Several cases addressed the issue of investment prudence in 1999, and fiduciaries won many of them.
One of the most significant, overlooked by many, was the 5th U.S. Circuit Court of Appeals decision in Laborers National Pension Fund vs. Northern Trust Quantitative Advisors Inc. et al. This case is significant because the court held that modern portfolio theory is the appropriate standard to apply in evaluating the prudence of a fiduciary's investment.
The case involved a suit by the trustees of the Laborers National Pension Fund against one of the fund's investment managers, American National Bank of Chicago. The plaintiffs claimed that investment by ANB in stripped interest-only mortgage-backed securities, or IOs, was imprudent and violated the trust's investment guidelines.
An IO is a right to the interest payments on a mortgage pool. When a mortgage is refinanced, the payments stop. If refinancing rates exceed expectations, there may be a significant loss. Thus, IOs lose value as interest rates go down, because refinancing rates go up. In the early 1990s, many IO investments lost money because interest rate decreases triggered an unprecedented level of mortgage refinancings. The fixed-income portfolio of the Laborer's Fund managed by ANB was among those hit.
The plaintiffs' attack on the prudence of the fiduciary's investment was part of a charge that the fiduciary did not follow the fund's investment guidelines. The fund's general investment policy provided that investments should be made that would "preserve principal while recognizing the need for income and appreciation with a minimal risk." It also stated, however, that investments were to be diversified among government securities, bonds, mortgages, common stock, real estate, insurance company contracts, money market instruments and other appropriate investments. Bond investments were limited to federal or federal agency obligations or corporate bonds of the first three quality grades.
The IOs purchased at ANB's direction appear to have been either agency obligations or in the highest three quality grades, and thus technically satisfied the guidelines. The lower court found, however, that the IO investments violated the "spirit" of those guidelines -- apparently because they presented a risk to principal. Moreover, the lower court rejected that the appropriateness of the IO investments should be evaluated in the context of the fixed-income portfolio managed by ANB as a whole. The court held that "it does not matter that other investment consultants in the industry held the opinion that IOs were appropriate for modern investment portfolios or that the portfolio as a whole made an adequate return."
Risk to principal
The court of appeals rejected the lower court's finding, pointing out that stocks, real estate and other investments authorized by the policy also involved risk to principal. It found that the lower court's analysis erroneously focused on the performance of the IOs in isolation from the performance of the rest of the portfolio. Interpreting the Department of Labor's prudence regulations, the appellate court stated a fiduciary is "required to act as a prudent investment manager under the modern portfolio theory rather than under the common law of trusts standard which examined each investment with an eye toward its individual riskiness."
It rejected the notion that the fund guidelines required the IO investment to be analyzed in isolation. Going further, the court held that if the guidelines did require that the investment be separately analyzed, the guidelines would have to give way to the Employee Retirement Income Security Act's commitment to modern portfolio theory, which focuses on the portfolio as a whole.
The 5th Circuit emphasized that, in determining whether a fiduciary has been imprudent, "courts objectively assess whether the fiduciary, at the time of the transaction, utilized proper methods to investigate, evaluate and structure the investment; acted in a manner as would others familiar with such matters; and exercised independent judgment when making investment decisions. (ERISA's) test of prudence is one of conduct, and not a test of the result of performance of the investment. The focus of the inquiry is how the fiduciary acted in his selection of the investment, and not whether his investments succeeded or failed."
Applying these standards, the court held ANB had acted prudently, finding ANB considered the characteristics of IOs, used stress simulation models to project performance under different scenarios and investigated the available data on the nature of the particular IOs prior to purchasing them. It further found the investment community in general did not anticipate the unprecedented interest rate drop that resulted in a dramatic increase in mortgage prepayments in 1992. Further, based on "modern portfolio ERISA principles," the use of IOs as part of a broader investment strategy was prudent and did not violate trust guidelines.
The implications of the Laborers case were borne out by the First Union litigation involving a suit by participants in the Signet Banking Corp. defined contribution plan (Sue B. Franklin, et al. vs. First Union Corp. et al). This suit was filed in May. No decision has been reached yet; both parties have moved for summary judgment.
In this case, the plaintiffs claim, among other things, that when the Signet plan was merged into the First Union plan, and assets were moved out of Signet mutual funds into First Union funds, the funds into which the Signet money was transferred did not perform as well as the Signet funds. Nobody lost any money, but the participants were still complaining.
The lesson with respect to fiduciary investment decisions: there is no safe answer. The traditional trust law approach of asset preservation no longer will suffice; participants are now prepared to sue on the basis of lost opportunity. A fiduciary must be able to defend his or her choice as the right one, not just the "safe" or "conservative" one.
Another area in which investment prudence issues were directly addressed was in litigation over investment in GICs with insurance companies that went into receivership.
This is an interesting area of litigation because investment decisions in 401(k) plans mostly are made by the participant. And if something goes wrong, the participant has no one to sue but himself. However, fiduciaries, often in-house, still play a big role in picking GIC investments, which sometimes go bad. Two cases decided this year dealt with GIC investments: Unisys and Crowhurst.
In Re: Unisys Savings Plan Litigation involved a suit by the Unisys employees and employee organizations who claimed the purchase by Unisys of $217 million in guaranteed investment contracts with Executive Life Insurance Co. in 1987 and 1988, was imprudent. The GICs were purchased for stable-value funds in three of Unisys' savings plans.
Executive Life recognized significant junk-bond losses in 1990. In April 1991, the insurer was seized by the California Department of Insurance, and Unisys' plan account balances invested in Executive Life GICs were frozen. A class of Unisys participants sued, claiming losses stemming from the freezing of the Executive Life GICs.
Long history of Unisys
The case has a long history. This most recent decision was a review by the 3rd U.S. Circuit Court of Appeals of a lower court decision, following a bench trial undertaken after the lower court's decision -- on summary judgment and in favor of Unisys -- was reversed and remanded.
One of the key issues was whether the initial purchase of the Executive Life GICs violated ERISA's prudence requirement. When the appellate court initially sent the decision back to the trial court, in effect ruling against Unisys, it found there were questions about whether Unisys: had adequately reviewed the data used by its consultant in recommending the initial Executive Life GIC purchase; was justified in relying on rating agencies' evaluation of the creditworthiness and claims-paying abilities of Executive Life; and had the requisite knowledge to conduct GIC bids unassisted.
After a trial on the merits, the District Court then held, on each of the key issues, that the testimony and documentary evidence produced at trial supported Unisys' version of the facts. Unisys demonstrated that its in-house fiduciaries -- the Unisys officials with primary responsibility for selecting GIC contracts for the plans -- were competent to select GIC providers and that they engaged in a thorough review of each GIC provider.
William H. Crowhurst et. al. vs. California Institute of Technology involved attempts by fiduciaries at CalTech to extricate CalTech 403(b) plan assets from a contract with Mutual Benefit Life Insurance Co. of New Jersey, as information came out in the press that Mutual Benefit was in financial trouble.
CalTech fiduciaries sent in requests for individual transfers and also attempted an aggregate transfer of all assets under the contract. Before the aggregate transfer was made, however, Mutual Benefit went into receivership. Some CalTech participants then sued, claiming that by processing the individual transfers, CalTech held up 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 the aggregate transfer would not take place -- was borne out by events. Mutual Benefit raised numerous problems with such a transfer and never responded to CalTech's request for a confirmation that the transfer would take place on the date specified. And, as of the date of the freeze, Mutual Benefit had taken no internal action to effect the transfer.
Both Unisys and Crowhurst were won on the facts. In both cases, the fiduciaries were able to demonstrate that they did their homework, followed a sound procedure and documented their decision process.