Prudential Ret. Ins. & Annuity Co. v. State St. Bank & Trust Co. (In re State St. Bank & Trust Co. Fixed Income Funds Inv. Litig. )

• Decision Date: 01 February 2012
• Docket Number: MDL No. 1945.,No. 07 Civ. 8488 (RJH).,07 Civ. 8488 (RJH).
• Citation: 52 Employee Benefits Cas. 1168,842 F.Supp.2d 614
• Parties: In re STATE STREET BANK AND TRUST CO. FIXED INCOME FUNDS INVESTMENT LITIGATION. Prudential Retirement Insurance and Annuity Co., Plaintiff, v. State Street Bank and Trust Company, et al., Defendants.
• Court: U.S. District Court — Southern District of New York

842 F.Supp.2d 614

52 Employee Benefits Cas. 1168

In re STATE STREET BANK AND TRUST CO. FIXED INCOME FUNDS INVESTMENT LITIGATION.Prudential Retirement Insurance and Annuity Co., Plaintiff,

v.State Street Bank and Trust Company, et al., Defendants.

MDL No. 1945.

No. 07 Civ. 8488 (RJH).

United States District Court, S.D. New York.

Feb. 1, 2012.

MEMORANDUM OPINION AND ORDER

RICHARD J. HOLWELL, District Judge.

Plaintiff Prudential Retirement Insurance and Annuity Co. (“PRIAC”), brought this action pursuant to sections 409(a) and 502(a)(2) and (3) of the Employee Retirement Income Security Act of 1974 (“ERISA”) against defendant State Street Bank and Trust Company (“State Street”) on October 1, 2007. PRIAC commenced this suit as an ERISA fiduciary on behalf of nearly 200 retirement plans (the “Plans”) that invested, through PRIAC, in two collective bank trusts managed by State Street—the Government Credit Bond Fund (“GCBF”) and the Intermediate Bond Fund (“IBF”) (collectively, the “Bond Funds”). This Memorandum Opinion and Order follows a seven day bench trial on the issue of whether State Street breached its fiduciary duty to the Plans by (1) failing to manage the Bond Funds prudently, (2) failing to manage the Bond Funds solely in the interest of the Plans, and (3) failing adequately to diversify the Bond Funds' assets.¹ The Memorandum Opinion and Order sets forth the Court's Findings of Fact and Conclusions of Law in accordance with Federal Rule of Civil Procedure 52. For the reasons that follow, the Court finds that (1) State Street breached its duty to manage the Bond Funds prudently, (2) State Street did not breach its duty to manage the Bond Funds solely in the interest of the Plans, (3) State Street breached its duty to diversify the Bond Funds, (4) State Street's breaches caused losses to the Plans, and (5) PRIAC's calculation of damages is appropriate.

FINDINGS OF FACT

I. The Parties

PRIAC is a Connecticut corporation that was established in 2004 when Prudential Financial, Inc. (“Prudential”) acquired CIGNA Retirement & Investment Services (“CIGNA”) and renamed it PRIAC. (Stipulations of Fact ¶ 1.) PRIAC provides investment options to defined benefit and defined contribution retirement plans; it provides these options to over 7000 organizations and three million participants and beneficiaries.

State Street is a bank organized under Massachusetts law; State Street Global Advisors (“SSgA”) is State Street's investment management arm. (Stipulations of Fact ¶ 4.) SSgA provides asset management services to State Street clients.

State Street managed two collective bank trusts that PRIAC made available to its retirement plan clients: the Intermediate Bond Fund (“IBF”) and the Government Credit Bond Fund (“GCBF”) (collectively, the “Bond Funds”). (Stipulations of Fact ¶ 5.) The Bond Funds were pooled investment vehicles made available to qualified groups of investors. ( Id. ¶ 7.) State Street alone held discretion over the management of the Bond Funds' assets. ( Id. ¶ 5.) PRIAC had no input into State Street's management of the Bond Funds, in State Street's assessment of the risks the Bond Funds incurred, or in State Street's investment decisions for the Bond Funds. ( Id.)

Nearly 200 of PRIAC's retirement plan clients (the “Plans”) invested in the Bond Funds through separate accounts maintained by PRIAC. ( See id. ¶ 16.) PRIAC's role in this regard was to serve as an intermediary between the Plans and State Street. On August 29, 2007, PRIAC requested that State Street redeem the Plan's investments in the Bond Funds. ( Id. ¶ 20.) On October 1, 2007, PRIAC commenced this action on behalf of the Plans seeking to recover losses incurred by the Plans as a result of their investment in the Bond Funds.

II. The Bond FundsA. Benchmarks

Each of the Bond Funds used a Lehman Brothers Index as a benchmark by which the fund's performance could be measured; the GCBF used the Lehman Brothers Government Credit Bond Index, and the IBF used the Lehman Brothers Intermediate Government Credit Bond Index. ( See Stipulations of Fact ¶ 17.) As stated in the Amended Fund Declarations for each Bond Fund, the investment objective of each Bond Fund “shall be to match or exceed the return of the” applicable benchmark index. (DX 467 (for the GCBF); DX 468 (for the IBF).) The Fund Declarations also provided, “At the time of purchase, all securities purchased by the Fund will be rated at or above investment grade by either Standard & Poor's or Moody's Investor Services.” (DX 467; DX 468.)

B. Enhanced Index Funds

A significant amount of the testimony and evidence at trial focused on the meaning of the term “enhanced index fund” and whether State Street presented the Bond Funds to PRIAC as “enhanced index funds.” PRIAC's position is that it reasonably understood from its communications with State Street that the Bond Funds were “enhanced index funds,” which, in PRIAC's view, are funds that seek to “modestly outperform the benchmark while taking on minimal additional risk.” (PX 10; see Tr. 63:17–21 (Blume testimony).) State Street, on the other hand, contends that it did not present the Bond Funds as “enhanced index funds,” but rather as “active” funds, and that, in any event, the term “enhanced index” has no fixed industry definition, so any attempt to use it to establish the character of the Bond Funds would be inappropriate.

1. Definitions: Excess Return Target (Alpha), Predicted Tracking Error, Information Ratio

The Bond Funds' risk and return characteristics can be described with reference to two figures: targeted excess return (or alpha target) and predicted tracking error. Both of these figures are measured in “basis points.” Each basis point represents a 0.01% deviation from the benchmark. The basis points for targeted excess returns represent the margin by which the Bond Funds strove to outperform their benchmark; the predicted tracking error measured the anticipated deviation from the benchmark. Predicted tracking error is a way of measuring the risk of a particular portfolio. Predicted tracking error is the variable that an investment manager can control, while targeted excess return (or alpha target) is a goal an investment manager seeks within the targeted tracking error parameters. ( See Tr. 90:5–7 (testimony of PRIAC's expert Dr. Marshall Blume (“The item that an investment manager can control is the risk's characteristics. The alpha or the expected difference between the returns that you obtain and the index are goals.”)); Tr. 112 (Blume testimony (“I would agree that the alpha is a goal of this fund and the tracking error is the variable that you actually can control.”)).)

A third figure that is relevant to understanding the risk and return characteristics of the Bond Funds is the information ratio. The information ratio is the ratio of a fund's excess return target to its predicted tracking error. ( See DX 10, at 2.) A higher information ratio is indicative of a fund that seeks to achieve alpha without a significant amount of risk. ( See DX 10.) A higher information ratio “can distinguish between the skilled portfolio manager, who achieves outperformance with relatively little risk, from the ‘cowboy’ who achieves outperformance through very high-risk strategies.” (DX 10; Tr. 775:11–14 (Reigel).) An information ratio of 0.5 is reasonable in the investment management industry, ( see Tr. 817:5–7 (Reigel)); an information ratio of approximately 0.7 is “challenging,” ( see Tr. 1092); and an information ratio of 1 is “very optimistic” and arguably unrealistic, (Tr. 127:23 (Blume); Tr. 917:24–918:9 (Armstrong)). Each of these figures is relevant in understanding the parties' dispute about the characterization of the Bond Funds.

2. State Street's Understanding and Use of the Term “Enhanced”

a. Industry Norms

There is no well-established industry-wide definition of an “enhanced index fund.” ( See PX 10.) There also are no well-established industry guidelines for the appropriate alpha target and predicted tracking error of an enhanced index fund. Nonetheless, the evidence at trial established some general principles.

An enhanced index fund generally seeks to “modestly outperform the benchmark while taking on minimal additional risk, thus achieving a high information ratio.” (PX 10; see Tr. 63:17–21 (Blume).) “The investment management industry generally defines enhanced index strategies as investment approaches within predetermined risk and return parameters.” (PX 10; see also Tr. 1187–88 (testimony of State Street's expert Dr. Andrew Carron).) Predicted tracking error for enhanced index funds typically ranges between 25 and 75 basis points. (Tr. 67:7–14.) Predicted tracking error for passive funds generally ranges between 5 and 25 basis points, and predicted tracking error for active funds typically is greater than 75 basis points. ( Id.) Thus, enhanced index strategies are considered to fall somewhere between passive and active strategies. ( See PX 46.) In addition, a fund whose stated investment objective is to “match or exceed” its benchmark fits “the generally accepted definition of what an enhanced index fund is.” (Tr. 460 (Fischel testimony).)

b. State Street's Description of an Enhanced Strategy

A State Street document from the mid–1990s reflects the industry norms discussed above. ( See PX 61.) The document is undated, but footnote references suggest that it was produced around 1996. ( See id.) The document does not mention either Bond Fund by name nor does it represent a contractual agreement about how the Bond Fund would be managed, but it is relevant in assessing State Street's understanding of the term “enhanced.”

The document states, “The objective of enhanced managment [sic] is to add value over the index while mirroring its risk profile. As a result, our strategy combines the predictable strengths of passive management with the repeatable aspects of active management.” ( Id.; see also Tr. 226 (Hatfield...