Appellate Court Revives Putnam Self-Dealing Suit

The 1st U.S. Circuit Court of Appeals found “several errors of law in the district court’s rulings.”

In a case alleging disloyalty and imprudence against fiduciaries of Putnam Investment’s 401(k) plan, the 1st U.S. Circuit Court of Appeals ruled, “Finding several errors of law in the district court’s rulings, we vacate the district court’s judgment in part and remand for further proceedings.”

A district court ultimately found that since plaintiffs did not establish a case in which a particular fiduciary breach caused a loss to the plan, their arguments fail. Prior to that, U.S. District Judge William G. Young of the U.S. District Court for the District of Massachusetts dismissed prohibited transactions claims saying they were time-barred under the Employee Retirement Income Security Act’s (ERISA)’s three-year statute of limitations. However, he offered discussion on two points, which the Appellate Court addressed.

On the question of whether the payments received by Putnam subsidiaries for their services to Putnam mutual funds were reasonable, the Appellate Court agreed with the District Court; however, it vacated another claim deciding whether “other dealings” between the plan and Putnam were any less favorable to the plan than dealings between Putnam and other shareholders investing in the same Putnam funds. The District Court did not find whether or to what extent the revenue sharing paid to or for the benefit of some third-party plans would have exceeded the fees borne by third-party plans but not by the Putnam plan. Instead, at defendants’ behest, the district court pointed to the fact that Putnam paid into the plan (for the benefit of most participants) discretionary 401(k) employer contributions that totaled much more than the rebates would have.

Pointing to the fact that Prohibited Transaction Exemption 77-3 calls for an assessment of “[a]ll other dealings between the plan and the investment company,” the District Court reasoned that, on a net basis, Putnam treated its plan even more favorably than it treated those that received the benefit of revenue-sharing payments. The 1st Circuit did not agree with this analysis because it did not regard Putnam’s payment of discretionary contributions to be a relevant “dealing” between Putnam and the plan.

The Appellate Court’s opinion noted that because the defendants had not yet presented the entirety of their case, Young refrained from making conclusive findings and rulings about whether the defendants breached their duty of prudence. It began with the District Court’s tentative finding that the plan’s investment committee breached its fiduciary duty by automatically including Putnam funds as investment options for the plan then failing to independently monitor the performance of those funds. The 1st Circuit said the District Court correctly observed that such a breach does not mean that the plan necessarily suffered any loss. While the lower court discounted the plaintiffs’ expert testimony comparing the Putnam funds to Vanguard funds; the 1st Circuit reviewed the District Court’s reasoning and found that plaintiffs’ evidence was sufficient to support a finding of loss.

Assuming the plan suffered a loss, the Appellate Court said the District Court was correct that the lack of prudence in the procedures used to select investments may not have caused the loss. There’s a split of authority at the Federal circuit level about who bears the burden of proving what is called loss causation, but the 1st Circuit said it joins those circuits that approve a burden-shifting approach. Its reasoning begins with the language of the statute—establishing that a breaching fiduciary shall be liable for any losses to the plan “resulting from” its breach—which clearly requires a causal connection between a breach and a loss in order to justify compensation for the loss. However, the statute does not explicitly state whether the plaintiff bears the burden of proving that causal link or whether the defendant must prove the absence of causation.

The Appellate Court noted that when the Supreme Court confronts a lack of explicit direction in the text of the Employee Retirement Income Security Act (ERISA), it regularly seeks an answer in the common law of trusts. The common law of trusts places the burden of disproving causation on the fiduciary once the beneficiary has established that there is a loss associated with the fiduciary’s breach. “Common sense strongly supports this conclusion in the modern economy within which ERISA was enacted. An ERISA fiduciary often—as in this case—has available many options from which to build a portfolio of investments available to beneficiaries. In such circumstances, it makes little sense to have the plaintiff hazard a guess as to what the fiduciary would have done had it not breached its duty in selecting investment vehicles, only to be told ‘guess again.’ It makes much more sense for the fiduciary to say what it claims it would have done and for the plaintiff to then respond to that,” the Appellate Court said in its opinion. “For the foregoing reasons, we align ourselves with the Fourth, Fifth, and Eighth Circuits and hold that once an ERISA plaintiff has shown a breach of fiduciary duty and loss to the plan, the burden shifts to the fiduciary to prove that such loss was not caused by its breach, that is, to prove that the resulting investment decision was objectively prudent.”

Regarding the violation of loyalty claims, the 1st Circuit ruled that since the plaintiffs point to no action of Putnam that can be explained only by a disloyal motivation, the District Court had the discretion to dismiss those claims.