“The Relentless Rules of Humble Arithmetic: 401(k) Fiduciary Litigation at the Crossroads”

If we desire respect for the law, we must first make the law respectable.”
Justice D. Brandeis Brandeis

SCOTUS is currently deciding whether to hear the Hughes v. Northwestern University1 403(b) case. The key issue in the case is an allegation of fiduciary breach by the plan with regard to the level of the plans fees.

SCOTUS had an opportunity to address this issue earlier in the Brotherston2 decision. However, SCOTUS decided not to hear the Brotherston decision, based largely upon the Solicitor General’s amicus brief advising them not to do so.

However, the Solicitor General’s recommendation not to hear the case was based primarily on the fact that the Brotherston case was an interlocutory appeal, as the case was still ongoing and all the evidence had not been presented. The Solicitor General’s amicus brief actually presented a compelling and well-reasoned discussion in support of shifting the burden of proof as to causation in 401(k) fiduciary litigation once the plan participants have met their burden of notice pleading on the fiduciary’s breach of duty and a resulting loss.

The Solicitor General’s argument was based on the common law of trusts. The Solicitor General referenced several sections of the Restatement (Third) of Trusts3 (Restatement) in support of his arguments. This is consistent with the Court’s acceptance of the Restatement as a valued resource in resolving fiduciary questions.

We have often noted that an ERISA fiduciary’s duty is ‘derived from the common law of trusts.’ .In determining the contours of an ERISA fiduciary’s duty, court often must look to the law of trusts.4

Just as in the Brotherston decision, SCOTUS has asked the current Solicitor General to file an amicus brief in the Hughes case. Since both Brotherston and Hughes involve similar issues, there would nothing improper about SCOTUS from going back and reconsidering the Solicitor General’s research and opinions on such issues. In short, the Solicitor concluded that Section 100 of the Restatement supported both the use of index funds as comparators in ERISA cases and the shifting of the burden of proof as to causation.

Citing the First Circuit’s Brotherston decision and Section 100, comment f, of the Restatement, the Solicitor General pointed out that

ERISA incorporates the ‘the common law of trusts’ and that trust law ‘places the burden of proof of disproving causation on the fiduciary once the beneficiary has established that there is a loss associated with the fiduciary’s breach.5

The Solicitor General, like the First Circuit, noted the equitable nature of such a shift given the fact that plans usually are the only party with all of the relevant information during the early stages of such litigation. Citing Section 100, comment c, the Solicitor General stated that

[t]he fiduciary is in the best position to provide information about how it would have made investment decisions in light of the objectives of the particular plan and the characteristics of plan participants. Indeed, this Court recognized in {earlier cases] that it is appropriate in some circumstances to shift the burden to establish ‘facts peculiarly within the knowledge of one party.”6(cites omitted)

The Solicitor General noted other benefits from shifting the burden of proof regarding causation to plans.

Applying trust law’s burden-shifting framework to ERISA fiduciary-breach claims also furthers ERISA’s purposes. In trust law, the burden shifting rests on the view that ‘as between innocent beneficiaries and a defaulting beneficiary, the latter should bear the risk of uncertainty as to the consequences of its breach of duty…Indeed, in some circumstances, ERISA reflects congressional intent to provide more protections than trust law.7 (cites omitted)

The amicus brief went on to note that

Applying trust law’s burden-shifting framework which can serve to deter ERISA fiduciaries from engaging in wrongful conduct, thus advances ERISA’s protective purposes. By contrast, declining to apply trust-law’s burden-shifting framework could create significant barriers to recovery for conceded fiduciary breaches.8 (emphasis added) (cites omitted)

As several of my other posts on this site have noted, ERISA fiduciary breach litigation has already seen too many instances of this type of injustice through legal fictions such as the “apples to oranges” and “menu of options” defenses, both of which are seemingly inconsistent with both ERISA and/or the Restatement.

Humble Arithmetic and ERISA Fiduciary Breach Litigation
With the end of the quarter approaching, I will be preparing my “cheat sheet” on the most popular mutual funds in U.S. defined contribution plans, based on invested amounts. A recent Active Management Value Ratio (AMVR) has caused some discussion.

This image is a perfect example of the truth of Justice Brandeis’ statement regarding the “relentless rules of humble arithmetic.” Both of the funds are categorized as large cap growth funds by Morningstar. Both funds are from same fund family. Fidelity Contrafund is consistently ranked as one of the top five mutual funds offered as an investment option within U.S. defined contribution plans.

Based on this AMVR analysis, thi image would seem to provide the evidence plan participants need to prove both a fiduciary breach and a sustained loss. On the other hand, if the burden of proof regarding causation were shifted to the plan, it would seem to be a heavy burden to fulfill.

From years of conducting such AMVR forensic analyses, I can state that the image is a fairly consistent representation of the cost-inefficiency of most U.S. domestic equity funds. Those findings are also consistent with most academic studies of the such funds, resulting in findings such as

  • “99% of actively managed funds do not beat their index fund alternatives over the long-term net of fees.”9
  • “[I]ncreasing 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.10
  • “[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.”11
  • “[T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.”12

Going Forward
A number of large financial services firms have recently sold their 401(k)/403(b) divisions. Could a possible explanation be concern over a possible review and adverse decision by SCOTUS and the inability to successfully such a burden? Could the humble arithmetic and simplicity of the Active Management Value Ratio metric be be a contributing factor in these decisions to leave the 401(k)/403(b) arena?

While this post has discussed the issues in terms of 401(k)/403(b) plans, it should be noted that the Solicitor General’s amicus brief addressed the issues in terms of the Restatement in general, which applies to all investment fiduciaries, e.g., trustees, RIAs, wealth managers, not just plan sponsors. Therefore, to use 401(k) legend Fred Reish’s familiar admonition, “forewarned is forearmed.”

Notes
1. Brotherston v. Putnam Investments, LLC, 907 F.3d 17 (1st Cir, 2018.
2. Hughes v. Northwestern University
3. Restatement (Third) Trusts (American Law Institute).
4. Tibble v. Edison, Intl., S. Ct. 1823 (2015).
5. Restatement (Third) Trusts, (American Law Institute).
6. “Brief for the United States as Amicus Curiae,” Putnam Investments, LLC v. Brotherston, available at Hughes v. Northwestern University – SCOTUSblog
7. Ibid.
8. Ibid.
9.Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
10. 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.
11. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
12. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).

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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 facts and circumstances. If legal or other professional assistance is needed, the services of an attorney other appropriate professional adviser should be sought.

About jwatkins

I am a securities and ERISA attorney. I am a Certified Financial Planner(r) professional (32 years) and an Accredited Wealth Management Advisor. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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