By James W. Watkins, III, J.D., CFP Board Emeritus™, AWMA®

People often ask me why I write and comment so much about the Matney case.¹ As a fiduciary risk management counsel, my job is to monitor developments in fiduciary law and help my fiduciary clients avoid unnecessary liability risk exposure.

Three issues have continued to trouble fiduciary law: the “menu of options” defense, the issue of whether index funds are meaningful comparators in assessing fiduciary prudence, and the issue of who has the burden of proof as to loss causation regarding plan participant losses. The Hughes² decision finally resolved the “menu of options” issue. Section 100 of the Restatement (Third) of Trusts should resolve the “meaningful comparators” issue.

The Matney case, as well as the Home Depot case, involve a common question, namely which party in a 401(k)/403(b) litigation action has the burden of proof on the issue of loss causation. The problem is that there is currently a split of opinion on the question in the federal courts, effectively denying some plan participants the rights and protections guaranteed to them under ERISA.

Legal Background – Brotherston
The issue of who carries the burden of proof on the issue of causation was a key issue in the First Circuit Court of Appeal’s Brotherston decision.³ The First Circuit relied heavily on the common law of trusts in ruling that the burden of proof on causation necessarily belonged to the plan sponsor. The Court noted that fiduciary prudence vis-à-vis causation is process oriented, determined by looking at the prudence of the process employed by a plan sponsor in selecting investment options for a plan, rather than at the ultimate performance of the investment option itself.

The Court noted that since the process used by the plan sponsor is typically known only to the plan sponsor, and since many courts do not plan participants the opportunity for discovery to learn what processes, if any, were used by the plan sponsors, placing the burden of proof of causation on the plan sponsor is both inequitable and inconsistent with the standards established by the common law of trusts. Numerous courts have since adopted the First Circuit’s position.

In an interesting development, the Sixth Circuit recently noted the inequity of requiring plan participants to prove that the plan’s fiduciary process was flawed without the benefit of being allowed to discover exactly what the plan sponsor’s process was, stating that

[D]iscovery holds the promise of sharpening this process-based inquiry…. In the absence of discovery or some other explanation that would make an inference of imprudence implausible, we cannot dismiss the case…. 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.⁴

Legal Background – Sacerdote
Another key case on the issue on who has the burden of proof on the issue of causation is the Sacerdote v. New York University (NYU) case.⁵ Some of the facts in this case border on the unbelievable and the absurd, including some members of the investment committee testifying that they did not even know that they were on the investment committee and others testifying that they did not know what they were doing and why they were on the investment committee. Nevertheless, the district court ruled in favor of NYU.

On appeal, the Second Circuit of Appeals reversed several of the district court’s key ruling, including the court’s ruling on the fiduciary prudence of the investment options chosen by the plan. The Court started out by stating the applicable standard for consideration of a motion to dismiss in 401(k) litigation:

[The fiduciary prudence] standard focuses on a fiduciary’s conduct in arriving at an investment decision, not on its results, and asks whether a fiduciary employed the appropriate methods to investigate and determine the merits of a particular investment.⁶

A claim for breach of the duty of prudence will “survive a motion to dismiss if the court, based on circumstantial factual allegations, may reasonably infer from what is alleged that the process was flawed” or “that an adequate investigation would have revealed to a reasonable fiduciary that the investment at issue was improvident.”⁷

The Court then addressed the case itself:

Plaintiffs allege that this information was included in fund prospectuses and would have been available to inquiring fiduciaries when the fiduciaries decided to offer the funds in the Plans. In sum, plaintiffs have alleged “that a superior alternative investment was readily apparent such that an adequate investigation” —simply reviewing the prospectus of the fund under consideration—”would have uncovered that alternative.” On review of a motion to dismiss, we must draw reasonable inferences from the complaint in plaintiffs’ favor.⁸

While the plausibility standard requires that facts be pled “permit[ting] the court to infer more than the mere possibility of misconduct,” we do not require an ERISA plaintiff “to rule out every possible lawful explanation for the conduct he challenges.” To do so “would invert the principle that the complaint is construed most favorably to the nonmoving party” on a motion to dismiss.⁹

Second, we caution against overreliance on cost ranges from other ERISA cases as benchmarks. While such comparisons may sometimes be instructive, their utility is limited because the assessment of any particular complaint is a “context-specific task.” We cannot rule out the possibility that a fiduciary has acted imprudently by including a particular fund even if, for example, the fees that fund charged are lower than a fee found not imprudent in another case.¹⁰

When the university attempted to present some notes as evidence that the investment committee did employ a prudent process in reviewing and selecting the plan’s investment option, the Court cautioned that simply employing some semblance of a “process” does not automatically ensure compliance with ERISA.

The fact that one document purports to memorialize a discussion about whether or not to offer retail shares does not establish the prudence of that discussion or its results as a matter of law.¹¹

We have no quarrel with the general concept of using retail shares to fund revenue sharing. But, there was no trial finding that the use here of all 63 retail shares to achieve that goal was not imprudent. Simply concluding that revenue sharing is appropriate does not speak to how the revenue sharing is implemented in a particular case. We do not know, for example, whether revenue sharing could prudently be achieved with fewer retail shares.¹²

The Court then addressed a key problem in far too many dismissals of 401(k)/403(b), courts confusing “losses” with “damages,” and the party bearing the burden of proof as to each.

Moreover, we are hard-pressed to rely on the discussion of loss that the district court did undertake because the discussion was somewhat unclear in several respects. It conflated loss with damages, appeared to answer a question the court claimed to leave undecided, and effectively misallocated the burden of proof on damages.¹³

To be clear, these terms are not interchangeable. Loss is measured in this context by “a comparison of what the [p]lan actually earned on the investment with what the [p]lan would have earned had the funds been available for other [p]lan purposes. If the latter amount is greater than the former, the loss is the difference between the two.” The question of how much money should be awarded to the plaintiffs in damages is distinct from, and subsequent to, whether they have shown a loss. The district court’s conflation of the two concepts saps our confidence in its analysis on this subject.¹⁴

Although plaintiffs bear the burden of proving a loss, the burden under ERISA shifts to the defendants to disprove any portion of potential damages by showing that the loss was not caused by the breach of fiduciary duty. This approach is aligned with the Supreme Court’s instruction to “look to the law of trusts” for guidance in ERISA cases. Trust law acknowledges the need in certain instances to shift the burden to the trustee, who commonly possesses superior access to information.¹⁵

The Court then cited the First Circuit’s observation in Brotherston that “[i]t 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.”¹⁶

The DOL’s Amicus Brief
The Department of Labor (DOL) recently filed a welcome amicus brief in the Home Depot 401(k) action addressing the issue of the party carrying the burden of proof regarding loss causation in 401(k)(403(b) litigation.

Under the correct burden-shifting framework, where Home Depot (the movant) bears the burden to disprove loss causation, Home Depot could have prevailed at summary judgment on that element only if it presented evidence allowing a reasonable fact finder to conclude that the alleged breach did not cause the Plan’s losses. In short, Home Depot would have to prove “that a prudent fiduciary would have made the same decision.”¹⁷

The DOL then provided the potential “shot heard around the ERISA world,” a statement that will no doubt re repeated in future 401(k)/403(b) litigation, especially motions to dismiss:

If a plaintiff succeeds in showing that “no prudent fiduciary” would have taken the challenged action, they have conclusively established loss causation, and there is no burden left to “shift” to the fiduciary defendant.¹⁸ (citing Sacerdote)

Common Law, ERISA, and the Restatement of Trusts
In the Tibble decision¹⁹, SCOTUS recognized the Restatement of Trusts (Restatement) as a valuable resource in resolving questions involving questions regarding a fiduciary’s legal duties. SCOTUS also noted that both the Restatement and ERISA are largely based on the common law of trusts.

Two dominant themes that run throughout ERISA are cost-consciousness and importance of diversification to minimize the risk of large losses. Regarding cost-consciousness, the Restatement, sets out three important considerations:

1. Section 88, comment b, of the Restatement states that fiduciaries have a duty to be cost-conscious.

2. Section 90, aka the “Prudent Investor Rule,” comment f, states that a fiduciary has a duty to seek the highest rate of return for a given level of cost and risk or, conversely, the lowest level of cost and risk for a given level of expected return.

3. Section 90, comment h(2), goes even further regarding a fiduciary’s duty to be cost-efficient, stating that due to the extra costs and risks typically associated with actively managed mutual funds, such funds should not be recommended to and/or used unless their use/recommendation can be “justified by realistically evaluated return calculations” and can be “reasonably expected to compensate” for their additional costs and risks.

Studies have consistently shown that the overwhelming majority of actively managed funds are not cost-efficient.

99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.²⁰  

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.²¹

[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.²²

[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.²³

The Active Management Value Ratio (AMVR)
Several years ago I created a metric, The Active Management Value Ratio (AMVR), which allows investors, investment fiduciaries, and attorneys to quickly evaluate the cost-efficiency of an actively managed fund. The AMVR is based on the research and concepts of noted investment experts such as Nobel laureate Dr. William F. Sharpe, Charles D. Ellis, Burton G. Malkiel. The latest iteration of the AMVR includes the valuable research of Ross Miller, whose Active Expense Ratio metric factors in the correlation of returns between an actively managed fund and a comparable index fund to provide a more accurate evaluation of cost-efficiency.²⁴

The beauty of the AMVR is its simplicity. In interpreting a fund’s AMVR scores, an attorney, fiduciary or investor only must answer two questions:

1. Does the actively managed mutual fund produce a positive incremental return?
2. If so, does the fund’s incremental return exceed it incremental costs?

If the answer to either of these questions is “no,” then the fund does not qualify as cost-efficient under the Restatement’s guidelines.

The Fiduciary Prudence Score^TM is a proprietary trademark of InvrestSense, LLC. The proprietary trademark for the actively managed fund shown in the referenced AMVR slide would be negative seven (-7.00)

The AMVR only requires the ability to do simple arithmetic calculations using performance and costs data that is freely available on several web sites such as morningstar.com, yahoo.com, and marketwatch.com. For more information on the AMVR, click here.

Going Forward
While the Brotherston and Sacerdote are valuable decisions in deciding the issue as to the party required to carry the burden of proof regarding loss causation in 401(k)/403(b) litigation, The DOL’s amicus brief provides the quick and easy answer for resolving the pending Matney and Home Depot cases.

As I always remind my fiduciary clients, prudent plan sponsors do not select cost-inefficient investment options for their plan.

By using the AMVR to evaluate the fiduciary prudence of potential plan investment options and the potential resulting loss, 401(k)/403(b) plan sponsors can minimize the risk of unnecessary fiduciary liability exposure and improve the plan participants’ odds of “retirement readiness. At the same time, ERISA plaintiff attorneys can use the AMVR to evaluate the fiduciary prudence of potential plan investment options and calculate any losses due to non-compliance with ERISA.

The DOL’s amicus brief, together with the Brotherston and Sacerdote decisions, have provided SCOTUS with the necessary evidence as to why the burden of proof as to loss causation, by necessity, must either be shifted to the plan sponsor or plan participants must be allowed to have “controlled,” or limited, discovery to determine the prudence of the process the plan used in investigating and evaluating the investment options chosen by the plan. Now the courts have the opportunity to do so.

Notes
1. Matney v. Briggs Gold of North America, Case No. 2:20-cv-275-TC (C.D. Utah 2022). (Matney)
2. Hughes v. Northwestern University, 142 S.Ct. 737 (2022).
3. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (2018). (Brotherston)
4. Forman v. TriHealth, Inc., 40 F.4th 443, 450 (6th Cir. 2022).
5. Sacerdote v. New York University, 9 F.4th 95 (2021) (Sacerdote).
6. Sacerdote, 107.
7. Sacerdote, 108.
8. Sacerdote, 108.
9. Sacerdote, 108.
10. Sacerdote, 108-109.
11. Sacerdote, 109.
12. Sacerdote, 111.
13. Sacerdote, 112.
14. Sacerdote, 112.
15. Sacerdote, 113.
16. Sacerdote, 113.
17. Department of Labor amicus brief in Pizarro v. Home Depot, Inc., No. 22-13643 (11th Cir. 2022), 24. (Amicus Brief). http://www.dol.gov/sites/dolgov/files/SOL/briefs/2023/HomeDepot_2023-02-10.pdf
18. Amicus Brief, 26
19. Tibble v. Edison International, 135 S. Ct 1823 (2015)
20. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
21. 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.&nbsp.
22. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
23.. Mark Carhart, On Persistence in Mutual Fund Performance,  52 J. FINANCE, 52, 57-8 (1997).
24. Ross Miller, “Evaluating the True Cost of Active Management by Mutual Funds,” Journal of Investment Management, Vol. 5, No. 1, 29-49 (2007) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926.
25. Amicus Brief, 26.

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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.