By Pension and Benefits Editorial Staff
Employees participating in a 401(k) plan maintained by their employer, Putnam Investments, will be afforded the opportunity to prove that the plan fiduciaries breached their duties of prudence under ERISA by restricting employees’ investments to proprietary funds and failing to monitor and remove underperforming funds, according to a U.S. Court of Appeals in Boston (CA-1). Vacating a trial court order, the First Circuit stressed that, on remand, once the beneficiaries have established a loss to the plan, the burden would shift to the fiduciaries to show that the loss most likely would have occurred even if the fiduciaries had observed a prudent selection and monitoring process.
Plan investment options primarily proprietary mutual funds. Putnam Investments maintains a 401(k) plan. Between 2009 and 2017 over 85 percent of the plan’s assets were invested in mutual funds owned and managed by Putnam. In addition, during the class period of November 2009 through January 31, 2016, plan fiduciaries offered no mutual funds other than the proprietary and actively managed Putnam funds. Plan participants wishing to invest in non-affiliated funds could do so only through a self-directed brokerage account.
Investment management services are provided to Putnam funds by a wholly owned subsidiary of Putnam (Putnam Management). Investor servicing functions are provided to Putnam mutual fund investors by another wholly-owned subsidiary (Putnam Investor Services). Separate Putnam committees are responsible for managing investments and assisting participants in the investment of their individual accounts.
The Putnam mutual funds pay management fees to Putnam from the assets of each mutual fund as compensation for the provision of investment management services and as reimbursement for certain investment management-related expenses. The plan invests in mutual funds by acquiring two distinct classes of shares: Y shares and R6 shares. The share classes charge the same investment fees, but the servicing fees charged by the R6 shares are lower than those charged by the Y shares.
The Y shares of the mutual funds also offer revenue sharing payments to certain financial intermediaries. Putnam pays revenue sharing of up to 25 basis points (0.25% of plan assets) in connection with Class Y shares of Putnam mutual funds held by third party plans. However, with respect to Y shares of Putnam mutual funds held by the plan, Putnam, by contrast, pays recordkeeping fees (3 basis points (0.03% of plan assets) upfront for its plan, rather passing the cost to the plan
Plan participants who were invested in investment options under the plan brought suit, alleging that the payment of fees by Putnam mutual funds to Putnam constituted prohibited transactions under ERISA §406(a) and ERISA §406(b). The Putnam fiduciaries countered that the transactions did not constitute prohibited transactions because: (1) they did not involve plan assets and (2) the fees assessed were exempt as reasonable compensation for services. The participants also charged that the plan fiduciaries breached their duties of prudence and loyalty under ERISA by “blindly stocking” the plan with the proprietary Putnam funds.
A federal trial court in Massachusetts dismissed the prohibited transaction claims, ruling that the payment of management fees from mutual funds owned by the plan sponsor to wholly-owned subsidiary companies did not constitute a prohibited transaction because the fees were not paid from plan assets. In addition, the court ruled that management fees paid by the mutual funds to the affiliates of the plan sponsor did not constitute a prohibited transaction because the fees were reasonable. The court expressly rejected a comparison of the actively managed mutual funds with passively managed indexed funds.
After seven days of a bench trial, during which only the participants presented evidence, the trial court entered judgment on partial findings under Rule 52(c) of the Federal Rules of Civil Procedures, concluding that, while the plan fiduciaries did not independently investigate or monitor the Putnam funds included in the plan, the participants failed to establish that the fiduciary breach caused loss to the plan.
The participants waived any challenge to the ruling that the fees were not derived from plan assets, but appealed the trial court’s order dismissing the prohibited transaction and fiduciary breach claims. The First Circuit affirmed the trial court’s disposition of the ERISA Sec. 406(a) prohibited transaction claims, but vacated the court’s dismissal of the ERISA Sec. 406(b) claim. In addition, the appeals court affirmed the dismissal of the breach of the duty of loyalty claim, but vacated the finding that the participants had failed as a matter of law to show loss.
Note: The primary significance of the case was the court’s disposition of the breach of the fiduciary duty of prudence claim and the allocation of the burdens of proof.
Breach of the duty of prudence. The federal district court terminated the trial before the plan fiduciaries could present a defense to the participants’ charge that the fiduciaries breached their duty of prudence by failing to follow a prudent and objective process for investigating and monitoring the individual merits of each of the plan’s investments in terms of costs, redundancy, or performance. The court did not definitively determine whether the alleged violations occurred, but noted that the evidence would be sufficient to support a finding that the fiduciaries imprudently selected the Putnam funds and failed to monitor the plan investments. However, the court dismissed the participants’ claim, finding that they failed to prove that the alleged fiduciary breach resulted in a loss to the plan.
Establishing loss. In arguing that the plan did incur a loss, the participants produced an expert analysis comparing the high cost, actively managed Putnam funds with low cost, passively managed funds (Vanguard and BNY Mellon). According to the participants’ expert, the plan and its beneficiaries paid a premium of $30 to $35 million to obtain overall net returns that fell below the returns generated by the passive investment options that could have been offered. The trial court, however, ruled, as a matter of law, that the evidence was insufficient to establish a prima facie case of loss. The court seemed reluctant to hold the fiduciaries liable for losses stemming from the funds that may have been good investment options, even if the process by which the investments were selected was imprudent.
The appeals court disagreed, explaining that in ascertaining loss, it is reasonable to compare the actual returns on a portfolio to the returns that would have been generated by a portfolio of comparable benchmark funds and indexes. Accordingly, the court concluded that the evidence proffered by the participants was sufficient to support a finding of loss.
Loss causation. The issue central to the fiduciary breach claim was whether the alleged loss incurred by the plan and its beneficiaries was caused by the imprudent procedures used in selecting the investments. The parties agreed that causation was a prerequisite to recovery for fiduciary breach, but differed as to whether the participants were required to prove causation, or the fiduciaries were required to disprove causation, once loss was established.
The First Circuit noted that, in the 4th, 5th, and 8th Circuits, once loss has been established, the burden of disproving causation (i.e., that the loss was not caused by the alleged breach) is borne by the fiduciaries. By contrast, the 6th, 9th, 10th, and 11th Circuits impose the burden on plaintiff participants and beneficiaries of proving an alleged loss was caused by the fiduciary breach.
In joining the 4th, 5th, and 8th Circuits, the First Circuit, noted that ERISA Sec. 409(a), which requires a causal connection between the breach and the loss, does not explicitly allocate the burden of causation. Given ERISA’s silence on the issue, courts have followed two interpretive approaches.
Under the “ordinary default rule,” plaintiffs generally bear the burden of proving the essential elements of the claim, unless the facts are “peculiarly within the knowledge” of the defendant. By contrast, the court explained that, under the common law of trusts, which informs judicial analysis of ERISA’s fiduciary duties in the absence of explicit textual direction, the burden of disproving causation falls on a fiduciary once a beneficiary has established loss associated with the alleged breach.
The court found that the allocations of burdens under common law trust law best fit the balance ERISA seeks to achieve between promoting the interests of fiduciaries and enhancing the protection of beneficiaries’ retirement benefits. Moreover, the court maintained, the interpretation did not conflict with the ordinary default rule. Specifically, the court reasoned that the trust law rule, allocating the burden of disproving causation to fiduciaries, could fit within the exception to the ordinary default rule applicable when a fiduciary possesses superior knowledge regarding the elements of a participant’s claim. Accordingly, the trial court’s judgment denying the participants’ breach of prudence claim was vacated. On remand, the trial court was instructed to complete the bench trial in order to first definitively decide whether the fiduciaries breached their duties of prudence. The court would then need to determine whether the participants established loss to the plan and whether the fiduciaries could not meet their burden of showing that the loss most likely would have occurred even if the fiduciaries had adhered to prudent selection and monitoring procedures.
SOURCE: Brotherston v. Putnam Investments, LLC (CA-1).
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