The First Circuit Court of Appeals (First Circuit) recently handed down its decision in Brotherston v. Putnam Investments, LLC. The First Circuit vacated the lower court’s decision in which the court had dismissed the plaintiff’s ERISA excessive fees/breach of fiduciary duty action.
I have practiced law for almost 38 years. The First Circuit’s decision was unquestionably one of the best decisions I have ever read, well-reasoned and well-written. While the decision itself was important, perhaps the most memorable aspect of the decision was the First Circuit’s admonition to 401(k) and, by implication, 403(b) ERISA plans and plan sponsors:
More importantly, the Supreme Court has made clear that whatever the overall balance the common law might have struck between the protection of beneficiaries and the protection of fiduciaries, ERISA’s adoption reflected “Congress'[s] desire to offer employees enhanced protection for their benefits.
Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need cry ‘wolf.’1
The First Circuit’s words were reminiscent of a similar warning 40 years earlier by law professor John Langbein, who had served as the Reporter for the committee that drafted the Restatement (Third) Trust:
When market [aka index] funds have become available in sufficient variety and their experience bears out their prospects, courts may one day conclude that it is imprudent for trustees to fail to use such vehicles. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.2
Where to Now?
Prior to the First Circuit’s Putnam decision several courts had dismissed a number of ERISA excessive fees/breach of fiduciary actions on seemingly questionable grounds, including,
- the number of investment options offered by a plan, aka the “menu of options” defense, despite the fact that the Hecker II decision explicitly rejected the “menu of options” defense;3
- the argument that certain ranges of fund expense ratios were prudent as a matter of law solely on their own merit, despite the fact that the Restatement (Third) Trusts states that expense ratios are only prudent to the extent that the fund provides a commensurate return for such costs;4 and
- the argument that low-cost Vanguard mutual funds are unacceptable as benchmarks in assessing the prudence of actively managed mutual funds given the difference in the business platforms between the two types of funds, despite the fact that ERISA states that its primary mission is to promote and protect the interests of pension plan participants and their beneficiaries.5
The First Circuit’s statement raises a number of questions for ERISA 401(k)/403(b) excessive fees/breach of fiduciary duty litigation going forward. Let’s start at the beginning – Congressional intent.
Whenever questions arise about a law, the best place to start is to learn the intent of the body that enacted the law. Since Congress enacted ERISA, the House and Senate reports filed in connection with ERISA should help determine what Congress felt was important about ERISA.
While an exhaustive analysis of ERISA is beyond the scope of this article, a few passages do provide meaningful insight. From House Report No. 93-533 and Senate Report No. 93-127:
The fiduciary responsibility section, in essence, codifies and makes applicable to these fiduciaries certain principles developed in the evolution of the law of trusts….It is expected that courts will interpret the prudent man rule and other fiduciary standards bearing in mind the special nature and purposes of employee benefits plans intended to be effectuated by the Act.6
Common Law of Trusts and the Restatement (Third) Trusts
Congress’ specific reference to the common law of trusts, specifically the prudent man rule, raises the importance of the Restatement (Third) Trust (Restatement). The United States Supreme Court has recognized the Restatement as a source that the legal system refers to in answering fiduciary questions, especially questions involving ERISA.7
The Restatement sets out the common law of trusts, including the Prudent Investor Rule.8 The Prudent Investor Rule establishes the general standards for prudent fiduciary investing.
The Prudent Investor Rule contains three comments that could, and should, define future ERISA excessive fees/breach of fiduciary duty actions.
- A fiduciary has a duty to be cost-conscious. (cmt. a)
- A fiduciary has a duty to select mutual funds that offer the highest return for a given level of cost and risk; or, conversely, funds that offer the lowest level of costs and risk for a given level of return.(cmt. f)
- Actively managed mutual funds that are not cost-efficient are imprudent. (cmt. h(2).9
Comment f – Reasonableness of Fees
An ERISA fiduciary’s duty to be cost-conscious would impact a popular defense often asserted by plans, plan sponsors and the courts-ERISA does not require that a plan choose the least expensive funds for a plan. However, the lack of any such specific requirement is not necessarily dispositive of the question.
The common law of trusts ‘offers a starting point for analysis of ERISA…. 10
[R]ather than explicitly enumerating all of the powers and duties of trustees and other fiduciaries, Congress invoked the common law of trusts to define the general scope of their authority and responsibility.”11
Thus a federal common law based on the traditional common law of has developed and is applied to define the powers and duties of ERISA plan fiduciaries….12
As a result of these court decisions, a good faith argument can be made that plan sponsors and other plan fiduciaries do not have carte blanche power in approving funds’ fees, but that funds chosen for a plan must satisfy the conditions set forth in comment f of the Prudent Investor Rule.
Comment h(2) – Cost-Efficiency
Plan sponsors, investment fiduciaries and mutual funds do not like to discuss cost-efficiency or the related issue of “closet indexing.”
Restatement Section 90, comment h(2) actually asks whether an actively managed fund is able to cover the additional costs and risk associated with actively managed mutual funds. Research has consistently found that the majority of actively managed mutual funds do not cover their costs.
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.13
[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.14
[T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.15
These findings suggest that a plan sponsor faces a difficult task in satisfying ERISA’s duty of prudence requirements, namely
to act ‘with the care, skill prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use’ and ‘with single-minded devotion’ to these plan participants and beneficiaries. 16
Anyone who practices in the ERISA arena should time the time to review the Enron court’s excellent in-depth analysis of ERISA. In addressing compliance with ERISA’s duty of prudence, the court pointed out that
[a]ccording to the Department of Labor , 29 C.F.R. § 2550.404a-1(b), those requirements are satisfied if the fiduciary
1. Has given appropriate consideration to those facts and circumstances that, given the scope of such fiduciary’s investment duties, the fiduciary knows or should know are relevant to the to the particular investment or investment course of action involved (emphasis added)…; and
2. Has acted accordingly.
‘Appropriate consideration’ for purposes of this regulation includes but is not limited to
- A determination by the fiduciary that the particular investment or investment course of action is reasonable designed, as part of the portfolio…to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain (or other return) associated with the investment or investment course of action….17
Not to be overlooked that there are different prudence standards for defined benefit and defined contribution plans. Prudence of investments in defined benefit plans is viewed in terms of “the portfolio as a whole,” However, due to the fact that plan participants in defined contribution carry the risk of investment loss, each individual investment in a defined contribution plan must qualify as prudent.18
The courts have weighed in on the standards for determining compliance with ERISA’s prudence man standard, stating that
[c]ourts] objectively assess whether the fiduciary, at the time of the transaction, utilized proper methods to investigate, evaluate and structure the investment; acted in a manner as would others familiar with such matters; and exercised independent judgment when making investment decisions. [ERISA’s] test of prudence …is one of conduct, and not a test of performance of the investment. Thus, the appropriate inquiry is ‘whether the individual trustees, at the time they engaged in the challenged transactions, employed the appropriate methods to investigate the merits of the investment and to structure the investment.19
Not to be overlooked is the Enron court’s reminder that the prudent man standard is “an objective standard and good faith is not a defense to a claim of imprudence.”20
Given the Restatement’s requirement regarding the cost-efficiency of a plan’s mutual fund options and the obvious harm that could result from choosing cost-inefficient investments, the failure of a plan sponsor to verify the cost-efficiency of a plan’s investment options could have severe consequences under the ERISA’s “knew or should have known” standard.
The Active Management Value Ratio™ 3.0 Metric
Recognizing the importance of cost-efficiency in complying with ERISA and the Restatement’s Prudent Investor Rule, I developed a metric, the Actively Managed Value Ratio™ 3.0 (AMVR). The AMVR is a free metric that allows plan sponsors, investment fiduciaries, investors and attorneys to simply and quickly determine the cost-efficiency of an actively managed mutual fund.
The AMVR is the combination of several ideas and findings of some of the most respected experts in the area of investing and wealth management, including the late Vanguard legend John Bogle, Charles D. Ellis, Burton M. Malkiel, Mark Carhart, Roger Edelen and Ross Miller. Anyone with a basic understanding of the basic My Dear Aunt Sally math skills we learned in elementary school (multiplication, division, addition and subtraction) can perform the AMVR calculations. For further information about the AMVR and its calculation process click here and here.
At the end of each calendar quarter, I use the AMVR to do a cost-efficiency analysis in the top ten non-index funds from “Pensions and Investments” top 100 mutual funds in U.S. defined contribution plans. The results are always interesting. The results of the analysis for 3Q 2018 are available here.
As I have read some of the recent court decisions dismissing ERISA excessive fees/breach of fiduciary duty actions, it seems to me that too much attention is being directed toward collateral issues rather than ERISA’s primary purpose-promoting and protecting the best interests of plan participants and their beneficiaries. Making cost-efficiency the primary focus in plans would hopefully avoid litigation altogether or, if litigation is unavoidable, reduce the costs of litigation by simplifying the issues in the action.
I believe the three comments from the Restatement’s Prudent Investor Rule could be effectively used to create legitimate questions of fact, thereby reducing or eliminating dismissals of excessive fees/breach of fiduciary duties actions. By combining the Congressional intent points, related court decisions, and the Prudent Investor Rule standards discussed herein, I believe that proactive plan sponsors can avoid unnecessary and unwanted liability for both themselves and the plan.
The First Circuit has laid down the gauntlet for plan sponsors, investment fiduciaries and ERISA attorneys. The issues, as well as the solutions, are obvious and available. During my closing arguments at trial, I liked to leave the jury with a quote from the late General Norman Schwarzkopf
The truth of the matter is that you always know the right thing to do. The hard part is doing it.
The First Circuit seems to agree with General Schwarzkopf.
Copyright © 2019 The Watkins Law Firm. All rights reserved.
This article is for informational purposes only. It is neither designed nor intended to provide legal, investment, or other professional advice as such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.
1.Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018)
2. John H. Langbein and Richard A. Posner, “Market Funds and Trust Investment Law(1976). (Faculty Scholarship Series: Paper 498) available online at http://digitalcommons.law.yale.edu/fss_papers/498
3. Hecker v. Deere & Co., 569 F.3d 708, 711 (7th Cir. 2009) (Hecker II).
4. Restatement (Third) Trust, Section 90, cmt. h(2). (American Law Institute)
6. H. R. Rep. No. 93-533, at 11; S. Rep. no. 93-127, at 29 (1973).
7. Tibble v. Edison Int’l, 135 S. Ct 1823 (2015).
8. Restatement (Third) Trusts, Section 90. (American Law Institute)
9.Restatement (Third) Trust, Section 90, cmt. a, f, and h(2). (American Law Institute)
10. In re Enron Corp. Securities, Derivatives, and “ERISA” Litigation, 284 F. Supp. 2d 511, 546 (N.D. Tex 2003) (Enron).
11. Enron, 546.
12. Enron, 546.
13. Charles D. Ellis, “The Death of Active Investing, Financial Times, January 20, 2017, available online at https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-eb37a6aa8e
14. Philip Meyer-Braun, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Fund Advisors, L.P., August 2016.
15. Mark Carhart, “On Persistence in Mutual Fund Performance,” Journal of Finance, 52, 57-82.
16. 29 U.S.C. § 1104(a)(1)(B).
17. Enron, 547.
18. DiFelice v. U.S. Airways, 497 F.3d 410, 423, fn. 8 (4th Cir.)
19. Enron, 548.
20. Enron, 548.
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