NO EXCUSES

A PRACTICAL ANALYSIS OF THE COURT’S RULING THAT SOUTHERN CALIFORNIA EDISON BREACHED THEIR FIDUCIARY DUTY OF CARE IN SELECTING A TOO EXPENSIVE MUTUAL FUND SHARE CLASS

A trustee is held to something stricter than the morals of the marketplace. Not honesty alone,

but the punctilio of an honor the most sensitive, is then the standard of behavior.

Judge Benjamin Nathan Cardoza, 1928

In legal circles, this famous quote (by one of America’s most influential judges) articulates a founding principle of the common law of trusts. The Employee Retirement Income Security Act of 1974 (ERISA) derives from and is grounded in this common law. ERISA governs fiduciaries of 401(k) plans, both fiduciaries that are named and those who are not named but exercise fiduciary powers de facto. ERISA was enacted in the crucible of congressional concern over the misuse and mismanagement of plan assets, and so imposes strict duties on plan fiduciaries. Two primary duties are the duty of loyalty and the duty of care. ERISA § 404(a)(1) says, in part:

…[A]fiduciary shall discharge his duties with respect to a plan solely in the interest of participants and beneficiaries [the duty of loyalty] and for the exclusive purpose of providing benefits to participants and their beneficiaries; and defraying reasonable expenses of administering the plan; with the care, skill prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims…[the duty of care]

The courts have repeatedly ruled that these duties are “the highest known to the law.” Fiduciaries jointly and individually are personally responsible for any losses or damages suffered by the plan due to a breach of fiduciary duty.

Unlike most trust laws, ERISA permits fiduciaries to wear “two hats”: that is, they may work as an employee, officer or director of a firm, and serve as a fiduciary of a 401(k) plan (or other ERISA plan), even if, at times, there are conflicts of interest. NEVERTHELESS, SUCH PERSONS MAY WEAR ONLY ONE “HAT” AT A TIME. While this exception was made for practical reasons (employers by and large are responsible for their own plans), it puts an additional burden on the fiduciaries to document compliance and a pattern of review and decision making that demonstrates loyalty and care.

On July 7, 2010 in the matter of Glenn Tibble, et al v. Edison International, et al (CV 07-5359 SVW (AGRx)), decided at the United States District Court, Central District of California, the court found that the Defendants violated their duty of prudence in the Edison 401(k) Savings Plan (“the Plan”). They did so choosing to invest in a retail share class rather than the institutional share class for three mutual funds. The following entities and individuals were sued and held to be fiduciaries: Edison International (“Edison”), Southern California Edison Company (“SCE”), the Southern California Edison Company Benefits Committee and its members, the Edison International Trust Investment Committee, the Secretary of the SCE Benefits Committee, SCE’s Vice President of Human Resources, and the Manager of SCE’s Human Resources Service Center. Other officers and the board of directors were not named because the written plan documents and policies had clearly delegated the responsibilities for fund selection and monitoring to the above-named individuals (absence such written delegation other officers and the board may well have been included among the defendants). Additionally, SCE had an internal investment staff that monitored the investments and reported to the Benefits Committee, but as it had no authority over the administration of the plan, the selection of the Plan’s third-party service providers, or the selection of Plan’s investment options, the staff did not have fiduciary status. IN OTHER WORDS, SUCH LAW SUITS WILL GENERALLY INVOLVE A WIDE GROUP OF INDIVIDUALS. Lack of clarity in delegation and lack of rigor in how decisions are carried out both conspire to work against individuals. Sometimes employees who serve in some Plan oversight capacity are surprised when they learn they may be personally liable for damages to a plan.

Each year of the Plan was comprehensively and meticulously scrutinized. That is what happens once a Plan is caught in the radar. According to the court, the fiduciaries had done many things right. , and much can be learned by looking at a list of all things that were correctly done.

They had a carefully crafted investment policy statement:

• It unambiguously detailed who was responsible for what;
• It set forth standards for selecting and evaluating funds;
• Those standards were clear: funds passed the standards, failed or were put on watch;
• The policy required the ongoing consideration of performance, risk, the type of fund (asset class, style);
• Funds were compared to peer groups and benchmarks;
• Changes, if any, in the manager or the organization are reviewed (stability, change in ownership); and
• Each fund’s expense ratio (including fees and revenue-sharing) is considered.
• They dotted each “i” and crossed each “t”. In other words, everyone was duly appointed. Changes happened in accordance with the policies.
• They documented the process. They kept minutes and (mostly) copies of reports.
• They had a committee in charge of investment monitoring and selection.
• Over the long-term, they reduced costs as assets grew.
• As it was a large plan, they had an internal investment staff that monitored the Plan’s investment options and, when needed, recommended changes.
• They utilized an affiliate of the record keeper, Hewitt Financial Services (“HFS”), to review the contents of the staff’s report to the committee and to meet with HFS annually to undergo a more in-depth analysis. While HFS made itself available to discuss the investments, it did not serve as a fiduciary or as an advisor to the plan.
• The mutual funds offered in the plan provided revenue sharing to the plan, largely through 12b-1 fees. The revenue sharing offset part of the fees Hewitt charged for recordkeeping, and it billed SCE for its services after deducting revenue sharing (note the potential conflict of interest).

So what happened?

Six mutual funds were examined: (1) Janus Small Cap Value Fund, (2) Allianz CCM Capital Appreciation Fund; (3) Franklin Small-Mid Cap Growth Fund; (4) William Blair Small Cap Growth Fund; (5) the PIMCO (Allianz) RCM Global Tech Fund; and (6) MFS Total Return A Fund.  These mutual funds offered more than one share class.  Why? Mutual funds, by law, charge all investors the same expenses as a percentage of its assets, whether an investor has $1,000 dollars or $100 million in the fund. Retail investors typically have five-figure account balances, and funds offered to retail investors take that into account. Institutional investors, however, have a large number of assets to manage, perhaps millions and even hundreds of millions of dollars. Thus they have the scale to negotiate for a better deal. In order to sell to institutional investors, the mutual fund company will offer the same fund but in a different share class. It is called a hub and spoke arrangement. All the funds have exactly the same portfolio (the “hub”), but the hub has “spokes” that together make up all the share classes. Each spoke has its own fee structure, but otherwise is invested in the same portfolio. In this matter, each of the above funds had a retail share class and an institutional share class. The institutional share classes were approximately 0.25% less in cost than the retail share classes. Such institutional shares typically have large minimum investment requirements. Such minimums may be applied to the fund, or the aggregate investment of all in the mutual fund family, or may be available to a 401(k) plan of a certain size or bigger (e.g., $50 million) regardless of how much is invested in that fund. Also, plans may call the fund and ask for the minimum to be waived, and often succeed. The Plan invested in the retail shares over the time period the court considered, with one exception. At one point a fund was closed and new money was mapped to the PIMCO fund; because the amount of money was substantial, they did an in-depth investigation and discovered the lower share class for that fund. They subsequently switched to the institutional share class for old and new monies.

One of the plaintiffs’ allegations was that they had breached the duty of loyalty, as the retail class shares increased the amount of revenue share, and thereby reduced the amount that Edison paid to Hewitt. The court considered many years of monitoring and decisions, which the defendants were able to produce because of what was described above. Here it was shown that whenever a conflict came up, they decided in favor of participants, not Edison, as in the PIMCO situation just described. When it comes to the duty of loyalty, intentions matter. Their actions showed otherwise. But if they had not had a rigorous and documented process, they would not have been able to show that they had always worn the fiduciary hat. One mistake illustrates this. They said they thought Hewitt had recommended the retail class shares, but as there was no documentation, the court rejected that defense. Nor could they provide a plausible reason for such a recommendation (they tried but failed).

The second allegation was that they had breached the duty of care in having retail instead of institutional funds. Here the intention of the fiduciaries does not matter. The standard is what a prudent person familiar with such matters would do in like circumstances. The duty of care is the duty of prudence: prudence is measured according to the objective prudent person standard developed in the common law of trusts. The prudence standard is not that of a prudent lay person (ok), but rather that of a prudent fiduciary experienced in dealing with a similar enterprise. The court focuses not only on the merits of the transactions under review, but also on the thoroughness of investigation into the merits of such transactions. Did the fiduciaries employ appropriate methods to investigate the merits of the investment? Furthermore, a fiduciary must secure independent advice from counsel or a financial advisor if the fiduciary lacks the requisite education, experience and skill required for such an investigation. The failure to investigate and evaluate a particular investment decision is a breach of fiduciary duty.

Three of the mutual funds were added to the Plan within the statue of limitations period. Three were added before August 16, 2001, which was outside the statute of limitations period. The plaintiffs’ argument for those three funds, therefore, was that those funds all underwent significant changes that should have triggered a full extensive review, the same as adding a new fund. That review, they argued, would have resulted in realizing the availability of the institutional shares classes, and resulted in lower costs of the funds to the plan. Here again, the plan’s solid process saved them. They were able to convince the court that nothing had occurred that would have triggered a full review; the one exception was with the PIMCO fund as described above, and, at that point they acted appropriately.

However, for the three funds within the statute of limitations, the court had to examine whether or not the fiduciaries engaged in a thorough investigation of the merits of the investments at the time they were added to the plan. The defendants provided no evidence that they even considered the different share classes available. If they had, it would have been clear that the class of shares selected would subject the participants to wholly unnecessary fees. Thus, the court concluded, the fiduciaries did not act with the care, skill, and diligence of a prudent man acting in a like capacity when deciding to invest in the retail share classes of those three funds. They had breached the fiduciary duty of care. Thus, they are required to make the plan whole by paying back the unnecessary fees, as well as the earnings those fees would have made had they not been paid out. They must also transfer the monies to the institutional share class, and, one would expect that this is an event that should trigger changing to the institutional share classes of all their retail class investments.

This is the verdict of one district court. Both the plaintiffs and defendants may appeal the verdict, of course. And the ruling only applies in the U.S. district that had jurisdiction. But there can be little doubt that any other court would apply the law in the same way. There are no excuses for adding a mutual fund that is available for a lower cost. The courts and the Department of Labor agree: even in ERISA 404(c) participant-directed plans, fiduciaries are subject to the highest standards for the funds that are made available through such plans. And what might have happened if the plan did not have a documented thorough process for investment selection and monitoring? It would have been similar to claiming a tax deduction without having the required receipts. If it comes to light, whether by a government audit, or attorneys conducting due diligence in a sale involving the plan sponsor, or by the plaintiffs’ bar, fiduciaries will find themselves having breached their duty, the “highest duty known to law.”

Time to make sure that your 401(k) plan’s house is in order.