In a line of recent cases, the 2nd Circuit has limited ERISA plaintiffs’ claims for breach of the duty of prudence by holding that investments of benefit plan funds in employer securities pursuant to plans calling for such investments are presumptively prudent and dismissing claims at the motion to dismiss stage.1 On April 2, 2013, the 2nd Circuit Court of Appeals issued a decision in Saint Vincent Catholic Medical Centers et al. v. Morgan Stanley Investment Management Inc., further tightening the pleading standards for claims of breach of fiduciary duty by ERISA fiduciaries in a case that did not involve the presumption of prudence.
The Underlying Case
Saint Vincent’s sponsored and administered the Saint Vincent Catholic Medical Centers Retirement Plan, a defined-benefit pension plan for Saint Vincent’s retirees governed by ERISA. Saint Vincent’s hired Morgan Stanley to manage the plan’s fixed-income portfolio, about 35 percent of the plan’s assets. As the portfolio’s manager, Morgan Stanley was subject to the fiduciary duties imposed by ERISA.
Saint Vincent’s also provided Morgan Stanley with written investment guidelines for managing the portfolio. The guidelines stated that the “primary investment objective for the Pension Plan shall be preservation of principal with emphasis on long-term growth to meet the future retirement liability of the Plan.” The guidelines designated the Citigroup BIG index as the benchmark against which the portfolio’s performance would be measured. Plaintiffs alleged that the selection of this index as a benchmark signaled that Morgan Stanley was expected to implement a “low-risk, conservative investment strategy.”
The amended complaint alleged that Morgan Stanley breached its fiduciary duties under ERISA by deviating from the stated investment strategy and directing increasingly large amounts of the plan’s assets into high-risk investments, particularly non-agency mortgage-backed securities that are not guaranteed by government-sponsored entities like Fannie Mae. Plaintiffs also alleged that Morgan Stanley failed properly to diversify the portfolio, imprudently and disproportionately exposing it to the mortgage securities markets. In addition, plaintiffs alleged that the portfolio’s purported overconcentration in non-agency mortgage-backed securities caused it to underperform relative to the Citigroup BIG benchmark. Plaintiffs claimed that the consequent damages to the plan’s assets exceeded $25 million.
The amended complaint also included two New York common-law counts for breach of fiduciary duty and breach of contract, alleging that Morgan Stanley mismanaged Saint Vincent’s malpractice insurance fund in the same way.
The district court dismissed the complaint, finding it contained no allegations of inadequacy in Morgan Stanley’s investigation of the merits of its investments, and that it was premised on the poor returns on the investments. Such a hindsight critique of returns is inadequate to show a breach of fiduciary duty under ERISA. Further, the district court held, the amended complaint failed to demonstrate how the discrepancy between the portfolio’s performance and that of its benchmark amounted to a breach of Morgan Stanley’s duty under ERISA to exercise reasonable care in managing the portfolio. The district court then declined to exercise supplemental jurisdiction over the state law claims regarding the malpractice insurance fund. The court granted plaintiffs 21 days to move to amend their complaint again.
The Second Circuit Decision
Rather than amending their complaint, plaintiffs appealed to the 2nd Circuit. There, a three-judge panel affirmed the district court’s decision, with one judge dissenting in part. The court found that the district court properly dismissed Saint Vincent’s claims for breach of fiduciary duty under ERISA, because the allegations in the amended complaint did not give rise to a reasonable inference (i) that Morgan Stanley’s investment decisions with respect to the fixed-income portfolio were imprudent under the circumstances at the time; (ii) that Morgan Stanley did not properly diversify the portfolio; or (iii) that Morgan Stanley failed to act in accordance with the plan documents.
The 2nd Circuit noted that courts must judge a fiduciary’s actions based on information available to the fiduciary at the time of each investment decision, and not from the vantage point of hindsight. Courts thus cannot rely after the fact on the magnitude of the decrease in the investment’s price, and must consider whether the fiduciary could reasonably have predicted the outcome of its investment decision. As the 3rd Circuit has summarized the standard, courts must focus on the fiduciary’s conduct in arriving at an investment decision, not on its results, and ask whether a fiduciary employed the appropriate methods to investigate and determine the merits of a particular investment. In re Unisys Sav. Plan Litig., 74 F.3d 420 (3d Cir. 1996). Finally, the prudence of each investment is not assessed in isolation, but rather as the investment relates to the portfolio as a whole.
“Prudent Man” Duty of Care
Like the district court, the 2nd Circuit rejected Saint Vincent’s first allegation that Morgan Stanley violated its duty as an ERISA fiduciary to use the care, skill, prudence and diligence under the circumstances 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. Saint Vincent’s referred to “warning signs,” including analysts’ predictions and S&P ratings on certain mortgage-backed securities generally, that it alleged should have caused Morgan Stanley to reduce its exposure to the non-agency-backed securities. None of these alleged warning signs, however, gave rise to a plausible inference that Morgan Stanley knew or should have known that the specific securities in the portfolio were imprudent investments, or that Morgan Stanley breached its fiduciary duty by not selling the plan’s investments in those specific securities. The decline in the price of a security does not by itself give rise to a plausible inference that the security is no longer a good investment, and Saint Vincent’s failed to plead any other facts to suggest that conclusion. To be sure, the 2nd Circuit noted, a precipitous price drop would likely lead a prudent fiduciary to investigate whether it was still prudent to hold that investment, but Saint Vincent’s did not allege Morgan Stanley failed to conduct such an investigation. Most significantly, the amended complaint offered no insight into how risky the unspecified securities in the portfolio were relative to their price, and it did not allege any facts suggesting that a prudent investor at the time would have viewed the unspecified risk as high enough to render the investments imprudent.
The 2nd Circuit further noted that such imprecise pleading is particularly inappropriate in a case like this one, where Saint Vincent’s, as plan administrator, had the benefit of pre-discovery access to plan documents and reports that would provide specific and detailed information upon which to draw in drafting a complaint. But the amended complaint made no factual allegations about the specific investments in the portfolio, nor about how a prudent investor would have viewed the portfolio’s securities at the relevant times and in the relevant circumstances. The amended complaint alleged imprudence by association, reasoning that because the portfolio contained non-agency mortgage-backed securities, and because the investing world now knows that many subprime mortgages (which comprise only a subset of non-agency securities) turned out to be bad investments, the portfolio’s concentration in mortgage-backed securities generally and non-agency securities in particular was imprudent.
The 2nd Circuit also agreed with the district court’s rejection of Saint Vincent’s allegation that, even if the particular investments were not imprudent, Morgan Stanley failed properly to diversify the portfolio so as to minimize the risk of large losses, as required by ERISA.
Once again, the court found, Saint Vincent’s failed to support its claim with factual allegations sufficient to elevate it above the level of mere legal conclusions. Although the amended complaint stated the percentage of the plan’s investment concentrated in non-agency mortgage-backed securities, Saint Vincent’s alleged no additional facts that would allow the court to determine whether that concentration reflected an improper failure to diversify.
Similarly, the amended complaint’s allegation that the portfolio’s percentage of mortgage-backed securities exceeded that of its benchmark was not useful without facts suggesting whether and how the disparity was material to the portfolio’s diversification.
Finally, the court also found insufficient Saint Vincent’s allegation that Morgan Stanley invested more than 60 percent of the plan’s fixed-income assets in a single proprietary fund owned by Morgan Stanley. There was no allegation that the unidentified proprietary fund was the basis for the plan’s losses, nor was there any allegation that the proprietary fund was not itself diversified.
Compliance with Plan Documents
The 2nd Circuit also rejected Saint Vincent’s allegation that Morgan Stanley violated its duty to act in accordance with the documents and instruments governing the plan. Saint Vincent’s alleged that Morgan Stanley breached this duty by deviating from the written investment guidelines, which specified that the plan’s primary investment objective would be the preservation of principal with emphasis on long-term growth to meet the plan’s future retirement liability. However, the amended complaint did not contain any factual allegations showing that Morgan Stanley failed to pursue this long-term growth objective. In fact, although the plan’s guidelines include 13 specific investment restrictions, the amended complaint did not allege Morgan Stanley violated any of those restrictions.
The court also rejected Saint Vincent’s argument that Morgan Stanley failed to act in accordance with the plan guidelines’ provision setting Citigroup BIG as the portfolio’s performance benchmark. The amended complaint did not allege Morgan Stanley was required to replicate Citigroup BIG’s investments. To the contrary, the guidelines stated Morgan Stanley was expected to exceed Citigroup BIG’s returns, anticipating that the portfolio would contain different – and riskier – investments than the benchmark.
State Law Claims
The 2nd Circuit found that the district court did not err in declining to exercise supplemental jurisdiction over the remaining New York-law claims. The court therefore affirmed the dismissal of those claims.
Judge Straub joined in the 2nd Circuit’s decision in part and dissented in part. While agreeing that the district court was correct to dismiss Saint Vincent’s claims for breach of the duty to diversify and breach of the duty to act in accordance with the plan’s documents and instruments, Judge Straub believed that Saint Vincent’s had adequately stated a claim for a breach of the fiduciary duty of prudence.
The dissent found that reasonable inferences drawn from Saint Vincent’s factual allegations render it at least plausible that Morgan Stanley’s process for selecting and managing plan investments was imprudent. Specifically, Judge Straub would have found that, when taken together, Saint Vincent’s “warning signs” allegations constituted contemporaneous information that was available to Morgan Stanley at the time the investments were made, and therefore gave rise to the reasonable inference that Morgan Stanley failed to act prudently.
The Saint Vincent’s case demonstrates the strictness of pleading requirements to be applied to ERISA fiduciary claims of imprudence in investment selection, lack of diversification, and failure to comply with plan guidelines by courts in the 2nd Circuit. The decision is noteworthy because the Court of Appeals tightened pleading requirements in a case that did not involve the Moench presumption of prudence that the court adopted in its Citigroup decision and its progeny. Insureds under fiduciary liability insurance policies and their insurers should take note of the new strengthened defenses available in such cases, which may greatly reduce the exposure these cases present.