I was recently interviewed by Robin Powell for “The Evidence-Based Investor,” a U.K.-based blog. Robin is a highly respected journalist and one the leaders of the evidence-based investment movement. The topic of our discussion was the investment litigation trend in the U.S., especially ERISA-based litigation. Click here to read the interview.
I think I may have caught Robin a little off-guard when I told him that I expected securities related litigation, both ERISA and non-ERISA related litigation, to increase. As I explained to Robin, I think we are going to see the plaintiff’s bar focus more on the fiduciary standards set out in the Restatement (Third) of Trusts (Restatement), specifically Section 90, aka the Prudent Investor Rule.
As I have previously posted , a number of courts have recently dismissed ERISA actions involving allegations of excessive fees and/or breach of plan sponsor fiduciary duties. In my opinion, a number of the dismissals were based on very questionable grounds if one relies on the fiduciary standards established by the Restatement.
I believe that the plaintiff’s bar can strengthen their cases and possibly prevent such questionable dismissals by focusing on Section 90, comment h(2). Comment h(2) essentially states that the use or recommendation of an actively managed mutual fund is imprudent unless the fund is cost-efficient. This position is a follow-up to Section 90, comment b, which states that fiduciaries have a duty to be cost-conscious.
People that follow me know that I am an unabashed advocate of the Restatement and its fiduciary standards. In most cases, the Restatement is simply a codification of common sense. For that reason, I firmly believe that most of the standards set out in Section 90 are arguably applicable in non-fiduciary investment situations.
One such example is the cost-efficiency requirement. A fund that is not cost-efficient means that the fund’s incremental costs exceed its incremental return, resulting in a net loss for an investor. Losing money in clearly the antithesis of a prudent investing.
John Langbein was the Reporter for the committee that wrote the Restatement in 1972. A law professor at Yale University, he co-wrote an excellent law review article discussing the new standards of prudent investing as set out in the new Restatement. One of the questions posed by the article was whether investment fiduciaries had “a duty to buy the market,” aka index funds.
We begin with the question whether trust law would permit the trustee to implement the lessons of capital market research and adopt a buy-the-market investment strategy. We think we should conclude our review of the trust law by warning fiduciaries that they cannot “play safe” by ignoring the new leaning and continuing uncritically to put trust money into old-fashioned, managed portfolios. When market [aka index] funds have become available in sufficient variety and their experience bears out their prospects, court may one day conclude that it is imprudent for trustees to fail to use such vehicles. Their advantages seem decisive: at any given risk/return level, diversification is maximized and investment costs minimized. A trustee who declines to procure such advantage for the beneficiaries of his trust may in the future find his conduct difficult to justify.
That advice was as valid in 1976, when the article was originally written, as it is today. The combination of that commentary and the Restatement’s cost-efficiency requirement make a strong and compelling argument for indexing, especially given the fact that evidence shows that very few actively managed mutual funds are cost efficient.
As always, I simply offer this information to plan sponsors and other investment fiduciaries to consider in hopes of avoiding unwanted and unnecessary professional liability exposure.
