“Facts do not cease to exist because they are ignored” – Aldous Huxley 

In 2018, the First Circuit handed down its decision in Brotherston v. Putnam Investments, LLC.¹ The decision is arguably the best analysis of the applicable fiduciary standards in 401(k) litigation. Among the court’s best points: 

The Restatement calls “for determining whether and in what amount the breach has caused a `loss’ . . . by reference to what the results `would have been if the portion of the trust affected by the breach had been properly administered.’”²  

Finally, the Restatement specifically identifies as an appropriate comparator for loss calculation purposes “return rates of one or more. . . suitable index mutual funds or market indexes (with such adjustments as may be appropriate).”³ (citing § 100 cmt. b(1) 

ERISA itself is not so specific. Rather, it states that a breaching fiduciary shall be liable to the plan for “any losses to the plan resulting from each such breach.” Certainly this text is broad enough to accommodate the total return principle recognized in the Restatement. Behind the text, too, stands Congress’s clear intent “to provide the courts with broad remedies for redressing the interests of participants and beneficiaries when they have been adversely affected by breaches of fiduciary duty.”⁴ (cjtes omitted) 

And as the Supreme Court has instructed, when we confront a lack of explicit direction in the text of ERISA, we often find answers in the common law of trusts. (citing Varity Corp. v. Howe, 516 U.S. 489, 496-97, 502, 506-07 (1996) (relying on “ordinary trust law principles” to fill gaps created by ERISA’s lack of definition regarding the scope of fiduciary conduct and duties).⁵

[T]he burden of showing that a loss would have occurred even had the fiduciary acted prudently falls on the imprudent fiduciary. By allowing its analysis on loss to be driven by its concern regarding the objective prudence of the Putnam funds, the district court in essence required plaintiffs to show causation as part of its case on loss-even as it correctly sought to reserve that requirement to defendants.⁶ 

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).⁷

In concluding, Judge Kayatta made two significant points: 

The Supreme Court has time and again adopted ordinary trust law principles to construe ERISA in the absence of explicit textual direction.⁸ 

[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…. 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.⁹ 

Putnam applied for certiorari so SCOTUS would review the First Circuit’s decision. SCOTUS invited the Solicitor General to file an amicus brief with the Court, which it eventually. While the Solicitor General agreed with both the First Circuit’s decision and its reasoning behind the decision, the Solicitor General advised the Court not to grant cert since Putnam’s application since it was technically an interlocutory appeal, meaning the case was still ongoing. SCOTUS ultimately denied Putnam’s request for review. 

Post-Brotherston 401(k) Litigation 
While both SCOTUS’ and the Solicitor General’s decisions are understandable, it still left left a significant void in 401(k) litigation, one that has arguably resulted in questionable and inconsistent interpretations of ERISA and unnecessary harm to 401(k) plan participants. At a time when the public’s perception of the American legal system is at one of its all-time lows, plan participants are openly questioning why courts can have such divergent interpretations on the same piece of legislation, knowing the harmful impact that such inconsistencies have created. 

ERISA plaintiff’s attorneys have the same question in light of SCOTUS’ decision in Tibble v. Edison International. In Tibble¹⁰, SCOTUS specifically noted that the courts often turn to the Restatement for guidance in resolving questions involving fiduciary law, including questions involving ERISA. 

Some have tried to dismiss the 401(k) cases filed as nothing more than “Monday-morning quarterbacking,” complaints about the ultimate performance of a plan’s investment options. That complaint rings hollow for several reasons. First, neither financial advisors nor plan sponsors are generally held liable for the ultimate performance of their recommendations/selections, as neither can control the performance of the financial markets. Second, ERISA claims of fiduciary imprudence are based on the prudence of a plan sponsor’s investment decisions as of the time such decisions were made. 

Despite SCOTUS’ endorsement of the Restatement as a resource in ERISA cases, some courts continue to refuse to accept the objective and equitable established by the Restatement. As the First Circuit noted, Section 100 of the Restatement expressly approves of the use of comparable index funds as comparators in 401(k) litigation. Yet, numerous courts continue to dismiss 401(k) actions using index funds, describing them as “unacceptable comparators” and as trying to compare “apples and oranges.” 

The fact that SCOTUS passed on the opportunity to expose the disingenuousness of the “apples and oranges” argument is especially troubling. As the First Circuit pointed out, the Restatement’s support for index funds establishes that denial of the use of index funds based solely on the active/passive characterization has no merit.  

That said, the Restatement does condition the use of index funds as comparators to comparable index funds. Some courts have seized upon this requirement to argue that actively managed funds may have different strategies and/or different goals that resuklt in the extra costs and extra risks typically associated with actively managed funds and active strategies. 

Said court rarely address the other side of argument, the fact that the ultimate goal of ERISA and its stated purpose is to provide for and protect the plan participants’ best interests. An actively managed plan has the same opportunity as a comparable index fund to meet such goals. If the actively managed fund fails to do so, the fact remains that a plan participant is better served by the comparable index fund. 

Facts are stubborn things. Studies have consistently established that the overwhelming majority of actively managed mutual funds are not cost-efficient relative to comparable index funds. 

• 99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees^.10 
• 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.¹¹ 
• [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.¹² 
• [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.¹³ 

Furthermore, as some courts try to justify the use of cost-inefficient active funds in 401(k) plans, an often-unaddressed issue involves the fundamental issue of just how much active management do “actively” managed funds, both in terms of absolute return, i.e., “closet indexing,” and cost-efficiency.  

Closet indexing is an international issue that continues to demand additional attention…except in the U.S. The financial implications of closet indexing for investors are well-known.  

[A] large number of funds that purport to offer active management and charge fees accordingly, in fact persistently hold portfolios that substantially overlap with market indices….Investors in a closet index fund are harmed by paying fees for active management that they do not receive or receive only partially….¹⁴ 

The issue of closet indexing was a key issue in the Caterpillar 401(k) case.¹⁵ Closet indexing was a significant factor in the plaintiffs’ ability to defeat a motion to dismiss, which quickly led to a settlement of the action. 

Costs matter. When the Securities and Exchange Commission (SEC) announced and implemented Regulation “Best Interest” (Reg BI), then SEC chairman Jay Clayton acknowledged the importance of cost-efficiency of investments: 

rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes utility.¹⁶  

[A]n efficient investment strategy may depend on the investor’s utility from consumption, including…(4) the cost to the investor of implementing the strategy.¹⁷  

The situation becomes even worse if the costs are adjusted for the correlation between the active suite funds and the comparable index funds, shown here based on Miller’s Active Expense Ratio (AER). Miller described the importance of the AER: 

Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in ‘closet’ or ‘shadow’ indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index.¹⁸ 

The fact that more ERISA plaintiff’s attorneys do not incorporate a closet indexing claim into their complaints is surprising to me, especially given its proven effectiveness and available research. An additional arrow in one’s quiver can never hurt.

Brotherston Revisited in the 10th Circuit? 
Could the frustrations resulting from SCOTUS’ refusal grant cert in Brotherston and the ongoing misinterpretations of ERISA and unnecessary harm to plan participants potentnially be coming to an end?  
 
A case is currently pending in the 10th Circuit Court of Appeals involves many of the same issues that were in Brotherston, specifically the “apples and oranges” argument and the issue of whose has the burden of proving causation in 401(k) actions.¹⁹ The district court ruled against the plan participants on both questions and dismissed the action.  

The questions before the Court have already been addressed herein. However, an amicus brief filed with the Court deserves special mention. One argument raised by the amicus brief was that the plaintiffs failed to establish the imprudence of the process used by the plan sponsors. The brief conveniently fails to mention that the plaintiffs were never provided to learn of the process used, as no discovery had been allowed. Without discovery, any argument would have been pure speculation.  

This case is a perfect example of how some courts are improperly confusing the two distinct stages of pleading and proof of causation.  The First Circuit noted the impropriety of combining the two stages for the purpose of prematurely dismissing meritorious 401(k) actions.  

Some courts have attempted to justify combining the two stages by alleging the costs of discovery if plan participants are permitted to have discovery. The amicus brief made a similar argument. Fortunately, the Sixth Circuit recently exposed the lack of legal merit to such arguments and premature dismissals based on same. 

This wait-and-see approach also makes sense given that discovery holds the promise of sharpening this process-based inquiry. Maybe TriHealth ‘investigated its alternatives and made a considered decision to offer retail shares rather than institutional shares’ because ‘the excess cost of the retail shares paid for the recordkeeping fees under [TriHealth’s] revenue-sharing model….’ Or maybe these considerations never entered the decision-making process. In the absence of discovery or some other explanation that would make an inference of imprudence implausible, we cannot dismiss the case on this ground. Nor is this an area in which the runaway costs of discovery necessarily cloud the picture. An attentive district court judge ought to be able to keep discovery within reasonable bounds given that the inquiry is narrow and ought to be readily answerable.²⁰ 

Common sense supports this argument. If in fact the plan sponsors conducted the legally required objective and thorough independent investigation and evaluation of the funds selected for a plan, discovery could easily be limited to producing any and all materials used and relied on by the plan sponsor. The time and costs involved in such controlled discovery should be minimal. Then again, as the Sixth Circuit points out, such controlled discovery would also expose plan sponsors who did not comply with ERISA’s fiduciary requirements.  

Going Forward 
The unresolved issues from Brotherston need to be addressed and resolved in order that the federal courts operate under a universal and consistent interpretation of ERISA in enforcing the rights and protections guaranteed under ERISA. The 10th Circuit will have the opportunity to do so. If they fail to do so, one can only hope that SCOTUS will be given an opportunity to revisit Brotherston and the Solicitor General’s excellent analysis of fiduciary law and ERISA.

Notes 
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018) (Brotherston)
2. Brotherston, 31.
3. Brotherston, 31.
4. Brotherston, 31.
5. Brotherston, 33.
6. Brotherston, 34.
7. Brotherston, 36.
8. Brotherston, 36.
9. Brotherston, 37.
10. Tibble v. Edison International, 135 S. Ct 1823 (2015).
11.Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
12. 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. 
13. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
14. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
15. Martijn Cremers and Quinn Curtis, Do Mutual Fund Investors Get What They Pay For?:The Legal Consequences of Closet Index Funds, https://papers.ssrn.com/sol/papers.cfm?abstract_id=2695133 (Cremers), 5, 42.
16. Martin v. Caterpillar, Inc., (not reported) 2008 WL 5082981 (C.D. Ill. 2008), 453,
17. SEC Release 34-86031, “Regulation Best Interest: The Broker-Dealer Standard of Conduct” (Reg BI), 279. (2020)
18. Reg BI, 279.
19.  Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-4.
20. Matney v. Barrick Gold of N. Am., Inc. 2022 WL 1186532 (D.Ut. April 21, 2022)
21. Forman v. TriHealth, Inc., 40 F.4th 443, 453 (2022).

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