A California federal district court recently reviewed a challenge to the way California Institute of Technology plan fiduciaries handled a difficult investment situation -- the regulatory "freeze" of the assets of its annuity carrier, Mutual Benefit Life Insurance Co.
Being a fiduciary isn't easy. Consider the situation in which Caltech officials found themselves in 1991. Their plan was invested in an insurance contract with Mutual Benefit Life, a New Jersey company that they and the rest of the investment community knew was in financial trouble. Under the contract with Mutual Benefit, Caltech had the right to transfer all of its assets to another financial institution, but the timing of that transfer was largely dependent on Mutual Benefit's cooperation. And the transfer itself could trigger a regulatory freeze of Mutual Benefit's operations. On the other hand, continuing individual transfers, which were being processed by Mutual Benefit, would slow down the aggregate transfer. They were looking for a solution that would be risk-free.
Some background: Caltech sponsored a 403(b) plan, essentially a 401(k) plan for tax-exempt entities, with a few differences -- 403(b) plans may only invest in mutual funds or insurance contracts. Caltech's plan was invested in an insurance contract with Mutual Benefit Life. A 403(b) plan usually involves a direct relationship between the insurance carrier and the participant, often with little employer involvement. Because of the lack of employer involvement, 403(b) plans are not always subject to ERISA; Caltech's plan, however, was.
In May 1991, The Wall Street Journal published articles raising questions about the financial condition of Mutual Benefit and discussing the downgrading of its rating by Standard & Poor's Corp. At that time, however, Mutual Benefit still had an investment-grade rating.
In response to these events, Caltech hired a consultant, and Caltech officials and the consultant had several conversations with Mutual Benefit officials. On June 10, the consultant gave Caltech a preliminary report. While this report advised that Mutual Benefit could be taken over by insurance regulators as a result of the increased withdrawal activity following S&P's downgrade, it did not advise that a freeze was imminent.
From mid-May on, Caltech forwarded to Mutual Benefit, and Mutual Benefit processed, requests by individual participants for a transfer of their assets from Mutual Benefit to another financial institution. As of June 17, 1991, 30% of the participants in Caltech's plan had submitted such individual transfer requests.
On June 17, the consultant and Caltech's outside counsel advised:
* Caltech had the right (unusual in an insurance contract of this type) to demand an aggregate transfer of Caltech assets from Mutual Benefit to another financial institution;
* The contract did not specify when that transfer had to be made, giving Mutual Benefit an excuse for delaying such a transfer.
* Mutual Benefit was susceptible to further deterioration through substantially increased withdrawal activity which, in turn, could cause New Jersey insurance commissioners to freeze operations.
On June 19, Caltech officials faxed a letter to Mutual Benefit discontinuing contributions and electing an aggregate transfer, followed by wrangling with Mutual Benefit about whether an aggregate transfer could actually be made. Ultimately, Mutual Benefit agreed that it would make an aggregate transfer as of July 10 but demanded an indemnity, in case any participant objected to the transfer. Mutual Benefit also raised questions about the taxation of transfers. On July 1, Caltech faxed the indemnity to Mutual Benefit, along with a request that Mutual Benefit confirm that the transfer would take place on July 10. It never received a reply to that request.
While pursuing its "aggregate transfer" strategy, Caltech had to decide what to do about individual transfers. Concerned that Mutual Benefit might never actually perform the aggregate transfer, on advice of the consultant Caltech continued to collect and forward to Mutual Benefit individual transfer requests. As the consultant had indicated, however, these individual requests could have the effect of slowing down the aggregate transfer.
And, indeed, on July 8, Mutual Benefit told Caltech it could not make the aggregate transfer on July 10 because of delays caused by processing individual transfers. The continued processing of these transfers would take at least a week. In response, Caltech said it would submit no additional individual transfer requests after July 9 and told Mutual Benefit to continue processing transfers received before that date and make the aggregate transfer on July 17.
On July 16, 1991, New Jersey regulators froze all Mutual Benefit withdrawal activity. Mutual Benefit did not honor any individual transfer request after July 1.
Caltech fiduciaries were clearly between a rock and the hard place.
Participants in the Caltech plan who had not transferred out prior to the freeze sued Caltech fiduciaries in federal district court in California. Their main claim was that Caltech was imprudent in continuing to submit individual transfer requests, thereby delaying the aggregate transfer.
From one point of view, that is a valid claim -- if the aggregate transfer had taken place on July 10, it would have "beat the freeze." But the aggregate transfer itself was of such a magnitude that processing it could actually have precipitated the freeze. And, in fact, Mutual Benefit never took any internal administrative steps to make the aggregate transfer.
In holding that Caltech did not violate its ERISA prudence obligation, the U.S. District Court for the Central District of California first observed that "the prudent person standard is an objective one that focuses upon the fiduciary's conduct preceding the challenged decision. Courts must investigate whether the fiduciaries, at the time they engaged in the challenged transactions, 'employed the appropriate methods to investigate the merits of the investment and to structure the investment.'"
In view of these principles, Caltech fiduciaries could not be found to have acted imprudently. Indeed, their judgment that there was a risk that the aggregate transfer would not take place was borne out by events. And Mutual Benefit raised numerous problems with such a transfer.
From one point of view, this is a very simple case. The plaintiffs claimed Caltech did the wrong thing. The court looked at the facts and concluded Caltech did the right thing. But the judgment Caltech officials were called upon to make was very difficult.
In fact, there are no risk-free options for a fiduciary. You have to do your homework, make reasonable judgments, and be prepared to defend them. And if you do, the courts will support you, even when it seems almost impossible to figure out what the right thing is.