After the scope of the subprime mortgage crisis became clear in 2007, a number of pension and 401(k) plans with assets invested in subprime mortgage obligations filed lawsuits in federal district court to recover their losses.

They cite a provision of ERISA that holds fiduciaries liable for losses resulting from a breach of fiduciary responsibilities.

Additional lawsuits have been filed against Bear Stearns, Countrywide and other plan sponsors whose 401(k) and employee stock ownership plans were invested in company stock.

As of press time, there have been no decisions on the merits in these cases, but the arguments raised by plaintiffs and the alleged facts raise the possibility that they could lead to changes in the rules of fiduciary responsibility.

State Street litigation

Several lawsuits have been filed against State Street Bank as manager of intermediate and government bond funds that held subprime mortgage obligations. One suit was filed by Prudential on behalf of its customer plans invested in these funds.

This suit alleges that State Street caused losses of roughly $80 million to 165 retirement plans for which Prudential is responsible, affecting 28,000 plan participants. Prudential indicated in a filing with the Securities and Exchange Commission that it had already reimbursed these losses.

Another suit was filed by the New York publishing company Unisystems, Inc.'s employee profit-sharing plan, seeking certification as a class action representing all ERISA plans that invested in State Street bond funds between January 2007 and October 2007. The Unisystems complaint requests that an independent fiduciary be appointed to manage the bond funds.

Legal arguments

These suits might be an attempt to pre-empt suits by participants against the plan sponsors for investing with State Street funds. They raise the same arguments that would be raised as defenses by the plan sponsor or primary adviser in such challenges, namely that State Street violated its obligations under ERISA by imprudently- Prudential also alleges "incompetently" -investing in these funds; by deviating from the conservative investment guidelines it was supposed to be following without disclosing that it was doing so; and by withholding information about the true state of the market until participants were unable to withdraw from the funds because the market had become illiquid.

State Street responded to the subprime suits filed against it by establishing a reserve of $618 million, on a pretax basis, to address its legal exposure. However, according to a recent Bloomberg report, State Street's actual exposure approaches $8 billion.

Two facts relating to the State Street investments may help plaintiffs make their case:

First, the complaints describe the funds as collective trusts made available to plans through separate accounts. When it is managing these investments as an investment manager, State Street is automatically a fiduciary and will be liable if plaintiffs prevail. The difficulty in arguing that mutual fund managers are ERISA fiduciaries may be one reason we have not seen a wave of ERISA suits involving bond mutual fund investments in subprime mortgages yet. Plans can initiate or join securities law class actions to recover subprime losses, such as one filed in Massachusetts against Charles Schwab for losses in its Yield Plus funds.

Second, because plaintiffs allege that State Street marketed the bond funds as conservative investments and deceptively deviated from the investment guidelines it was supposed to be following, misrepresentation - and not just the prudence of these investments - will be at issue.

Prudence under ERISA is determined by looking at what a prudent expert would have foreseen at the time of investment, and there is no list of permissible and impermissible types of investments under ERISA. If a court were to determine that State Street misrepresented the safety of investment in these funds, there could be a liability, even if plaintiffs fail to prove that the risks of the subprime market were known and that these investments were clearly imprudent.

Results uncertain

The cases could be settled without clear resolution of the legal issues. Plaintiffs will not necessarily prevail if they do go to trial. There are hurdles beyond proving the allegations in the complaints. For example, most 401(k) plans are structured so that fiduciaries are not responsible for losses when participants control the investment of their accounts, but plaintiffs will claim that this rule should be inapplicable to the extent participants chose the State Street funds because they were not provided with the information necessary for them to make informed investment decisions.

In addition, class-action certification in the Unisystems suit requires a finding of commonality of claims. Recently, a federal appeals court in another case refused to certify a class action involving 401(k) plan accounts invested by participant election, partly because the accounts had different investment histories.

Surely, the same argument could be raised that each plan - and perhaps each plan account - sought to be included in the Unisystems class has a separate investment history.

Stock drop suits

Another class of lawsuits has been filed against subprime mortgage lenders, including Countrywide and Bear Stearns, by participants whose defined contribution plan accounts plummeted in value as a result of subprime losses.

This type of suit is reminiscent of the Enron litigation, which ultimately ended in a court-approved settlement. Plaintiffs claim that company stock was an imprudent investment and should have been removed as an investment option.

However, the vast majority of decisions in this area have refused to find that company stock investments in troubled employers were imprudent. The decisions hold that, if the plan explicitly requires investment in company stock, fiduciaries are entitled to a presumption that the investment is prudent. This presumption is difficult to overcome, although plaintiffs could prevail if the decline of the company appears to be irreversible. Some courts have refused to require fiduciaries to disclose information about the company to participants if disclosure would violate the U.S. securities laws.

According to a complaint filed against Bear Stearns and named individuals, defendants knew that Bear Stearns stock was overvalued and that there would be inevitable losses from overexposure to subprime mortgages when information about the market became public.

Plaintiffs claim that the defendants knew that company stock was an imprudent and inappropriate investment for the plan. The Bear Stearns ESOP allegedly held over $280 million of Bear Stearns stock, some of which was not invested by participant election. The suit seeks hundreds of millions of dollars in losses. It alleges that Bear Stearns placed the company's interests over the plan participants' interests, misled plan participants and should have engaged an independent fiduciary to make unbiased judgments about the plan investments.

More uncertainty

It is impossible to predict whether the courts will make new law in the Bear Stearns case or similar cases, but it should be noted that ESOPs are designed to be invested primarily in company stock and that plaintiffs should have to show that particular defendants sued as fiduciaries had at least supervisory responsibility for the plan.

It will be interesting to see whether the Bear Stearns case leads to new clarifications of the responsibility to supervise fiduciaries and the duties of prudence and loyalty.