[Adapted from a speech given to the Columbia University School of Business, New York City, NY, April 1, 2009]

We meet at a time of financial and economic crisis in our nation and around the globe. I venture to assert that when the history of the financial era which has just drawn to a close comes to be written, most of its mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that “a man cannot serve two masters.”

No thinking man can believe that an economy built upon a business foundation can permanently endure without some loyalty to that principle. The separation of ownership from management, the development of the corporate structure so as to vest in small groups control over the resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to that principle if the modern world of business is to perform its proper function.

Yet those who serve nominally as trustees, but relieved, by clever legal devices, from the obligation to protect those whose interests they purport to represent, corporate officers and directors who award to themselves huge bonuses from corporate funds without the assent or even the knowledge of their stockholders ... financial institutions which, in the infinite variety of their operations, consider only last, if at all, the interests of those [whose] funds they command, suggest how far we have ignored the necessary implications of that principle. The loss and suffering inflicted on individuals, the harm done to a social order founded upon business and dependent upon its integrity, are incalculable.

As you may have already figured out, those words (except for the very first sentence) are not mine. Rather, they are the words of [Justice] Harlan Fiske Stone, excerpted from his 1934—yes, 1934—address at the University of Michigan Law School, reprinted in The Harvard Law Review later that year. But his words are equally relevant—perhaps even more relevant—on this very day. For they could hardly present a more appropriate analysis of the causes of the present-day collapse of our financial markets and the economic crisis now facing our nation and our world.

You could easily react to Justice Stone’s words by falling back on the ancient aphorism, “the more things change, the more they remain the same,” and move on to a new subject. But I hope you’ll react differently, and share my reaction: In the aftermath of the Great Depression and the stock market crash that accompanied it, we failed to take advantage of the opportunity to demand that our giant businesses and financial organizations—the trustees of so much of our nation’s wealth—measure up to the stern and unyielding principles of fiduciary duty described by Justice Stone. Seventy-five years later, for heaven’s sake, let’s not make the same mistake again.

Fiduciary Duty

The concept of fiduciary duty has a long history, going back more or less eight centuries under English common law. Fiduciary duty is essentially a legal relationship of confidence or trust between two or more parties, most commonly a fiduciary or trustee and a principal or beneficiary, who justifiably reposes confidence, good faith and reliance in his trustee. The fiduciary acts at all times for the sole benefit and interests of another, with loyalty to those interests. A fiduciary must not put personal interests before that duty, and, importantly, must not be placed in a situation where his fiduciary duty to clients conflicts with a fiduciary duty to any other entity.

It has been said, I think accurately, that fiduciary duty is the highest duty known to the law.

It is less ironic than it is tragic that the concept of fiduciary duty seems far less embedded in our society today than it was when Justice Stone expressed his profound conviction.

As ought to be obvious to all educated citizens, over the past few decades, the balance between ethics and law, on the one hand, and the markets on the other have heavily shifted in favor of the markets. As I have often put it: We have moved from a society in which “there are some things that one simply does not do,” to one in which “if everyone else is doing it, I can do it too.”

I’ve described this change as a shift from moral absolutism to moral relativism. Business ethics, it seems to me, has been a major casualty of that shift in our traditional societal values. You will hardly be surprised to learn that I do not regard that change as progress. My principal objection to moral relativism is that it obfuscates and mitigates the obligations that we owe to society, and shifts the focus to the benefits accruing to the individual.

Self-interest, unchecked, is a powerful force, but a force that, if it is to protect the interests of the community of all of our citizens, must ultimately be checked by society. The recent crisis—which has been called “a crisis of ethic proportions”—makes it clear how serious that damage can become.

Causes Of The Recent Crisis

The causes of that crisis are manifold. Metaphorically speaking, the collapse in our financial system has 1,000 fathers: The cavalier attitude toward risk of our bankers and investment bankers, holding a toxic mix of low-quality securities on enormously leveraged balance sheets; the laissez-faire attitude of our federal regulators, reflected in their faith that “free competitive markets” would protect our society against excesses; the Congress, which rolled back legislative reforms going back to the depression years; “securitization,” in which the traditional link between borrower and lender—under which lenders demanded evidence of the borrowers’ ability to meet their financial obligations—was severed; and reckless financial innovation, in which literally tens of trillions of dollars of derivative financial instruments (such as credit default swaps) were created, usually carrying stupefying levels of risk and unfathomable levels of complexity.

The radical increase in the power and position of the leaders of corporate America and the leaders of investment America has been a major contributor to these failures. Today’s dominant institutional ownership position of 70 percent of the shares of our (largely giant) public corporations compares with only about 8 percent of all corporate shares a half-century ago. This remarkable increase in ownership has placed these managers—largely of mutual funds (holding 25 percent of all shares), pension funds (20 percent), hedge funds and endowment funds—in a position to exercise great power and influence over corporate America.

But they have failed to exercise their power. In fact, the agents of investment America have failed to honor the responsibilities that they owe to their principals—the last-line individuals who have much of their capital wealth committed to stock ownership, including mutual fund share owners and pension beneficiaries. The record is clear that, despite their controlling position, most institutions have failed to play an active role in board structure and governance, director elections, executive compensation, stock options, proxy proposals, dividend policy and so on.

Given their forbearance as corporate citizens, these managers arguably played a major role in allowing the managers of our public corporations to exploit the advantages of their own agency, not only in executive compensation, perquisites, and mergers and acquisitions, but even in accepting the “financial engineering” that has come to permeate corporate financial statements, endorsed—at least tacitly—by their public accountants.

But the failures of our institutional investors go beyond governance issues to the very practice of their trade. These agents have also failed to provide the “due diligence” that our citizen/investors have every reason to expect of the investment professionals to whom they have entrusted their money.

How could so many highly skilled, highly paid securities analysts and researchers have failed to question the toxic-filled leveraged balance sheets of Citicorp and other leading banks and investment banks and, lest we forget, AIG?1 [How could they miss] the ethics-skirting sales tactics of Countrywide Financial? Even earlier, what were these professionals thinking when they ignored the shenanigans of “special purpose entities” at Enron and “cooking the books” at WorldCom?

Again, going back to the stock market high reached in 2007, how many analysts questioned the typical corporate assumption that their pension plans would earn future returns of 8.5 percent per year, now obviously a deeply flawed assumption that is sowing the seeds of another crisis in the financing of our private and public retirement systems.

The Role Of Institutional Managers

The failure of our newly empowered agents to exercise their responsibilities to ownership is but a part of the problem we face. The field of institutional investment management—the field in which I’ve now plied my trade for almost 58 years—also played a major, if often overlooked, role.

As a group, we veered off course almost 180 degrees from stewardship to salesmanship, in which our focus turned away from prudent management and toward product marketing. We moved from a focus on long-term investment to a focus on short-term speculation. The driving dream of our adviser/agents was to gather ever-increasing assets under management, the better to build their advisory fees and profits, even as these policies came at the direct expense of the investor/principals whom, under traditional standards of trusteeship and fiduciary duty, they were duty-bound to serve.

Conflicts of interest are pervasive throughout the field of money management, albeit different in each sector. Private pension plans face one set of conflicts (i.e., minimizing plan contributions helps maximize a corporation’s earnings), public pension plans another (i.e., political pressure to invest in pet projects of legislators) and labor union plans yet another (i.e., pressure to employ money managers who are willing to “pay to play”). But it is in the mutual fund industry where the conflict between fiduciary duty to fund shareholder/clients often directly conflicts with the business interests of the fund manager.

Perhaps we shouldn’t be surprised that our money managers act first on their own behalf.

As Vice Chancellor Leo E. Strine Jr., of the Delaware Court of Chancery has observed, “It would be passing strange if ... professional money managers would, as a class, be less likely to exploit their agency than the managers of the corporations that make products and deliver services.”

In the fund industry—by far the largest of all financial intermediaries—that failure to serve the interests of fund shareholders has wide ramifications. Ironically, the failure has occurred despite the clear language of the Investment Company Act of 1940 that demands that, “mutual funds should be managed and operated in the best interests of their shareholders, rather than in the interests of (their) advisers.”2

Here, in summary form, are just a few examples of how far so many fund managers have departed from that basic fiduciary principle, clearly enunciated in the 1940 Act:

1. The domination of fund boards by chairmen and chief executives who also serve as senior executives of the management company that controls the funds.

2. The mutual fund “time zone trading” scandals that came to light in 2003, in which some 23 companies—including many of the largest firms in the field—were implicated.

3. “Pay-to-play” distribution agreements using fund brokerage commissions (“soft dollars”) to finance share distribution that benefits the adviser.

4. As fund assets soared during the 1980s and 1990s, fund fees grew even faster, reflecting higher fee rates, as well as the failure of managers to adequately share the enormous economies of scale with fund shareholders.

5. Rising expense ratios for established funds; the average ratio of the seven largest funds of 1960 rose from 0.48 percent to 1.02 percent in 2003, an increase of 144 percent.3

6. Managing assets for giant pension funds for fees that are dwarfed by those that they charge the mutual funds that they control. Three of the largest advisers, for example, charged an average fee rate of 0.08 percent to their pension clients and 0.61 percent to their funds, resulting in annual fees averaging $600,000 for the pension funds and $56 million for the mutual funds (presumably while holding the same stocks in both portfolios).

7. Spending enormous amounts on advertising—almost $500 million in the last two years alone—to bring in new fund investors, using money obtained from existing fund shareholders.

8. Creating exotic and untested “products” that have far more ephemeral marketing appeal than investment integrity.

Given such failures as these, doesn’t Justice Stone’s warning that I cited at the outset seem even more prescient?

Let me repeat the key phrases: The separation of ownership from management ... corporate structures that ... vest in small groups control over the resources of great numbers of small and uninformed investors ... corporate officers and directors who award to themselves huge bonuses ... financial institutions which consider only last, if at all, the interests of those whose funds they command.

Just as we ignored the fiduciary principle all those years ago, so we have clearly continued to ignore it in the recent era. The result in both cases, using Justice Stone’s words: The loss and suffering inflicted on individuals, the harm done to a social order founded upon business and dependent upon its integrity, are incalculable.

[Despite all the negative changes] in the very nature of corporate ownership, we have failed to change the rules of the game. Indeed, in the financial sector, we have rolled back most of the historic rules regulating our securities issuers, our exchanges and our investment advisers. While we should have been improving regulatory oversight and administering existing regulations with increasing toughness, both have been relaxed, ignoring the new environment and therefore bearing much of the responsibility for today’s crisis.

Of course American society is in a constant state of flux. It always has been, and it always will be. I’ve often pointed out that our nation began as an agricultural economy, then became largely a manufacturing economy, then largely a service economy, and most recently an economy in which the financial services sector had become its dominant element. Such secular changes are not new, but they are always different, so enlightened responses are never easy to come by.

To deal with the new and complex economic forces our failed agency society has created, of course we need a new paradigm: a fiduciary society in which the interests of investors come first, and ethical behavior by our business and financial leaders represents the highest value.

Building A Fiduciary Society

While challenges of today are inevitably different from those of the past, the principles are age-old. We must develop a new fiduciary society that guarantees our last-line owners—those mutual fund shareholders and pension fund beneficiaries whose savings are at stake—their rights as investment principals. These rights must include:

1. The right to have their money-manager/agents act solely on their behalf. The client, in short, must be king.

2. The right to rely on due diligence and high professional standards on the part of our money managers and securities analysts who appraise securities for our portfolios.

3. The right to demand some sort of discipline and integrity in the mutual funds and financial products that they offer.

4. The assurance that our agents will act as responsible corporate citizens, restoring to their principals the neglected rights of ownership of stocks, and demanding that corporate directors and managers meet their fiduciary duty to their own shareholders.

5. The establishment of advisory fee structures that meet a “reasonableness” standard based not only on rates but dollar amounts, and their relationship to the fees and structures available to other clients of the manager.

6. The elimination of all conflicts of interest that could preclude the achievement of these goals.

More than parenthetically, I should note that this final provision would seem to preclude the ownership of money management firms by financial conglomerates, now the dominant form of organization in the mutual fund industry. Among today’s 40 largest fund complexes, only six remain privately held. The remaining 34 include 13 firms whose shares are held directly by the public, and an astonishing total of 21 fund managers owned or controlled by U.S. and international financial conglomerates—including Goldman Sachs, Bank of America, Deutsche Bank, ING, John Hancock and Sun Life of Canada. Painful as this separation might be, it is the single most blatant violation of the principle that “no man can serve two masters.”

Of course it will take federal government action to foster the creation of this new fiduciary society that I envision. Above all else, it must be unmistakable that government intends, and is capable of enforcing, standards of trusteeship and fiduciary duty under which money managers operate with the sole purpose and to the exclusive benefit of the interests of their beneficiaries—largely the owners of mutual fund shares and the beneficiaries of our pension plans.

While the government action is essential, however, the new system should be developed in concert with the private investment sector, an Alexander-Hamilton-like sharing of the responsibilities. The task of returning capitalism to its ultimate owners will take time. But the new reality—increasingly visible with each passing day—is that the concept of fiduciary duty is no longer merely an ideal to be debated. It is a vital necessity to be practiced.

What I’ve passionately advocated in these remarks is hardly widely shared among my colleagues and peers. But soon, perhaps, many others will ultimately see the light. Only last week the idea of governance reform got encouraging support from Professor Andrew W. Lo of MIT, one of today’s most respected financial economists: . . . the single most important implication of the financial crisis is about the current state of corporate governance . . . a major wake-up call that we need to change [the rules]. There’s something fundamentally wrong with current corporate governance structures, [and] the kinds of risks that typical corporations face today.

In sum, the change in the rules that I advocate—applying a federal standard of fiduciary duty to their clients for institutional money managers—would be designed in turn to force these managers to use their own ownership position to demand that the managers and directors of the corporations in whose shares they invest honor their own fiduciary duty to the holders of their shares. Finally, it is these two groups that share the responsibility for the prudent stewardship over corporate assets and investment securities alike that have been entrusted to their care, not only reforming today’s flawed and conflict-ridden model, but developing a new model that, at best, will restore traditional ethical mores.

I owe it to Justice Harlan Fiske Stone’s legacy to conclude my remarks with yet one more quotation from his profound and prescient 1934 speech:

In seeking solutions for our social and economic maladjustments, we are too ready to place our reliance on what (the policeman’s nightstick of) the state may command, rather than on what may be given to it as the free offering of good citizenship . . .

Yet we know that unless the urge to individual advantage has other curbs, and unless the more influential elements in society conduct themselves with a disposition to promote the common good, society cannot function . . . especially a society which has largely measured its rewards in terms of material gains . . .

We must (square) our own ethical conceptions with the traditional ethics and ideals of the community at large. (There is) nothing more vital to our own day than that those who act as fiduciaries in the strategic positions of our business civilization, should be held to those standards of scrupulous fidelity which (our) society has the right to demand.

Note: The views expressed in this speech do not necessarily reflect the views of Vanguard’s present management.

Endnotes

1) I’m speaking here of the “buy-side” analysts employed directly by these managers. The conflicts of interest facing “sell-side” analysts were exposed by the investigations of New York Attorney General Spitzer in 2002–2003.

2) Securities & Exchange Commission decision, March 15, 1981.

3) 2002 data: pg. 199, “The Battle for the Soul of Capitalism,” by John C. Bogle, Yale University Press, 2005.