An excellent article from the Chronicle of Higher Education today regarding the potential problems with recent trends in the investment of university endowments. As we have discussed regularly on this blog, we find the lack of consequences for those who invested university monies unwisely to be appalling. Read the article below for more details.

Have Colleges Flouted the Prudent-Investor Rule?

By Lawrence Rosen

Over the past year and a half, many colleges have seen their endowments decline by as much as 30 percent, and their investment income cut even more. Staff members have lost jobs, student fees have escalated, and parents have had their financial planning severely disrupted. Much of the loss may have been caused by debatable investment practices. The question thus arises whether colleges have violated what is commonly known as the “prudent-investor rule.”

Colleges, like other institutions that operate in a trust relationship, have long been required to invest in a reasonably conservative way. The Massachusetts Rule, first articulated in an 1830 Harvard University case, suggested that trustees must “observe how men of prudence, discretion, and intelligence manage their own affairs,” taking both “probable income” and “probable safety” into consideration.

Since the early 1990s, however, laws adopted by almost all states have significantly altered the prudent-investor rule. in significant ways. Now diversification is virtually required, unless there is reason to invest otherwise, and references to prohibited “speculation” have been replaced by an emphasis on the risk tolerance appropriate to each trust. Moreover, the delegation of investing to professionals is not only encouraged but may be regarded as a duty. While risk is left undefined, and we no longer follow the 19th-century practice of permitting only those investments registered on an acceptable list, we do know that certain practices are still unacceptable. Colleges may not, for example, buy lottery tickets, since the chance of losing is simply too great. One court, faulting the practice of investing only in the S&P 500 index, required trustees to restore an estate to what it would have been if they had invested prudently. Similarly, selective diversification and total delegation are likely to be regarded as lacking in prudence.

College trustees, of course, seldom exercise investment control directly. Instead they delegate investing to brokers or have established separate investment companies. The law requires due care in selecting, instructing, and monitoring agents, but is silent on how much trustees must understand about their actual investments. Whether it is fair to expect college officers to understand the algorithms of, say, third-order derivatives, or to grasp the daily nuances of credit-default-swap insurance, statutes adopted by most states require trustees to be personally involved in the investment strategy and its oversight. Thus it is an open question whether trustees meet this standard if they do not make adequate efforts to understand the risks of these complex investment instruments.

Naturally, college officials offer many reasons for the decline in their endowments, often claiming, as a Harvard financial officer told the Harvard Gazette, that someone else had “ultimate financial responsibility.”

Explanations for their poor performance usually fall into several categories:

Everyone was doing it. Not since I tried that one on my second-grade teacher and received a look I will never forget would I commend this as a workable excuse. Doing one more deal because everyone else is doing them, particularly when history shows how easily the entire system may become destabilized, hardly seems consonant with responsible investing. To be told that “prudent” means “reasonable,” and, as John Langbein, a Yale Law School professor, notes, that “reasonable” in turn means the usual ways in which other trustees operate, may suit the lawyers and professors who drafted the rule. But doing it just because others do it still would not pass muster with my second-grade teacher.

We did very well for many years. For most of the past decade, of course, endowments benefited handsomely from their investment policies. Harvard had an annual return of 14.3 percent from 1990 to 2008, and many others approached or exceeded yearly double-digit gains. Reliance on modern portfolio theory, however, often seemed to promise more than it could deliver. Not only were the Dow and S&P 500 indexes lower in 2009 than a decade earlier, but, as the legal scholar Stewart E. Sterk has pointed out in a research paper, greater immunization of trustee liability only encouraged greater trustee risk-taking.

Nor has that risk-taking diminished since the market lows. A recent survey by Russell Investments, a pension-consulting firm, found that 58 percent of institutional investors had not changed their fundamental philosophy, and that many were actually increasing, by 5 percent, their investments in the same instruments that had gotten them in trouble before. Investment strategies based on the latest Nobel in economics may work for a time, but one is reminded of what the man who jumped off the roof said as he passed the second floor: “So far, so good.” Again, the proof of prudent investing is not solely in the results, but in the appropriateness of the risks taken to achieve them.

The level of risk was appropriate to institutional needs and purposes. Many colleges were able to offer more scholarships, support, improved facilities, and smaller classes when endowment returns were high. But if tolerance for risk is connected to the trust’s main purpose of the trust, then maybe colleges need to reconsider: Is constant construction always necessary? Will no good president be found for a salary lower than a million dollars? If held to a meaningful interpretation of risk under the prudent-investor rule, colleges might have to reconsider their priorities.

Even the professionals got it wrong. We all know examples: Long-Term Capital Management, a highly leveraged hedge fund set up by two Nobel-winning economists, failed; Lehman Brothers Holdings Inc. was leveraged to the point that a small downward movement in the property market wiped it out. As the political philosopher and author John Gray has written, much of the underlying free-market theory took hold in the 1990s, “when economists came to believe that complex mathematical formulae could tame uncertainty in the murky world of derivatives.” Colleges were caught up in an environment in which the operative theory was that “self-interest plus competition equals nirvana,” as John Cassidy wrote in How Markets Fail: The Logic of Economic Calamities (Farrar, Straus and Giroux, 2009). But not everyone failed to see the handwriting on the wall. Several people were forced out of Lehman when they warned of the impending crisis. And Iris Mack, an investment analyst at Harvard, was fired after warning Lawrence H. Summers, Harvard’s president at the time, of the risks of the university’s strategy.

But perhaps there is an even more important sociological factor in this process, which might be referred to as “the culture of complicity.” A powerful group may entice others into its practices so that the latter can neither extricate themselves without loss of stature nor blame others for what they are doing. As college boards have become dominated by business executives and investment bankers, and as college presidents are paid higher and higher salaries, the air of complicity has come to resonate with the title of that popular 1960s book I’m OK, You’re OK. An athletics coach with an atrocious record is quickly fired. Yet that has not been the case with administrators who make financial decisions. At a time when accountability is the watchword of the American public, colleges’ involvement in the culture of complicity helps explain their unwillingness to accept blame. It is just unfortunate that, along with their corporate culture-mates, they have so far escaped any such accountability.

A recent report by the Center for Social Philanthropy, in Boston, documents the prominence and potential conflicts of interest of financial professionals serving on the boards of six major colleges in New England. But even if there is no direct conflict of interest, is a trustee acting solely in the interests of the institution if he or she is caught up in what the center calls “the cult of the chief investment officer”?

Justice Louis D. Brandeis once said that “a lawyer who has not studied economics and sociology is very apt to become a public enemy.” It may also be true that those who fail to take note of their college’s involvement in the culture of complicity become equally complicit in its public misdeeds.

No one wants to return to an era when delegation and diversification are impermissible. And rules should not be constructed simply as a function of any one moment in the markets. But one may fairly ask whether a given institution has, in fact, used the care, skill, and caution required by the prudent-investor rule in choosing its investment professionals, and whether trustees have ignored warnings about their agents’ decisions. This is especially true for donors who have made contributions to a college in return for an annuity, only to find that their money has been merged with other endowment funds and now produces far less income as a result of the college’s risky investment strategy.

Given the legal requirement that risks be appropriate to purpose, one may even ask whether college endowments, notwithstanding their long-term horizon, can ever bear a substantial portion of volatile investments. Statutes could, of course, be rewritten to limit the portion of trust investment in risky instruments or to impose a greater obligation to assess beneficiaries’ needs. Because it could take a generation for new changes to be made in the statutes that govern trusts, however, the courts may be the only authority capable of clarifying the responsibilities of college officers in light of changing circumstances and theories. But the prudent-investor rule may be interpreted to require a greater quest for information and greater oversight of those responsible for an institution’s financial well-being. Although remedies like trustee reimbursement or removal may be sought, obtaining judicial clarification of an otherwise vague statute and achieving greater investment transparency for colleges may be the litigation goals most worth pursuing.

In the course of their testimony before Congress, several recent nominees to the Supreme Court referred to the proper role of the judge as that of an umpire. What Aristotle, who first made the analogy, actually said was that “the umpire has regard to equity, the judge to law.” And we all know about the baseball umpire who, contrary to colleagues who claim to see them as they really are, says, “There’s balls and there’s strikes and they ain’t nothin’ til I calls 'em.”

Like players and fans, however, those affected by decisions involving colleges’ investments will know if the prudent-investor rule has been violated only when the call is made. Perhaps, in the name of meaningful accountability, it is time that some of those who have borne the burden of their colleges’ investment practices got the umpire back in the game.

Lawrence Rosen, a fellow at the Center for Advanced Study in the Behavioral Sciences, at Stanford University, is a professor of anthropology at Princeton University and an adjunct professor of law at Columbia Law School.

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