Posted by Roger L. Levy, LLM, AIFA® on March 03, 2015
(Editor's note: The following post was written by Roger L. Levy, who is Managing Director of Cambridge Fiduciary Services, LLC. Mr. Levy is also an AIFA designee and CEFEX Analyst. In December 2014, Mr. Levy and Cambridge Fiduciary Services, LLC filed an amicus brief with the Supreme Court in support of the plaintiffs in the Tibble v. Edison case, a 401(k) fiduciary breach lawsuit regarding fees and the fiduciary duty to monitor investments. The brief includes substantial references to fi360's Prudent Practices handbooks, as well as CEFEX's assessment process. Mr. Levy, along with attorney Troy Doles and fi360 Policy Analyst Duane Thompson, will be appearing at INSIGHTS 2015 to discuss this case and other developments in fee litigation under ERISA.)
On February 24, the US Supreme Court heard oral arguments in Tibble v. Edison, a 401(k) fiduciary breach lawsuit that had garnered a lot of attention even before the hearing. The issue that the court has to decide is whether a claim may proceed for a breach of the fiduciary duty to monitor investments when a claim based on the initial imprudent selection of the investments is barred based on statutory limitation grounds because the initial selection occurred more than six years earlier.
In this case, the alleged imprudence is that the plan sponsor investment committee selected retail class shares for the chosen funds rather than institutional class shares that were available and would have reduced participants’ investment expenses. Because the claim based on the initial selection was barred by the statute of limitations, the participants argued that a subsequent breach occurred when the plan fiduciaries failed to monitor the investments and switch share class shares as a result of further investigation that they should have conducted.
Edison argued that permitting a claim based on a failure to monitor would allow participants to attack conduct that occurred outside the limitation period, namely the initial selection. However, Edison conceded that ERISA imposes a duty to monitor investments but sought to excuse Edison’s conduct by relying on the finding of the Court of Appeals for the Ninth Circuit that a claim for a breach of the duty to monitor must be supported by evidence of “changed circumstances,” and by arguing that less stringent due diligence is required when monitoring investments than when making an initial selection. Further, Edison argued that changing investments causes disruption that participants don’t like.
Although Supreme Court watchers will tell you that you can’t predict an outcome based on a reading of the oral arguments, commentators tend to agree that the questioning by the Justices indicated a favorable leaning towards the participants. However, the Justices questioned when the duty to monitor arises and what it involves.
Before the oral arguments, some commentators argued that this case is really about a duty of plan sponsors to select the cheapest funds available. That, of course, is wrong: the case is about the need to investigate the availability of the cheapest share class for a particular fund. Still, with oral arguments over, commentators are now predicting dire consequences for plan sponsors if the Supreme Court comes down in favor of participants, suggesting that it will be difficult to define the monitoring duty and that managing a 401(k) plan will become more burdensome and costly. Having been one of those who contributed to the amicus brief filed in this case by Cambridge Fiduciary Services, LLC, I disagree, and AIF® and AIFA® designees will readily understand why.
At the end of the day, the Supreme Court should have little difficulty in resolving the issue before it. Both sides agree that there is a fiduciary duty to monitor investments once selected, but they disagree upon what triggers monitoring and what is the extent of investigation that monitoring calls for. The answer is pretty simple. When monitoring investments, the same level of prudence is required as when making the initial selection: that is the level of prudence mandated by ERISA's prudent expert standard. Such a finding would be consistent with the Supreme Court decision in Fifth Third Bancorp. V. Dudenhoeffer 134 S. Ct. 2459 (2014) that effectively found that there were no different levels of prudence under ERISA. Prudence is judged on the facts and circumstances and requires fiduciaries to perform that level of monitoring that is prudent based on the facts and circumstances with which they are faced at the time. The Supreme Court probably does not need to go further, but the Justices might indicate that monitoring requires investigation of performance, costs, manager tenure, and circumstances that might distract the manager, such as regulatory action, litigation, or corporate transactions, such acquisitions and divestitures. This would, of course, be consistent with the fi360 Prudent Practices handbooks.
In our amicus brief before the Supreme Court, we argued that most diligent fiduciaries already perform prudent monitoring so that there is no huge burden or additional cost to requiring ongoing monitoring as a fiduciary responsibility. As mentioned earlier, Edison's counsel argued that plan sponsors are wary of the disruption caused when funds are changed but, as one of the Justices asked, what kind of disruption is it worth when a significant difference in fees is on the line?
Prudent Practices and CEFEX Assessment
We filed our amicus brief as a firm engaged in advising plan sponsors and investment advisors on fiduciary best practices and in performing assessments of fiduciary conformity. In so doing, we drew attention to the particular Practices and Criteria in the fi360 Prudent Practices handbooks that inform the process employed by diligent fiduciaries. It is worth mentioning here broader material from the Handbooks in order to demonstrate that advisors and their plan sponsor clients who follow the Practices will have little difficulty in meeting their monitoring obligations, once the Tibble decision is handed down.
The Handbooks explain with respect to monitoring:
No one should be lulled into thinking that the ‘heavy lifting’ was done in the previous three steps (Organizing, Formalizing and Implementing) and the client portfolio is now on ‘auto pilot,’ marked only by periodic re-balancing, quarterly performance reports, and routine client meetings.
For the investment fiduciary, the starting point of monitoring is working backwards through the four-step Fiduciary Quality Management System. The logic is simple: activities involved in monitoring are dependent upon what was done in the first three Steps. As you work your way back through the process, you will typically analyze what you did in the first three steps.
The Handbooks continue:
Step 4 is where many fiduciary breaches occur, and the cause may be inadequate preparation and execution in the earlier parts of the investment process, resulting in errors of omission, which are more common than acts of commission. For example, a poorly written investment policy statement undermines effective monitoring. Another common form of an omission is failure to follow through on established policies and procedures.
Thus, it can be seen that the duty to monitor and perform due diligence does not simply arise when there is a need to respond to changed circumstances as found by the Ninth Circuit.
The specific Practices and their Criteria which are relevant to the monitoring issue in this case are as follows:
- Practice 4.1 - “Periodic reports compare investment performance to appropriate index, peer group, and investment policy statement objectives.”
- Practice 4.4 - “Periodic reviews are conducted to ensure that investment-related fees, compensation, and expenses are fair and reasonable for the services provided.”
- Criterion 4.4.1 - “A summary of all parties compensated from the portfolio or from plan or trust assets and the amount of compensation has been documented.”
- Criterion 4.4.2 - “Fees, compensation, and expenses paid from the portfolio or from plan or trust assets are periodically reviewed to ensure consistency will all applicable laws, regulations, and service agreements.”
- Criterion 4.4.3 - “Fees, compensation, and expenses paid from plan or trust assets are periodically reviewed to ensure such costs are fair and reasonable based upon the services rendered and the size and complexity of the portfolio or plan.”
- Practice 4.5 - “There is a process in place to periodically review the Steward’s (or Advisor’s) effectiveness in meeting its fiduciary responsibilities.”
- Criterion 4.5.1 – “Fiduciary assessments are conducted at planned intervals to determine whether a) appropriate policies and procedures are in place to address fiduciary obligations, b) such policies and procedures are effectively implemented and maintained, and c) the investment policy statement is reviewed at least annually.
The referenced Criterion brings in the role of CEFEX as a fiduciary certification body and it should be noted that entities undergoing CEFEX certification assessments would likely be cited with a deficiency or shortfall if they did not examine available fund share classes. In the case of an assessment of an investment advisor, the assessment questionnaire known as the “CAFE” (CEFEX Assessment of Fiduciary Excellence) asks:
If applicable, does the Advisor select share classes in accordance with the purchasing power of the client?
The note to the CEFEX analyst included in the CAFE states:
Advisors should make recommendations based on the share classes available and must educate plan sponsors about available share classes, including their costs.
Importantly from the perspective of the Tibble case, the referenced assessment question is tested annually in a CEFEX assessment not just in the year in which the initial fund and share class selection is made. Accordingly, a failure to monitor share class selection will come to light.
When looking at the Practices and the CEFEX assessment process, a number of conclusions can be drawn:
- The duty to prudently select plan investments and the duty to prudently monitor plan investments are separate fiduciary responsibilities, but there is no difference in the standard of prudence required in each case;
- Most plan fiduciaries are already performing the type of monitoring that is prescribed by the Practices, thus protecting themselves and existing participants, as well as newly appointed plan fiduciaries and new participants, from risks associated with prior imprudent decisions;
- Such monitoring, if performed in this case, would have uncovered the imprudent selection of retail-class mutual fund shares in time to avoid or at least mitigate the loss to participants and/or risk of participant legal claims;
- A CEFEX assessment performed with respect to the Edison plan would have uncovered a failure to investigate and evaluate the appropriate share class when selecting mutual funds and the subsequent selection of retail class shares.
In conclusion, the Supreme Court should have little difficulty in supporting ERISA’s fiduciary standard of care by explaining the duty to monitor, and advisors and their retirement clients who conform to the Practices should be well prepared to deal with the Tibble outcome. To the extent that advisors and plan sponsors want independent evidence that they are meeting their monitoring and other fiduciary obligations, CEFEX offers the appropriate solution.