United States: Fiduciary Responsibility in Light of U.S. Mutual Fund Industry Problems

By Paul M. Hamburger and Natalie M. Newton

Originally Published November 24, 2003

During the past several weeks, a number of U.S. federal and state investigations of mutual fund trading practices have resulted in the public disclosure of troubling practices at many well-known mutual fund providers. With nearly one-third of mutual fund assets held in retirement plan accounts and approximately 36 million U.S. households owning mutual funds through employer-sponsored retirement plans, this news has caused a great deal of alarm. Plan fiduciaries, the parties responsible for selecting and monitoring plan investments, are particularly concerned with deciding how to respond to these disclosures--especially in light of the recent heightened scrutiny of fiduciary actions in the post-Enron era.

Who Is Doing the Investigating?

Various state and federal securities law regulators, including the U.S. Securities and Exchange Commission (SEC), have recently launched a widespread investigation into allegedly illegal and unethical practices employed by some mutual fund providers. Several funds have already been named in targeted investigations, and some have begun to negotiate remedial measures with the SEC. However, the allegations are still being investigated and pursued, and more mutual fund providers may still be named. As the number of mutual funds involved increases, more retirement plans will be affected.

Most recently, the U.S. Congress is considering legislation to address the problems of illegal after-hours trading and improper market timing. If enacted, this legislation may affect the way 401(k) plan investments are handled in the future. The current proposals include specific rules to address concerns of the 401(k) plan industry. Fiduciaries should continue to monitor these legislative developments.

Additionally, the Investment Company Institute, which is an influential regulatory body that is not slowed by the constraints of congressional legislation, has proposed a number of regulatory changes to the SEC. The most significant proposed rule would require all mutual fund transactions to be received by the mutual fund itself by 4:00 p.m. EST. The proposed changes would have a hard-hitting impact on the current system of trading, especially for those on the West Coast that, because of the time it takes record keepers to audit, reconcile and batch trades, may be relegated to next-day trading status only.

The charges being investigated primarily relate to "after hours" trading and market timing. "After hours" trading is the illegal practice of accepting a trade order after 4:00 p.m. EST at that day’s market price in violation of a legal requirement that orders placed after 4:00 p.m. EST must be made at the next day’s price. Market timing is a method of taking advantage of price fluctuations in the stocks underlying a mutual fund that are often not reflected in the mutual fund’s value until the next day. Some providers have noted increased market timing activity in international mutual funds. Market timing is not illegal per se, but it may be a securities law violation if the fund has policies against market timing set forth in its prospectus or if the fund allowed some fund shareholders to participate, but not others. Another negative impact of market timing is the increased administrative costs to the fund that can cause all fund shareholders to suffer from a lower overall rate of return.

As the effects of this widespread investigation takes shape, plan fiduciaries must consider how to respond. Fiduciaries should not overreact or act too quickly out of panic. As a rule, ERISA requires that fiduciaries act with the "care, skill, prudence, and diligence under the circumstances then prevailing" that a prudent person "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."

To satisfy their ERISA fiduciary responsibilities, fiduciaries should review the mutual fund investments held by their plans and determine whether the investments continue to conform to the plan’s investment policy. In addition, the fiduciaries should decide whether it is appropriate to consider removing the investment fund from the plan’s investment matrix.

Just as the original investment decision should have been carefully reviewed and evaluated by the plan fiduciary (in a manner consistent with the plan’s investment policy), the ongoing monitoring function also must be carefully and completely documented. As the circumstances and the market climate change, a fiduciary must continually evaluate whether or not it is appropriate for a plan to continue to use a previously selected mutual fund.

The fiduciary of a plan invested in a mutual fund that is under investigation must consider whether to replace the fund, pursue a claim on behalf of the plan participants and/or communicate the related issues to plan participants. Rash decisions based on media headlines do not comply with the prudent person standard and must be avoided. The effects of any investigation may be limited and a fund might provide restitution or otherwise make sure that investors are not disadvantaged.

On the other hand, if a large number of investors withdraw from an investment fund, the fund’s performance could be impaired and fees could be increased significantly for the remaining fund shareholders. Additionally, a highly publicized scandal may cause a fund to lose key personnel, and these events may affect the fund so substantially that it is no longer an appropriate plan investment. These are just some of the key factors for the fiduciary to consider.

Generally, before changing mutual fund providers, a fiduciary should analyze the following issues:

• whether the reasons the fiduciary selected a particular fund for investment are still valid, even if no changes result from an investigation;

• whether there is reason to believe a particular mutual fund has engaged in any of the improper conduct; and

• whether any other mutual funds in which the plan would invest (assuming a fund change is appropriate) are also engaging in improper activity.

Additionally, a plan fiduciary should consider contacting the plan’s mutual fund providers (directly or through an investment consultant hired by the fiduciary) to advise the fund that the plan must be kept informed of developments as they occur. If a mutual fund is going to provide restitution to shareholders for SEC violations, a plan fiduciary should ensure that the plan receives its share of any restitution award.

Even if the plan’s mutual fund provider has not been targeted for investigation, it is important for a fiduciary to evaluate and reconsider investment decisions. A fiduciary is required to monitor plan investment performance and practices. One approach to follow is to send a letter to the fund manager asking for the following:

• Written assurance that the fund and its employees have not participated in suspect trading activities;

• Written assurance that the fund is not aware of any ongoing investigation of its trading practices;

• A copy of any public statement related to the recent allegations the fund has issued or plans to issue; and

• A copy of the fund policies and prospectus.

If market timing by plan participants is affecting the plan’s investment return for a particular investment fund, it may be advisable to consider taking steps to address the problem. There are a number of potential solutions that vary widely in their degree of restrictive impact on plan participants. All options should be carefully considered in light of the ERISA Section 404(c) regulations that protect plan fiduciaries from participant investment decisions as long as (among other technical requirements) participants may redirect investments at a frequency commensurate with the investment risk of the fund.

Fiduciaries should be sure to document the steps taken to monitor investment fund performance and the decisions made due to the fiduciary evaluation. Satisfying ERISA fiduciary duties requires diligent and thorough actions by the fiduciary to monitor investments and document all decisions. Such documentation can help the fiduciary demonstrate that the fiduciary acted in the best interest of the plan and plan participants.