Putnam Investments has filed a petition with the Supreme Court (SCOTUS) asking the Court to review the First Circuit Court of Appeals decision vacating a lower court’s decision that ruled in favor of Putnam. Brotherston had alleged that Putnam breached its fiduciary duties in connection with the company’s 401(k) plan by allowing excessive fees and selecting/maintaining imprudent investments within the plan.

The lower court had dismissed the action, alleging that Brotherston had not proven that the allegedly imprudent mutual funds were the cause of any losses sustained by the plan’s participants. The First Circuit ruled that Putnam, not Brotherston, had the burden of proving that the allegedly imprudent funds had not caused the plan participants’ losses. The court vacated the lower court’s ruling and remanded the case back to the district court for further consideration.

However, before the case could be sent back to the district court, Putnam decided to petition SCOTUS for a writ of certiorari. Non-legalese, they asked the Court to review the the First Circuit’s decision. Putnam has posed two questions to SCOTUS:

1. Whether an ERISA plaintiff bears the burden
of proving that ‘losses to the plan result[ed] from’ a
fiduciary breach, as the Second, Sixth, Seventh,
Ninth, Tenth, and Eleventh Circuits have held, or
whether ERISA defendants bear the burden of disproving
loss causation, as the First Circuit concluded,
joining the Fourth, Fifth, and Eighth Circuits.

2. Whether, as the First Circuit concluded, showing
that particular investment options did not perform
as well as a set of index funds, selected by the
plaintiffs with the benefit of hindsight, suffices as a
matter of law to establish ‘losses to the plan.’

I believe the second question is a mischaracterization of the facts and the applicable law. Prudence under ERISA law is not determined on the actual performance of of a plan’s investment options. Prudence is determined on the quality of the due diligence process that a plan sponsor and other plan fiduciaries used in conducting their independent investigation and evaluation of a plan’s potential investment options.  Therefore, I will not focus as much on that question in this post. The bigger issue is the question as to who has the burden of proof on the causation issue.

Why Putnam Investments, LLC v. Brotherston Is Really Important
As Putnam has pointed out, there is currently a split in the various U.S. Court of Appeals with regard to who has the burden of proof regarding causation in ERISA actions. That is one argument for SCOTUS to hear the case in order to establish one uniform rule on the issue. Employees’ ERISA rights are too important to have the extent and protection of such rights depend on where an employee works and lives.

Just my opinion, but I believe SCOTUS has not yet decided whether to accept this case because they do not really want to accept it, as the First Circuit’s decision¹ was the proper decision and their opinion was a masterpiece that SCOTUS knows it does not, and cannot, improve on. However, SCOTUS may be wrestling with the need to establish one uniform rule on the issue.

As soon as Putnam announced that it was going to apply for cert, several clients and followers online asked me why they would do so. Again, just my opinion, but I think Putnam had to apply for cert due to the potential consequences of both the First Circuit’s decision and the potential nationwide application of the strong arguments they presented in their decision

The First Circuit’s Decision and the Future of the 401(k)/403(b) Industry
Having read the parties’ filings (scotusblog.com), as well as several amicus briefs filed by the investment industry, one thing seems clear. The industry understands the potential implications of the First Circuit’s decision for the 401(k)/403(b) industry as a whole. That is why I fell that Putnam had no choice but to file a petition for cert with SCOTUS.

As Brotherston points out in his response to Putnam’s petition

Petitioners contend that the actively managed funds in the Plan cannot be compared to index funds. However, leading economics professors recommend precisely this approach to measuring the value of active fund managers like Putnam. As Economics Nobel Laureate William Sharpe has stated: ‘[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.’²

If the First Circuit’s decision is upheld by SCOTUS, or allowed to stand by SCOTUS refusing to grant cert, then the problem is that the industry knows it simply cannot meet the burden of proving that the overwhelming majority of actively managed mutual funds are prudent investments for plan participants. Since that burden of proof would actually fall on plan sponsors and, possibly possibly plan service providers if they are named as defendants in the 401(k)/403(b) litigation, both parties should closely follow the case to SCOTUS’ ultimate decision.

In their response to Brotherston’s response to their petition, Putnam suggests that any suggestion that index funds are a better investment option for plan participants would be “contrary to Congress’s design , [and] detrimental to plan participants….”³ I addressed a number of those arguments in an earlier post

In their amicus brief, the Investment Company Institute (ICI) made a number of interesting statements:

Although fiduciaries will undoubtedly continue to act in participants’ best interests, the knowledge that their selections will be compared ex post to index funds and the onerous burden of disproving loss causation may lead plan fiduciaries to offer fewer investment options.⁴

First, fiduciaries do not always act in a plan participants’ best interests, as evidenced by the continuing number of ERISA fiduciary breach actions and subsequent settlements. Second, fiduciary liability is not based on an investment’s actual performance. As pointed out earlier, fiduciary liability is based solely on the quality of the due diligence process that a fiduciary used in evaluating and selecting prudent investments for the plan. The ICI is well-aware of that fact.

The ICI went on to state that

[B]asic financial planning stresses the importance of investing in a diversifiable mix of assets accessible through a variety of investment offerings. But the First Circuit’s decision pushes fiduciaries toward homogeneity, and the resultant decrease in options would hamper participant’s ability to build a diversified portfolio.⁵

While diversification is unquestionably a valuable component of prudent investing, true diversification involves investing in various categories of investments, e.g., large cap funds, small cap funds, growth funds, value funds. True diversification involves both horizontal diversification (investing across asset categories) and vertical diversification (within asset categories). Again, the ICI is well-aware of these facts.

Index funds are readily available in various categories that would easily allow plan participants to effectively diversify their retirement investment accounts. The ICI’s “homogeneity” argument regarding the potential exclusion of actively managed funds simply has no merit in any of the research materials I have ever read. Nobel Laureate Harry Markowitz’s Modern Portfolio Theory certainly was not based on the ICI’s index funds-actively managed funds “homogeneity” theory.

Studies by investment icons and leading professors have consistently reached the same conclusion – the overwhelming majority of actively managed mutual funds are not cost-efficient. Brotherston’s responsive pleading noted the finding of a study that concluded that

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.⁶

Brotherston also noted that comment m of Section 90 of the Restatement (Third) of Trusts (Restatement) cited an SEC study finding that “most actively managed funds failed to earn market returns net of their cost.”⁷ Brotherston also cited comment h(2) of Section 90, which essentially states that actively managed mutual funds are imprudent investment choices unless they are cost-efficient.

Other studies on the cost-efficiency of actively managed mutual funds have also concluded that such funds are largely not cost-efficient:

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.⁸

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.⁹

[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.¹⁰

Signs of Desperation?
The First Circuit made the following statement in its decision:

More importantly, the Supreme Court has made it 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.’¹¹

In its petition for cert, Putnam claims that the court’s statement constitutes an establishment of a “per se rule” regarding the use of index funds in proving losses in ERISA action. I published the First Circuit’s statement to let readers decide for themselves.

Brotherston responded to Putnam’s “per se rule” allegations by stating that the court’s statement was just that, a statement. Brotherston also pointed out that the court pointed out that plan sponsors will be immune from liability if they are successful in finding funds that are prudent selection process. Brotherston’s conclusion – “there is nothing in the First Circuit’s opinion that compels the use of index funds.¹²

The Evidence on the Cost-Efficiency of Actively Managed Mutual Funds
Several years ago I created a simple metric, the Actively Managed Value Ratio 3.0™ (AMVR). Based on the findings of Sharpe and investment icon Charles D. Ellis, the basic AMVR compares an actively managed mutual fund to a comparable index fund, comparing the incremental cost and incremental return of the two funds. Other adjustment are possible to screen for possible “closet” indexing and implicitly higher fees and costs.

At the end of each calendar quarter, I perform a forensic analysis of the top ten non-index funds in U.S. defined contribution plans. The ten funds are based on the “Pensions and Investments” annual list of the top mutual funds in U.S. defined contribution plans. My quarterly forensic analysis factors in key cost-efficiency factors such as different types of returns,  R-squared correlation numbers, and “closet” indexing. The analysis for the first quarter is available here.

Additional information about the Active Management Value Ratio and its calculation process is available here.

Going Forward
While the First Circuit’s decision received widespread attention when it was announced, I have not seen much discussion on the decision since Putnam announced that it would petition SCOTUS for a writ of certiorari. Perhaps that will change once the Court announces whether it will hear the case.

I believe that the ultimate resolution of this case will  be pivotal in the future of the 401(k)/403(b) industry, whether SCOTUS upholds the First Circuit’s decision or decides not to hear the case, leaving the First Circuit’s decision intact.  If SCOTUS decides that plaintiff/plan participants have the burden of proof on the issue of causation, I believe that the plaintiffs’ bar can easily meet that burden by showing that the funds in question are cost-inefficient using the Active Management Value Ratio™ 3.0.

However, if the burden of proof on causation is ruled to rest with the plan sponsors and, possibly, plan service providers, based on the studies cited herein and my own forensic analyses, I believe both parties will be hard-pressed to carry their burden of proof on causation. As an ERISA attorney and risk management consultant to a 401(k)/403(b) plans, my concern is that most plans are not aware of the liability exposure and challenges that they may face.

The investment industry is well-aware of the potential impact that is involved for their business platforms. I personally believe that that is why we have seen such a dedicated opposition to any true fiduciary standard by the investment and the insurance industry. They know, and have known for some time, that the majority of the investment products they offer are not cost-efficient and, therefore, not in the best interests of pension plan and their participants.

If the burden of proof on causation is placed on plan sponsors and plan providers, I would not be surprised to see even more broker-dealers prohibit their brokers from providing services to 401(k)/403(b) plans due to the resulting potential liability exposure. As for protecting plan participants, I have no doubt that Vanguard and other no-load and low-load mutual fund companies, as well as fee-only advisers, would quickly step in to meet any and all needs.

In 1914, future legendary Supreme Court Justice Louis D. Brandeis predicted that the stock market would eventually crash due to the “self-serving [interests of] financial management and interlocking interests…”a victim of the relentless rules of humble arithmetic.”¹³ Actively managed funds sometimes do outperform comparable index funds. The problem is their significantly higher costs, due to management fees and higher level of trading, reduce their returns net of fees, resulting in underperformance relative to comparable index funds.

So the good news is that actively managed funds could become more cost-efficient relative to comparable index funds. However, the odds of them voluntarily reducing their management fees to the extent necessary to do so are unlikely, since most investors do not recognize the inherent issues.

As this case has unfolded, I cannot help but think about the prediction that John Langbein made over forty years ago. Langbein was the reporter for the committee that wrote the Restatement (Third) of Trusts. In analyzing the rules under the new Restatement, he offered the following advice:

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.¹⁴

Has that day arrived?

Notes
1.  Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1^st Cir. 2018) (Brotherston)
2. Brotherston Responsive Brief, 34, available at https://www.scotusblog.com. (Blog)
3. Putnam Response to Brotherston Response, 34
4. Amicus Brief of Investment Company Institute, 21
5. Amicus Brief of Investment Company Institute, 22
6. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE, 179, 181 (2010).
7. Restatement (Third) of Trusts, Section 90, cmt. m.
8. 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. 
9. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
10. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997)
11. Brotherston.
12. Brotherston
13. Louis D. Brandeis, Other People’s Money and How Bankers Use It, (CreateSpace, 2009).
14. 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