Economic Analysis in ERISA Litigation over Fiduciary Duties

ERISA provides little guidance on the extent to which fiduciaries should consider the likely behavior of plan participants. ERISA 404(c) absolves plan administrators from liability for the consequences of participants' investment choices, as long as a plan offers “broad range of investment alternatives” and a plan fiduciary provides participants with information on the investment alternatives, among other requirements. Yet among the possible portfolios that might be constructed from options offered by a plan, some portfolios are likely to be more prudent than others. It is unclear the extent to which administrators need to consider the poor choices that participants might make. Indeed, this may be an impossible task, as the prudence of different portfolios may depend on other investments participants may have outside their plan assets.

'Eligible Individual Account Plans'

In the case of “eligible individual account plans,” employer stock is an exception to the ERISA requirement that plan investments be diversified. Courts have developed a doctrine of a rebuttable presumption that employer stock is a prudent investment in these situations. A Department of Labor bulletin (Field Assistance Bulletin 2004-03, “Fiduciary Responsibilities of Directed Trustees”) suggested limited circumstances in which an employer's stock might be imprudent, especially a situation of bankruptcy filing in which there is little likelihood of a stock's obtaining any value. But under the Efficient Markets Hypothesis (EMH) ' or even if markets are not efficient but still reasonably responsive to public information ' it is highly unlikely that a stock could be liquidated with any substantial recovery in such a situation.

Litigation

Against this possibility, the Seventh Circuit has suggested in Summers v. State Street Bank & Trust Co., 453 F.3d 404 (Seventh Cir. 2006), that as a stock declines in value, it also generally becomes riskier as the market value of a company's debt/equity ratio increases, and that there may be a point at which the stock becomes sufficiently risky for it to be imprudent. But at least in part because this issue was not specifically before the court, the court provided no guidance as to the level of risk that would trigger a finding of imprudence.

A separate issue arises in many cases involving drops in the value of employer stock. These cases, which generally piggyback on shareholder class actions involving alleged securities fraud, are based on allegations that corporate officials possessed negative, non-public information about the company's business and, therefore, about the value of the company's stock. Plaintiffs assert that defendants are liable both for not having properly disclosed pertinent information and for not having removed the company stock as an investment option in the plan.

Shareholder Class Actions

The disclosure parts of these claims closely track claims in the shareholder class actions. In these situations, the lack of disclosure, assuming it is material to at least some investors (and assuming an efficient market), implies that the stock would have been trading at an inflated price. Investors who purchased at the inflated price are considered in securities cases to have relied on the fraudulent information because that information would be incorporated into the stock price in an efficient market. (For some stocks, courts reject a finding of an efficient market, leaving plaintiffs unable to use this “fraud-on-the-market” approach.)

Participants in an ERISA plan who invested in employer stock would presumably suffer the same harm as other investors who are members of the class for the shareholder class action. A grey area is whether the plan would be a member of the securities class or whether each participant of the plan who bought stock at an inflated price and held past the corrective disclosure (or disclosures) would be a member of the class.

Shareholder class actions generally presume that a loss due to revelation of previously misstated information was foreseeable to defendants. In an ERISA context, the existence of such a foreseeable loss obviously lowers the expected return on the stock below general market returns (adjusted for risk). An unresolved issue is the amount by which the expected return would have to decline for the investment to become imprudent. An insider who knows about the misstated information may know other, more favorable facts about the company that might suggest strong returns in the future. A plaintiff would presumably need to show that the balance of information available to the defendant indicated that the stock would have a below market return.

If all information except the misstated information is public, then an efficient market implies that the misstated information will lead to a negative return on average. However, that negative return might be small relative to the overall variation in the stock's return. A typical measure is the Sharpe ratio, which is the ratio of an investment's expected return (in excess of a risk-free return) to its volatility. For volatile stocks, a small change in the expected return may result in little difference in the Sharpe ratio.

Stock-Drop Cases

ERISA stock-drop cases that piggyback on shareholder class actions also typically include a claim that the defendants harmed plan participants by failing to disclose the misstated information correctly. In a shareholder class action, the misstated information would be tied to an inflated stock price. The only plan participants who could be harmed by inflation would be those who purchased more shares at an inflated price than they sold.

Several types of analysis used in shareholder class action are also relevant in this context. First, an analysis of company disclosures, news, and analyst reports can shed light on whether the allegedly misstated information was, in fact, misstated, or whether it was provided to the market on a timely basis. Second, an “event study” can determine whether the corrective disclosure had a meaningful, statistically significant impact on the stock price. The economist using this statistical technique can filter out fluctuations in the stock price due to market or industry factors, and the economist can also determine whether the resultant “excess return” is statistically significant, that is, whether it is larger than the overwhelming share (generally defined as 95%) of typical, random movements in the stock price, and, therefore, likely the product of the release of information that was material to investors. Third, the analyst can perform a battery of tests related to the stock trades in an efficient market, in which all information is rapidly incorporated into the stock price. If the market is efficient, then courts would typically support a finding that the misstated information resulted in an inflated stock price.

Discussions of efficient markets often imply that there is only one “correct” price for a security. Under this view, investors, considering the same public information, all arrive at the same belief about the value of an investment. All investors, or at least all professional investors, would have the same expectations for an investment's return.

A more nuanced approach, however, is that investors may have different beliefs about the value of an investment, even when in possession of the same information. The price of an investment, in this instance, represents a balance of opinions by different investors, some of whom might think it undervalued and others who might think it overvalued (and either do not hold the investment or hold a short position). Others may simply rely on the market price providing a fair estimate of the value of the investment, given all other opinions.

What It Means

The implication of this approach for fiduciary duty is that a range of actions may be equally reasonable. One prudent investor might invest in a risky asset, thinking it undervalued or at least fairly valued, while another might avoid the investment or sell it short, thinking it overvalued. Both may make their investment decisions carefully, but they may be shaped by different approaches or beliefs. The market price ends up at the point at which demand by the optimists absorbs the market float and any short interest created by the pessimists.

The Seventh Circuit, in Summers, at least, has held that it is “not imprudent” to rely on the market price. This is consistent with the presumption that the market price represents a good approximation of the stock's true value, even if investors hold varying opinions. In at least one other instance, a circuit court has decided that a prudent fiduciary need not rely on the market price and may expend time and resources to develop its own opinion on the value of the stock. See Bunch v. W.R. Grace & Co., 555 F. 3d 1 (1st Cir. 2009). The usefulness of such an exercise, at least for large capitalization, heavily traded stocks, is open to doubt.

Provision of Financial Services with Choice

A defined contribution (DC) plan is a financial service to its participants. The primary service provided is a vehicle for saving for retirement. It can also provide a means to invest in one's own company, with that investment also providing a vehicle for savings. The provision of various ancillary services is also part of the package, including loans from plan balances and mechanisms for learning about and choosing among different investment options.

The concept of a DC plan as a financial service is particular relevant in litigation over allegedly excessive fees in a 401(k) plan. The fees paid by a plan must be weighed against the services that those fees provide. These services are typically provided in a bundle, so there is often no information about the cost of particular services. A comparison of the costs of a 401(k) plan to other financial services used for retirement savings can therefore provide evidence on the reasonableness of fees for the 401(k) plan. A natural comparison is to mutual funds, since a set of mutual funds embodies the options normally found in a DC plan, excluding employer stock, and since mutual funds also provide investment information and accounting similar to that provided in a DC plan.

The convenience of a 401(k) plan may justify a higher level of cost. When an individual undertakes investment, he or she has to search for appropriate financial firms and for appropriate investments. By offering these conveniently to employees, a 401(k) plan can help economize on participants' time. Its availability and convenience also encourages savings, counteracting the typical psychological reluctance to delay gratification.

Lessons from behavioral finance are particularly relevant here. First, the default option offered by a plan can have a substantial impact of participant investment choice. This could be because participants perceive an endorsement of the investment option by their company's officials (acting as plan fiduciaries). It could also be due to the substantial inertia in investment decisions that has been documented among investors.

Consumers of financial services have also been shown to have difficulty managing complex information. Thus, more complex investment menus may not yield better investment decisions, and in fact may lead participants to adopt rules of thumb. Moreover, allegations in excessive fees cases that participants should have received more detailed disclosure of fee arrangements imply that participants should have received more complex information. It is not evident that participants would benefit from this type of disclosure, in that the need to understand all the information may lead them to avoid making active decisions to contribute to their 401(k) and choose suitable investments.

Loss Calculations: The Selection of But-for Returns

ERISA gives participants the right to sue fiduciaries for plan losses. These losses are normally calculated as the difference between the actual plan value and the “but-for” value if the breach did not occur. In lawsuits over the selection of investment options (including company stock), the approach laid out in Donovan v. Bierwirth, 680 F.2d 263, 272 (2d Cit. 1982), is often followed. That approach involves a comparison between the actual investment returns and the returns on an alternative investment.

This raises the question of what the alternative investment should be. Donovan says that of the “plausible” investment alternatives, the one with the returns most favorable to the plaintiffs should be chosen. If the litigation is about a 401(k) plan, then the plausibility test requires a coherent argument about what loss the breach might have caused: if the offending investment (usually employer stock) had not been offered by the plan, in what alternative would participants instead have invested?

Plaintiffs in such cases would obviously want to claim that the all investments are plausible, permitting them to choose the best performing investment in the plan, which would maximize the calculated loss. But this approach fails to pass the test of plausibility. It is not possible to choose the best-performing investment option in advance, and, therefore, it is not plausible to argue that participants would all have placed their money in this option. This argument is emphasized by the Seventh Circuit in Leister v. Dovetail, Inc., 546 F.3d 875, 880 (Seventh Cir. 2008).

The court instead supported taking the overall investment return in the plan as the alternative investment. This approach makes sense if there is reason to think that the additional investment would be similar to existing investments. The Leister case involved a lawsuit over money that the defendant had failed to deposit in the plaintiff's 401(k) plan, and the Seventh Circuit suggested the return on the plaintiff's actual investments would be a guide to the return she would have obtained on additional contributions. In other circumstances, however, this may not be plausible.

In particular, for lawsuits alleging that an investment option should have been removed from a plan, we would expect that when an investment option is removed, participants would reallocate their portfolios to maintain a similar balance of risk and return to the balance they had before the removal of the investment option. Employer stock, for example, would plausibly be replaced by equity investments of similar volatility. Part Three, to appear next month, will discuss damages calculations.

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. (See Part One of this article in the July 2011 issue of Employment Law Strategist.)

Implications of Behavioral Finance for ERISA Litigation

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. 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.

ERISA provides little guidance on the extent to which fiduciaries should consider the likely behavior of plan participants. ERISA 404(c) absolves plan administrators from liability for the consequences of participants' investment choices, as long as a plan offers “broad range of investment alternatives” and a plan fiduciary provides participants with information on the investment alternatives, among other requirements. Yet among the possible portfolios that might be constructed from options offered by a plan, some portfolios are likely to be more prudent than others. It is unclear the extent to which administrators need to consider the poor choices that participants might make. Indeed, this may be an impossible task, as the prudence of different portfolios may depend on other investments participants may have outside their plan assets.

'Eligible Individual Account Plans'

In the case of “eligible individual account plans,” employer stock is an exception to the ERISA requirement that plan investments be diversified. Courts have developed a doctrine of a rebuttable presumption that employer stock is a prudent investment in these situations. A Department of Labor bulletin (Field Assistance Bulletin 2004-03, “Fiduciary Responsibilities of Directed Trustees”) suggested limited circumstances in which an employer's stock might be imprudent, especially a situation of bankruptcy filing in which there is little likelihood of a stock's obtaining any value. But under the Efficient Markets Hypothesis (EMH) ' or even if markets are not efficient but still reasonably responsive to public information ' it is highly unlikely that a stock could be liquidated with any substantial recovery in such a situation.

Litigation

Against this possibility, the Seventh Circuit has suggested in Summers v. State Street Bank & Trust Co. , 453 F.3d 404 (Seventh Cir. 2006), that as a stock declines in value, it also generally becomes riskier as the market value of a company's debt/equity ratio increases, and that there may be a point at which the stock becomes sufficiently risky for it to be imprudent. But at least in part because this issue was not specifically before the court, the court provided no guidance as to the level of risk that would trigger a finding of imprudence.

A separate issue arises in many cases involving drops in the value of employer stock. These cases, which generally piggyback on shareholder class actions involving alleged securities fraud, are based on allegations that corporate officials possessed negative, non-public information about the company's business and, therefore, about the value of the company's stock. Plaintiffs assert that defendants are liable both for not having properly disclosed pertinent information and for not having removed the company stock as an investment option in the plan.

Shareholder Class Actions

The disclosure parts of these claims closely track claims in the shareholder class actions. In these situations, the lack of disclosure, assuming it is material to at least some investors (and assuming an efficient market), implies that the stock would have been trading at an inflated price. Investors who purchased at the inflated price are considered in securities cases to have relied on the fraudulent information because that information would be incorporated into the stock price in an efficient market. (For some stocks, courts reject a finding of an efficient market, leaving plaintiffs unable to use this “fraud-on-the-market” approach.)

Participants in an ERISA plan who invested in employer stock would presumably suffer the same harm as other investors who are members of the class for the shareholder class action. A grey area is whether the plan would be a member of the securities class or whether each participant of the plan who bought stock at an inflated price and held past the corrective disclosure (or disclosures) would be a member of the class.

Shareholder class actions generally presume that a loss due to revelation of previously misstated information was foreseeable to defendants. In an ERISA context, the existence of such a foreseeable loss obviously lowers the expected return on the stock below general market returns (adjusted for risk). An unresolved issue is the amount by which the expected return would have to decline for the investment to become imprudent. An insider who knows about the misstated information may know other, more favorable facts about the company that might suggest strong returns in the future. A plaintiff would presumably need to show that the balance of information available to the defendant indicated that the stock would have a below market return.

If all information except the misstated information is public, then an efficient market implies that the misstated information will lead to a negative return on average. However, that negative return might be small relative to the overall variation in the stock's return. A typical measure is the Sharpe ratio, which is the ratio of an investment's expected return (in excess of a risk-free return) to its volatility. For volatile stocks, a small change in the expected return may result in little difference in the Sharpe ratio.

Stock-Drop Cases

ERISA stock-drop cases that piggyback on shareholder class actions also typically include a claim that the defendants harmed plan participants by failing to disclose the misstated information correctly. In a shareholder class action, the misstated information would be tied to an inflated stock price. The only plan participants who could be harmed by inflation would be those who purchased more shares at an inflated price than they sold.

Several types of analysis used in shareholder class action are also relevant in this context. First, an analysis of company disclosures, news, and analyst reports can shed light on whether the allegedly misstated information was, in fact, misstated, or whether it was provided to the market on a timely basis. Second, an “event study” can determine whether the corrective disclosure had a meaningful, statistically significant impact on the stock price. The economist using this statistical technique can filter out fluctuations in the stock price due to market or industry factors, and the economist can also determine whether the resultant “excess return” is statistically significant, that is, whether it is larger than the overwhelming share (generally defined as 95%) of typical, random movements in the stock price, and, therefore, likely the product of the release of information that was material to investors. Third, the analyst can perform a battery of tests related to the stock trades in an efficient market, in which all information is rapidly incorporated into the stock price. If the market is efficient, then courts would typically support a finding that the misstated information resulted in an inflated stock price.

Discussions of efficient markets often imply that there is only one “correct” price for a security. Under this view, investors, considering the same public information, all arrive at the same belief about the value of an investment. All investors, or at least all professional investors, would have the same expectations for an investment's return.

A more nuanced approach, however, is that investors may have different beliefs about the value of an investment, even when in possession of the same information. The price of an investment, in this instance, represents a balance of opinions by different investors, some of whom might think it undervalued and others who might think it overvalued (and either do not hold the investment or hold a short position). Others may simply rely on the market price providing a fair estimate of the value of the investment, given all other opinions.

What It Means

The implication of this approach for fiduciary duty is that a range of actions may be equally reasonable. One prudent investor might invest in a risky asset, thinking it undervalued or at least fairly valued, while another might avoid the investment or sell it short, thinking it overvalued. Both may make their investment decisions carefully, but they may be shaped by different approaches or beliefs. The market price ends up at the point at which demand by the optimists absorbs the market float and any short interest created by the pessimists.

The Seventh Circuit, in Summers, at least, has held that it is “not imprudent” to rely on the market price. This is consistent with the presumption that the market price represents a good approximation of the stock's true value, even if investors hold varying opinions. In at least one other instance, a circuit court has decided that a prudent fiduciary need not rely on the market price and may expend time and resources to develop its own opinion on the value of the stock. See Bunch v. W.R. Grace & Co. , 555 F. 3d 1 (1st Cir. 2009). The usefulness of such an exercise, at least for large capitalization, heavily traded stocks, is open to doubt.

Provision of Financial Services with Choice

A defined contribution (DC) plan is a financial service to its participants. The primary service provided is a vehicle for saving for retirement. It can also provide a means to invest in one's own company, with that investment also providing a vehicle for savings. The provision of various ancillary services is also part of the package, including loans from plan balances and mechanisms for learning about and choosing among different investment options.

The concept of a DC plan as a financial service is particular relevant in litigation over allegedly excessive fees in a 401(k) plan. The fees paid by a plan must be weighed against the services that those fees provide. These services are typically provided in a bundle, so there is often no information about the cost of particular services. A comparison of the costs of a 401(k) plan to other financial services used for retirement savings can therefore provide evidence on the reasonableness of fees for the 401(k) plan. A natural comparison is to mutual funds, since a set of mutual funds embodies the options normally found in a DC plan, excluding employer stock, and since mutual funds also provide investment information and accounting similar to that provided in a DC plan.

The convenience of a 401(k) plan may justify a higher level of cost. When an individual undertakes investment, he or she has to search for appropriate financial firms and for appropriate investments. By offering these conveniently to employees, a 401(k) plan can help economize on participants' time. Its availability and convenience also encourages savings, counteracting the typical psychological reluctance to delay gratification.

Lessons from behavioral finance are particularly relevant here. First, the default option offered by a plan can have a substantial impact of participant investment choice. This could be because participants perceive an endorsement of the investment option by their company's officials (acting as plan fiduciaries). It could also be due to the substantial inertia in investment decisions that has been documented among investors.

Consumers of financial services have also been shown to have difficulty managing complex information. Thus, more complex investment menus may not yield better investment decisions, and in fact may lead participants to adopt rules of thumb. Moreover, allegations in excessive fees cases that participants should have received more detailed disclosure of fee arrangements imply that participants should have received more complex information. It is not evident that participants would benefit from this type of disclosure, in that the need to understand all the information may lead them to avoid making active decisions to contribute to their 401(k) and choose suitable investments.

Loss Calculations: The Selection of But-for Returns

ERISA gives participants the right to sue fiduciaries for plan losses. These losses are normally calculated as the difference between the actual plan value and the “but-for” value if the breach did not occur. In lawsuits over the selection of investment options (including company stock), the approach laid out in Donovan v. Bierwirth, 680 F.2d 263, 272 (2d Cit. 1982), is often followed. That approach involves a comparison between the actual investment returns and the returns on an alternative investment.

This raises the question of what the alternative investment should be. Donovan says that of the “plausible” investment alternatives, the one with the returns most favorable to the plaintiffs should be chosen. If the litigation is about a 401(k) plan, then the plausibility test requires a coherent argument about what loss the breach might have caused: if the offending investment (usually employer stock) had not been offered by the plan, in what alternative would participants instead have invested?

Plaintiffs in such cases would obviously want to claim that the all investments are plausible, permitting them to choose the best performing investment in the plan, which would maximize the calculated loss. But this approach fails to pass the test of plausibility. It is not possible to choose the best-performing investment option in advance, and, therefore, it is not plausible to argue that participants would all have placed their money in this option. This argument is emphasized by the Seventh Circuit in Leister v. Dovetail, Inc. , 546 F.3d 875, 880 (Seventh Cir. 2008).

The court instead supported taking the overall investment return in the plan as the alternative investment. This approach makes sense if there is reason to think that the additional investment would be similar to existing investments. The Leister case involved a lawsuit over money that the defendant had failed to deposit in the plaintiff's 401(k) plan, and the Seventh Circuit suggested the return on the plaintiff's actual investments would be a guide to the return she would have obtained on additional contributions. In other circumstances, however, this may not be plausible.

In particular, for lawsuits alleging that an investment option should have been removed from a plan, we would expect that when an investment option is removed, participants would reallocate their portfolios to maintain a similar balance of risk and return to the balance they had before the removal of the investment option. Employer stock, for example, would plausibly be replaced by equity investments of similar volatility. Part Three, to appear next month, will discuss damages calculations.

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.