Considering a Duty to Hedge

The Hartford (CT) CFA Society recently hosted a workshop on “Pension Risk Management and Governance.” The discussion proved to be mostly, though not exclusively, about ERISA and about how plan sponsors may arm themselves against the sorts of litigation it may inspire.

Moderator Martin Rosenburgh, who is both an attorney and a financial analyst, and currently working as a compliance consultant to investment managers, set the tone early. He discussed “fiduciary duty on the strategic level,” saying that most of the case law in which plan managers are found to have violated their duty arises out of the manager “acting affirmatively,” by for example buying over-priced works of art.

But he then asked us to consider the possibility that breaches of duty may arise not just from malfeasance but from non-feasance. What if a fiduciary fails to hedge where he clearly could have? He ran through a hypothetical involving 10-year zero coupon bonds in which the purchase of those bonds was a “clear winner” over the other options available.

Real World Choices

As Rosenburgh immediately acknowledged, the real world is not that simple, and courts have been (appropriately) reluctant to use hindsight to second-guess plan sponsors. Still, he cautioned against the premise that there is a “fiduciary line in the sand” protecting a fiduciary from being in breach for failure to hedge.

ERISA has two fundamental fiduciary duties, a duty of loyalty and a duty of prudence. These statutory duties inspired the Employee Benefits Security Administration of the Department of Labor to issue an important interpretive bulletin, 29 C.F.R. §2509.08-1, in October 2008, offering “supplemental guidance relating to fiduciary responsibility in considering economically targeted investments.” ETIs are plan investments “selected for the economic benefits they create apart from their investment return to the employee benefit plan.” For example, if a pension plan covering construction workers invested in a building project in downtown Hartford in the expectation that the project would create jobs for its members: that would be an ETI.

Specifically, the Department of Labor defined what it called the “rigid rule” that there is to be no trade-off of economic benefits against sponsor responsibilities to the plan itself. Only if two investment alternatives are determined, after deliberation, to be of “equal value” can a sponsor allow such an economic goal to tip its decisions in favor of one over the other. Rosenburgh sees the ETI bulletin as strengthening the case for a duty to hedge.

Other speakers picked up upon and expanded on some of Rosenburgh’s points.

Books and Papers

There was also a good deal of discussion of books and papers. Panelist Gordon Eng, general counsel and chief compliance officer at SKY Harbor Capital Management LLC, said that a tree that falls in a forest unheard makes no sound. Less philosophically, “there are no facts without evidence.” An ERISA sponsor should be able to document its investment decisions in the event they come under fire from regulators or the plaintiffs’ bar, so it can show for example that it deliberated over how a specific decision would affect portfolio diversification, asset liquidity, potential risk and return and (if two choices were seen as of equal value after all that) perhaps that it then studied other economic considerations.

Susan Mangiero, managing director, FTI Consulting, concurred with Gordon’s point, while noting that “you don’t want to document bad procedures” and find a “magic e-mail” showing up in court. She soon clarified that of course you don’t want to engage in bad procedures.

The observation that your books and records should give ammunition to your attorneys, not the plaintiffs’, set off some lively discussion. The general consensus was that, as Eng said, “you don’t want to necessarily document every single word” in a board meeting. But you want to document a weighing of the costs, risks, and benefits of possible courses of action. “Provide that sort of ammunition” to your lawyers, not to theirs.

Plaintiffs’ lawyers were the Banquo at this feast because, as more than one panelist observed, recent statutes and Supreme Court decisions have made it more difficult than it was 20 years ago for securities plaintiffs’ lawyers to overcome various hurdles and contest the merits of a lawsuit in the federal courts. They have learned, though, that they can get a foot in the door in the federal courts by filing an ERISA action, and using the discovery phase of that action to build their securities-fraud case.

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