Plaintiff as Victim and Investor: Prudent Investing and the Calculation of Economic Damages, The

Journal of Legal Economics, Mar 2008 by Breeden, Charles H, Brush, Brian C

Abstract In recent years, 45 states have adopted laws regulating the actions of those with fiduciary responsibilities over invested funds of their principals. Under these new laws, trustees are required to behave as would a "prudent investor" in light of modern portfolio theory and are freed from depression-era statutes prohibiting all but low-yielding government securities as investment vehicles. Prudent investing recognizes the risk/return trade-off, the role of diversification and financial intermediaries in eliminating default risk, and the importance of aligning investment decisions with specific circumstances of individuals.

This paper explores the implications for forensic economists of these legal changes and the changes in background financial institutions and practices that they mirror. In cases of longer-term pecuniary loss where modern investment practices are likely to be followed by the victim with median attitudes toward risk, the discount rate used by forensic economists should reflect the returns that can reasonably be expected from an at least partially diversified investment. If tort damages are calculated based exclusively on risk-free discount rates, a typically diversified investment approach for the lump sum will result in a significant positive balance at the end of the loss period.

Introduction

In the course of calculating present value pecuniary damages, forensic economists do their science according to the dictates of their science, but within a legal context that often intrudes. For example, tort law in the majority of states prohibits consideration of "collateral benefits" such as insurance payments received by an injured party. But if those insurance payments were precipitated by the injury whose economic impact is being assessed, then economic logic would require a comprehensive assessment that allows gains due to the injury to be offset against losses in the tally of total pecuniary damages. Similarly, personal injury awards are exempt from federal taxation, yet in most state jurisdictions, the economist is instructed to ignore tax effects which can favor either the plaintiff or defendant depending on the time period of future loss and other circumstances (Brush and Breeden 1996).

In recent years, a preponderance of states has adopted laws regulating the actions of those with fiduciary responsibilities over invested funds of their principals. The Uniform Law Commission is behind this development. This Commission has developed several model laws that deal with the fiduciary responsibilities of trustees in the management of investment funds. These model laws require that trustees act as a "prudent person" or a "prudent investor" would act. It is quite clear from the language of these model laws and the actual state laws patterned after them that prudence does not mean avoiding risk at all costs. Rather, it means investing in a manner that reflects the body of knowledge, largely developed in the past three decades, that has come to be known as "modern portfolio theory." Prudent investing recognizes the risk/return trade-off, the role of diversification in reducing risk, and the importance of aligning investment decisions with the specific circumstances of the individual.

This paper explores the possible implications of these legal developments for forensic economists' measurement of economic damages. Largely on the basis of lay interpretations of legal pronouncements, many forensic economists continue to perform their calculations of economic damages with the implicit assumption that victims will invest all their awards in "risk-free" securities such as U.S. Treasury bills, notes and bonds. Yet the newly emerging legal frameworks require, in cases where a fiduciary relationship exists, that funds be invested in a diversified manner that increases average investment returns at an acceptable exposure to risk.

The "liberalization" of investment practices of trustees and legal guardians no doubt reflects the improving access to and growing participation in financial markets by the U.S. public. For example, in 2004 nearly half of all U.S. households owned mutual funds, and 80% of these households owned equity funds (Investment Company Institute, 2005). If the goal of the tort system is to make an injured victim financially whole and thus to give them the same economic opportunities that they would have enjoyed but for the injury, then the method by which they invest cannot be irrelevant. If average victims exhibit average aversion to risk vis- �-vis return, then at least partial diversification of investment can be expected. If the initial lump sum award did not contemplate such diversification, there would exist on average a positive balance at the conclusion of the loss period.

In view of this greater financial literacy and the recent reductions in legal constraints over trustees' investment actions, a more reasonable basis for present value calculations in many cases may be the rate of return that could be obtained from diversified prudent investing. This paper lays out the theoretical and empirical basis for the position that an investment that is at least partially diversified should be contemplated in present value calculations and should be presented to the jury along with the traditional risk-free scenario.