ERISA Litigation Update - January 2011 January 20, 2011
In This Issue

District Court Holds Complaint Sufficiently Alleges ERISA Fiduciary Status of Advisor to Fund That Invested with Madoff

On October 5, 2010, the U.S. District Court for the Southern District of New York in In re Beacon Associates Litigation, 09-cv-777 (LBS) (S.D.N.Y. Oct. 5, 2010) issued a lengthy and complicated ruling on motions to dismiss the complaint in an action involving investments with Bernard Madoff made through a feeder fund (the “Fund”).  The complaint, which asserted violations of ERISA’s fiduciary provisions as well as other state and federal laws, is brought against the sponsor of the Fund (the “Sponsor”) and the firm that provided advice to the Sponsor (the “Advisor”), among other defendants. While the court’s opinion addresses numerous issues under ERISA and other laws, much of the ERISA analysis is focused on whether the Advisor was an ERISA fiduciary with respect to ERISA plans that invested in the Fund for having rendered “investment advice” within the meaning of ERISA Section 3(21)(A)(ii).

With respect to the plaintiffs’ investment advice theory of fiduciary liability, the complaint alleged that the Fund’s offering memorandum provided to potential investors (including ERISA plans) stated that the Sponsor would, after consulting with the Advisor, allocate assets of the Fund among investment managers selected and monitored by the Sponsor, but that a substantial majority of the Fund’s assets would be placed with a single manager. The plaintiffs further alleged that, once the Fund began operating, over 70% of the Fund’s assets were invested with Madoff, who had been introduced to the principals of the Sponsor by the Advisor. A consulting agreement between the Sponsor and the Advisor further provided that the Advisor would perform administrative services for the Sponsor in return for 50% of management fees earned by the Sponsor (and 50% of any fees the Sponsor received as a result of introducing third parties to Madoff). In 2008, after the facts concerning Madoff’s Ponzi scheme became public, the Fund was liquidated, with investors – including ERISA plans – allegedly incurring significant losses. The complaint asserts that the Advisor was an ERISA fiduciary because it rendered investment advice within the meaning of ERISA, and breached ERISA fiduciary duties by failing to recommend that the Fund end its relationship with Madoff when it became suspicious of his investment activities years before his fraud became public.

The Advisor moved to dismiss the ERISA claims on the ground that it was not a fiduciary because it had not rendered investment advice within the meaning of ERISA Section 3(21)(A)(ii) or Department of Labor (“DOL”) regulations thereunder. See 29 C.F.R. Section 2510.3-21(c)(1) (the “Regulation”). The Sponsor did not dispute that it was an ERISA fiduciary for purposes of the motion to dismiss, and the decision assumes without addressing the question that the Fund's assets are plan assets for purposes of ERISA.

The court denied the Advisor’s motion on several grounds. First, relying on DOL authority, the court held that “advice” under the statute includes not only advice concerning particular investments, but also recommendations regarding investment managers. Second, the court held that the Advisor’s recommendations could constitute ERISA investment advice, even though they were provided to the Sponsor and not the ERISA plans, because the Sponsor was alleged to be a fiduciary with authority to make investment decisions regarding the plan’s assets. Third, the court held that the complaint’s allegations were sufficient to state a claim that the Advisor’s advice was “individualized … based on the particular need of the plan[s]” within the meaning of the Regulation because the plaintiffs alleged that the advice had been provided to the Fund on an ongoing basis and in connection with the Advisor’s long-term relationship with the Sponsor. Fourth, the court rejected the Advisor’s argument that it had not provided investment advice “for a fee” within the meaning of the statute. Although the fees the Advisor received were for administrative services received under its consulting agreement with the sponsor, the court noted that the Fund’s offering memorandum specifically referred to the advisory services to be performed by the Advisor. Lastly, the court held that the complaint sufficiently alleged that the Advisor’s advice was “a primary basis” for the Fund’s decision to invest with Madoff, given that there was no indication that the Sponsor had received substantial advice from any other party and the Advisor had introduced the sponsor to Madoff.

While the court dismissed a number of claims against the Advisor and other defendants, the ERISA breach of fiduciary duty claims against the Advisor survived because the court concluded that the complaint sufficiently alleged that the Advisor had provided investment advice within the meaning of ERISA.

Federal Circuit Court Affirms Dismissal of Stock Drop Suit

In Brown v. Medtronic, Inc., et al., Case No. 09-2524 (8th Cir. Dec. 13, 2010), the U.S. Court of Appeals for the Eighth Circuit affirmed dismissal of a putative class action complaint filed by a former participant in an employee stock ownership plan sponsored by a medical device manufacturer (the “Sponsor”).

The complaint, filed against the Sponsor, several of its directors, a retirement plan committee and various other alleged fiduciaries, asserted that the defendants breached ERISA fiduciary duties by imprudently continuing to invest in Sponsor stock after receipt of adverse information regarding the performance of certain of the Sponsor’s medical products, and by making material misrepresentations and nondisclosures concerning those products. The plaintiff further alleged that the plan purchased Sponsor stock at artificially inflated prices, and that the stock price dropped following The Wall Street Journal’s publication of an article regarding the product issues.

In the decision, the U.S. District Court for the District of Minnesota looked at the dates of share-price changes and the dates of the plaintiff’s purchases and sales of shares and determined that plaintiff benefited from any artificial price inflation allegedly caused by the defendants’ actions or failures to act. Because the plaintiff had suffered no cognizable injury fairly traceable to any of the defendants’ alleged breaches of duty, the district court dismissed the complaint on the ground that the plaintiff lacked constitutional standing. On appeal, the Eighth Circuit affirmed the dismissal, but on slightly different grounds.

The appellate court agreed with the district court that the plaintiff pleaded no injury fairly traceable to any alleged breach of duty with respect to one of the Sponsor’s product lines where, by the plaintiff’s own allegations, the negative information about that product line did not reach the public until after the plaintiff had liquidated his plan account. Accordingly, the plaintiff had not realized any share price inflation caused by the allegedly improper promotion of that product line. In so holding, the appellate court agreed with the district court that a plaintiff must allege a “net loss” in investment value in order to maintain suit. Under a net loss theory, a plan participant has suffered no cognizable injury if the participant sold shares at an inflated price and, therefore, was a net beneficiary of the inflated share price. Here, where the alleged breach “actually conferred a financial benefit,” the plaintiff had pleaded no net loss, and any “abstract injury” he asserted was insufficient to give rise to standing because it could not be redressed by the court.

While other of the plaintiff’s claims survived the standing challenge, the Eighth Circuit ultimately dismissed the case in its entirety, concluding that the complaint failed to state a claim for relief where the plaintiff made no plausible allegation that the Sponsor stock became an imprudent investment merely because the Sponsor received adverse information regarding the performance of certain of its products. In dismissing the complaint, the court declined to reach the question of whether the Eighth Circuit should adopt the presumption applied by the court in Moench v. Robertson, 62 F.3d 553, 571 (3d Cir. 1995) that investments in company stock are entitled to a rebuttable presumption of prudence. Noting that several other circuits had adopted the Moench presumption, and that no circuit has expressly rejected the presumption on its merits, the Eighth Circuit nonetheless concluded that it did not need to reach the question of whether plan fiduciaries were entitled to any presumption of prudence where the plaintiff at bar failed to meet his threshold burden of stating a plausible imprudence claim. This contrasts with a decision by the Ninth Circuit on December 2, 2010, denying a petition for rehearing and rehearing en banc in Quan v. Computer Sciences Corp., et al, 623 F.3d 870 (9th Cir. 2010) over objection by the Department of Labor and other amici. In Quan, the Ninth Circuit joined the Fifth and Sixth Circuits in expressly adopting the Moench presumption.

Southern District of New York Dismisses ERISA Imprudence Claims Arising from Mortgage-Backed Securities Investments

The U.S. District Court for the Southern District of New York dismissed an ERISA breach of fiduciary duty action alleging that an investment manager imprudently invested retirement plan assets in mortgage-backed securities. Saint Vincent Catholic Medical Centers, et al. v. Morgan Stanley Investment Management, Inc., No. 09-9730 (S.D.N.Y. Oct. 4, 2010). An appeal has been taken to the U.S. Court of Appeals for the Second Circuit.

The plaintiffs allegedly engaged the defendant, a registered investment adviser, to manage a fixed-income portfolio for their defined benefit plan. According to the complaint, the defendant concentrated between 9% and 12% of the portfolio in mortgage-backed securities, some or all of which were not guaranteed by Fannie Mae or Freddie Mac. The complaint asserted that the portfolio was subject to written investment guidelines specifying that the portfolio’s primary investment objective was preservation of principal and long-term growth. When the market for securitized mortgages declined following the subprime real estate crash in 2007 and 2008, the investments in this portfolio allegedly lost approximately $25 million. The plaintiffs alleged that the investments were made by the defendant in violation of ERISA because they contained excessive risk, and thus were imprudent, and because their portfolio was not appropriately diversified.

The court dismissed the plaintiffs’ allegations as a matter of law for failure to state a claim. It stated that a fiduciary’s “actions are not to be judged from the vantage point of hindsight.”  In the absence of any allegations as to the adequacy of the manager’s investigation of the merits of the investment, the court held that the resulting performance itself could be the basis of liability. The court specifically referenced the overall poor performance of securitized mortgages during the recent crash. The court followed three other decisions from the Southern District of New York that had also dismissed ERISA breach of fiduciary duty claims that involved plan investments tied directly or indirectly to real estate and mortgage-backed securities: Southern California IBEW-NECA Defined Contribution Plan Board of Trustees v. Bank of New York Mellon Corp., No. 09 Civ. 6273 (S.D.N.Y. April 14, 2010); In re Lehman Bros. Sec. and ERISA Litig., 683 F. Supp. 2d 294 (S.D.N.Y. 2010); and In re Citigroup ERISA Litig., No. 07 Civ. 9790, 2009 WL 2762708 (S.D.N.Y. Aug. 31, 2009) (discussed in Goodwin Procter’s March 2010 ERISA Litigation Update).

In addition to rejecting the plaintiffs’ “hindsight critique of returns,” the court also refused to adopt the plaintiffs’ diversification theory, stating that investing 9% to 12% of a portfolio in one asset category did not demonstrate a failure to diversify. Moreover, although the plaintiffs alleged that 60% of the portfolio was invested in a single fund, the complaint did not allege that that fund itself was undiversified and so the court held that the allegation could not support a legal claim.

Federal Court Dismisses ERISA Breach of Fiduciary Claims over 401(k) Plan Holdings in Stock of Bank Receiving TARP Funds

On November 24, 2010, the U.S. District Court for the Southern District of Ohio dismissed ERISA breach of fiduciary duty claims arising from the continued holding of a bank’s stock in a 401(k) plan sponsored by the bank for its employees. Dudenhoeffer v. Fifth Third Bancorp, et al, No. 1:08-cv-538 (S.D.OH) (Nov. 24, 2010). The case was notable in the court’s rejection as a matter of law of the plaintiffs’ allegations that a bank’s stock was an imprudent investment for ERISA plan participants because the bank allegedly “switched from being a conservative lender to a subprime lender” and that the bank participated in the TARP Capital Purchase Program.

The plaintiffs were participants in the bank’s 401(k) plan. They brought a putative class action on behalf of themselves and all other current and former participants and beneficiaries of the plan from July 19, 2007 through the present whose plan accounts were invested in the bank’s stock. They sued the bank, its directors, certain officers and members of the 401(k) plan committee. The plaintiffs alleged four counts under ERISA involving the plan’s holding in bank stock: that it was a breach of ERISA’s duty of loyalty and prudence to maintain the stock, and defendants breached ERISA fiduciary duties in not providing greater information about the stock; that certain defendants failed in their ERISA fiduciary duties to monitor their appointees with responsibility for plan investments; that certain defendants failed to ameliorate their alleged conflict of interest in continued holding and purchasing of bank stock for the plan; and that defendants had obligations to correct breaches by co-fiduciaries.

The complaint alleged that the purported shift in lending philosophy from a bank first characterized as a “conservative lender” to a “subprime lender” caused the bank’s stock to fall 74% during a 26-month period from July 2007 to September 2009. The court applied a legal presumption in favor of the prudence of holding employer stock, a presumption that is applied in some, but not all circuits. (For a discussion of the presumption of prudence, see James O. Fleckner, “The Case for a Presumption of Prudence,” 37 Pension & Benefits Reporter 2204, Oct. 5, 2010.)  The court held that a 74% decline alone was insufficient to rebut the presumption of prudence. Most importantly, the court held that a business decision to enter subprime lending, the write-down of non-performing assets, and participation in the TARP program, are together insufficient to defeat the presumption of prudence. It specifically rejected the plaintiffs’ proposition that the bank’s “participation in the Capital Purchase Program (‘CPP’) [was] a stigma and a sign of financial stress.”

An appeal of this decision was docketed in the U.S. Court of Appeals for the Sixth Circuit on January 5, 2011, No. 11-3012.

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The above article originally appeared in Goodwin Procter’s December 7, 2010 Financial Services Alert.

Upcoming Conferences

Fiduciary Duties of Investment Advisors, Broker-Dealers and Fund Managers
February 24, 2011

Jamie Fleckner and Marco Adelfio will serve as a faculty members for this Strafford Publications teleconference, which will provide financial services counsel with an overview of the evolving nature of fiduciary duties in an era of financial reform. The panel will discuss regulatory and litigation trends and developments, and outline risk management strategies to minimize fiduciary liability claims.

43rd Annual SIFMA Compliance & Legal Conference
March 20-23, 2011
Phoenix, AZ

Jamie Fleckner will present on a panel focused on retirement savings. SIFMA’s mission is to support a strong financial industry, investor opportunity, capital formation, job creation and economic growth, while building trust and confidence in the financial markets. Jamie will discuss Department of Labor initiatives on fee disclosure and fiduciary duties through provision of investment advice.

16th Annual ALI-ABA Advanced Conference on Insurance and Financial Services Litigation
May 5-6, 2011
Washington, D.C.

Jamie Fleckner will present at this ALI-ABA conference on ERISA litigation. The conference covers the latest developments and trends in litigation involving the insurance and financial services industries. A faculty of experts will focus on changes affecting the marketing, sale and administration of financial and insurance products, including annuities, life insurance, variable products, retirement plan contracts, mutual funds, health insurance, disability insurance, long-term care, and other consumer and commercial financial and insurance products.