How Should Plan Fiduciaries Respond to Current Investigations of Mutual Fund Practices?

Fiduciaries of 401(k) and other retirement plans are facing some tough issues as a result of last month’s allegations by New York Attorney General Elliot Spitzer of improper "late trading" and "market timing" in mutual fund shares by hedge funds. Initially limited to four fund families, the investigation has reportedly broadened to include other mutual fund companies. The inevitable class action lawsuits have been filed.

This overview (which is not intended as legal advice for any particular situation) highlights important points that should be kept in mind by fiduciaries of ERISA retirement plans, where plan assets are invested in funds of companies that have been implicated in this investigation. Plans not subject to ERISA (such as state or local governmental plans) that are subject to state law fiduciary duty rules similar to those of ERISA, may also find this discussion relevant.

The decision to use or offer a particular fund for the investment of plan assets is a fiduciary act, subject to ERISA’s fiduciary duty standards. A decision on whether to continue to use or offer a fund is also a fiduciary act that requires ongoing monitoring of a plan’s investment vehicles and consideration of events such as the current investigation. Even though the fiduciaries’ review process may result in retention of the fund, it is important to go through the process. To do nothing invites a claim that the fiduciaries neglected their duties.

• We understand that third-party investment consultants are devoting considerable time to analyzing the effect of these events on the affected fund families. If the plan has such a consultant, the fiduciaries should request an immediate briefing (and ongoing follow-ups) from the consultant. If the plan has no third-party consultant, the fiduciaries should request explanations and follow-ups from the funds themselves or consider hiring a third-party consultant to make these inquiries. In either event, the fiduciaries should not hesitate to ask questions and should not just rely on general statements from the fund families.

• Should a fund be replaced? While the initial inclination may be "yes," there are considerations on both sides. For example, the plan fiduciaries went through a careful evaluation process and had good reasons for putting the fund in the plan. (At least we hope this was the case.) The investigations might "blow over" and participants would then have lost access to a good fund. On the other hand, other investors in the same fund might not wait for the outcome of the investigation. There are thousands of mutual funds, so alternatives exist for any implicated fund. If there was a "rush to redeem" out of an implicated fund, the fund could fall into a downward spiral of selling holdings to make redemptions, which could impair fund performance as well as the fund manager’s asset-based fees. Key fund personnel might be lured away, and the fund might end up being very different from the fund the plan had originally picked. Plan fiduciaries must weigh considerations like these when they determine what to do.

• What information should be given to participants? Many plan participants may be unaware of the New York investigations, and it is understandable to want to avoid alarming participants. If the plan is a self-directed plan and the fiduciaries take action such as replacing a fund or adding a new, alternative fund, information about the new fund must be provided as required under ERISA § 404(c). Absent such a change, disclosure would generally not be required, except that any information that shows how the trading practices affect fund returns should be disclosed or made available upon request. In addition, plan fiduciaries must be prepared to respond to any participant inquiries. When responding to these inquiries, a simple explanation of the matter, including which of the plan’s funds are involved, and a statement that the fiduciaries or their consultants are evaluating the effect on the plan and what action to take should be responsive to most questions. If most plan participants are financially sophisticated, the plan fiduciaries may want to go ahead and provide disclosure along the lines described in the previous sentence. If additional information becomes available, then further communication to participants may be appropriate.

In their consideration of these or other issues relating to the plan’s investment funds, plan fiduciaries must keep the following principles in mind:

• ERISA fiduciaries are required to act according to ERISA’s fiduciary duty standards, which include the duty to act "solely in the interest of the participants and beneficiaries" and as a "prudent man" would act under the circumstances.

• The "prudent man" standard has been repeatedly described by courts as one that focuses on procedure. Thus, fiduciaries are not required to come to the "right answer," but they are to give "appropriate consideration" to the relevant circumstances and act accordingly.

• Relevant circumstances in a situation like this would include the impact of the alleged acts (if true) on the fund’s performance, the effect of the investigation on the funds involved, and the costs associated with any change in funds.

The foregoing is an overview of what fiduciaries should be thinking about and doing if their plan uses or offers funds that are affected by the investigation.