On January 12, 2020, the Supreme Court denied review of the First Circuit Court of Appeals decision for plaintiffs in Brotherston v. Putnam. One of the critical issues in Brotherston was the First Circuit’s holding (reversing the lower court) that plaintiffs could establish their claim, that the inclusion of certain actively managed Putnam funds in a 401(k) plan fund menu was imprudent, by comparing those funds’ performance to the performance of two “comparator” index funds.
The issue of the “appropriate comparator” to be used in judging alleged imprudence based on underperformance has been presented in a number of recent high profile 401(k) fiduciary cases, including, e.g., Home Depot and Lowe’s. Given the (somewhat extraordinary) performance over the last 10 years of US large cap equity vs. other strategies, the courts’ acceptance of this argument is a significant concern for plan sponsors.
In this article we review the First Circuit’s decision, the Solicitor General’s brief to the Supreme Court arguing that the First Circuit decision should not be reviewed, defendant Putnam’s arguments for review, and the significance – for ongoing litigation – of the Supreme Court’s decision not to review.
We note that the issues in this case are complicated, and the discussion that follows is something of a deep dive. We expect, however, as defendant Putnam argued in its briefs to the Court, that the issue of what is a “suitable comparator” is going to continue to be especially problematic for plan sponsors in ongoing 401(k) prudence litigation.
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 than 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 claimed (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 was 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 case, 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 distinct 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, among other things:
(1) That 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.”
Solicitor General’s brief
In its brief to the Supreme Court recommending that the Court not review the First Circuit’s decision, the Solicitor General argued that the Brotherston case “would be an unsuitable vehicle for resolving” issue (2) for several reasons having to do with the mid-trial procedural posture of the case (discussed above).
In this article our focus is on issue (1) – “proof of loss.” With respect to that issue, the Solicitor General argued that “[t]he court of appeals … correctly concluded that passively managed index funds are not, as a matter of law, improper comparators for determining whether a loss has occurred from an ERISA fiduciary’s breach involving the improper monitoring of actively managed funds.” And that “[t]he selection of comparator funds largely depends on the facts and circumstances of the case … [and] [f]or that reason, and given the limited scope of the court of appeals’ decision, … does not warrant the Court’s review.”
Effectively, the SG was arguing that the use of an index fund as an active fund comparator could not be ruled out as a matter of law, and if defendants wanted to argue that it was unsuitable as a matter of fact they would have to put on a case proving so.
Defendant Putnam’s briefs
In its original petition to the Supreme Court for review, Putnam argued that, since the plan’s fund menu already included passive investments (in which “participants as a whole had invested only about 6% of the plan’s assets”), use of a passive comparator to prove losses with respect to the targeted Putnam actively managed funds should not have been allowed. And in a supplemental petition responding to the SG’s brief, Putnam argued that the First Circuit had in fact disregarded these facts, including, e.g., “the characteristics of the Putnam plan and index funds’ demonstrable unpopularity with Putnam participants.”
The need for a ruling on the disputed issue of comparators
As we noted at the beginning of this article, what is an appropriate comparator – to prove loss or (as in Home Depot and Loew’s) imprudence – is very much a disputed issue in current 401(k) fiduciary litigation. In this regard, the exceptional performance of US large cap (as a whole) and, e.g., the S&P 500 have created a problem for plans that include funds that pursue a more diversified investment strategy and/or are actively managed.
The First Circuit’s ruling – which, by denying review, the Supreme Court let stand – was (to put it as simply as possible), that defendant must factually prove, in a trial, that the index funds used by plaintiffs were not proper comparators for the targeted actively managed funds. That ruling (in the First Circuit at least) creates a situation in which plaintiffs can impose significant litigation costs on defendant-plan sponsors simply by alleging that a targeted actively managed fund has underperformed an index.
Defendant Putnam had argued in its petition that:
Granting review of this issue will provide much-needed clarity in the myriad cases filed against plan sponsors and fiduciaries. The approach taken by respondents [i.e., plaintiff-participants] and endorsed by the First Circuit is not an aberration: this same method has been advanced by plaintiffs repeatedly. … And because recent years have also seen an explosion in settlements, … the opportunities for appellate guidance are exceedingly rare despite the significant practical impact of this issue.
The Court’s failure to grant review leaves the issue of suitable comparators unclear, with limited chances for future clarification.
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Thus, the Supreme Court’s denial of a hearing on Putnam’s petition for review is a missed opportunity, and litigation premised (in a variety of ways) on claims of fund “underperformance” relative to passive investments is likely to continue.
We will continue to follow this issue.