People constantly ask me why I am so fixated on the Hughes v. Northwestern University case (Northwestern403b). Simply put, SCOTUS’ decision in this case will have a significant impact on 401(k)/403(b) plan sponsors and every other investment fiduciary.

The plan participants described the issue before the Court as follows:

Whether allegations that a defined-contribution retirement plan paid or charged its participants fees that substantially exceeded fees for alternative available investment products or services are sufficient to state a claim against plan fiduciaries for breach of the duty of prudence under the Employee Retirement Income Security Act of 1974, 29 U.S.C. § 1104(a)(1)(B).¹

The Solicitor General described the issue before the Court as follows:

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.²

In any type of civil litigation, the typical sequence of events is that the plaintiff files a document, known as the complaint, alleging the defendant’s wrongful acts. The defendant typically responds with a motion to dismiss the case, in essence claiming that they did nothing wrong.

In some cases, the defendant’s motion to dismiss also focuses on alleged technical deficiencies in the complaint which justify dismissing the legal action. In federal court, Rule 8 of the Federal Rules of Civil Procedure sets out the pleading requirements for complaints.

Rule 8 basically adopts what is known as “notice” pleading. Under notice pleading, a plaintiff is n0t required to provide detailed factual allegations, only enough information to allow the defendant to understand the general nature of the plaintiff’s allegations.

Northwestern is basically alleging that the plan participants did not provide enough information to them about their allegations. The plan participants essentially allege that the plan provided them with over expensive and underperforming mutual funds as investment options.

So essentially, Northwestern and the Seventh Circuit are attempting to force the plan participants to meet both the federal pleading requirements and the evidentiary requirements to prove causation, a requirement they arguably do not have under either ERISA or the common law of trusts. However, given the disparity in access to the essential details, a court would presumably place the burden of proof on a 401(k) plan.

Northwestern403b is made even more interesting from the First Circuit Court of Appeals’ decision in Putnam Investments, LLC v. Brotherston.³ Brotherston involved many of the same issues involved in the Northwestern403b case.  In one of the best written and well-reasoned decisions I have ever read, the First Circuit reviewed the basic principles of fiduciary law and ruled in favor of the plan participants, remanding the case back to the lower court for further litigation.

The First Circuit made the following observations:

[T]here is what the Supreme Court has called the “ordinary default rule.” Under this rule, courts ordinarily presume that the burden rests on plaintiffs “regarding the essential aspects of their claims.” That normal rule, however, “admits of exceptions….” For example, “[t]he ordinary rule, based on considerations of fairness, does not place the burden upon a litigant of establishing facts peculiarly within the knowledge of his adversary,” although there exist qualifications on the application of this exception.⁴

That exception recognizes that the burden may be allocated to the defendant when he possesses more knowledge relevant to the element at issue…. Common sense strongly supports this conclusion in the modern economy within which ERISA was enacted. 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.⁵

[T]he 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.”⁶

By analogy, in cases involving a fiduciary relationship, requiring that plaintiffs provide detailed information given the disparity of access to such details, is untenable, inequitable and contrary to the stated purposes of ERISA and the basic principles of the common law of trusts. As a result, once a plaintiff establishes a fiduciary’s beach of their duties and a resulting loss, the First Circuit and the Solicitor says that the burden of proof with regard to causation of such losses should fall on the fiduciary.

One reason for such concern over the Northwestern403b case and SCOTUS’ decision among investment fiduciaries is the plans fear of having the burden of proof as to causation placed on them and having to prove the prudence of their investment selections and investment selection process. The reason for such concern is the numerous studies that have consistently shown that the overwhelming majority of actively managed mutual, still the primary investment option in most plans, are not cost-inefficient and, thus, a breach of their fiduciary duties.

And finally, to address that concern, the First Circuit offered some advice for plans concerned about the ability to carry the burden of proving that it was not guilty of wrongdoing.

In so ruling, we stress that nothing in our opinion places on ERISA fiduciaries any burdens or risks not faced routinely by financial fiduciaries 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.”⁷

The Solicitor General’s Analysis of Northwest403b

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.⁸

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. In Northwestern, the plan participants argued that there were lower cost institutional shares available. Based on the language in the Brotherston decision, 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.⁹

In language that I believe we may see incorporated into SCOTUS’ eventual decision, the Solicitor General 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….¹⁰

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.¹¹

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.”¹²

“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 statement 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 of a plan.

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);¹³

A simple metric I created, the Active Management Value Ratio™4.0 (AMVR), allows fiduciaries, 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.

The concept of the AMVR is simple and the calculation only requires basic mathematics skills. The AMVR compares the costs and returns of an actively managed mutual funds with those of a a comparable index fund. If the actively managed fund’s incremental costs exceed the fund’s incremental returns, the actively managed fund is imprudent relative to the index fund.

The Court of Appeals’ “apples and oranges” argument is contrary to the requirements set out in ERISA Section 404(a), which states that each investment option within a plan must be prudent both individually and collectively.

The threshold question is whether a fiduciary’s duty to remove investments applies to individual investments or whether the decisions are judged on the basis of the investments in the aggregate. The trial court in DeFelice v. US Airways, Inc., applied an aggregate test. Based on that court’s reasoning, there is no need to remove an investment option, regardless of its individual merits, so long as there is an adequate number of investments to satisfy modern portfolio theory and to balance the risk and return characteristics of the portfolio. Put another way, if prudence is judged solely on the basis of the investment options in the aggregate, there is no need for a fiduciary to consider the prudence of an individual investment.

The court was wrong. The duty of fiduciaries is to select, monitor, and remove individual investments prudently, in addition to considering the portfolio as a whole. It is not an “either-or” scenario; both requirements must be satisfied.

The DOL made it clear in the preamble of a regulation that its view is that the prudent selection of investments incorporates both a consideration of the individual investments and the portfolio.¹⁴

Going Forward
The Solicitor General summed up the basic problem with the current inconsistent within the federal courts in interpreting ERISA and deciding such cases:

[I]f petitioners’ complaint had been filed in the Third or Eighth Circuit, [their complaint] would have survived respondents’ motion to dismiss.”¹⁵

The guarantees and protections provided to workers under ERISA are simply too important to be determined by where a worker resides. Likewise, the deliberate attempt by the courts and the defendants to force the plan participants to meet the applicable requirements for meeting the burden of proof regarding causation in order to defeat ERISA is equally unacceptable since the plaintiff in such fiduciary action arguably does not that burden.

Regardless of what SCOTUS’ ultimate decision is in the Northwestern403b action, their decision will have a significant impact on 401(k)/403(b) plans and, potentially, all investment fiduciaries. Hopefully, SCOTUS will further ERISA’s stated purp0ose by ensuring that all federal courts interpret and enforce ERISA using one set of uniform guidelines.

Notes
1. Hughes v. Northwestern University, Unites States Supreme Court, No. 19-1401.
2. Brief for the United States as Amicus Curiae, Hughes v. Northwestern University, United States Supreme Court, No. 19-1401.           
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018).
4. Brotherston, 35-36.     
5. Brotherston, 37.
6. Brotherston, 38.
7. Brotherston, 39.
8. Brief for the United States as Amicus Curiae, Hughes v. Northwestern University, United States Supreme Court, No. 19-1401, 7 (Amicus Brief)
9. Amicus Brief, 9.
10. Amicus Brief, 14.
11. Amicus Brief, 14.
12. Amicus Brief, 16.
13. Brotherston, 31.
14. “Removal Spot: The Duty to Remove Investments” https://www.faegredrinker.com/en/insights/publications/2009/12/removal-spot-the-duty-to-remove-investments
15. Amicus Brief, 20.

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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.