Alert June 25, 2009

New Wave of ERISA-Related Litigation: Securities Lending

Securities lending programs involving assets held by retirement plans have become the latest target of litigation under ERISA. In a series of recent lawsuits – including several putative class actions – involving major custodial banks and their affiliates, plaintiffs have challenged securities lending practices as violating ERISA’s fiduciary prudence and prohibited transaction provisions, among other laws.  

Securities lending typically involves the loan of a security by its owner to a borrower who needs the security for short-term purposes. Commonly, the borrower provides cash collateral, which can be invested in short-term instruments or funds (cash collateral pools) to achieve investment returns for the lender. The specific terms of the lending arrangement are governed by contract and will vary. When the loan is terminated, the borrower returns the security to the lender, which is obligated to transfer to the borrower the value of the collateral (along with agreed-upon interest). Thus, the lender bears the risk of loss on collateral investments.

Historically, ERISA plans and collective trusts holding ERISA plan assets have been significant lenders of securities – through programs managed by custodian banks or other securities lending fiduciaries – and have generally benefited from the incremental income securities lending added to their portfolios. However, due to recent substantial disruptions in the fixed income market, some securities lending cash collateral investments have suffered losses and/or a sudden erosion of liquidity. This in turn has caused some fiduciaries of collective trusts and other funds that have loaned securities to implement restrictions on redemptions to avoid further impairment of value and harm to non-redeeming clients, who could otherwise be left with disproportionate investments in illiquid securities.

On fact patterns such as this, at least a dozen lawsuits have been filed across the country alleging, among other claims, violations of ERISA. Among other claims, these suits allege that investment managers and advisers to retirement plan assets acted imprudently in participating in securities lending programs, that securities lending programs were not administered as agreed, and/or that fees collected by securities lending fiduciaries were excessive. The plaintiffs claim violations of ERISA sections 404 (duty of prudence) and 406 (prohibited transactions), and seek equitable as well as monetary relief.

These cases are still in the early stages of litigation, with a number having only recently been filed (see, e.g., Diebold v. Northern Trust Investments, No. 09-cv-1934 (N.D. Ill. filed Mar. 30, 2009) and Fishman Haygood Phelps Walmsley Willis & Swanson L.L.P. v. State Street Corp., No. 09-cv-10533 (D. Mass. filed Apr. 7, 2009)), and no class has been certified to date. Early decisions have gone to both plaintiffs and defendants. For example, defendants successfully defeated a request for a preliminary injunction in BP Corp. North America Inc. Savings Plan Investment Oversight Committee v. Northern Trust Investments, N.A., No. 08-cv-6029 (N.D. Ill. Dec. 16, 2008). The fiduciaries of the BP pension plans filed suit against the funds’ investment managers and their securities lending agents, alleging that the defendants breached ERISA fiduciary duties by exposing retirement fund assets to inappropriate risk in connection with the securities lending practices of index funds in which the plans’ assets were invested. The funds’ collateral pools allegedly were adversely affected by market conditions, resulting in collateral deficiencies that caused the lending agent to impose withdrawal limitations on the index funds. The plaintiffs sought a preliminary injunction requiring the defendants to distribute the BP plans’ assets in cash or as liquid securities. The court denied the plaintiffs’ request for a preliminary injunction, finding no danger of irreparable harm where the damages the plaintiffs sought could be measured at any point, if they prevailed. The court also rejected the assertion that an injunction was uniquely warranted where the plaintiffs made no showing that an individual pensioner needing to withdraw his or her pension assets was at risk.

Just last month, the Western District of Tennessee in FedEx Corp. v. The Northern Trust Co., No. 08-cv-2827 (W.D. Tenn. May 20, 2009), denied the defendant’s motion to dismiss a suit filed by a plan administrator asserting claims against the plan’s trustee and custodian for ERISA breach of fiduciary duty and other common law causes of action in connection with the defendant’s lending of the plan’s securities. The defendant moved to dismiss the common laws claims for breach of contract and breach of a settlement agreement on the ground, among others, that such claims are preempted by ERISA. Denying the motion, the court stated that the scope of ERISA preemption is not entirely settled, but that the agreement that formed the basis for the plaintiffs’ allegations – a compromise agreement regarding the redemption of plan assets invested in funds that engaged in securities lending – had only a tenuous connection to ERISA and was not preempted.

While most of the suits challenging securities lending practices have been filed by plan fiduciaries, the issues targeted in these suits also raise the specter of a new wave of participant-filed class actions. The recently filed case of Diebold v. Northern Trust Investments, No. 09-cv-1934 (N.D. Ill. filed Mar. 30, 2009), was brought by a retirement plan participant who invested in only a single index fund among the many options available in his plan. Nevertheless, the plaintiff seeks to assert claims on behalf of a putative class of participants not only in his plan but in other plans that invested in any defendant-sponsored collective trust or other fund that engaged in securities lending. The defendants have moved to dismiss the Diebold complaint on several grounds, including the plaintiff’s lack of standing to pursue claims on behalf of plans he did not participate in and funds in which he did not invest. That motion is pending.

Some financial institutions have been targeted in a number of these suits, in some instances by the same plaintiffs’ firm. The Southern District of New York recently consolidated three such related putative class actions against the same defendant stemming from losses allegedly incurred by securities lending cash collateral pools. See Board of Trustees of the AFTRA Retirement Fund v. JP Morgan Chase, N.A., No. 09-cv-686, (S.D.N.Y. filed Jan. 23, 2009); Board of Trustees of the Imperial County Employees’ Retirement System v. JP Morgan Chase, N.A., No. 09-cv-3020, (S.D.N.Y. filed Mar. 27, 2009); and The Investment Committee of the Manhattan and Bronx Service Transit Operating Authority Pension Plan v. JP Morgan Chase Bank, N.A., No. 09-cv-4408 (S.D.N.Y. filed May 7, 2009). Further consolidation of cases may be seen if the same institutions continue to be targeted.