Putnam requests Supreme Court review of active vs. passive management

On January 11, 2019, Putnam Investments LLC, fiduciaries of the Putnam 401(k) plan, and related persons filed a Petition for a Writ of Certiorari (in effect, a request for review) with the Supreme Court, requesting review of the First Circuit Court of Appeals’ October 15, 2018 decision for plaintiffs in Brotherson v. Putnam.

The case, an “in-house plan” 401(k) fee suit, involves one of the critical issues in current 401(k) fee litigation: the extent to which a plaintiff can bring a 401(k) fee claim based on a comparison of the performance of actively managed funds included in the plan’s fund menu with “passive comparators that belonged to the same Morningstar category.”

In this article we review the issues in this case.

Background

The Putnam 401(k) plan menu includes “many of Putnam’s proprietary mutual funds,” most of which are actively managed. During most of the period at issue, more 85% of the plan’s assets were invested in those Putnam funds, and “participants were given the option to invest in non-affiliated funds only through a self-directed brokerage account.”

Plaintiffs claim (among other things) that, in selecting the Putnam funds for inclusion in the plan fund menu, Putnam fiduciaries breached their duty of prudence under ERISA, and this claim is the focus of the Supreme Court petition. All parties agreed that such a claim includes three elements: breach, loss, and causation.

First Circuit decision

The case is in a slightly unusual procedural situation: after trial had begun, and plaintiffs had presented their evidence, defendants filed a motion for judgment in their favor, arguing (among other things) that “even assuming a fiduciary breach, respondents had failed to establish loss causation.” (This formulation is a little ambiguous – defendants’ Supreme Court petition raises questions with respect to both loss and causation.) The district court (in the relevant part) found for defendants on that motion.

The First Circuit vacated the district court’s decision and remanded it for further proceedings. In doing so it held that:

(1) Plaintiffs had proved “loss” “by comparing one at a time the total return for each Putnam fund to the total return for two passive comparators, a Vanguard index fund that belonged to the same Morningstar category as the Putnam fund and a BNY Mellon collective investment trust.”

(2) 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.”

To prove “objective prudence,” Putnam would have to prove that, even though its process was imprudent, the decision it came to (to include the Putnam funds in the plan fund menu) was nevertheless prudent – that is, that a prudent fiduciary could have made the same decision.

Defendants then petitioned the Supreme Court to review the First Circuit’s holdings with respect to “the loss-causation question.”

Split in the circuits on burden of proving causation

One reason the Supreme Court may take this case is that there is, on issue (2) – the burden of proof issue – a split in the circuits. As the Putnam defendants characterize it, 10 Courts of Appeal are split on this issue, with six of them siding with the defendants (that is, requiring the plaintiff to prove causation) and four siding with plaintiffs (requiring the defendant to prove the absence of causation).

As the First Circuit notes, the “ordinary default rule” is that plaintiffs bear the burden of proving all elements of their case – in this case, breach, loss, and causation. The First Circuit explained its decision not to follow the ordinary default rule, and instead to require that defendants prove that their breach did not cause plan losses, based on the (related) law of trusts, the purposes of Congress in passing ERISA, and “common sense.”

An ERISA preference for passive investments?

With respect to the latter (“common sense”) point, the court observed that “[a]n ERISA fiduciary often – as in this case – has available many options from which to build a portfolio of investments available to beneficiaries. In such circumstances, it makes little sense to have the plaintiff hazard a guess as to what the fiduciary would have done had it not breached its duty in selecting investment vehicles, only to be told ‘guess again.’”

The court then went on to suggest that the “solution” to this sort of 401(k) fee litigation is for 401(k) plans to prefer passive investments:

[N]othing in our opinion places on ERISA fiduciaries any burdens or risks not faced routinely by financial fiduciaries. While Putnam warns of putative ERISA plans foregone for fear of litigation risk, it points to no evidence that employers in, for example, the Fourth, Fifth, and Eighth Circuits [the other federal circuit adopting the rule that the burden of proof shifts], are less likely to adopt ERISA plans. Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds.

The Putnam defendants, in their Supreme Court petition, argue that the First Circuit’s proposition is, for two reasons, “deeply flawed”:

First, … it would radically reshape the face of retirement planning by forcing a universal shift to index funds, which many investors are not currently choosing. … And second, plaintiffs sue plan fiduciaries even when they offer index funds. They may argue that index funds underperformed, that there were even cheaper index funds available [citing, among others, Bell v. Anthem], or that a different investment structure (CITs or separate accounts) should have been chosen instead [citing White v. Chevron].”

Can the performance of active and passive funds be fairly compared?

To make their argument that the inclusion of certain actively managed funds in the fund menu is “objectively imprudent,” plaintiffs in 401(k) fee cases often (nearly inevitably) rely on comparisons with the performance of index funds.

There are at least a couple of problems with this argument. First, it is axiomatic that in a bull market index funds typically outperform actively managed funds. The last 10 years have seen a bull market in US equities, and indeed most more diversified investment strategies underperformed, e.g., the S&P 500 over that period.

Good enough vs. best

Second, and more fundamentally, there is the question of what the ERISA standard is. As defendants will point out, and as the district court, in finding for the defendants in Brotherson v. Putnam, did point out, “all of the Putnam mutual funds the Plan invested in were also offered to investors in the general public, therefore, their expense ratios were ‘set against the backdrop of market competition.’” That is: prudent investors are buying these allegedly imprudent actively managed funds. Indeed, as the Putnam defendants’ Supreme Court petition notes, “nearly $12 trillion in assets are held in active mutual funds and only about $3.5 trillion are invested in index mutual funds.”

As we have discussed, in current 401(k) plan fee litigation, the question often comes down to whether sponsor fiduciaries are required to get the “best deal” for plan participants, as plaintiffs (typically with the benefit of hindsight) will argue, or are they simply required to get a “good enough” deal.

Clarity on this issue would be welcomed both by sponsors and providers.

At what stage in the judicial process will the critical decision be made?

As we noted, _Brotherson v. Putnam_is at an unusual procedural stage – the parties had actually gone to trial, and plaintiffs had presented their case. But, as the Putnam defendants point out in their Supreme Court petition, “[a]lready, nearly every case challenging a defined-contribution plan line-up settles before trial given the potential monetary liability involved ….”

What is needed at this point is clear guidance from the courts, in all circuits, as to whether the mere assertion that there was a similar (or, sometimes, “identical”) lower cost fund available with a lower expense ratio is sufficient to state an ERISA prudence claim. And whether the consequent loss can be measured by the difference between the performance of an actively managed fund vs. the performance of a passive index fund.

That sort of guidance would allow the disposition of most cases at an early stage in the pleadings, e.g., after the complaint and answer have been filed and before discovery has begun.

If the Supreme Court grants the Putnam defendants’ petition for review, it is possible that we will get that guidance.

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We will continue to follow these issues.