Hughes v. Northwestern University and the Future of 401(k) Plans

I thoroughly enjoy reading a well-reasoned legal brief or decision. For instance, the Enron1 decision, while lengthy, is an excellent treatise on ERISA. The First Circuit’s decision in Brotherston v. Putnam Investments, LLC2 is one of the best decisions I have ever read from a technical perspective.

The amicus brief filed by the Solicitor General (SG) in Hughes v. Northwestern University3 (Northwestern) is both well-written and well-reasoned. The Northwestern case is a highly anticipated case, as SCOTUS’s decision will change the entire landscape of the 401(k) industry, regardless of what SCOTUS ultimately decides

Anyone who has taken the time to read the amicus brief filed the Solicitor General (SG) in the Northwestern case know that the SG relied heavily on the Restatement (Third) of Trusts (Restatement), which states the common law of trusts. Some people have asked me why the SG did so. My answer:

  • “We have often noted that an ERISA fiduciary’s duty is ‘derived from the common law of trusts.’ In determining the contours of an ERISA fiduciary’s duty, courts often must look to the law of trusts”.4
  • ERISA is essentially the codification of the common law of trusts.
  • The Restatement (Third) of Trusts (Restatement) is a restatement of the common law of trusts.

Whether participants in a defined-contribution ERISA plan stated a plausible claim for relief against plan fiduciaries for breach of the duty of prudence by alleging that the fiduciaries caused the participants to pay investment-management or administrative fees higher than those available for other materially identical investment products or services.5

That is the question before SCOTUS in the Northwestern case. In reading the amicus brief, a couple of the SG’s comments particularly stood out to me, as they may offer an insight into key factors in SCOTUS’s decision. The actual question presented to SCOTUS for consideration is simple and direct.

So, the question before the Court involves what level of pleading is required in order for the plan participant’s case to survive a defendant’s motion to dismiss. This is a crucial question, as once a case survives a motion to dismiss, the case goes forward and the plaintiff is entitled to discovery, the ability to requests documents and other evidence from the defendants. Defendants desperately want to avoid discovery, as it may reveal unfavorable evidence against them and result in expensive settlements or decisions.

Civil Litigation and the “Notice” Pleading Requirement
In civil litigation, the plaintiff is generally only required to provide “notice” pleading, sufficient information to inform the defendant of the general nature of the plaintiff’s claims. In many 401(k) cases, the defendants have argued that the plan participants needed to provide more specific information about their claims.

Unfortunately, in some cases the courts agreed and, in my opinion, prematurely dismissed the action. In other cases, the court granted the plan participants an opportunity to amend their complaints to provide such information.

However, the inequity in even requiring such specifics, in effect, to prove their case in its initial pleading without the benefit of discovery, was noted by the First Circuit’s in its decision in Brotherston, where the court stated that

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.’ 

In other words, Congress sought to offer beneficiaries, not fiduciaries, more protection than they had at common law, albeit while still paying heed to the counterproductive effects of complexity and litigation risk.

In short, when interpreting the application of ERISA in the absence of statutory guidance, the Supreme Court has usually opted for the common law approach except when rejection was necessary to provide enhanced beneficiary protections.6 

That exception recognizes that the burden may be allocated to the defendant when he possesses more knowledge relevant to the element at issue. Schaffer, 546 U.S. at 60, 126 S.Ct. 528. Trust law has long embodied similar logic. See Restatement (Third) of Trusts, § 100 cmt. f (noting that the general rule placing on the plaintiff the burden of proving his claim “is moderated in order to take account of . . . the trustee’s superior (often, unique) access to information about the trust and its activities”

An ERISA fiduciary often — as in this case — has available many options from which to build a portfolio of investments available to beneficiaries. In such circumstances, it makes little sense to have the plaintiff hazard a guess as to what the fiduciary would have done had it not breached its duty in selecting investment vehicles, only to be told “guess again.” It makes much more sense for the fiduciary to say what it claims it would have done and for the plaintiff to then respond to that.7

Now the issue in Brotherston was who carried the burden of proof regarding causation, not pleading per se. The SG’s amicus brief ultimately argued in favor of placing the burden of proof on plans given the superiority of knowledge argument. However, the quotations are included here because many in the legal profession view Brotherston and Northwestern as companion cases for purposes of 401(k) litigation.

The Seventh Circuit Court of Appeals handed down the Northwestern decision currently under review by SCOTUS. One of the key issues before the Seventh Circuit was whether a plan sponsor was insulated from fiduciary liability if a plan included investment options that included both prudent and imprudent investments. In denying the plan participants’ appeal, the Seventh Circuit stated that

[P]lans participants had options to keep the expense ratios (and, therefore, recordkeeping expenses) low (by choosing to) invest in various low-cost index funds….[P]lans may generally offer a wide range of investment options and fees without breaching any fiduciary duty.8

Compare that with the following statement from the Seventh Circuit in an earlier case. Hecker v. Deere & Co., or more commonly known as “Hecker II.”9 In Hecker I, the Seventh Circuit decided the case based largely on statements similar to the ones just referenced. The uproar was immediate, causing the Seventh Circuit to issue a “clarification” of its earlier statements.

The Secretary also fears that our opinion could be read as a sweeping statement that any Plan fiduciary can insulate itself from liability by the simple expedient of including a very large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them. She is right to criticize such a strategy. It could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It also would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives. The panel’s opinion, however, was not intended to give a green light to such “obvious, even reckless, imprudence in the selection of investments”10

Many legal experts construed the court’s “clarification” as, in fact, a “reversal.” And yet, now SCOTUS is about to review a Seventh Circuit decision arguing the same faulty logic, logic which is clearly inconsistent with ERISA Section 404(a), which requires that the investment options within a plan be prudent, both individually and collectively. Equally disturbing is that the Seventh Circuit’s position is inconsistent with that of the majority of other federal appellate courts.

The Solicitor General effectively discredited the Seventh Circuit’s argument, commonly referred to as the “menu of options” argument, including numerous references to sections of the Restatement and common law.

The court’s reasoning was unsound. Under the law of trusts, which informs ERISA’s fiduciary standards, fiduciaries are not excused from their obligations not to offer imprudent investments with unreasonably high fees on the ground that they offered other prudent investments. See, e.g., Davis, 960 F.3d at 484 (“It is no defense to simply offer a ‘reasonable array’ of options that includes some good ones, and then ‘shift’ the responsibility to plan participants to find them.”) And the Court made clear that this duty applies to each of the trust’s investments….

The judgment and diligence required of a fiduciary in deciding to offer any particular investment fund must include consideration of costs, among other factors, because a trustee must “incur only costs that are reasonable in amount and appropriate to the investment responsibilities of the trusteeship.” Restatement (Third) of Trusts § 90(c)(3), at 293 (2007) (Third Restatement); see id. § 90 cmt. b, at 295 (“[C]ost-conscious management is fundamental to prudence in the investment function.”). “Trustees, like other prudent investors, prefer (and, as fiduciaries, ordinarily have a duty to seek) the lowest level of risk and cost for a particular level of expected return.” Id. § 90 cmt. f(1), at 308. For mutual funds specifically, trustees should pay “special attention” to “sales charges, compensation, and other costs” and should “make careful overall cost comparisons, particularly among similar products of a specific type being considered for a trust portfolio.” Id. § 90 cmt. m, at 33211

In short, “[w]asting beneficiaries’ money is imprudent.” Tibble v. Edison Int’l, 843 F.3d 1187, 1198 (9th Cir. 2016) (en banc)12

The Solicitor General’s Analysis of ERISA’s Pleading Standards

Petitioners’ Amended Complaint states at least two plausible claims for breach of ERISA’s duty of prudence, and the court of appeals’ decision reaching the opposite conclusion is incorrect in certain important respects. Taking petitioners’ factual allegations as true at the pleading stage, petitioners have shown that respondents caused the Plans’ participants to pay excess investment-management and administrative fees when respondents could have obtained the same investment opportunities or services at a lower cost.(emphasis added)13

If petitioners succeed in proving those allegations, then respondents breached ERISA’s duty of prudence by offering higher-cost investments to the Plans’ participants when respondents could have offered the same investment opportunities at a lower cost. (emphasis added)14

In Northwestern, the plan participants argued that there were lower cost institutional shares available. I would suggest that in cases where institutional shares are not available, the same argument could be made for using comparable, lower-cost index funds.

In language that I believe we may see incorporated into SCOTUS’ eventual decision, the SG stated that

Considering those allegations together and taking them as true at the pleading stage, the Amended Complaint plausibly states a claim that respondents acted imprudently….15

Petitioners did not merely present a conclusory assertion that the Plans’ recordkeeping fees were too high; they substantiated their claim with specific factual allegations about market conditions, prevailing practices, and strategies used by fiduciaries of comparable Section 403(b) plans.16

Last, the court of appeals stated that “plan participants had options to keep the expense ratios (and, therefore, recordkeeping expenses) low.” But that simply repeats the same error discussed above by wrongly suggesting that fiduciaries can avoid liability for offering imprudent investments with unreasonably high fees by also offering prudent investments with reasonable fee”17

“Taking petitioners’ factual allegations as true at the pleading stage” and “plausible claims.” Remember those two terms. The first states a basic rule of law in considering a motion to dismiss given the draconian nature of the motion itself, denying a plaintiff their day in court and the opportunity for discovery.

The second emphasizes the need to support a claim of fiduciary breach with some factual evidence of the harmful nature of the plan sponsors actions or failure to act. I have been advising some plaintiff’s attorneys that a simple way of satisfying that requirement would be to argue the cost-inefficiency of the actual investment options chosen.

A simple metric I created, the Active Management Value Ratio™4.0 (AMVR), allows investors and attorneys to quickly evaluate the cost-efficiency of an actively managed fund using low-cost index funds as benchmarks. While plan sponsors and the investment industry claim that using index funds as benchmarks is inappropriate, comparing “apples and oranges,” the First Circuit effectively discredited that argument in its Brotherston decision, referencing the Restatement and common law.

So to determine whether there was a loss, it is reasonable to compare the actual returns on that portfolio to the returns that would have been generated by a portfolio of benchmark funds or indexes comparable but for the fact that they do not claim to be able to pick winners and losers, or charge for doing so. Restatement (Third) of Trusts, § 100 cmt. b(1) (loss determinations can be based on returns of suitable index mutual funds or market indexes); 

Going Forward

[I]f petitioners’ complaint had been filed in the Third or Eighth Circuit, [their complaint] would have survived respondents’ motion to dismiss.”18

That is the crux of the Northwestern case and why SCOTUS needed to hear the case. The rights and protections guaranteed to employees under ERISA are simply too important to be determined by the legal jurisdiction in which they reside. SCOTUS must establish one uniform standard applicable to all federal courts, both the U.S. Courts of Appeal and the lower federal courts.

I would also argue that the combination of the Northwestern and Brotherston decisions effectively discredit both the “apples and oranges” and the “menu of options” arguments that plan sponsors and others in the 401(k) industry have relied upon to convince courts to dismiss 401(k) actions.

While the SG’s Northwestern amicus brief cited the Restatement in support of its arguments, it failed to cite Section 90, comment h(2).19 The comment essentially states that before recommending or using a strategy that utilizes actively managed mutual funds, it must be objectively determined that the fund/strategy would provide an investor with a level of return commensurate for the additional cost and risk typically associated with such investments.

Research has consistently shown that very few actively managed mutual funds are cost-efficient. The AMVR metric provides a quick and simple means of determining cost-efficiency.

Regardless of what SCOTUS decides, the landscape of the 401(k) industry will be changed forever.

1. In Re Enron Corp. Securities, Derivatives and ERISA, 238 F.Supp.3d 799 (2017).
2. Brotherston v. Putnam Investments, LLC,, 907 F.3d 17, 39 (1st Cir. 2018).
4. Tibble v. Edison Int’l, 843 F.3d 1187, 1198 (9th Cir. 2016) (en banc).
6. Amicus Brief of the Solicitor General (AB), 37
7. AB, 38.
8. Hughes v. Northwestern University, 953 F.3d 980 (2020).
9. Hecker v. Deere & Co., 569 F.3d 708 (2009) (Hecker II).
10. Hecker II, 711.
11. AB, 11-12.
12. AB, 13.
13. AB, 8.
14. AB, 9.
15. AB, 14.
16. AB, 14-15.
17. AB, 16.
18. AB, 20.
19. Restatement (Third) Trusts, Section 90, cmt. h(2). American Law Institute. All rights reserved.

© 2021 InvestSense, LLC. All rights reserved.

This article is for informational purposes only and is neither designed nor intended to provide legal, investment, or other professional advice since 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.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member 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 on sound, proven investment strategies that will help them protect their financial security.
This entry was posted in fiduciary compliance and tagged , , , . Bookmark the permalink.