Recent fiduciary litigation has featured fiduciary prudence claims based not on fees but on fund underperformance, typically comparing specific funds in a plan’s fund menu to benchmarks proposed by plaintiffs. This claim was a feature of the Intel litigation discussed in our recent article Target Date Fund litigation – Intel plaintiffs challenge the use of alternative asset classes in 401(k) plan TDFs.
In this article we discuss the decision for plaintiffs (on a motion to dismiss) by the United States District Court for the Western District of North Carolina in Reetz v. Lowe’s Companies (September 6, 2019), typical of many of these sorts of fund underperformance-equals-imprudence cases.
In Reetz, plaintiffs claimed (among other things) that the Lowe’s plan fiduciaries breached their ERISA fiduciary duty of prudence “by removing certain investment options from Lowe’s 401(k) retirement plan … and replacing them with an option to invest in a growth fund established and managed by Aon Hewitt ….”
Lowe’s moved to dismiss this claim, arguing that the complaint did “not contain allegations ‘that the process for selecting or monitoring the Hewitt Growth Fund’s performance was deficient.’”
The court rejected the pleading standard proposed by Lowe’s – that plaintiffs had to allege facts directly showing a deficiency in Lowe’s fiduciary process. Instead, it held that to survive a motion to dismiss in this context:
Plaintiff is not required to directly allege all the facts demonstrating how the process for selecting or monitoring the [fund] was deficient …. However, Plaintiff must allege sufficient facts that give rise to a plausible inference that the process for selecting or monitoring the [fund] was deficient.
In discussing this pleading standard, the court quoted extensively from the Eighth Circuit’s decision in Braden v. Wal-Mart Stores, Inc. (2009) (one of the first round of 401(k) fee decisions):
[P]laintiffs adequately state a claim for breach of fiduciary duty under ERISA … when the complaint, taken as a whole, “pleads facts indirectly showing unlawful behavior, so long as the facts pled give the defendant fair notice of what the claim is and the grounds upon which it rests . . . and allow the court to draw the reasonable inference that the plaintiff is entitled to relief. …
“[W]hile a plaintiff must offer sufficient factual allegations to show that he or she is not merely engaged in a fishing expedition or strike suit, we must also take account of their limited access to crucial information. …These considerations counsel careful and holistic evaluation of an ERISA complaint’s factual allegations before concluding that they do not support a plausible inference that the plaintiff is entitled to relief.” [Citing Braden.]
Facts in support of a “plausible inference”
In holding for plaintiffs on this issue, the Reetz court found the necessary factual allegations giving rise to a “plausible inference” in the complaint’s allegations that the Aon Hewitt fund:
Had a “limited track record” and “a negative rate of return” (when it was selected).
Replaced “popular, established, more diverse and profitable investment options.”
Used a “novel” investment strategy that was “difficult for [Aon] Hewitt to execute.”
Had no “consistent benchmark.”
These allegations – constituting, in effect, an “indirect” case for an imprudent process – were sufficient to defeat defendant’s motion to dismiss.
The importance of the motion to dismiss
Perhaps the most critical stage in the legal process for fiduciary litigation is the motion to dismiss for failure to state a claim. If plaintiffs can survive that stage, they can via discovery (e.g., depositions and interrogatories) “fish” for facts supporting their allegations and impose litigation costs, improving their case and making settlement more likely.
As the Reetz court noted (quoting Braden), in these cases plaintiffs have “limited access to crucial information” – specifically, they don’t have information about the process the defendant-fiduciaries used to arrive at the allegedly imprudent decision.
What does plaintiff have to allege to survive a motion to dismiss?
In our article on the Intel complaint, we noted that the Intel plaintiffs’ complaint simply rehearsed the generic critique of hedge fund and private equity investments and then asserted that no fiduciary aware of that critique and using a prudent process would have allocated as much TDF assets to alternatives as Intel had.
Is that allegation enough to state a claim (that is, survive a motion to dismiss)? If not, what more is required?
The Reetz court takes on this issue directly: It articulates a standard under which plaintiffs (1) need not allege facts that directly show an imprudent process but (2) must at least allege facts from which imprudence may be reasonably inferred.
The pattern of plaintiffs’ allegations
In this regard, we are seeing a number of cases that allege, in effect, that the funds defendant-fiduciaries chose (in this case, the Hewitt Growth Fund) performed significantly worse than some other funds (in this case, the funds that the Hewitt Growth Fund replaced). To this plaintiffs typically add arguments that purport to explain why the plan fiduciaries decision was a bad (i.e., imprudent) idea: In Reetz, plaintiffs pointed to the new fund’s limited track record, negative rate of return, “novel” investment strategy, and lack of a consistent benchmark. In Intel, the novelty of the strategy, the generic problems presented by hedge funds and private equity (e.g., lack of liquidity), and the relatively high fees were stressed.
This sort of argument raises at least two significant questions: First, what is a reasonable comparator fund? This question is especially problematic with respect to target date funds – where different glide paths and investment styles can produce very different investment performance.
Second, what happens to courts’ commitment to not evaluating ERISA imprudent-investment claims based on a “hindsight” analysis? A critical element of all of these “underperformance” cases is an allegation that the fiduciary made a decision in the past that, in the event, did not work out as well as some other decision it could have made. Isn’t it conceivable that a plaintiff (or her lawyer) could simply identify “underperforming” funds (relative, e.g., to the S&P 500), and then reverse engineer additional reasons for why picking those underperforming fund was imprudent? E.g., that the fiduciary used a novel investment strategy.
Takeaways for sponsor fiduciaries
This is an emerging area of litigation: a challenge to a fiduciary fund menu decision based not on fees (or not exclusively on fees) but on the underperformance of the fund relative to a comparator. Courts are taking different approaches to these claims, and at this point only some very tentative observations can be made:
The issue of the pleading standard (more or less the subject of the Reetz decision), while technical, is critical. As noted, dismissal of a claim avoids the expense (and risk) of discovery.
It’s not clear that a fiduciary can, in advance, prepare itself to defeat this sort of claim at the motion-to-dismiss stage. In this regard, however, plan fiduciaries may want to consider specifying the appropriate benchmark (with emphasis here on “appropriate”) for fund performance – and (generally) base fiduciary decisions on that relative performance. And making as explicit as possible the investment strategy implemented by the fund – thereby providing an explanation of alleged “underperformance” that might be referenced even at the motion-to-dismiss stage.
We note that in both Reetz and Intel there is an allegation that the challenged fund(s) employed a “novel” strategy. Where plan fiduciaries are considering a non-standard investment option/strategy, they generally will want to be especially careful in documenting their reasons for doing so.
If the case proceeds beyond the motion-to-dismiss stage, the plan fiduciary’s best defense will be to produce evidence that they used a thorough and prudent process in arriving at their decision.
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We will continue to follow this issue.