In the case of Brotherston v. Putnam Investments, LLC, No. 17-1711 (1st Cir. 2018), the First Circuit Court of Appeals handed down a decision that could have far-reaching impact in the 401k industry.
Putnam’s efforts to have the decision reviewed by the U.S. Supreme Court certainly speaks to this but, now that the Supreme Court has denied that opportunity, the industry seems to have gone silent, either in hopes that no one is paying attention or because they are stunned into inactivity.
Here’s the story, and it starts with Tibble.
In the seminal fiduciary breach case, Tibble v. Edison (Tibble v. Edison, 135 S. Ct. 1823), the Supreme Court held that ERISA’s fiduciary duty is derived from the common law of trusts.
Therefore, in selecting and monitoring investments, plan fiduciaries must have regard to trust law in determining their fiduciary responsibilities.
The most noted trust law authority is the Restatement (Third) Trusts, published by the American Law Institute. Several provisions of the Restatement Third address responsibilities which plan fiduciaries should observe in making investment decisions. These include the following:
- Cost-conscious management is fundamental to prudence in the investment function. (§ 90, comment b)).
- 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-or, inversely, the highest return for a given level of risk and cost, (§ 90, comment f)).
- Active strategies… entail investigation and analysis expenses and tend to increase general transactional cost… If the extra costs and risks of an investment program are substantial, these added costs and risks must be justified by realistically evaluated return expectations, (§ 90, comment h(2)).
Accordingly, an investment must be cost-efficient for a given level of risk and return. How then, should the cost-efficiency of investment be evaluated? The 2018 First Circuit Court of Appeal’s decision in Brotherston informs the answer.
In Brotherston, the plaintiffs were participants in the Putnam 401k plan, and they challenged the lack of a prudent process whereby Putnam selected its own mutual funds without regard to whether such funds were prudent investment options, noting that most of the funds were actively managed.
The district court found that the Putnam investment committee did not independently investigate Putnam funds before including them as investment options under the Plan, did not independently monitor them once in the Plan, and did not remove a single fund from the Plan lineup for underperformance, even when certain Putnam funds received a “fail” rating from Advised Asset Group, a Putnam affiliate.
However, the District Court found that, notwithstanding the fiduciary breach, the plaintiffs failed to prove loss. Therefore, the issue of how investment loss is established came before the First Circuit.
The First Circuit said:
“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…”
The First Circuit did not leave matters there. The Court was also called upon to determine, once a breach and a loss is established, who has the burden of proof? In other words, must the plaintiffs prove that that the breach caused the loss, i.e., the general rule in litigation? Or, should the plan fiduciaries bear the burden of proving that the loss resulted from a cause other than the breach, i.e, should the plan fiduciaries have to prove that the resulting investment decision was objectively prudent?
Applying trust law principles, the First Circuit found that the burden shifted to the plan fiduciaries. The Court relied in part on the Restatement Third, § 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”).
The First Circuit said:
“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.”
This shift in the burden of proof could have significant impact on the role of plan fiduciaries and their investment advisors to whom plan fiduciaries will turn to justify their recommendations. Putnam argued that this could have a chilling effect on the adoption of 401k plans, but the First Circuit was having none of it. The Court went on to say:
“While Putnam warns of putative ERISA plans foregone for fear of litigation risk, it points to no evidence that employers ……. are less likely to adopt ERISA plans. 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 to cry ‘wolf.'”
Although the First Circuit does not apply to all US Circuit Courts, the Brotherston decision is regarded as highly influential and should certainly influence those who wish to conform to prudent practices. What then are the takeaways from the Restatement Third and Brotherston?
- In evaluating the prudence of a/(an active) fund, a prudent fiduciary must compare the cost and risk of that fund to that of an appropriate index fund;
- Fiduciaries must evaluate whether traditional fund scoring methodologies meet the needs of the Restatement Third without further analysis;
- Selection of an appropriate menu of index funds represents a “safe harbor.” Indeed, this is consistent with the position taken by the DOL in adopting regulations under ERISA Section 404(a) (29 C.F.R. § 2550.404a-1, Federal Register/Vol 44. No.124/ June 26, 1979, at 37221); and
- Prudent fiduciaries will document their investment process in order to establish a written record of the due diligence they have performed, their investment analysis and the reasons for their decisions. Of course, many will not conform, for fear of producing a smoking gun in the event of a fiduciary breach claim, but, if called into question, how else will they justify their decisions? Will they simply rely on what then-Judge Scalia described in Fink v. National Sav. and Trust Co., 772 F.2d 9511 (1985), as “prayer, astrology or just blind luck”?
In conclusion, one’s tempted to ask of the 401k industry and plan sponsors: What’s in your wallet?
About the author
Roger Levy is CEO of Scottsdale, Ariz.-based Cambridge Fiduciary Services, LLC. and a Senior Analyst for CEFEX. He is a member of the 401(k) Specialist Advisory Board and the co-author of Your 401K – The Danger Within. He has provided expert testimony in several 401k fiduciary breach lawsuits.
Roger Levy, LLM, AIFA®, is CEO of Scottsdale, Ariz.-based Cambridge Fiduciary Services, LLC. and a Senior Analyst for CEFEX. He is a member of the 401(k) Specialist Advisory Board and the co-author of Your 401K – The Danger Within. He has provided expert testimony in several 401k fiduciary breach lawsuits.
