Third Circuit Holds That 401(k) Fiduciaries' Good Process Defeats Claims of Imprudence

At a Glance

• This decision affirms some key ERISA concepts that fiduciary committee members should consider and defendants should emphasize in nearly every lawsuit alleging fiduciary imprudence.
• The most important principle is that ERISA was designed to grant fiduciaries discretion in making decisions and to defer to fiduciaries who employ a good process.
• An appropriate process for 401(k) fiduciaries involves retaining expert advisers and taking reasonable steps to understand the advisers' advice.

Over the past couple of decades, hundreds of lawsuits have been filed against 401(k) fiduciaries alleging that investment options offered to plan participants were imprudent. The prevailing theory in these cases is that some investment options in the plans performed worse, or were more expensive, than alternative investment options; so the 401(k) fiduciaries must have acted imprudently in selecting or keeping the poorer-performing or more costly investments.

In In re: Quest Diagnostics ERISA Litigation, the Third Circuit rejected this theory of fiduciary imprudence. The decision affirms several key ERISA principles that, if applied correctly by other courts, should lead to the defeat of similar lawsuits that challenge 401(k) investment options.

The Court's Decision

Quest's 401(k) plan offered participants a menu of investment options that included Fidelity Freedom Funds, which is a popular suite of target-date funds, and the Invesco Global Real Estate Fund. Both funds are actively managed, meaning their holdings are actively monitored and changed by the investment companies. According to the plaintiffs, these funds performed worse than passively managed funds, were riskier than some other passive options, and underperformed certain other comparators. Because of this, the plaintiffs alleged that the 401(k) fiduciaries breached their duty of prudence in failing to remove these funds and replace them with something better. The district court granted summary judgment in the defendants' favor, and the plaintiffs appealed.

The Third Circuit's review began with a discussion of some key ERISA and investment concepts. ERISA's statutory standard of fiduciary prudence expressly requires a fiduciary to act appropriately under the particular "circumstances then prevailing" and considering the type and "aims" of the "enterprise" involved. This means that the standard of conduct for an ERISA fiduciary depends on the specific facts involved, the particular type of plan involved, and the particular decision being made. As a corollary, and as the Supreme Court has explained, a court's analysis of a fiduciary's conduct must be "context specific." Courts also must recognize that fiduciaries have a "range of reasonable judgments" they are allowed to make based on their experience and expertise. "Categorical rule[s]" under ERISA are disfavored.

With these principles in mind, the Third Circuit then explained that there are two ways a plaintiff can lose a claim for breach of fiduciary duty. Because ERISA's standard of prudence generally is one of conduct or process, if the fiduciary's process was prudent, then that "ends the inquiry and plaintiffs lose." Even if the process was imprudent, the plaintiffs still would lose if a hypothetical prudent investor would have made the same decision anyway. (Although the court did not explain why that latter principle defeats a claim, it is because there is no causation of loss if a hypothetical prudent fiduciary would (or could) have made the same decision.)

The plaintiffs' claims failed because the Quest fiduciaries had a prudent process. Importantly, that process included retaining and relying on independent financial advisers, and when a fiduciary retains an adviser for advice, the inquiry into an ERISA fiduciary's prudence focuses on the fiduciary's reasonable reliance on the adviser.

In Quest's case, the fiduciaries retained two expert financial advisers. At the outset, reliance on professional advice alone is "significant evidence of the prudence" of the fiduciaries' action. But a fiduciary cannot "reflexively" rely on advice, because reliance must be justified and informed. To assess whether reliance was reasonable, meaning justified and informed, the court identified three considerations that apply to fiduciaries who obtain investment advice in a 401(k) plan: (1) did the fiduciaries review the advisers' data and seek more if needed? (2) did they analyze and understand the bases for the opinions on which they relied? and (3) did they otherwise use a reasonable process under the circumstances?

With respect to the Freedom Funds, the fiduciaries met quarterly and got annual relevant training. The investment adviser drafted reports discussing the Freedom Funds' performance, noting some concerns but not finding strong reasons to replace them. The fiduciaries then critically considered those findings. They commissioned a comparison with alternative target-date funds and ultimately received favorable recommendations for the Fidelity Freedom Funds from the investment adviser. The fiduciaries also met with Fidelity to discuss the funds, weighed passive alternatives with different investment approaches, and re-analyzed some potential alternatives a few years later. The Freedom Funds had some characteristics the fiduciaries liked: greater upside potential, and almost no difference in potential downside because participants tended to keep the investment after retirement age to weather potential market dips. It was perfectly reasonable for the fiduciaries to consider these characteristics and exercise their discretion in choosing to keep the Freedom Funds.

The plaintiffs claimed that this process was not enough, because the Freedom Funds performed in the bottom half of all target-date funds from mid-2013 through mid-2014. But "short-term" underperformance does not prove long-term imprudence. These funds were meant to grow over perhaps 50 years. There may be sound reasons to keep funds that have periods of underperformance, and "[t]he key question is whether the fiduciary did that analysis." They did. Plus, even if underperformance alone could prove imprudence, it would "have to be severe and sustained enough to warrant that conclusion." Freedom Funds outperformed alternatives during other relevant periods, and ERISA does not require fiduciaries to "cut every below-average fund," because that "would create chaos."

Turning to the Invesco fund, that also was the subject of sound fiduciary oversight. That fund was put on an internal watch list, and the fiduciaries met with Invesco and considered alternatives. They reconsidered the fund a couple of years later, along with alternatives. They kept the fund on the watch list, but based on the investment adviser's research, they did not remove it. The process was prudent.

The fiduciaries also were able to explain why they relied on the investment adviser's recommendations. They understood the Freedom Funds' and Invesco fund's characteristics and why the investment adviser was recommending that the fiduciaries keep those funds. Although, two committee members could not recall specifics at their depositions, those "came six to eight years after the fact," and that "natural forgetfulness is not enough to create a genuine issue of material fact" about whether the fiduciaries understood the investment adviser's advice at the time.

Finally, the court explained the role an investment policy statement might play in a claim of fiduciary imprudence. Without deciding whether an investment policy statement (IPS) is a binding plan document that ERISA fiduciaries are obligated to follow (it may not be), the court held that the defendants' IPS had "permissive language" that granted the fiduciaries discretion. Under trust law, when an ERISA fiduciary exercises a discretionary power, the fiduciary "is not subject to control by the court" unless the fiduciary abused its discretion. The fiduciaries acted well within their discretion when they reviewed the investment options in light of discretionary factors set forth in the IPS.

Takeaways

This decision affirms some key ERISA concepts that fiduciary committee members should consider and defendants should emphasize in nearly every lawsuit alleging fiduciary imprudence.

The most important principle is that ERISA was designed to grant fiduciaries discretion in making decisions and to defer to fiduciaries who employ a good process. Courts should not be second-guessing fiduciaries' discretionary decisions. This point often gets lost in litigation, particularly because litigants become over-focused on the underlying investment or financial issue and the court gets drawn into overly technical disputes about the underlying issue.

Defendants should remind courts at every reasonable opportunity that ERISA does not micromanage characteristics of plans. It regulates by requiring those who make certain decisions to do so prudently, deferring to their judgment if they act appropriately.

An appropriate process for 401(k) fiduciaries involves retaining expert advisers and taking reasonable steps to understand the advisers' advice. That does not, of course, require fiduciaries to become experts themselves. But fiduciaries should generally be conversant in key issues in order to demonstrate to courts that they understood the advice they were receiving and acted reasonably in relying on that advice.