Recent Mutual Fund Developments-What Should A Retirement Plan Fiduciary Do?

By John E. Rich, Jr.

December 2003

Recently, a number of securities regulators have announced investigations and have brought charges relating to the trading practices of several mutual fund providers and financial services companies. These investigations raise a number of issues for employers who utilize mutual funds as investment vehicles for retirement plans.

Overview of Allegations
The current allegations generally involve two types of practices, “late trading” and “market timing”. Late trading involves the purchase or sale of mutual fund shares after the 4:00 p.m. "cut-off" time for orders based on that day's fund values. Late trading violates federal securities laws and can dilute or devalue the interests of other shareholders. Market timing takes advantage of price changes in the stocks underlying a mutual fund that are often not reflected in the mutual fund's value until the next day. Market timing itself is not illegal but can violate securities laws if the mutual fund has policies against market timing in its prospectus or if only selected shareholders are allowed to market time.

Federal Law Governing Fiduciary Responsibilities in Retirement Plans
The Employee Retirement Income Security Act of 1974 (“ERISA”) requires employers and other fiduciaries associated with 401(k) and other types of retirement plans, to act solely in the interests of plan participants and beneficiaries. Fiduciaries must act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting as a fiduciary and familiar with retirement plan matters would use to manage a retirement plan. As a result, fiduciaries must make a careful inquiry into the merits of any investment offered by the retirement plan. This inquiry must include consideration of all fees and expenses paid from plan assets. If the fiduciaries do not have sufficient knowledge to evaluate investments, the fiduciaries must obtain expert advice in making the decision.

Fiduciaries also have a continuing duty to monitor the investments selected. In the case of a 401(k) plan that allows employees the opportunity to self-direct their own accounts among various mutual funds, the fiduciaries must monitor and evaluate whether it is prudent to continue to offer the original funds. Employers should adopt a written investment policy statement containing the standards for investment selection and monitoring criteria. ERISA provides that fiduciaries are responsible for reimbursing a retirement plan for losses that are incurred if the fiduciaries have not complied with their responsibilities.

What Fiduciaries Should Do in the Current Environment?
Given the broad scope of the current investigations, as part of their duty to monitor plan investments, fiduciaries need to consider whether to investigate or review the practices of the funds owned by their plans regardless of whether any currently implicated funds are owned. If a plan owns a fund that has been implicated, some action is required. The fiduciaries need to consider whether to replace the fund, pursue a claim against the fund on behalf of the plan participants and whether to disclose to participants that the fund is under investigation.

The first step is to review public information and request specific information from independent investment consultants and, where possible, fund managers about the funds' trading practices, trading policies, results of internal investigations and actions management is taking to remedy any damages to investors and prevent future abuses. The fiduciary needs to determine if the ratings of the fund have been affected, whether there have been any personnel changes or significant out flows of money from the fund or any other events that will have an adverse impact on the fund. The fiduciary needs to analyze (or hire an investment professional to analyze) whether the investigation itself is likely to result in a significant loss in the value of the mutual fund. Before a fiduciary considers withdrawing the plan's investment from suspect funds, the fiduciary needs to consider the transaction costs associated with the replacement of the funds and the likelihood that the replacement fund company could be targeted in future investigations.

There are numerous other questions that should be asked. If plan fiduciaries do not have the expertise to evaluate the information and analyze the alternative courses of action, investment and legal advisors should be consulted to ensure that plan fiduciaries are acting prudently.

It is important to keep in mind that a fiduciary does not always have to make the right decision. In the case of whether to retain a fund implicated in the trading scandal, the impact of the investigations on the fund's performance may not be known for several years. The legal standard is whether the fiduciary’s action and conduct led to a well-informed decision. If a fiduciary diligently investigated the relevant information, a court will generally uphold the fiduciary’s judgment even if in hindsight it is possible to conclude that the fiduciary did not make the correct decision. In order to prove that a prudent decision-making process was utilized, the fiduciary should document the process followed in writing.

In summary, the current mutual fund scandals serve as a good reminder that retirement plan fiduciaries must continually monitor the investments associated with their plans. When special circumstances arise, such as the current mutual fund scandals, fiduciaries must make additional inquires in order to comply with their fiduciary duties.

John E. Rich, Jr. is a Director at McLane, Graf, Raulerson & Middleton, Professional Association. Mr. Rich is a frequent speaker on employee benefit plan and pension, estate planning, and tax-related topics, and can be contacted directly at (603) 628-1438, or by email at john.rich@mclane.com.