Economic Analysis: ERISA Litigation over Fiduciary Duties

From an economic point of view, the question of liability involves three related questions. First, what should investors do? Second, what do they do? And third, what should fiduciaries do about these facts? In financial economics, as in other branches of economics, researchers study two related subjects: the normative question of what investors should do, and the positive question of what they actually do. Normative questions are typically structured around a model of how financial markets work, and ask what analyses and choices constitute the optimal approach for investors. Positive questions involve the examination of data on financial markets and investor actions to assess how investors actually make their investment choices and how far these choices differ from particular models of financial markets and optimal investor choices.

This article argues that both the normative and positive branches of financial economics are relevant to such litigation. The prescription of ERISA Section 404(a)(1)(B), the “prudent man” standard, involves both. Its requirements of “care, skill, prudence, and diligence” would appear to require that fiduciaries do the best possible job for participants, and the normative branch of financial economics addresses what constitutes the best possible job. However, the standard also involves a comparison to others acting in a “like capacity,” suggesting a positive analysis of the choices of others involved in similar financial decision-making.

The place to begin is by discussing the basic structure of the theory of investment decisions within financial economics ' based on portfolio theory and the efficient markets hypothesis; this can be viewed as a theory about what investors should do. A discussion of empirical challenges to this theory follows, constructed around work on behavioral finance, which introduces psychological insights on what investors actually do. The discussion includes the implications of both of these approaches to litigation on fiduciary duties within defined contribution (“DC”) retirement plans. The article then reviews the implications of financial economics for the administration of DC plans, including issues related to litigation over allegations of excessive fees.

The article concludes next month with a discussion of damages issues in litigation related to price drops in employer stock within DC plans, addressing both the issue of the appropriate alternative investment return for calculating losses and the question of whether initial plan holdings of employer stock should be included in damage calculations.

Efficient Markets and Portfolio Theory

In considering fiduciary decisions related to investment options offered in defined-contribution plans, courts have shown a particular interest in two concepts from financial economics. One is “Modern Portfolio Theory,” which relates to the body of knowledge on how investors should construct an investment portfolio. The other is the “Efficient Markets Hypothesis,” which holds that securities prices reflect available information, such that it is not possible to obtain predictable, extraordinary profits from investing. These concepts provide the basis for both normative approaches to financial economics and positive approaches, with empirical investigations focused on assessing the conformance of securities prices and investor behavior with these principles.

Rational models of investment decision-making form part of the bedrock of financial economics. These models are based on the assumption that investors are risk-averse, such that they seek to make investments that minimize risk for any given level of expected return, or (equivalently) maximize expected return for any given level of risk. An investment portfolio that meets these conditions is known as “an efficient portfolio.” The specific portfolio that meets these conditions depends on the information used to assess risk and expected returns, and also on the exact nature of an individual's risk aversion. It also depends on the statistical properties of financial returns. A general implication of portfolio theory is that diversified portfolios are more efficient than concentrated portfolios. This is a key insight of “Modern Portfolio Theory.” Interpreted strictly, it is a normative description of what investors should do, but to the extent that one accepts the assumption that investors rationally pursue their self-interest, it forms the basis for positive analysis of what investors actually do.

The Efficient Markets Hypothesis

The Efficient Markets Hypothesis (EMH) holds that competition among investors drives expected returns on investments to a level such that expected returns are a function only of the systematic risk factors embodied in the value of the underlying investment. A simple model of these risk factors is that of the Capital Asset Pricing Model, which predicts that the expected return on any investment depends only on the risk-free interest rate, the expected return on the entire market for investments, the correlation in returns between the market and the specific investment, and the relative volatility of the market and the specific investment. (The last two of these factors determine “beta,” the familiar statistic summarizing the relationship between a stock return and market returns.)

Financial economists have long distinguished between different forms of the EMH based on the types of information that market prices are assumed to reflect. The “weak” form implies that the market for an investment is efficient with respect to information about that investment's past prices; the “semi-strong” form implies that the market is efficient with respect to all publicly available information; and the “strong” form implies that the market is efficient with respect to all information, including private information. The general presumption among economists is that major financial markets are usually and approximately semi-strong-form efficient. This presumption is based on the idea that any return exceeding the markets' compensation for risk will quickly be competed away by investors.

The EMH has several important implications for investment decision-making. Probably the most important is that the EMH generally implies that expected returns on a particular stock (or other asset) will reflect only the baseline, risk-free interest rate plus a compensation for the non-diversifiable, systematic component of the risk of the stock. Thus the stock price already reflects the market's assessment of any possible future drops or jumps in a stock price due to negative or positive information.

In the case of a typical employer stock, this implies that the stock price already reflects any possibility of the stock's declining in value. Stocks of troubled companies, such as United Airlines following the 2001 terrorist attacks, already reflect bad news that has been publicly released. They do not have worse expected returns than other stocks.

However, as the Seventh Circuit noted in its opinion regarding United Airlines, it is possible that such a stock would embody greater risk than other stocks, because its previous decline in value diminished its equity value relative to its debt value, making that equity value more sensitive to any news about the company. See Summers v. State Street Bank & Trust Co., 453 F.3d 404 (7th Cir. 2006). Summers, 453 F.3d at 408-411. This issue is discussed below.

Another implication of the semi-strong form of the EMH is that diversified portfolios are superior to concentrated portfolios, at least in the absence of private information about the prospects of specific investments relative to the market. Since the EMH holds that extraordinary returns cannot be predicted, a diversified portfolio reduces risk without reducing expected returns. ERISA, of course, generally encourages diversification (see 29 U.S.C. ' 1104(a)(1)(C)), although the portfolio choices made by individuals in DC plans may sometimes be undiversified, particularly when undiversified options such as company stock are offered to participant.

Tests for Market Efficiency

Despite the general presumption of efficiency in major securities markets, the efficiency of markets for particular securities is frequently subject to question. Courts in securities matters have recognized numerous tests for market efficiency. Cammer v. Bloom is undoubtedly the most influential decision. It mentions factors that might be considered as part of an analysis of market efficiency. One of these considers the reaction of a security's price to relevant news. Cammer v. Bloom, 711 F. Supp. 1264, 1286-87 (D.N.J. 1989). Other courts have recognized these factors and added some other considerations. In In re Polymedica Corp. Sec. Litig., 453 F.Supp.2d 260 (D.Mass. 2006), a court also recognized constraints on securities lending as a factor that could inhibit short-selling and therefore prevent efficiency.

Relevance of Behavioral Finance

Despite the appeal of the semi-strong form of the EMH, several sources of doubt exist. The first is that various empirical anomalies have been documented that appear to represent departures from the EMH. These anomalies typically suggest the existence of predictable returns in excess of the market's compensation for systematic risk. A considerable debate exists over whether some of these anomalies represent departures from market efficiency or whether instead they might be due to different forms of systematic risk, such as a differential risk associated with stocks of smaller capitalization companies.

The existence of anomalies representing uncompensated excess returns is difficult to square with the existence of informed investors intent on maximizing their investment returns. A general explanation is that the anomalies may be due to the “limits of arbitrage,” involving limitations placed on traders and investors attempting to take advantage of excess returns available in the market. Arbitraging such excess returns involves the assumption of risk and may involve borrowing, or it may involve selling investments short. In either instance, there are limits to any trader's ability to undertake such activities. Aggregate limitations, such as limits on credit availability or on the availability of securities to borrow for short sales, may permit apparent market inefficiencies to persist. In the view of a seminal series of articles by J.B. DeLong and co-authors, rational traders may be unable to marshal the resources to prevent irrational, “noise” traders from driving securities prices away from fundamentals.

Since the early 1990s, a substantial literature has developed in behavioral finance, some of which is devoted to linking apparently irrational trading behavior to psychological tendencies and biases. One of the best known of these tendencies is “prospect theory,” developed by Kahneman and Tversky. In part this theory stresses the importance of a reference point for evaluating the risk of different outcomes. An application of this is the “disposition effect,” which holds that investors are reluctant to sell stocks on which they have a capital loss, because they are psychologically averse to recognizing the loss.

The direct relevance of behavioral finance for investment decision-making is unclear. It does not appear to change the basic goal of portfolio managers to aim for some combination of maximum expected return and minimum risk. It may, however, have implications for the dynamics of asset prices, and, to the extent that behavioral factors introduce market inefficiencies, it may also imply that optimal portfolios no longer track broad market indices.

Behavioral finance is probably more relevant for the specific task of administering a 401(k) plan, because it has lessons for the behavior of individual investors when faced with a menu of investment options. This issue will be addressed in Part Two.

John Montgomery, Ph.D., NERA Economic Consulting Senior Vice President, specializes in securities, financial economics, and valuation. He has testified on damages, materiality, prudence of investment decisions, costs of trading, and macroeconomic issues. He also provides analysis for shareholder class actions, ERISA class actions, and insider trading cases.

In the past decade, numerous lawsuits have been brought under ERISA against the fiduciaries and sponsors of 401(k) and other defined contribution retirement plans. Many of these lawsuits have been pled as class actions on behalf of all or many participants of the plan. The most common lawsuits have involved declines in the value of employer stock offered in the plans and allegations that decisions to maintain employer stock in the plans were imprudent. There have also been some lawsuits over other investment options, as well as lawsuits over the management of collateral from securities lending programs run by plan trustees. Another substantial category of litigation has involved allegations of excessive fees. Many of these cases, both investments and fees, have also involved allegedly inadequate disclosure of information to plan participants.

Economic analysis plays an important role in many of these cases. The purpose of this article is to discuss some of the important economic issues that arise in ERISA litigation, both in establishing liability and in calculating damages.

The Question of Liability

From an economic point of view, the question of liability involves three related questions. First, what should investors do? Second, what do they do? And third, what should fiduciaries do about these facts? In financial economics, as in other branches of economics, researchers study two related subjects: the normative question of what investors should do, and the positive question of what they actually do. Normative questions are typically structured around a model of how financial markets work, and ask what analyses and choices constitute the optimal approach for investors. Positive questions involve the examination of data on financial markets and investor actions to assess how investors actually make their investment choices and how far these choices differ from particular models of financial markets and optimal investor choices.

This article argues that both the normative and positive branches of financial economics are relevant to such litigation. The prescription of ERISA Section 404(a)(1)(B), the “prudent man” standard, involves both. Its requirements of “care, skill, prudence, and diligence” would appear to require that fiduciaries do the best possible job for participants, and the normative branch of financial economics addresses what constitutes the best possible job. However, the standard also involves a comparison to others acting in a “like capacity,” suggesting a positive analysis of the choices of others involved in similar financial decision-making.

The place to begin is by discussing the basic structure of the theory of investment decisions within financial economics ' based on portfolio theory and the efficient markets hypothesis; this can be viewed as a theory about what investors should do. A discussion of empirical challenges to this theory follows, constructed around work on behavioral finance, which introduces psychological insights on what investors actually do. The discussion includes the implications of both of these approaches to litigation on fiduciary duties within defined contribution (“DC”) retirement plans. The article then reviews the implications of financial economics for the administration of DC plans, including issues related to litigation over allegations of excessive fees.

The article concludes next month with a discussion of damages issues in litigation related to price drops in employer stock within DC plans, addressing both the issue of the appropriate alternative investment return for calculating losses and the question of whether initial plan holdings of employer stock should be included in damage calculations.

Efficient Markets and Portfolio Theory

In considering fiduciary decisions related to investment options offered in defined-contribution plans, courts have shown a particular interest in two concepts from financial economics. One is “Modern Portfolio Theory,” which relates to the body of knowledge on how investors should construct an investment portfolio. The other is the “Efficient Markets Hypothesis,” which holds that securities prices reflect available information, such that it is not possible to obtain predictable, extraordinary profits from investing. These concepts provide the basis for both normative approaches to financial economics and positive approaches, with empirical investigations focused on assessing the conformance of securities prices and investor behavior with these principles.

Rational models of investment decision-making form part of the bedrock of financial economics. These models are based on the assumption that investors are risk-averse, such that they seek to make investments that minimize risk for any given level of expected return, or (equivalently) maximize expected return for any given level of risk. An investment portfolio that meets these conditions is known as “an efficient portfolio.” The specific portfolio that meets these conditions depends on the information used to assess risk and expected returns, and also on the exact nature of an individual's risk aversion. It also depends on the statistical properties of financial returns. A general implication of portfolio theory is that diversified portfolios are more efficient than concentrated portfolios. This is a key insight of “Modern Portfolio Theory.” Interpreted strictly, it is a normative description of what investors should do, but to the extent that one accepts the assumption that investors rationally pursue their self-interest, it forms the basis for positive analysis of what investors actually do.

The Efficient Markets Hypothesis

The Efficient Markets Hypothesis (EMH) holds that competition among investors drives expected returns on investments to a level such that expected returns are a function only of the systematic risk factors embodied in the value of the underlying investment. A simple model of these risk factors is that of the Capital Asset Pricing Model, which predicts that the expected return on any investment depends only on the risk-free interest rate, the expected return on the entire market for investments, the correlation in returns between the market and the specific investment, and the relative volatility of the market and the specific investment. (The last two of these factors determine “beta,” the familiar statistic summarizing the relationship between a stock return and market returns.)

Financial economists have long distinguished between different forms of the EMH based on the types of information that market prices are assumed to reflect. The “weak” form implies that the market for an investment is efficient with respect to information about that investment's past prices; the “semi-strong” form implies that the market is efficient with respect to all publicly available information; and the “strong” form implies that the market is efficient with respect to all information, including private information. The general presumption among economists is that major financial markets are usually and approximately semi-strong-form efficient. This presumption is based on the idea that any return exceeding the markets' compensation for risk will quickly be competed away by investors.

The EMH has several important implications for investment decision-making. Probably the most important is that the EMH generally implies that expected returns on a particular stock (or other asset) will reflect only the baseline, risk-free interest rate plus a compensation for the non-diversifiable, systematic component of the risk of the stock. Thus the stock price already reflects the market's assessment of any possible future drops or jumps in a stock price due to negative or positive information.

In the case of a typical employer stock, this implies that the stock price already reflects any possibility of the stock's declining in value. Stocks of troubled companies, such as United Airlines following the 2001 terrorist attacks, already reflect bad news that has been publicly released. They do not have worse expected returns than other stocks.

However, as the Seventh Circuit noted in its opinion regarding United Airlines, it is possible that such a stock would embody greater risk than other stocks, because its previous decline in value diminished its equity value relative to its debt value, making that equity value more sensitive to any news about the company. See Summers v. State Street Bank & Trust Co. , 453 F.3d 404 (7th Cir. 2006). Summers, 453 F.3d at 408-411. This issue is discussed below.

Another implication of the semi-strong form of the EMH is that diversified portfolios are superior to concentrated portfolios, at least in the absence of private information about the prospects of specific investments relative to the market. Since the EMH holds that extraordinary returns cannot be predicted, a diversified portfolio reduces risk without reducing expected returns. ERISA, of course, generally encourages diversification (see 29 U.S.C. ' 1104(a)(1)(C)), although the portfolio choices made by individuals in DC plans may sometimes be undiversified, particularly when undiversified options such as company stock are offered to participant.

Tests for Market Efficiency

Despite the general presumption of efficiency in major securities markets, the efficiency of markets for particular securities is frequently subject to question. Courts in securities matters have recognized numerous tests for market efficiency. Cammer v. Bloom is undoubtedly the most influential decision. It mentions factors that might be considered as part of an analysis of market efficiency. One of these considers the reaction of a security's price to relevant news. Cammer v. Bloom , 711 F. Supp. 1264, 1286-87 (D.N.J. 1989). Other courts have recognized these factors and added some other considerations. In In re Polymedica Corp. Sec. Litig., 453 F.Supp.2d 260 (D.Mass. 2006), a court also recognized constraints on securities lending as a factor that could inhibit short-selling and therefore prevent efficiency.

Relevance of Behavioral Finance

Despite the appeal of the semi-strong form of the EMH, several sources of doubt exist. The first is that various empirical anomalies have been documented that appear to represent departures from the EMH. These anomalies typically suggest the existence of predictable returns in excess of the market's compensation for systematic risk. A considerable debate exists over whether some of these anomalies represent departures from market efficiency or whether instead they might be due to different forms of systematic risk, such as a differential risk associated with stocks of smaller capitalization companies.

The existence of anomalies representing uncompensated excess returns is difficult to square with the existence of informed investors intent on maximizing their investment returns. A general explanation is that the anomalies may be due to the “limits of arbitrage,” involving limitations placed on traders and investors attempting to take advantage of excess returns available in the market. Arbitraging such excess returns involves the assumption of risk and may involve borrowing, or it may involve selling investments short. In either instance, there are limits to any trader's ability to undertake such activities. Aggregate limitations, such as limits on credit availability or on the availability of securities to borrow for short sales, may permit apparent market inefficiencies to persist. In the view of a seminal series of articles by J.B. DeLong and co-authors, rational traders may be unable to marshal the resources to prevent irrational, “noise” traders from driving securities prices away from fundamentals.

Since the early 1990s, a substantial literature has developed in behavioral finance, some of which is devoted to linking apparently irrational trading behavior to psychological tendencies and biases. One of the best known of these tendencies is “prospect theory,” developed by Kahneman and Tversky. In part this theory stresses the importance of a reference point for evaluating the risk of different outcomes. An application of this is the “disposition effect,” which holds that investors are reluctant to sell stocks on which they have a capital loss, because they are psychologically averse to recognizing the loss.

The direct relevance of behavioral finance for investment decision-making is unclear. It does not appear to change the basic goal of portfolio managers to aim for some combination of maximum expected return and minimum risk. It may, however, have implications for the dynamics of asset prices, and, to the extent that behavioral factors introduce market inefficiencies, it may also imply that optimal portfolios no longer track broad market indices.

Behavioral finance is probably more relevant for the specific task of administering a 401(k) plan, because it has lessons for the behavior of individual investors when faced with a menu of investment options. This issue will be addressed in Part Two.

John Montgomery, Ph.D., NERA Economic Consulting Senior Vice President, specializes in securities, financial economics, and valuation. He has testified on damages, materiality, prudence of investment decisions, costs of trading, and macroeconomic issues. He also provides analysis for shareholder class actions, ERISA class actions, and insider trading cases.