Comments on “ERISA and the Prudent Man Rule”
Files
Description
As Professor Blair has pointed out, modern portfolio theory suggests a multitude of irrationalities in common law standards for trustees managing investment funds. In elaborating the statutory standards for the “prudent expert” established by the Employee Retirement Income Security Act, these perversities are certainly to be avoided. Using portfolio theory to criticize the current standards, however, is a different and much simpler task than using the theory to promulgate new standards that courts can use effectively. In the shift from criticism of rules to their reformulation, at least two kinds of difficulties may arise. First, the assumptions underlying the formal economics models—here, the capital assets pricing model and the efficient market hypothesis—may not be robust. In the economic analysis of tort law, for example, we have discovered that elegant efficiency results in the world of complete information, uniform costs, and Nash behavior must be modified substantially when any of the three assumptions is relaxed. Further, the inquiries suggested by the modifications are more complex than those in the simpler world. The second source of difficulty arises if the level of detail necessary for legal decisions is significantly greater than the analytic power of the economic models. This type of problem arises frequently in antitrust. The courts must determine whether a particular practice or a minute change in the market structure will adversely effect competition; economic theory fails to resolve the question at so microanalytic a level. A third type of difficulty should also be noted. In both tort law and antitrust law many judges and lawyers maintain that the law is and should remain informed by values other than economic ones. Thus the torts scholar argues that considerations of fairness require rules that deviate from ones that would be strictly efficient. In the analysis of ERISA, however, the goals of the law conform rather closely, if not completely, to goals of optimal economic decision making. Because the difficulty engendered by the need to trade off other values for efficiency seems minimal, I shall restrict myself to suggesting a few problems that may arise in connection with the other two kinds of difficulties. As will become evident, these two kinds of problems interact; the indeterminancy of the theory at some level of specificity arises from the need to distinguish some axioms. A number of challenges to a manager's decisions can be imagined. ERISA imposes a duty to diversify on the funds' managers. This duty should be elaborated in conformity with the findings of modern portfolio theory. How is this to be done? What questions will courts be likely to confront and in what format? What specific tests will implement the commands of portfolio theory? An employee may object to the inclusion or the exclusion of a particular security from the fund's portfolio. Alternatively, an employee may object to the portfolio as a whole not only because it results in an inappropriate mix of return and risk given the employee's preferences, but also because the manager has not included the proper number of securities in the portfolio and has not followed the best maintenance strategy of the portfolio. Finally, a pension beneficiary may object to the expenditure of funds on analyzing securities of various types. Each of these objections can be rephrased in economic terms; each new formulation raises an issue unresolved in the economics literature. First, one must note that court rules will be based not on Markowitz's formulation, which arises from the subjective expectations of the individual investor, expectations that are difficult to observe and to evaluate, but from the Sharpe-Lintner formulation, which compares the movement of the security to the movement of the market as a whole. The evaluation of any security, and whether it should be included or excluded from a portfolio, as well as the evaluation of the portfolio as a whole thus depend on the calculation method of the “betas.” Implementing the dictates of modern portfolio theory requires a set of rules to be used to ascertain when sufficient care has been taken in determining a beta. Unfortunately, betas of individual securities are not stable over time; their use in evaluating the choice of particular stocks thus becomes problematic. A recent empirical study of the betas of utility companies, for instance, indicated that the estimate of the beta from historical data—the only means of making the capital assets pricing model operational—did not always lead to accurate estimates of future behavior. The author of the study concluded that careful evaluation of the adjustment process may allow the use of betas “as one of the many factors to consider” in a rate of return proceeding.
Source Publication
Lexeconics: The Interaction of Law and Economics
Source Editors/Authors
Gerald Sirkin
Publication Date
1981
Recommended Citation
Kornhauser, Lewis A., "Comments on “ERISA and the Prudent Man Rule”" (1981). Faculty Chapters. 1047.
https://gretchen.law.nyu.edu/fac-chapt/1047
