Lawsuit Over Kentucky Retirement System Hedge Fund Investments Dismissed

The Kentucky Supreme Court has ruled that a lawsuit challenging the state public pension system’s use of “risky” hedge fund investments should be dismissed.

The plaintiffs filed the lawsuit against 11 Kentucky Retirement Systems (KRS) trustees and officers and against third parties who did business with KRS. They allege that, between 2011 and 2016, the defendants knew that KRS faced an appreciable risk of running out of plan assets but concealed the true state of affairs from KRS members and the public. Instead, the plaintiffs allege, the KRS trustees and officers attempted to “recklessly gamble” their way out of the actuarial shortfall by investing $1.5 billion of KRS plan assets in high-risk “fund-of-hedge-fund” products offered by the defendant hedge fund sellers.

The Kentucky Supreme Court opinion adds that, according to the plaintiffs, these investments ultimately lost more than $100 million by 2018 and further accumulated fees “expected to measure in the hundreds of millions of dollars.” These losses, according to the plaintiffs, contributed to what is now a $25 billion funding shortfall in the KRS general pool of assets.

The court noted that to sue in a Kentucky court, a plaintiff must have the requisite constitutional standing, which is defined by three requirements: (1) injury, (2) causation and (3) redressability. To establish the first requirement, “an injury must be ‘concrete, particularized and actual or imminent; fairly traceable to the challenged action; and redressable by a favorable ruling.’” It added that the United States Supreme Court has “repeatedly reiterated that ‘threatened injury must be certainly impending to constitute injury in fact’ and that ‘[a]llegations of possible future injury’ are not sufficient.”

The Kentucky court noted that if the plaintiffs had not received their vested monthly pension benefits, they would have the requisite injury in fact to support standing. However, they have received and will continue to receive all their monthly pension benefits.

The plaintiffs instead assert that the collective mismanagement of the KRS plan confers an injury in fact personal to themselves because the resulting decrease in plan assets substantially increased the risk that their retirement benefits will be denied in the future. Specifically, they assert that the imprudent investment decisions in question resulted in hundreds of millions of dollars in losses to the plan assets, thereby placing the solvency of the KRS fund at significant risk.

But the court noted that as KRS beneficiaries, the plaintiffs’ retirement benefits are part of a statutorily declared “inviolable contract” between KRS members and the commonwealth. Should KRS become so severely underfunded that it runs out of assets and terminates the plan, the plaintiffs are still entitled to their pension benefits under their inviolable contract with the commonwealth. And even before the risk of plan termination is realized, the commonwealth has the authority to increase its own contribution to the KRS plan to make up any actuarial shortfall in its assets. “In essence, then, the full faith and credit of the commonwealth serves as a backstop for plaintiffs’ pension benefits even in the event that severe plan mismanagement renders KRS insolvent,” the court opinion states.

The plaintiffs alternatively assert standing in a representational or derivative capacity on behalf of KRS and the commonwealth. The court noted that the requirement of an injury in fact is “a hard floor of our courts’ jurisdiction that cannot be set aside by courts or legislatures. So in order to claim ‘the interests of others,’ the litigants themselves still must have suffered an injury in fact.”

The plaintiffs also assert that they have standing as taxpayers suing on behalf of the commonwealth to recover misspent, misused or wasted tax dollars from those responsible. Specifically, they point to the allegedly wasted tax dollars that were paid into KRS based on false financial and actuarial information, roughly $1.5 to $1.8 billion spent on questionable investments for KRS and future costs to the commonwealth in otherwise avoidable taxpayer-funded payments to KRS to make up for the alleged misconduct. But the court said this theory of standing also fails.

“Plaintiffs appear to argue both that they have standing as taxpayers harmed by the misuse of taxpayer funds and as taxpayers bringing claims on behalf of the commonwealth. While Kentucky courts have historically permitted taxpayer claims in certain circumstances as a matter of equity, we have never allowed a suit like this,” the court wrote.

Under the direct-taxpayer theory of standing, according to the court, the plaintiffs seek damages from private third parties and KRS officials in their individual capacities for tort damages allegedly sustained to all Kentucky taxpayers. “Plaintiffs do not cite, and we cannot find, any Kentucky cases permitting such a novel theory of standing,” the court said.

The plaintiffs also purport to bring their claims on behalf of the commonwealth as a matter of equity because they have made a demand to the attorney general to assert their claims, but he declined. “But plaintiffs likewise provide no authority in support of their ability to bring claims in a derivative capacity on behalf of the commonwealth,” the court wrote.

In conclusion, the Kentucky Supreme Court said it “recognizes that plaintiffs allege significant misconduct, but, as a matter of law, these eight plaintiffs, as beneficiaries of a defined benefit [DB] plan who have received all of their vested benefits so far and are legally entitled to receive their benefits for the rest of their lives, do not have a concrete stake in this case.” The court remanded the case to the circuit court with direction to dismiss the complaint.