts on a basket of Spain’s anti-corruption prosecutor is investigating
owned stocks, Madoff reported only three down Santander and the BBVA bank to see if they acted
months between January 1996 and December correctly towards investors.
2004—a 9 year, 108 month period. Sophisticated
investors familiar with the strategy were mystified Mr Madoff is accused of running a massive pyramid
about how consistent and low volatility his returns scheme, using cash from new investors to fund
were.301 payments to earlier clients. A Santander spokesman
declined to comment.302
A trustee needs to be very wary indeed of an
investment adviser who advises him to invest in Five days after that refusal to comment, the bank
anything with that sort of record. There must be offered E1.38 billion in preference shares, with an
298. (Butterworths, Australia, 6th edn, 1997), para 1715.

299. LexisNexis Butterworths, Australia, 7th edn (2006).
300. See also Austin Mitchell MP and Prem Sikka, Dirty Business: The Unchecked Power of Major Accountancy Firms (Association for Accountancy & Business
Affairs, 2002).
301. ‘Madoff Investment Securities Revealed as ‘Stunning Fraud’’, 12 December 2008: http://www.topgunfp.com/madoff-investment-securities-revealed-as
-stunning-fraud/. Site last accessed 30 July 2009.
302. Keeley, ‘Spanish Madoff investors in bid to recover funds’, Times Online, 23 January 2009. http://business.timesonline.co.uk/tol/business/industry_sectors/
banking_and_finance/article5575328.ece. Site last accessed 30 July 2009.
annual 2% coupon, ‘to compensate its clients’ unrealized, notional. Hedge funds do not engage in
for their original investments.303 annual liquidation of their assets.
The ‘gains’ also may have been calculated under the
Rule ofthumb #10 influence of some variant of Jeffrey Skilling’s ‘mark to
The tenth rule of thumb: beware secretiveness. market’ accounting for Enron: the hoped-for profits
It was said that: from the investment being treated as ‘in the bag’
to such an extent as to justify their immediate
Madoff was secretive to the extent of not even wanting recognition.
his investors to tell anybody they were invested with Collateralized Debt Obligations, for example.
him. That’s a bizarre marketing strategy!304 These were caricatured brilliantly by John Bird and
John Fortune in their hedge fund skit in the
It is also an old marketing strategy. Think back to South Bank Show in mid-2008.307
1720, and the South Sea Bubble mania. The most— One interlocutor refers to ‘granting vast numbers
but only just the most—extreme prospectus of that of mortgages, to people who can’t afford them, on
era offered 5000 shares of £100 each, on a £2 deposit. properties which are diminishing in value’.
It promised that, by payment of this deposit, the By way of explanation, the other, an ‘investment
subscriber became entitled to £100 per annum per banker’, asks him to:
share in:
imagine, if you can, say, an unemployed black man,
A company for carrying on an undertaking of great sitting on a crumbling porch, somewhere in Alabama,
advantage, but nobody to know what it is.305 in his string vest. A chap comes along and says ‘would
you like to buy this house before it falls down; and
Fuller and better particulars of this venture were why don’t you let me lend you the money’.
promised in a month, when a call was to have been
made for the outstanding £98. A thousand of the The dialogue continues:
shares were subscribed in the five hours following
publication of the prospectus. At that stage, the And is this chap, who says this, a banker?
promoter was ‘philosopher enough to be contented
with his venture, and set off the same evening for Oh no: he’s a mortgage salesman. His income depends
the Continent. He was never heard of again.’306 entirely on the number of mortgages that he can
arrange.
‘Well, thank God I invested the trust estate in
So his judgment, to arrange mortgages, is completely
a hedge fund, and not in one of those dreadful
objective.
ponzi schemes!’
Don’t open the champagne yet. Completely objective. Yes.

First, annual gains reported by hedge funds, if any
hedge funds do report such gains, will be largely And what happens next?
303. Seib, ‘Santander offers E1.38 bn to compensate clients hit by Madoff’, The Times, 28 January 2009. http://business.timesonline.co.uk/tol/business/
industry_sectors/banking_and_finance/article5601108.ece. Site last accessed on 30 July 2009.
304. ‘Madoff Investment Securities Revealed as ‘Stunning Fraud’’, 12 December 2008: http://www.topgunfp.com/madoff-investment-securities-revealed-as
-stunning-fraud/. Site last accessed 30 July 2009.
305. Mackay, Extraordinary Popular Delusions and the Madness of Crowds (1841, Crown Trade Paperbacks, New York, reprint 1980), 58.
306. Idem.
307. Reproduced here with the kind permission of the production team at The South Bank Show and Vera Productions Ltd, as copyright holders.
Then this mortgage, this debt, is bought by a bank, In view of the fact that, in these packages, there’s a lot
and packaged together, on Wall Street, with a number of dodgy debt, what is there about it that attracts
of other, similar, debts. the financial—you know—risk taker?
Without going into much detail about what is Well, because these hedge funds, as they are called,
actually . . . which specialise in these debts . . . um, they all have
very good names.
Without going into any detail. That’s far too boring.
And so this is put into a package of debts, and so then You mean they are responsible companies?
it’s moved on to Wall Street and then, this, this . . . it’s
extraordinary what happens then: this package of No. No: it’s nothing to do with their reputation.
dodgy debts stops being a package of dodgy debts They have actually very, very, good names. The
and starts being what we call a structured investment names they think up are very, very, good. I’ll give
vehicle. you an example: there’s a very well-known
American, Wall Street, firm called Bear Stearns who
An SIV? have two of these hedge funds which specialise in
these mortgage debts. And they lost so much
An SIV, exactly; yes. money—lost so much of its value—that Bear
Stearns announced that they would have to put in
I see. And then someone like you comes along and $3.2 billion into one of the funds to try and keep
buys it. it afloat.
I buy it, yes; and then I will ring up—I don’t $3.2 billion?
know—somebody in Tokyo, and say ‘do you want
to buy it?’ $3.2 billion. Yes. Yes. And even then they said the
investors couldn’t get any money out of it and they
Mm? were going to let the other fund go: but, one of
these funds was called ‘High Grade Structured
And they say ‘what’s in it?’; and I say ‘‘I haven’t Credit Strategies Fund’, and the other was called the
the faintest idea.’ And they say ‘how much do ‘High Grade Structured Credit Enhanced Leverage
you want for it?’ And I say ‘A hundred million Fund.’
dollars.’ And they say ‘fine’. That’s it. That’s the
market. Well that sounds very good, doesn’t it.
Presumably this package, I mean that kind of thing Yes it’s good, isn’t it.
can happen several times to the same package.
Very trustworthy.
Oh yes
Yes, this is the magic of the market. What started off
And every time it does, of course, um, then, you, or lending a few thousand dollars to an unemployed
someone like you, will get a fee, and a markup. black man in a string vest has become a High Grade
Structured Credit Enhanced Leverage Fund
And a profit? Yes. Yes. I can’t be expected to do it for
nothing: it’s hard work being . . . I like the sound of it.
It is good. I mean, it’s got good words in it. It’s got I see. But now you see, people are saying that the crisis
words like ‘high’. is likely to turn into financial meltdown. I mean,
can that be avoided?
‘High’ is good.
It can be avoided provided governments and central
‘High’ is good. Better than low, anyway, isn’t it. banks give us, the financial speculators, back the
money that we’ve lost.
Yes; yes absolutely. But isn’t that rewarding greed and stupidity?
And ‘structured’: is another good word. No. No. It’s rewarding what the Prime Minister,
Gordon Brown, called ‘the ingenuity of the markets.’
Very good.
I see.
‘Enhanced’?
We don’t want this money to spend on ourselves.
I love ‘enhanced’. We want this money just to go into the market: so
that we can carry on borrowing and lending money as
‘Enhanced’ is very good. if nothing had happened, and without thinking
too much about it.
I’d buy anything if it said ‘enhanced’.
But even if the hedge fund’s investments were
Absolutely, yes. I mean, it might have been different to have been valued a good deal more accurately
if it had said ‘Unemployed Black Man in a String than Bear Stearns managed,308 let alone Jeffrey
Vest Fund’, but . . . . Skilling, a problem still was likely to arise when
investors wanted, or needed, to withdraw their
Because then, alarm bells might start . . . to ring. But, investment.
despite these very plausible names, surely the reality is At that stage the fund either sells its most liquid,
that the people that lent all this money are being and most valuable, assets to pay her out; or it pays
incredibly stupid? her out from funds being contributed by new
investors. In the former case, because the easiest
Oh no. No. No. No. The reality is that what was stupid funds to sell are also likely to be the most valuable,
is that, at some point somebody asked how much those remaining in the fund are stuck with the
money these houses were actually worth. I mean, if harder to sell, and less valuable, assets. They are
they hadn’t have bothered to ask that question then short-changed.
everything would have gone on as perfectly normal. The latter case is the simple Ponzi situation. So, the
But, unfortunately, they did. trustee who has invested in the hedge fund, will not
308. According to http://www.sec.gov/news/press/2008/2008-115.htm. Last accessed 30 July 2009.
The Securities and Exchange Commission has charged two former Bear Stearns Asset Management portfolio managers for fraudulently misleading
investors about the financial state of the firm’s two largest hedge funds and their exposure to subprime mortgage-backed securities before the collapse
of the funds in June 2007. The SEC’s complaint alleges that when the hedge funds took increasing hits to the value of their portfolios during the first
five months of 2007 and faced escalating redemptions and margin calls, then BSAM senior managing directors Ralph R. Cioffi and Matthew M.
Tannin deceived their own investors and certain institutional counterparties about the funds’ growing troubles until they collapsed and caused
investor losses of approximately $1.8 billion.
have escaped the Madoff sting after all. Furthermore, The recent failures in hedge funds, while rooted in
as Officer309 has put it: the financial meltdown, have been further fueled by
the lack of new investment as well as pressure from
Every year hedge funds do have to liquidate part of current investors to take their money and run.
their profits in order to pay their managers, traders Regardless of a fund’s investment strategy, liqui-
and other support staff. Fund managers typically keep dation tends to make unrealized gains smaller—
20% of (unrealized) trading profits. But first they and unrealized losses larger—when they are finally
must realize that 20% by selling the liquid assets. realized.
If a fund is overestimating the value of the illiquid
assets, then its manager’s profit is grossly overesti- By design, hedge funds benefit managers more than
mated. In most cases, the profit is at least slightly investors. Since the liquidation of assets always results
overestimated because of slippage in the liquid in slippage—the more that is sold, the worse the price—
assets. In other words, if a fund liquidated all profits, managers for every hedge fund always get the ‘best’
the supposed 20% taken out first would actually 20% of the profit.
be larger than 20% of the total realized profit.
So you see, there could be a little Ponzi scheme
If hedge funds had to regularly liquidate assets, in every hedge fund. It is inherent to the model
we would not see the spectacular returns reported of the modern hedge fund. The only way to avoid
in the past. One factor of the supposed success of these schemes is to regularly liquidate all assets
hedge funds is their ability to report unrealized and allow all investors to decide what to do with
gains and to be flexible in liquidation, since their cash returns. In the past, this would have
investors who believe they are getting high returns meant seemingly diminished returns. With returns
are unlikely to withdraw their money. That was seemingly high, investors did not complain about
how Madoff was able to maintain his charade for the status quo. Now, given that regular liquidation
so long. would mean more transparency and diminished
losses, in recent days investors’ opinions would
Wonder why Chicago-based hedge fund Citadel is not likely differ.
allowing investors to withdraw their money until at
least March? Citadel has already reported about 50%
losses for its two largest funds. Remember: these are
Nun sense: Sister Catherine Crowley
unrealized losses. If Citadel liquidated assets to pay
out to investors, losses would be even greater. The only person to head off the sparkling Bird–
Barring a miracle, the first investors out would lose Fortune duo, with a devastatingly accurate assessment
less than those going out later. But even in good times, of what really was going on, was a Catholic nun,
the withdrawal of money from a hedge fund impinges Dr Catherine Crowley. In her past life, she had been
its performance. a—clearly fearsomely competent—City financial
practitioner. Her 2006 book, The Value of Money:
Hedge funds are designed to take in more and more Ethics and the World of Finance,310 was the most
investors’ money. Then inefficiencies and perfor- pellucid, and balanced, account of what was
mance distortions of withdrawing money for investors going wrong, where it had the potential to lead us,
and profit-taking for managers are smoothed out. and why.
309. ‘The Ponzi Scheme in every Hedge Fund’, Time, 5 January 2009.
310. Continuum, London, 2006.
Dr Crowley sees the good in derivatives. After true risk exposure or the exposure of other partici-
a jargon-free explanation of their workings, she pants. Derivatives have quantifiable benefits but
concludes:311 unquantifiable risks. In part this is due to lack of
transparency and complexity, together with the
These considerations show that derivatives can make dynamic nature of the risks which can spill over into
a valid contribution to the functioning of financial many markets. This is compounded by the market
markets. These markets, in their turn, can make structure and the moral hazard of volatility, whereby
a positive contribution to the common good. the financial sector can generate more business and
Derivatives are one of the most flexible and efficient make bigger profits if assets have a volatile price.
means of transforming unwanted financial risks
through the transfer of exposures among counterpar- The effects are not, however, confined to market
ties. They can facilitate investment which might participants. The nonfinancial sector of business
otherwise be too expensive or cumbersome to under- bears increased costs in having to buy protection
take. The popular perception that derivatives have against volatility and must divert resources to mana-
little merit, often fostered by newspapers, is erroneous. ging risks—resources which are not then available
This is not to say, however, that they are without for their core business. . . . Whole economies can be
major defects, defects which can seriously undermine destabilized by speculative cross-border capital flows,
their contribution to the common good. often in the form of derivatives, together with spec-
ulative attacks on currencies not driven by market
So she is decidedly not of the theological school which fundamentals. The analysis in the following sections
will ‘blast against ‘‘structures of sin’’ and demand will have three strands: risk measurement, risk
‘‘a prophetic call’’ ’.312 She considers that Christian distribution and risk evaluation. I will be rejecting as
critics ‘have often moved too quickly from the inadequate the assumption of the financial sector that
description of human and institutional failure to risk is purely a technical, value-free matter. I also
solutions in the categories of biblical revelation of reject the assumption that risk is a professional issue
Christian theology’.313 alone. Rather, it is a public issue.
Nonetheless, she is clear that, for all the value
they can have, derivatives also can pose the very Certainly an issue too important to leave to the
systemic risk Robert Rubin feared, and that the ‘experts’ who profit from the trade:315
other members of the ‘Committee to Save the
World’ derided. Sister Crowley enters the ethical The next issue is what role to assign to expert opinion.
phase of her analysis by considering risk and moral One of the noticeable features of the finance sector is
hazard:314 its possession of expert and exclusive knowledge. This
may well contribute to the sector being seen by many
I have already drawn attention to a number of risk as ‘ethic resistant’. This is because the combination of
features inherent in derivative trading. These include knowledge which is both expert and exclusive can lead
the difficulty, indeed the near impossibility, market to the apparent exclusion of others in any discussion
participants have in gauging either their own about the activities upon which that knowledge bears.
311. The Value of Money: Ethics and the World of Finance, 125.
314. The Value of Money: Ethics and the World of Finance, 136–137. Cf Shirreff, Dealing with Financial Risk (Economist, London, 2004), p. 28: ‘‘The unfortunate
property of derivatives is that losses can rapidly be compounded.’’
315. The Value of Money: Ethics and the World of Finance, 146–147.
This in turn can give the appearance of any justification She spoke further of this in an interview with Chris
of that activity being little more than the creation of an Blackhurst:316
alibi through the sector’s power and isolation from
discourse in the public forum. In discussing the role Neither does Cowley feel the future shape of the
of expert opinion we need, however, to draw a markets should be left to a small group to determine.
very clear distinction between evaluations of risk ‘What we have experienced is a systemic failure, where
magnitude and evaluation of risk acceptability before a failure to appreciate and restrict risk in one area
considering whether expert or lay opinion is the threatened an entire economic meltdown—it’s too
better. big a problem to be left to a few.
Clearly experts have a greater knowledge and ‘What I do want to argue very strongly is that risk
understanding of particular risk probabilities and is not purely a ‘‘sectoral’’ issue to be decided by a
magnitudes. Some might argue, therefore, that as technocratic elite of experts, it’s actually a public
their knowledge is more reliable, it is experts who issue. Just as nuclear issues, genetic, biotechnica1
are most able to make rational decisions about risk issues used to be seen as the preserve of the expert,
acceptability. This position reflects the de facto situa- we now rightly say, ‘No, the public has got a voice in
tion with derivative risk, but it has major problems. this’ because of who bears the risk. I don’t think
The first problem is reflected in the discussion above there’s been anything like enough attention to the
on risk measurement. Measurement of derivative risk risk bearers. We know who benefits from the risk—
is neither exact nor objective. This weakens the claim for example, the companies making whacking big
of expert knowledge, although obviously it does not profits. They’ve sat and benefited from the risk, but
eliminate it. The second problem is that it is difficult the actual risk bearer was a much, much wider pool of
to accept the disinterestedness of those judging the people, of society as a whole.’
acceptability of a risk when they are the ones who
receive the benefits but are not the ones who bear Cowley is also a great believer in the frailty of human
the greatest risk. The presence of expert and exclusive beings—that no matter how theoretically brilliant the
knowledge disenfranchises the very persons likely to structure, ultimately it is people who will decide the
be risk victims. outcome. Critical in that, she argues, is our treatment
of money. ‘A large part of what I looked at is: what the
The third problem is that, although it is true that mere fact of trading money does to you and does to
society in general has less accurate knowledge of risk society; the very nature of money, the way that it
probabilities, that is beside the point. Even if risk brings distance into relationships, the way that it
estimation were objective, the determination of supports particular understandings of independence,
whether a risk is acceptable is not. It is determined autonomy, freedom—whatever word you want to
by our perceptions and constructs, sensitive to specific use—and the way that can feed into relatively
assumptions about measuring preferences, determin- young, therefore relatively emotionally immature
ing social choices and quantifying risks, costs and financial practitioners:’
benefits. Decisions about risk acceptability are less a
function of knowledge of risk probabilities than a Traders were dealing in derivatives that were ‘so
function of the value attached to avoiding potentially complex that no one understood them’. As a result,
catastrophic consequences and to obtaining benefits ‘no one knew where the risk actually lay. It was
from taking some risk. assumed it was dispersed but even as far back as
316. ‘The nun who knew first’, The Tablet 11 April 2009, 12, 13.
1999, the Bank of International Settlements, in one of Professor of Political Economy at Harvard probes
its documents dealing with high-leveraged institu- further:320
tions, was pointing out the possibility of risks actually
being amplified through the system rather An important question which no one seems interested
than contained and dispersed by the system.’317 in addressing is what fraction of the economy’s total
returns to productively invested capital is absorbed up
That formed part of her ‘beef’ as she puts it, but front by the financial industry as the costs of allocating
Cowley also admits to being taken aback by the scale that capital. . . . [T]he latest financial crisis is a sharp
of the bad or ‘toxic’ banking business that has reminder that the simple operating expense of run-
emerged. ‘I didn’t take sufficient account of how ning the financial system including profits of financial
many people in the sector didn’t understand what firms is not the only cost if this system also exposes
they were doing. I argued that there were some the economy at large to episodic losses in production
derivatives that were inherently so complex and and incomes, and to the need for taxpayer
dangerous they should not be sold, and I would main- subsidies. . . . Why is so little said about the trade-off
tain that still. If you do not understand what you are between the goal of allocating the economy’s capital
doing you should not be doing it.’318 efficiently and the need to shrink the enormous costs
of the financial industry in doing so?
It was there that the seeds for the disaster that
followed were sown. ‘They didn’t know who was That critical issue apart, Sister Crowley’s theme also
bearing or buying this risk and therefore their own raises uncomfortable questions in respect of Lindley
positions were unstable. If you don’t know who the LJ’s duty ‘to take such care as an ordinary prudent
counter-party is and the risk that counter-party is man would take if he were minded to make an invest-
bearing, how can you possibly assess how much risk ment for the benefit of other people for whom he
there is in the system, in your little slice of the pie? felt morally bound to provide’.
We saw that with AIG [the giant US insurer] with its
great default—no one realized how dependent on
‘If it is as bad as you say, I was darn lucky to
AIG was the entire market. withdraw a large amount of the trust estate
from the fund just before it stopped permitting
The financial experts’ ‘alibi’, of which Catherine withdrawals’
Crowley speaks, appears to have been blown by this
crisis. She is therefore raising an uncomfortable Hold the Champagne again! On 16 October 2008 the
political question, which trustees should be pressing United States Bankruptcy Court for the Southern
forcefully. It is an issue which, in a review of two District of New York decided In Re Bayou
important new books,319 the William Joseph Maier Group LLC.321 Redemptions were funded from the
317. As to this see Bank of International Settlements, Committee on Global Financial System Paper 34, ‘The Role of Valuation and Leverage in Procyclicality,’
which begins: ‘A number of developments in the global financial system seem to have strengthened the linkages between asset valuation and financial leverage.
These include: more marketable assets, especially structured credit products with high ‘‘embedded’’ leverage that are accounted for on a mark-to-market basis, and
more leveraged position-taking, both inside and outside the regulated sector (offbank balance sheets—structured investment vehicles (SIVs) and asset-backed
commercial paper (ABCP) conduits—broker-dealers, asset managers).
These changes in the financial system and in related market practices seem to have amplified business fluctuations and exacerbated financial instability
during the current cycle (‘‘procyclicality’’). While procyclical mechanisms are particularly disruptive during periods of market strain, they may encourage
excessive risk taking in the expansion phase. Hence, mitigating the procyclical interplay of valuation and leverage appears desirable to enhance the stability
of the financial system.’
318. Cf footnotes 46 and 52.
319. Akerlof and Shiller, Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism (Princeton University Press,
New Jersey, 2009), and Shiller, The Subprime Solution: How Today’s Global Financial Crisis Happened and What to Do About It (Princeton, New Jersey, 2008).
320. Benjamin M Friedman, ‘The Failure of the Economy & the Economists’, New York Review of Books, Vol 56 (9), 28 May 2009. Cf the Leader in The
Economist, 18 July 2009, ‘What went wrong with economics?’
321. US Bankruptcy Court, Southern District of New York, Case No. 06 B 22306 (ASH), 16 October 2008.
contributions of later investors—fictitiously treated were merely opinions. In our opinion, they’re
by the hedge fund as ‘profits’—and accordingly useless.323
were voidable in the hands of the investors.
As David Shirreff had pointed out some years pre-
‘But I relied on a rating agency’ 322 viously, the ratings were no better than the stochastic
models on which they had been based, and these
Ask the Carmelite nuns to pray for you. Time models had had a shaky performance history.324
magazine’s ‘Top 10 Scandals’ for 2008 included:
Conclusion
Moody’s, Standard & Poors and Fitch stood by their
AAA top ratings for Collateralized Debt Obligations As Professor Langbein pointed out in the passage
(CDOs), which are based in part on pools of subprime cited on page 1, ‘financial assets have become
mortgages. Some of that stuff was indeed top the characteristic asset of the modern managerial
drawer, but the bottom tranches were filled with trust.’325 With the right advice, fully understood,326
junk. So how do you make the call? The agencies, trustees of large trust estates might have legitimate
looking backward at the accumulated data, continued room for limited prudent investment in some deriva-
to give their top rating to securities that were piling up tive products as a risk-spreading element. How far, if
risk as each week went by and the real estate markets at all, trustees can go beyond that without transgres-
started to wobble. And did we mention that the sing Lindley LJ’s rule; and what part exemption
agencies get paid by the issuers of the CDOs to clauses and other expressions aimed at limitation of
make their supposedly objective rating? When it all liability will play: will fall to be established over the
went south—propelled in part by the same folks, next few years as the inevitable squaring-off begins
who suddenly started slapping bad grades on already between beneficiaries and trustees, and between
fragile firms like AIG—the agencies said their ratings trustees and investment advisers.
322. See The relevance of a ‘good name,’ p. 533 above.

323. http://www.time.com/time/specials/2008/top10/article/0,30583,1855948_1863946,00.html. Site last visited 30 July 2009.
324. Dealing with Financial Risk (Economist, London, 2004), 101.
325. See also Gabbert, Hedge Funds (LexisNexis, London, 2008); Brandts-Giesen and Wylie, ‘The Investment of Trust Funds’ [2008] New Zealand Law Journal
345; Riches ‘Trustees Hedging their Bets—Derivatives Come of Age’ Trust Quarterly Review October 2003; Wheeler ‘Private Equity: Fashion Cult or New Religion?
A Challenge for the Investment Advisor,’ 13 Trusts & Trustees (2007) 14; and Wilson ‘The Tension Between Trustees and Investment Managers’ [2003] Private
Client Business 31, 91.
326. Cowan v Scargill [1985] Ch 270, 289. See footnotes 46, 52, and 318, and see text attached to each of them.

49SCCO EVI 00DBSCH INQ 9325 1 A21307 AnthonyMolloy

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49SCCO EVI 00DBSCH INQ 9325 1 A21307 AnthonyMolloy

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EXTRACT FROM SEPTEMBER 2009 ISSUE

Trusts & Trustees, Vol. 15, No. 7, September 2009

Trusts & Trustees

Editors The Commissioning Editor will be happy to discuss in advance the

Abstract Nuns, Lord Nicholls, Pope John XXXIII, Lord

of Trust Investing’2 articulated what he called the ‘Investment’ not authorized

2. 81 Iowa L Rev 641 (1966).

called for an enlisting of the classical virtues into the

17. (1888) 39 Ch D 660.

34. (1886) 33 Ch D 347, 355.

40. Learoyd v Whiteley (1887) 12 App Cas 727, 736.

Being interrogated in cross-examination:

‘(Q) Did you and Mr Carter on that report And thus:62

56. See ‘But I relied on a rating agency,’ p. 595 below.

63. [1932] 1 KB 442, 448.

76. [1968] 1 WLR 866, 874.

81. [2008] WTLR 999.

84. [1968] 1 WLR 866, 874.

92. 214 NYLJ 31 (5 July 1995).

94. 214 NYLJ 31 (5 July 1995).

Balance mediates between risk and return:

102. Under ‘Consequences of authorized, but negligent, investment,’ p. 557 below.

108. 7th edn (2007) 465–466.

112. 7th edn (2007) pp. 468–469.

128. 214 NYLJ 31 (5 July 1995).

134. [1998] 1 NZLR 481, 502.

143. Trustee Act 1925 s 61.

166. [1996] AC 421 (HL)

180. [1987] 2 NZLR 443 (CA).

184. [1998] 1 NZLR 481, 507–508.

In my judgment either there was a loss in the present

The plaintiff therefore had to prove that a prudent

214. (1682) 2 Cas in Ch 130, 131; 22 ER 880, 881.

231. (Viking, New York, 2002), 147–148.

emerges that he should have been fronting The Money

238. Ibid. p. 196.

Given the limits on what could be accomplished

249. Summa Theologica I–II Q 57 a 5 c.

256. [1925] 2 KB 37, 39–40.

267. [1956] AC 14, 33 (HL).

278. [2005] EWCA Civ 1773.

279. Hinz v. Berry [1970] 2 QB 40, 42.

Rule ofthumb #6 ‘That’s Mr Morgan’s yacht on the right,’ the guide

298. (Butterworths, Australia, 6th edn, 1997), para 1715.

Don’t open the champagne yet. Completely objective. Yes.

308. According to http://www.sec.gov/news/press/2008/2008-115.htm. Last accessed 30 July 2009.

322. See The relevance of a ‘good name,’ p. 533 above.

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