ICI Says Supreme Court Holds Important Decision in Its Hands

The Investment Company Institute (ICI) is urging the U.S. Supreme Court to take on a case against Putnam Investments, arguing that if it lets an appellate court decision stand, Employee Retirement Income Security Act (ERISA) litigation will increase, retirement plan fiduciary decisionmaking will be distorted and plan participants will ultimately be harmed.

In the case of Brotherston v. Putnam Investments, Putnam and plan fiduciaries of the Putnam retirement plan were accused of self-dealing to promote that firm’s mutual fund business and maximize profits at the expense of the plan and its participants and of allowing excessive fees by a lack of monitoring and replacing investments. A Federal District Court found that Putnam followed a prudent process for selecting and monitoring funds in its retirement plan and that participants’ comparison of Putnam mutual funds’ average fees to Vanguard passively managed index funds’ average fees was flawed.

However, the 1st U.S. Circuit Court of Appeals vacated the District Court’s judgment in part and remanded the case for further proceedings. In its opinion, the Appellate Court said “we align ourselves with the Fourth, Fifth, and Eighth Circuits and hold that once an ERISA plaintiff has shown a breach of fiduciary duty and loss to the plan, the burden shifts to the fiduciary to prove that such loss was not caused by its breach, that is, to prove that the resulting investment decision was objectively prudent.”

Putnam asked, and the Appellate Court agreed, to stay the case pending the filing and disposition of a petition for a writ of certiorari to the Supreme Court. In addition to asking the high court to weigh in on whether the plaintiff or the defendant bears the burden of proof on loss causation under ERISA Section 409(a), Putnam asked the court to determine “whether, as the First Circuit concluded, showing that particular investment options did not perform as well as a set of index funds selected by the plaintiffs with the benefit of hindsight, suffices as a matter of law to establish ‘losses to the plan.’”

In its Brief of Amicus Curiae, ICI noted that many of the institutions facing litigation over their investment product selections in retirement plans, including Putnam, are ICI members, and those members who have not been sued operate under growing uncertainty as plaintiffs continue to bring new suits that, depending on the jurisdiction, may subject fiduciaries to the burden of disproving that the appropriate inclusion of actively managed funds in a plan lineup caused losses to a 401(k) plan and its participants.

ICI says the 1st Circuit’s ruling “has real-world implications that warrant the Court’s immediate attention.”

ICI argues that shifting the burden of proving causation, or the lack thereof, from the plaintiff to the fiduciary ignores the ordinary default rule and the plain language of ERISA specifying that fiduciaries are liable for “losses to the plan resulting from” a fiduciary breach. “The ruling will inevitably adversely skew fiduciaries’ selection decisions. Congress directed fiduciaries to make investment option selections in the best interests of participants. Participants’ best interests vary based on many factors, including individual needs (e.g., age, marital and family status, other financial resources, risk appetite, and other factors) and the marketplace, so fiduciaries typically make available to plan participants a wide range of options. The ruling gives fiduciaries greater—and potentially overwhelming—incentives to make choices driven by the threat of litigation based on a single point of reference (i.e., index funds), rather than simply by what plan participants’ best interests dictate,” the brief says.

ICI also argues that allowing plaintiffs in ERISA fiduciary-breach cases to meet the loss causation element of a fiduciary breach claim solely by comparison to an index-fund-only hypothetical ignores the differences between actively managed investments and index funds as well as their differing benefits for participants while assuming that, as a per se matter, a prudent fiduciary would necessarily substitute passively managed funds for active ones no matter the circumstances. “Because of their substantial differences and benefits, actively managed funds and index funds are not suitable as simple comparators for determining loss causation. Plan fiduciaries can prudently determine that including actively managed funds as investment options is consistent with the purposes, terms, investment strategy, and risk/return objectives of the plan and its participants,” the brief says.

The ICI adds, “Both aspects of this decision threaten to harm virtually all stakeholders in the marketplace for retirement planning products. The First Circuit’s ruling creates an incentive for plan fiduciaries to make available certain options and not others, to the detriment of plans, participants, sponsors, and fiduciaries.”

According to the ICI, the burden-shifting framework adopted by the 1st Circuit will only increase the frequency of ERISA litigation that is already on the rise because plaintiffs who have to prove one less element of a case have more incentive to bring the case in the first place. In addition, it says if the 1st Circuit’s ruling that comparisons between a plan’s investment options and a hypothetical lineup of only index funds to prove that a loss occurred is left standing, fiduciaries may offer only index funds to avoid litigation. “This disregards the nuances of constructing an investment lineup that serves the best interests of a broad array of plan participants,” the brief says.

Actively managed funds have an important function

ICI accuses the appellate court of misunderstanding of actively managed funds, saying “Such funds have a legitimate role in helping plan fiduciaries assemble a broad and diverse menu of investment options consistent with their responsibilities under ERISA.”

The brief goes on to point out that many actively managed funds over time outperform index funds, and overall have Morningstar ratings above those of index funds. In addition, it says the 10 largest actively managed funds had a smaller average return variability (measured as the standard deviation of monthly returns) than the ten largest index funds over time.

ICI also points out that, importantly, there are few, if any, index funds in certain investment categories. For example, world allocation or world stock funds, high-yield bond funds, corporate or world bond funds, small cap growth stocks, and diversified emerging market stocks have few or no index funds from which to choose.  Plan fiduciaries looking to include such in-vestments in plan menus often may rationally—or have no choice but to—select actively managed funds.

“The First Circuit’s decision pushes fiduciaries toward homogeneity, and the resultant decrease in options would hamper participants’ ability to build a diversified portfolio,” the brief says.

Finally, ICI addresses the use of proprietary funds in Putnam’s retirement plan, saying that “Asset manager employers generally want to offer proprietary products to employees; after all, these are the products they and the employees know best. The advantages of offering familiar products inure to participants.” Citing “Class Exemption Involving Mutual Fund In-House Plans Requested by the Investment Company Institute,” ICI also says Executive Branch regulations authorize the inclusion of proprietary mutual funds in investment com-anies’ retirement plans because it is “administratively feasible,” “in the interests of plans and of their participants and beneficiaries,” and “protective of the rights of participants and beneficiaries.”