Just a Thought: Is 401(k) Chaos Coming?

The 1st Circuit just handed down what in my opinion is one of the best well-reasoned and well-written opinions I have read in my 36 years of practicing law. If you practice in the 401(k)/403(b) arena, you should do yourself a favor and read it. It’s long, 50 pages, but if SCOTUS upholds the decision, it will result in significant changes in ERISA pension plans. Putnam clearly  understand  the potential ramifications for both the 401(k)/401(b) and actively managed mutual funds. You can find the decision here.

I’m currently working on a law review journal article on the potential synergy between SCOTUS adopting the 1st Circuit’s reasoning, which I expect, and the SEC’s proposed Reg BI. I’ve been soliciting various viewpoints from ERISA and securities attorneys as to my theories and strategies. So far the “yeas” significantly lead the “nays.” My concern is that many in the ERISA arena are not going to be ready if my scenarios do come true.

The SEC has steadfastly refused to use the term “fiduciary” in referencing Reg BI. Practically speaking, I’m not sure it will matter in the end, as the plaintiff’s bar can argue, with merit, that call it what you will, a fiduciary duty will apply.

I believe the plaintiffs’ argument would, and should, be based on the following argument:

1. FINRA is on as saying that their suitability standard is “inextricably intertwined” with the “best interests” standard. (FINRA Regulatory Notice 12-25)
2. NASD, FINRA and SEC enforcement decisions have consistently ruled that

in interpreting the suitability rule, we have stated that a [broker’s] ‘recommendations must be consistent with his customer’s best interests.’ Scott Epstein, Exchange Act No. 59328, 2009 SEC LEXIS 217, at *40 n.24 (Jan. 30, 2009)

as we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests. Wendell D. Belden, 56 S.E.C. 496, 2003 SEC LEXIS 1154, at *11 (2003)

The SEC’s special study of broker-dealers and RIAs agreed, stating that

[A] central aspect of a broker-dealer’s duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the best interests of his customer.  SEC Staff Study on Investment Advisers and Broker-Dealers as Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, at 59 (Jan. 2011)

3. It is never in the best interests of a customer/client to waste money. (UPIA, Section 7)
4. A fiduciary has a duty to be cost-conscious. (Restatement (Third) Trusts, §90, cmt. b)
5. Due to the higher costs and risks generally associated with actively managed mutual funds, the use or recommendation of such funds is never in a customer’s/client’s best interests unless it can be objectively expected that the fund will produce commensurate incremental returns to cover such incremental costs. (Restatement (Third) Trusts, §90, cmt. b)

Whenever I have presented this to a stockbroker or to the personnel of a broker-dealer, the immediate response is “we are not fiduciaries and are not held to the prudence standard.” My response-“Explain how any investment recommendation can ever meet a “best interest” standard if the recommendation is not prudent?” As we all know, “prudence” is part of the fiduciary standard. I cannot wait to hear that debate.

That debate has already been contemplated and addressed:

Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge. – Charles Ellis

There is stong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs. -Philipp Meyer-Brauns

My proprietary metric, the Active Management Value Ratio™ 3.0, provides a means for plan sponsors, plan participants, courts and attorneys to document such issues, both on a nominal and an Active Expense Adjusted aka closet indexing) basis.

Restatement (Third) Trusts, §90, cmt h(2) is what should have most plan sponsors and ERISA fiduciaries concern, especially after reading the 1st Circuit’s Putnam decision. Putnam’s decision to appeal to SCOTUS was much-needed to resolve the key issue presented by the appeal-once an ERISA plaintiff establishes both the breach of fiduciary duty and a loss, who has the duty to establish the causation issue.

There is currently a three-way split between the eleven circuits of the federal courts of appeals. Justice for a pension  plan participant in an ERISA-covered plan should never depend on where they live.

The parties that should be most interested in the Putnam appeal are the plan sponsors and other the plan’s other fiduciaries. Most advisory contracts have provisions hidden in them that insulate the plan advisory from any liability that the plan’s advisor provides. Based on my experience, most plan sponsors are unaware of this provision until it is too late.

If SCOTUS upholds the 1st Circuit’s decision, and a plan’s advisory contract contains that clause insulating the advisor from liability, it will then fall solely on the plan sponsor to prove that it was prudent in the selection of their  plan’s investment options. Based on h(2), current data and research to date, in most cases they will simply not be able to do so, resulting in full liability, including unlimited personal liability for a plan’s fiduciaries.

Even if a plan’s advisors have the liability insulation clause in their advisory contract with a plan, I would not necessarily rest easy. Plaintiff’s attorneys are increasingly naming plan advisors as party plaintiffs in their complaints. In most cases to date, that strategy has not been successful, but legal policy can change, as evidenced by the Putnam case itself.

If you are in any way involved in the ERISA arena, I would read the 1st Circuit’s decision and proactively monitor the case as it proceeds through SCOTUS.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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