It is well-established that and ERISA pension plan administrator has a fiduciary duty to invest plan assets prudently. This duty is called, unimaginatively, the “prudent-man rule” – or perhaps the gender-neutral “prudent-person rule.” This rule, which existed long before ERISA was enacted, is enshrined in the text of the statute, which requires fiduciaries to use “the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” 29 U.S.C. § 1104(a)(1)(B).
With the benefit of hindsight, one might think that investing a significant fraction of plan assets in mortgaged-backed securities would be the height of imprudence. But, as the Second Circuit recently confirmed in Pension Ben. Guar. Corp. ex rel. St. Vincent Catholic Med. Centers Retirement Plan v. Morgan Stanley Investment Mgt Inc., 712 F.3d 705 (2d Cir. 2013), the use of hindsight is impermissible when considering the prudent person rule.
St. Vincent alleged that Morgan Stanley, which functioned as plan administrator, had disproportionately invested the plan’s assets in mortgage-backed securities. The plan had investment guidelines that told Morgan Stanley that its performance would be measured against a particular bond index called the Citigroup BIG index. St. Vincent’s alleged that, in 2007 and 2008 Morgan Stanley had imprudently invested the plan in mortgage-backed securities. For example, while the BIG index allegedly no mortgage-backed securities that were not guaranteed by a Fannie Mae or the like, Morgan Stanley had more than 12% of the plan in such securities. Despite “warning signs” in 2007 and 2008, Morgan Stanley did not rebalance the portfolio; it did not sell them when prices declined dramatically. As a result, St. Vincent’s alleged, the plan incurred significant losses.
Morgan Stanley moved to dismiss; the district court granted the motion, and the Second Circuit affirmed.
The Court began by noting that the prudent person standard is entirely prospective in nature, and that hindsight cannot play any role:
We judge a fiduciary’s actions based upon information available to the fiduciary at the time of each investment decision and not from the vantage point of hindsight[.] Accordingly,we cannot rely, after the fact, on the magnitude of the decrease in the relevant investment’s price; rather, we must consider the extent to which plan fiduciaries at a given point in time reasonably could have predicted the outcome that followed. In other words, as the Court of Appeals for the Third Circuit has nicely summarized, this standard “focus[es] on a fiduciary’s conduct in arriving at an investment decision, not on its results, and ask[s] whether a fiduciary employed the appropriate methods to investigate and determine the merits of a particular investment.” [brackets and quotation marks omitted]
With that in mind, the court examining what a complaint alleging a breach of fiduciary duty had to allege to properly state a claim. In general, the complaint must base the claim on one of two types of allegations: (1) factual allegations relating directly to the fiduciary’s knowledge, methods or investigations at the relevant times; or (2) circumstantial factual allegations which, if proved, would show that an adequate investigation would have revealed the imprudence of the investment to a reasonable fiduciary. St. Vincent’s complaint did neither.
St. Vincent’s did not allege any facts about the investigation or analysis that Morgan Stanley actually used in deciding to invest in the mortgage-backed securities. And, the court held, there were insufficient facts alleged to allow a conclusion that, at the time the investments were made, a reasonable fiduciary would have known they were imprudent.
For example, the court held it insufficient to allege that the plan held mortgage-backed securities issued by companies like Countrywide that suffered significant decline in value in 2007. There was no circumstantial evidence about the initial decision to make those investments. The fact that a security declines in value merely indicates, in hindsight, that it was a bad investment. Moreover, it is not necessarily imprudent not to sell investments that are rapidly declining in value. The court held that such a decline would be cause for investigation, but that St. Vincent’s did not allege that Morgan Stanley failed to investigate when the decline began, or that its investigation was inadequate. There might be prudent reasons for not selling securities that were now allegedly worthless.
The court summed up the problem with the complaint as follows:
In sum, viewing the allegations in the Amended Complaint as a whole, and drawing every reasonable inference in favor of Saint Vincent’s, the Amended Complaint does not allege facts plausibly showing that Morgan Stanley knew, or should have known, at the relevant times, that the securities held in the fixed-income Portfolio were imprudent investments. Instead, the Amended Complaint alleges imprudence by association, reasoning that because the Portfolio contained nonagency mortgage-backed securities—of which subprime mortgage-backed securities are now the most infamous type—and because the whole world knows (in hindsight) that many subprime mortgages turned out to be disastrous investments, the Portfolio’s concentration in mortgage-backed securities generally and nonagency securities in particular was imprudent. The relevant pleading standards do not permit such general accusations of imprudence, unsupported by well-pleaded factual allegations.
There is nothing particularly ground-breaking in this decision, but it is a helpful application of the modern rules of pleading to the problem of investment bubbles and their aftermath.