Come and Get It, Fellows

Forbes Magazine

How stupid can a court get? Thanks to a startling decision by the Supreme Court of Alabama, managers of trusts in that state are about to be besieged by suit-happy lawyers.

The lawyers smell blood because of the misguided way in which the court has used a hoary common law doctrine known as the “prudent man rule.” Basically, the rule holds that anyone serving as a fiduciary must use conservative and cautious business judgment in his investment decisions. Thus, it’s okay, for example, to invest Uncle Willie’s fortune in the stocks of the Dow industrials even if the market for blue chips is slumping. But woe to the fiduciary who invests instead in some hot biotechnology wonder stock that later collapses.

The idea behind the prudent man rule is generally, of course, to preserve capital even at some risk to growth. That makes sense enough in times of low or no inflation, but mere preservation of nominal capital can lead to loss of real capital when the dollar sinks in purchasing power. Some cases have held that failing to try to maintain purchasing power can also constitute imprudent investment decision making.

During the double-digit inflation of the 1970s the prudent man rule allowed stodgy bank trust departments to do a tidy business investing in stocks whose futures were behind them and bonds that steadily lost value while allegedly riskier investments like precious metals or even small-company stocks skyrocketed.

So the current move by Alabama’s major banks to change the rule is to be commended – but credit self-interest. The Alabama courts have taken the banks to task on the issue of the prudent man rule lately, and the banks have paid through the nose. Here’s what happened most recently.

In October the Supreme Court of Alabama upheld a trial judge’s decision that the trust of the late Marion Beirne Spragins Sr. had been mismanaged. The primary offense? Lack of diversification. It seems that Spragins’ designated trustee, the First Alabama Bank of Huntsville, had simply followed the old man’s wishes as allowed for in his will and kept 70% to 75% of his $536,000 estate in the stock of First Alabama Bancshares, the holding company of the Huntsville bank where Spragins had served as president or chairman since 1935.

The fact that the investment grew by a healthy 12% annually during the period, 1974 to 1983, meant nothing to Spragins’ heirs, who argued that if the trustees had simply scattered the money through T bills and the S&P 500, they would have done much better. A parade of helpful “experts” was brought forth to tell the court, with seemingly 20/20 hindsight, exactly where and how the money should have been invested. The sagely nodding justices agreed, and awarded Spragins’ heirs $764,784 in damages and interest, plus court costs – to be paid by the bank.

“Perfect market timing was permitted,” says L. Burton Barnes III, general counsel to First Alabama Bancshares, Adds N. Lee Cooper of the Birmingham law firm Maynard, Cooper, Frierson & Gale, “It’s an incredible decision. Now it doesn’t matter how much money you make for someone if some expert can testify that you could have made more.”

Will the Alabama court’s action provoke similarly misguided decisions from other jurisdictions? One hopes not. California, Minnesota and Delaware have scrapped the common law approach by passing legislation that focuses on “total portfolio strategy” rather than ranking each security on a scale of speculative to safe – the basic prudent man approach. The American Law Institute agrees, and is preparing a restatement of the rule for other states to follow.