Alert April 06, 2010

Federal District Court Dismisses ERISA Claims Relating to Securities Lending Practices

In Fishman Haygood Phelps Walmsley Willis & Swanson, LLP, et al. v. State Street Corp., et al., Case No. 09-10533 (D. Mass. Mar. 25, 2010), the U.S. District Court for the District of Massachusetts granted a motion to dismiss ERISA breach of fiduciary duty and prohibited transaction claims involving a bank’s securities lending program. 

The case involved the plaintiff law firm’s defined contribution plan (the “Plan”), which invested in collective trusts managed by the defendants.  Certain of the collective trusts participated in defendants’ securities lending program, under which the collective trust would lend securities to brokers and other borrowers.  Cash collateral provided by borrowers to secure the loans was invested through commingled cash collateral pools.  A portion of the income generated by the investments was retained by the collective trusts as compensation for lending their securities.

Certain collective trusts in which the Plan was invested participated in the securities lending program pursuant to a lending agreement that provided that the cash collateral would be invested in short-term instruments.  In a complaint filed in 2009, the plaintiff alleged that the defendants in fact invested the collateral in instruments with unusually high risk and unusually long duration, including mortgage-backed securities.  While none of the securities in the collateral pools was in default or considered impaired prior to the filing of the complaint, and the pools had adequate sources of liquidity to meet the obligations of lenders under the securities lending program, the plaintiff nonetheless alleged that the investments were imprudent and caused injury to the Plan as a result of decreases in the net asset value of the collateral pools.  The alleged negative impact on the net asset value of the collateral pools was based on mark-to-market valuation – valuing units of the pools based on current market prices of the underlying financial instruments.  However, the collateral pools at issue did not price on a mark-to-market basis, but rather used amortized cost pricing, under which the pools maintained a constant $1.00 unit price even when the net asset value of the underlying securities fell below a dollar.  As a result, investors who redeemed units of a collective trust participating in the securities lending program incurred no losses on account of the collective trust’s investment in the collateral pools, and in particular, the Plan’s transactions in the collective trusts were transacted at values per unit that reflected a constant $1.00 unit price of the collateral pools.

Defendants moved to dismiss the complaint on the ground that the claimed losses were speculative, and that without an actual injury, the plaintiff lacked standing to assert claims.  Because of the complexity of the facts, the court permitted the parties to conduct limited discovery and to submit expert reports and take expert depositions addressed to the threshold jurisdictional question – whether the Plan had incurred an injury.  Plaintiff’s expert calculated realized and unrealized losses based on collateral pool investments using mark-to market valuation.  Injury attributed by plaintiff to unrealized losses was based largely on defendants’ public filings, which reflected that the collective trusts had incurred “unrealized losses” due to “losses on longer duration instruments [in the collateral pools] stemming from a lack of liquidity in the secondary market.”  

Defendants and their expert argued, among other things, that the collateral pools’ respective net asset values had substantially recovered, that income received by the plaintiff from the securities lending program exceeded any unrealized loss, and that the hypothetical prudent alternative investment proffered by the plaintiff (a money market fund) earned lower returns than the those actually earned under the securities lending program. 

The court rejected the plaintiff’s claim that unrealized losses could form the basis for Article III standing.  The court held that, because the defendants did not value the collateral pools’ assets on a mark-to-market basis, but rather used the amortized cost method, which essentially guaranteed the withdrawal of invested funds with no loss, the plaintiff had not established any injury.  The court also credited defendants’ expert analysis that showed that the hypothetical prudent investments advanced by plaintiff would have obtained lower returns than those earned under the securities lending program.  Citing First Circuit authority defining the appropriate measure of damages in an ERISA case alleging imprudence as a comparison between investments made by a defendant and a hypothetical, prudent investor, the court agreed that the defense expert’s findings that defendants’ investment outperformed hypothetical investments in money market funds undermined any allegation of injury-in-fact.  On these grounds, the case was dismissed based on plaintiff’s lack of standing to assert claims.