Alert January 20, 2011

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.