McB Logo White

Call Us

(213) 600-6077


2022 Oct 28ERISA litigation, self-dealing

-Every 401(k) plan and defined pension plan has an investment advisor. The investment advisor has a fiduciary responsibility to avoid self-dealing. But in active investment strategies, that line can be blurred and easily crossed. The biggest potential for abuse comes in setting (or creating) the performance benchmarks that define an investment return.

The underlying concept in choosing a performance benchmark is the old saying that: “where there is mystery, there is margin.”

Standard Benchmarks. There is no “mystery” in a performance benchmark of public securities–and therefore there is no “margin.” An investment return might be benchmarked to, say, the S&P 500.  As the S&P moves (up or down), so moves the investment pegged to the S&P benchmark. This is one, of many, “standard benchmarks.” There is little, if any, potential for self-dealing abuse here, because the S&P public security benchmark can be readily confirmed in real time. But investment returns based on standard benchmarks do not, by definition, out-perform the general market, since market risk can be readily identified and adapted to by the general market in real time. This is the basic idea behind passive investing.

Custom Benchmarks. The goal of custom benchmarks is often to create “mystery”–to control of information of performance benchmarks based, in whole or part, on non-public information.  Custom benchmarks are often designed to move an investment (up or down) based on the inter-relationship of multiple reference benchmarks–which can be very complex and difficult to understand.  Hence, the “mystery.” (This situation can be made even more opaque if your pension fund is a “collective investment trust” that can evade SEC reporting requirements.)

Winners and Losers. Every securities trade has a buyer and a seller. By definition, one side makes money on the trade, while the other side loses money. And if you lose money in an investment trade made by your fund manager, an important question to ask is who made money on the trade? If the investment manager, or any related company, stands to win on a trade your fund loses on, there is a problem of self-dealing.  In my experience, this is not uncommon. This brings us back to a discussion of custom benchmarks. 

Inter-Related Custom Benchmarks. Custom performance benchmarks often create an inter-dependent relationship between reference securities. The temptation here is to limit the upside for individual investors, or those in a fund, while allowing a greater fall to the downside.  Conversely, downside risk for the counter-party can be protected, with upside benefit enhanced, simply by designing the custom performance benchmark and its securities references.

What to Look For? Custom benchmarks are part of an active management strategy.  These are often found in Collective Investment Trusts, where information need not be reported to the SEC, and therefore remains more opaque.  Beyond that, if your investment advisor, or any affiliated company, is an active buyer or seller of securities, an inference (but not a conclusion) may be drawn that your plan is trading in those securities. This environment suggests a careful due diligence review.

Cui Bono? The age-old question of “who benefits” must always be asked in assessing a fund whose performance is based on custom benchmarks. Does anyone associated with the investment manager stand to profit from transactions that otherwise cause the fund to lose money? If so, a clear case of self-dealing is present. These instances are identified by evaluating trading patterns and securities managers/owners that end up as counter-parties to the pension fund.

If you would like more information on this issue to better evaluate your own 401(k) plan or participation in a defined benefit plan, please contact us at [email protected].





About the Author

Kevin McBride 07 Blog

Kevin McBride is a Commercial Litigation Attorney located in the fascinating city of Los Angeles, California, USA.

He is admitted into three California US District Courts (Central, Southern, and Northern), the US District Court for the District of Utah, the Ninth Circuit Court of Appeals, and the Federal Circuit Court of Appeals. McBride holds a BA degree in Economics from the University of Utah and a JD from the University of Utah College of Law, where he served on the Utah Law Review. He is a member of the Federalist Society and the Federal Bar Association.

Privacy Policy

Legal Notice

Email Us

Attorney Advertising.
Prior results do not guarantee a similar outcome.