Two new suits have been filed against State Street Bank alleging that it breached fiduciary duties under ERISA by investing retirement plan assets in sub-prime mortgage products through one or more bond funds it operates. These suits contend that State Street served as investment manager for a number of plans that invested in one or more of its bond funds, which in turn invested in mortgage-backed securities contrary to the conservative investment strategies these funds advertised.
Prudential v. State Street
The first such suit was filed on October 1, 2007, by Prudential (through a subsidiary) against State Street (and one of its subsidiaries). The suit alleges that Prudential Retirement is a provider of retirement products and services to pension plans and offers to its clients a bond fund (structured as a bank collective trust) offered by State Street. According to the suit, this State Street bond fund was advertised as a conservative investment option offering “stable, predictable returns.”
However, State Street allegedly deviated from its announced investment strategy by investing in mortgage-related financial instruments, including derivative products contingent on the performance of home equity loans and other mortgage-backed securities. Prudential alleges that State Street did not disclose this change in its investment strategy or that the risk characteristics of the fund had changed.
According to the complaint, in a two-month period starting on July 1, 2007, the benchmark indexes increased by 3 percent and 2 percent while the corresponding State Street bond fund returns declined by 25 percent and 12 percent, respectively. Prudential seeks to recover the losses realized through investment in this bond fund for each of its plan sponsor clients. However, Prudential has not sought to proceed as a class representative.
Unisystem v. State Street
The second suit was filed on October 17, 2007, by Unisystems, Inc. (a book publisher). The suit was filed as a putative class on behalf of all retirement plans that invested in State Street’s bond fund. Like Prudential, Unisystems alleges that State Street breached its fiduciary duties under ERISA by undertaking an allegedly “high-stakes gamble” in risky mortgage-backed securities through its bond funds.
Unisystem alleges that the State Street bond fund lost up to 40 percent of value when the market for mortgage-backed securities collapsed in August. Unisystems seeks to recover on a class-wide basis the losses any ERISA plan realized as a result of investments in the State Street bond funds.
The emphasis on the alleged investment strategy change is similar to the allegations contained in a new non-ERISA suit filed by MetroPCS against Merrill Lynch stemming from investments in mortgage-related investments. Similarly, there have been recent news reports of losses on investments in higher risk structured investment vehicles through money market funds.
Is This A New Trend?
It is no secret that the losses generated by investments in sub-prime mortgages will generate substantial litigation. Where such investments were made through ERISA plans, it is likely there will be attempts to recover losses under ERISA.
At first blush, it may even appear that suits such as these portend a huge wave of ERISA litigation. Surely a large number of investments in ERISA-governed retirement funds had significant exposure to sub-prime mortgages.
There are, however, several factors that suggest we may not see a massive proliferation of such suits under ERISA. First, the allegations of the current suits focus heavily on the alleged change in investment strategy and corresponding change in the fundamental risk characteristics of a supposedly conservative investment. It may be much more difficult to challenge investments in mortgage-backed securities where such investments are generally consistent with the funds’ publicly-disclosed investment strategy.
Further, it is noteworthy that suits of this type were brought against collective investment trusts, which are exempt from the Investment Company Act of 1940. 15 U.S.C. § 80a-3(c)(3); Bd. of Governors of the Fed. Reserve Sys. v. Inv. Co. Inst., 450 U.S. 46, 55 n.19 (1981). Similar suits may not be possible against investment companies registered under the Investment Company Act of 1940 (such as mutual funds) because of ERISA’s special exemptions for such companies.
For example, § 3(21)(B) of ERISA provides that the investment of pension plan funds in securities issued by a registered investment company does not of itself cause the investment company, its adviser or its underwriter to be deemed a fiduciary or party in interest. 29 U.S.C. § 1002(21)(B). Further, where a plan invests in a security issued by a registered investment company, the assets of the plan include the security, but do not include (solely by reason of such investment) the underlying assets of the investment company. 29 U.S.C. § 1101(b)(1). These provisions may shield mutual fund companies from the type of allegations contained in the recent suits.
Nevertheless, these suits are a highly interesting development in the ERISA litigation area. The recent wave of ERISA litigation, which focuses on the fees plan participants pay through the expense ratios of various investment products, has called attention to the fiduciary responsibility to select prudently and monitor pension plan investments. The new suits represent an expansion of that focus to investment performance as well as price. It is likely that future suits (whether by focusing on mortgage-backed securities or otherwise) will intensify this focus.