This may sound like a flippant question at first blush, but it draws attention to the difference between procedural prudence, the process by which a fiduciary reaches a decision, and substantive prudence, the outcome of the fiduciary’s process. Let us look at this in the context of investment selection.
The words of then-Judge Scalia from over 35 years ago encapsulate the distinction: [1]
I know of no case in which a trustee who has happened—through prayer, astrology, or just blind luck—to make (or hold) objectively prudent investments (e.g., an investment in a highly regarded “blue chip” stock) has been held liable for losses from those investments because of his failure to investigate and evaluate beforehand. Similarly, I know of no case in which a trustee who has made (or held) patently unsound investments has been excused from liability because his objectively imprudent action was preceded by careful investigation and evaluation. In short, there are two related, but distinct duties imposed upon a trustee: to investigate and evaluate investments, and to invest prudently.
There is no prudent process prescribed by regulation when it comes to selecting an investment or an investment course of action[2], and there are no investments or investment courses of action that are inherently imprudent.[3] A fiduciary must nonetheless engage in a careful, deliberative process, comparable to that used by other fiduciaries, in which multiple factors are considered, such as expected rates of return, degree of risk, cost, liquidity, competing investments, and the role of an investment or strategy in diversifying the portfolio.[4] Further, a fiduciary is expected to rely on experts, if the fiduciary determines that such is required in order to make an informed and reasoned decision.
Assuming that a fiduciary pursues an objectively prudent process, it will have fulfilled its procedural prudence obligation and then has a complete defense to a claim of imprudence, irrespective of the investment outcome. One court put it this way:
So long as a fiduciary undertakes a reasoned decision-making process, it need never fear monetary liability for an investment decision it determines to be in the beneficiaries’ best interest. This is so, even if that investment decision yields an outcome that in hindsight proves ……. less than “optimal”. Indeed, our holding, like ERISA’s statutory scheme, acknowledges the uncertainty of outcomes inherent in any investment decision.[5]
What then, if the investment process fails to meet the test of procedural prudence and is found to be imprudent? This is where the courts will consider substantive prudence and test whether the outcome was imprudent and resulted in loss. The test here is simply stated. If the fiduciary failed to employ a prudent process, would a hypothetical prudent fiduciary have made the same decision?[6] Put another way, courts will enquire whether the loss would have occurred regardless of the fiduciary’s imprudence.[7]
As for luck? Here is how the court in the Tatum case addressed it:
Of course, intuition suggests, and a review of the case law confirms, that while … “blind luck” is possible, it is rare. When a plaintiff has established a fiduciary breach and a loss, courts tend to conclude that the breaching fiduciary was liable.
Thus, when a fiduciary fails to pursue a prudent process – and this would apply to any fiduciary decision[8] – then, justifying the outcome, without demonstrating a prudent process, will be extremely difficult.
But the issue does not end there, and this is where a fiduciary who lacks a prudent process will encounter the most difficulty. Once a court finds that a fiduciary has acted imprudently in reaching a decision, the burden of proof will most likely shift from the plaintiffs, who generally bear the burden of proof in civil suits, to the plan fiduciaries. Accordingly, in cases where it is proved that a plan fiduciary failed to follow a prudent investment process, it will be the defendant fiduciaries who must establish that, despite a lack of prudent process, a hypothetically prudent fiduciary would have made the same decision[9]. This burden-shifting is borne out of trust law[10] and is followed by most courts[11] but has yet to be applied universally through a decision of the U.S. Supreme Court.[12]
Given the burden-shifting described above, it is especially important that a fiduciary should not trust to luck but should be meticulous in documenting the fiduciary decision-making process. Thus, fiduciaries should have documentation which: (i) defines the issue to be decided and the criteria to be applied; (ii) records the research which they performed; (iii) demonstrates their analysis of the research performed; (iv) identifies the decision which they made: and (v) describes the reasons which support the decision. Institutional fiduciaries should pay particular attention to the sufficiency of their meeting minutes and verify that the recorded decision and its reasoning are amply justified by the preceding research and analysis.
Many fiduciaries rely on independent service providers because of their expertise, such as an investment advisor. Fiduciaries should, therefore, ensure that they have qualified their independent service providers as experts, through documented investigation, and that the independent experts maintain the documentation which supports their advice and recommendations. If the fiduciaries are sued for fiduciary breach, the independent expert upon whom the fiduciaries relied becomes the essential first line of defense, and, as a caution to investment advisors and others acting as experts, they should recognize that, if a client loses a fiduciary breach suit, the independent expert may well become a target of a client’s efforts to recover its losses. Recognition of these matters should cause all those acting in a fiduciary capacity to put their fiduciary documentation under increased scrutiny.
While much of the preceding discussion is borne out of fiduciary responsibilities relating to ERISA plans, fiduciaries aspiring to the highest standard of care should conform their practices to address these issues in relation to all fiduciary relationships, whether involving trusts, foundations or endowments, or other persons for whom they act in a fiduciary capacity.
Returning to the issue of luck, maybe words attributed to Benjamin Franklin are the most apt in relation to fiduciary responsibility: “Diligence is the mother of good luck.”
[1] Fink v. National Savings and Trust Co., 772 F.2d 951, 962, 6 EBC 2269 (D.C. Cir. 1985). [2] See CFR § 2550.404a-1 for the department of Labor’s regulatory definition of ERISA investment duties. [3] See Restatement (Third) of Trusts, § 90. comment e (1): “.…although it is ordinarily helpful in justifying the reasonableness of a trustee’s conduct to show that an investment or strategy is widely used by trustees in comparable trust situations, the absence of such use does not render imprudent the informed, careful use of the unconventional assets or techniques.” [4] Note that for a 401(k) plan, an investment must be a prudent option on its own merits, not as part of a portfolio as whole. See Hecker v. Deere & Co., 569 F.sd 708, 711 (7th Cir. 2009), and DiFelice v. U.S. Airways, 497 F.3d 410,420 (4th Cir. 2007) – “… “a fiduciary must initially determine, and continue to monitor, the prudence of each investment option available to the plan participants. Here, the relevant “portfolio” that must be prudent is each available Fund considered on its own …”. [5] Tatum v. RJR Pension Investment Committee, No. 13-1360 (4th Cir. 2014). See also Donovan v. Walton, 609 F. Supp. 1221 (S.D. Fla. 1985): “ERISA § 404(a) (1) (B) requires only that the Trustees vigorously and independently investigate the wisdom of a contemplated investment; it matters not that the investment succeeds or fails, as long as the investigation is “intensive and scrupulous and … discharged with the greatest degree of care that could be expected under the circumstances by reasonable beneficiaries and participants of the plan.” Leigh v. Engle, 727 F. 2d 113, 124 (7th Cir. 1984)….”
Economists and finance experts have also considered the role of luck in investment outcomes involving actively managed mutual funds. See, for example, Luck versus Skill in the Cross-Section of Mutual fund Returns, Eugene F. Fama and Kenneth R. French, October 2010, available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1356021 . See also Luck, Skill, and Investment Performance, Bradford Cornell, The Journal of Portfolio Management 2009, available at: https://doi.org/10.3905/JPM.2009.35.2.131 . These experts tend to suggest that most of the annual variation in mutual fund performance is due to luck and not skill. However, the impact of luck, good or bad, may balance out over long periods of time. See Expert Analysis: Using Simulation to Assist Courts in Assessing the Prudence of Retirement Plan Investment Decisions, D. Lee Heavner PhD, Pension & Benefit Daily™, © 2014 The Bureau of National Affairs, Inc., available at: Expert Analysis: Using Simulation to Assist Courts in Assessing the Prudence of Retirement Plan Investment Decisions (analysisgroup.com). Notwithstanding, these opinions, no court has determined that actively managed funds are inherently imprudent. However, the decision in Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018) supports the argument that, to justify the selection of an actively managed fund, fiduciaries should compare its performance and cost to similar attributes of a comparable index fund.
[8] See for example: Seventh Circuit Creates Uncertainty About 401(k) Provider RFPs, Jamie O. Fleckner and D. Lee Heavner, PhD, Pension & Benefit Daily™, © 2011 The Bureau of National Affairs, Inc., available at: https://www.analysisgroup.com/globalassets/content/insights/publishing/heavnerfleckner_bna2011_401k_provider-rfps.pdf [9] Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir. 2018). See also Tatum v. RJR Pension Investment Committee, No. 13-1360 (4th Cir. 2014). [10] Restatement (Third) of Trusts § 100 comment e. [11] See U.S. Supreme Court Amicus Brief of the United States in Putnam v. Brotherston, Case No. 18-926. [12] Putnam Investments filed a petition with the U.S. Supreme Court to appeal the 2018 decision of the First Circuit Court of Appeals, but the petition was denied, perhaps, in partial reliance of the Solicitor General’s amicus brief referred to in the preceding footnote. Putnam v. Brotherston, U.S. Supreme Court, No. 18-926.