Plan Expense Litigation
Some
Surprising Developments
Brennan
Reilly
ERISA
Industry Group of
June 8, 2010
I.
Why Do Plans Need to Worry About Plan Expenses?
A.
Prohibited
Transaction Exemption. As
described in more detail below, the plaintiffs in the plan expense cases allege
that revenue sharing and excessive expenses do not comply with applicable
prohibited transaction exemptions under sections 408(b)(2) and 408(c)(2)
and therefore violate the prohibited transaction rules of section 406 (all
section references are to ERISA except as otherwise noted).
1.
ERISA Section 408(b)(2). Plan service providers are
“parties in interest” with respect to the plan pursuant to section
3(14)(B). Compensating a party in
interest from plan assets[1]
violates the section 406 prohibited transaction rules unless the payment
complies with the prohibited transaction exemption set forth in section 408(b)(2). Specifically, section 408(b)(2) provides
that section 406 does not apply to
[c]ontracting or making reasonable arrangements with a
party in interest for office space, or legal, accounting, or other services
necessary for the establishment or operation of the plan, if no more than
reasonable compensation is paid therefor.
2. ERISA Section 408(c)(2). Compensatory payments to plan fiduciaries are subject to a separate prohibited transaction exemption under section 408(c)(2). Thus, section 406 does not prohibit a plan fiduciary from
receiving any reasonable compensation for services rendered, or for the reimbursement of expenses properly and actually incurred, in the performance of his duties with the plan ….
However, the exemption does not apply to compensation paid from the plan to a fiduciary who already receives full-time pay from the employer or employee association sponsoring the plan (expense reimbursements to such individuals are permissible).
3.
Final Regulations. In 1977 the DOL issued final regulations
under sections 408(b)(2) and 408(c)(2).
The regulations under section 408(b)(2) limit the prohibited transaction
exemption to transactions in which “no more than reasonable
compensation” is paid for the services or office space furnished by a
party in interest. Reg. §
2550.408b-2(a). Regulations under section
408(c)(2) determine what constitutes reasonable compensation. Reg. § 2550.408b-2(d). By its terms, that regulation defines
what constitutes reasonable compensation for services for purposes of both sections
408(b)(2) and 408(c)(2). Reg.
§ 2550.408c-2(a). The general
rule is that the reasonableness of compensation depends on the particular facts
and circumstances of each case.
Reg. § 2550.408c-2(b)(1). In any event, however, compensation is
considered unreasonable if the compensation would be considered excessive under
Treasury regulation section 1.162-7 (relating to the non-deductibility of
excessive compensation). Reg.
§ 2550.408c-2(b)(5). The
deduction standard is an absolute ceiling for reasonable compensation, and is
not the true test for determining the reasonableness of the compensation. The regulations specify that
compensation may be considered unreasonable for purposes of sections 408(b)(2)
and 408(c)(2) even if the compensation is not considered excessive for purposes
of Treasury regulation section 1.162-7.
Finally, the regulations take the position that the exemption under section
408(b)(2) only applies to prohibited transactions under section 406(a) and not section
406(b).[2] Reg. § 2550.408c-2(a).
4. Opinion Letters.
a. Reasonable Compensation. The DOL has generally declined to opine on whether compensation is reasonable because that issue requires a facts and circumstances analysis. See, e.g., DOL Op. Ltr. 79‑42A.
b. Revenue Sharing. Our own Mark Miller obtained the seminal DOL opinion letter regarding the payment of mutual fund 12b-1 fees to a plan trustee. See DOL Op. Ltr. 97-15A. The DOL opined that if a plan fiduciary receives 12b-1 or similar fees from a mutual fund the trustee recommends, the receipt of those fees would generally violate section 406(b)(1). However, if the fiduciary discloses the fees to the plan and offsets its other expenses owed by the plan by the amount of the fees (and refunds any excess), the transaction would not violate section 406(b)(1) (self-dealing) or 406(b)(3) (kickbacks). Moreover, if the trustee is a directed trustee and otherwise not a fiduciary with respect to the selection of mutual funds, the trustee’s receipt of 12b-1 or similar fees from the funds would not violate section 406(b)(1) or 406(b)(3) even if the trustees’ fees are not offset by the amounts received from the mutual funds. The DOL issued similar rulings with respect to non-fiduciary service providers (See DOL Op. Ltr. 97-16A and DOL Op. Ltr. 2003-09A ) and IRA custodians (DOL Op. Ltr. 2005-10A). The DOL opinion letters do not address whether the revenue sharing payments constitute plan assets.
c. Float. The DOL has opined that a trustee’s exercise of discretion to collect “float” on plan distribution checks generally would constitute a prohibited transaction under section 406(b)(1) in the absence of adequate disclosure to the plan. See DOL Op. Ltr. 93-24A. However, the DOL subsequently issued guidance indicating that the collection of float by a fiduciary from funds pending investment or funds pending distribution would not constitute a prohibited transaction if the arrangement is adequately disclosed to the plan and evaluated as part of the total compensation of the fiduciary and if the arrangement contains fixed guidelines that do not allow the fiduciary discretion to affect the amount of its compensation (e.g., fixed timeframes for investing funds or collecting float on distributions). DOL FAB 2002-03.
5. Proposed Regulations. In late 2007 the DOL issued proposed regulations that would have required a plan service provider to provide extensive disclosure of all direct and indirect compensation it receives and any conflicts of interest that arise in connection with providing services to the plan. Prop. Reg. § 2550.408b-2(c). In addition, the service provider would have to disclose any information related to the contract with the plan or the compensation payable thereunder that is requested by the plan administrator for purposes of complying with its reporting and disclosure obligations under ERISA (e.g., Form 5500s). The disclosure obligations would have to be included in a written contract between the plan and the service provider. The regulations also required contracts to be terminable by the plan on “reasonably short notice” without penalty to the plan. Failure to comply with the requirements would result in a prohibited transaction and the imposition of the Code section 4975 excise tax on the service provider (a related proposed prohibited transaction class exemption would have provided relief to plan fiduciaries from certain failures caused by service providers). The DOL attempted to finalize the regulations in early 2009, but the regulations were not approved by the OMB. The regulation was rewritten in 2010 by the new administration, and the DOL informally indicated that it expected the revised regulation to be published (in substantially final form) in May of 2010 (that date has come and gone). Although the regulations remain on the DOL’s semi-annual regulatory agenda, presumably they will not be finalized in their present form if the fee disclosure provisions of the American Jobs and Closing Tax Loopholes Act of 2010 (see below) are enacted.
B.
Fiduciary
Obligations. One of the courts
considering a plan expense case summarized the duty of loyalty under section
404(a)(1)(A) and the duty of prudence under section 404(a)(1)(B) as they relate
to plan expenses as follows: “[f]iduciaries
thus have an obligation to always act in the best interests of the plan, and
that includes determining whether expenses unreasonably detract from investment
returns and overall portfolio performance.”
1. ERISA Section 404(a)(1)(A). Requires plan fiduciaries to comply with a duty of loyalty. A fiduciary must discharge his duties “for the exclusive purpose of providing benefits to participants and their beneficiaries; and defraying reasonable expenses of administering the plan.” (emphasis added)
2. ERISA Section 404(a)(1)(B). Requires plan fiduciaries to comply with a duty of prudence. A fiduciary must discharge his duties
with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man 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.”
3. Proposed Regulations. In 2008 the DOL issued proposed regulations under section 404(a) (and amended regulations under section 404(c)) to require fiduciaries of participant-directed individual account plans to provide uniform disclosure to plan participants of plan-related information and investment information, including detailed disclosure of plan administrative and investment expenses. Prop. Reg. §§ 2550.404a-5; 2550.404c-1. The proposed regulations were issued in part as a response to the District Court decision in Hecker v. Deere & Co. (the regulations specify that the applicable plan fiduciary has an obligation to prudently select and monitor plan service providers and investment options and that section 404(c) does not relieve the fiduciary of that obligation). Like the section 408(b)(2) regulations described above, a final version of the regulations was rejected by the OMB. The DOL has informally indicated that it is rewriting the regulation, and it remains on the semi-annual regulatory agenda for finalization by May of 2011. However, the regulation would likely require additional revisions if the disclosure provisions of the American Jobs and Closing Tax Loopholes Act of 2010 are enacted.
C.
Pending
Legislation. As indicated
above, the American Jobs and Closing Tax Loopholes Act of 2010 (the “2010
Act”) includes disclosure requirements originally included in the 401(k)
Fair Disclosure and Pension Security Act of 2009 introduced by George Miller. The 2010 Act has been approved by the
House and is awaiting approval by the Senate (the bill also includes pension
funding relief that is supported by ERIC and ABC). The proposed legislation would mandate
detailed compensation and fee disclosures by service providers to plans as well
as detailed investment and expense disclosures by plan administrators to
participants (including new quarterly benefit statement disclosures). Service providers would be subject to a civil
penalty or excise tax of up to $1,000 per day for failure to comply with the
disclosure obligations. Plan
administrators would be subject to a civil penalty or excise tax of up to $110
per day per participant for violations of the new disclosure obligations.
II.
What are the Principal Claims in the Expense Lawsuits?
A.
Revenue
Sharing. Plaintiffs in the fee
litigation bring several claims relating to “revenue sharing,” the
practice of mutual fund investment options paying a portion of 12b-1,
sub-transfer, and similar fees to 401(k) plan recordkeepers and trustees.
1.
Excessive Fees. The plaintiffs claim that the revenue
sharing payments do not benefit plan participants and result in excessive fees
paid to plan recordkeepers and trustees, violating the fiduciary duties of
loyalty and prudence. See, e.g., Taylor v. United Technologies Corp., 2009
WL 535779 (D.C. Conn. 2009), affirmed,
2009 WL 4255159 (2nd Cir. 2009). Because of the procedural posture of the
cases (most have been decided upon a motion to dismiss with a few summary
judgment decisions), likely justifications for fee sharing arrangements have
only been hinted at rather than clearly discussed. For those cases that have not been
dismissed upon the pleadings, many sponsors will presumably argue at trial (or
upon summary judgment) that revenue sharing does not violate fiduciary
obligations because the shared expenses would have otherwise been paid by the
plan in the form of higher administrative fees and/or because the participants
receive additional services (e.g., recordkeeping and investment education services). That is, the higher investment fees were
not actually “higher” because the plans received additional
administrative services in exchange for the fees.
2.
Prohibited Transactions. The plaintiffs claim that revenue
sharing payments violate section 406.
Several theories have been offered by the plaintiffs.
a.
The payments to Plan trustees and recordkeepers violate
sections 406(b)(1) (self-dealing) and 406(b)(3) (kickbacks) and section
408(b)(2) does not apply to section 406(b). See Kanawi
v. Bechtel Corp., 590 F.Supp.2d 1213 (N.D. Cal. 2008); but see Dupree
v. The Prudential Ins. Co. of
b.
To the extent the plan sponsor otherwise pays
plan administration fees but the fees are reduced by revenue sharing credits
(consistent with DOL Op. Ltr. 97-15A), the revenue sharing payments result in
indirect “kickbacks” to the plan sponsor in violation of sections
406(b)(1) and/or 406(b)(3). See, Tibble v.
c.
To the extent the fee payments were excessive
and unreasonable, the prohibited transaction exemption under section 408(b)(2)
does not apply. See Braden v. Wal-Mart Stores, Inc. 588 F.3d
585 (8th Cir. 2009).
B.
Failure
to Disclose Expenses and Revenue Sharing.
In addition to the substantive claims regarding revenue sharing the
plaintiffs allege that plan fiduciaries breach their duties of loyalty when
they fail to disclose revenue sharing and other aspects of allegedly excessive
fees. The plaintiffs’
argument is that the failure to make such disclosures constitutes a
“material omission” that is misleading to participants. See, e.g., Braden v. Wal-Mart Stores, Inc., 588 F.3d 585 (8th Cir.
2009) (in addition to revenue sharing, the plaintiffs in Braden alleged that the plan fiduciaries failed to disclose that
the plan’s investment options were more expensive than other investment
alternatives with the same performance benchmarks, that the plan utilized
retail mutual funds even though institutional shares were available, and that
the plan did not evaluate investment options based on the reasonableness of
their fees).
C.
Retail
Mutual Funds vs Institutional Funds or Separate Accounts. The plaintiffs assert that the
payment of higher fees for retail mutual funds is imprudent when lower
institutional fees are available for the same fund or when the plans have the
leverage to instead negotiate for separate accounts. See, e.g., Braden (claiming that an investment in retail shares of the PIMCO
Total Return Fund with an expense ratio of 0.68% was imprudent compared to the
lower expense ratio of 0.43% for institutional shares of the same fund); Tibble v. Edison Int’l (claiming
that retail mutual funds were imprudent compared to the lower cost and better
performing separate accounts they replaced). The plaintiffs also claim that the payment
of 12b-1 fees charged by many retail funds is imprudent because the fees are
mainly used for advertising to attract new customers, and that activity does
not benefit plan participants. See,
e.g., Braden.
D.
Failure
to Capture or Account for Other Revenue.
In addition to the classic revenue sharing claims based on 12b-1
and/or sub-transfer fees, plaintiffs have alleged breaches of fiduciary duty
due to a failure to capture or take into account float, securities lending
fees, finders’ fees, and other fees in setting service provider
compensation. See, e.g., Tibble and Taylor (float); Martin v. Caterpillar,
Civ. Action 1:07-CV-01009 (C.D. Ill. 2008) (securities lending and
finders’ fees).
E.
Use
of Actively Managed Funds vs Index Funds.
Plaintiffs have claimed that index funds are cheaper and perform
better than similar actively managed funds. See, e.g., Braden (claiming that over the period in question, a basket of
similar Vanguard index funds outperformed the actively managed funds in the
Wal-Mart plan by $140 million); Taylor v.
United Technologies (rejecting the same claim on summary judgment because
the relevant issue is procedural prudence with respect to the funds actually
selected, not generic comparison to index funds).
F.
Unitized
Employer Stock Funds. Plaintiffs
have made two claims relating to unitized employer stock funds. First and foremost, plaintiffs have
claimed that the cash component of such funds causes fund performance to lag
compared to direct investments in employer stock. See, e.g., Taylor (holding that the plan administrator’s evaluation of
the merits of retaining cash to provide transaction liquidity satisfied its
obligation of procedural prudence); Tibble
v. Edison Int’l (finding in favor of defendants on summary judgment
because the fiduciaries prudently managed the cash in the fund and because,
given the uncertainty regarding future performance, the cash component of a
fund can decrease volatility); Abbott v
Lockheed Martin Corp., 2009 WL 839099 (S.D. Ill. 2009) (declining to rule
on summary judgment due to a genuine issue of material fact as to whether a
breach of fiduciary duty occurred when cash investments exceeded the 10% ceiling
described in the plan’s prospectus).
Some plaintiffs have also alleged that employer stock fund fees are
excessive.
G. Employer Financial Institutions. Plaintiffs who participate in plans maintained by financial institutions (banks and insurance companies) have filed special expense and fiduciary claims given that the plans typically utilize investment funds managed by the sponsor or its affiliate (e.g., claims that the sponsors used plan assets as “seed money” to start new investment funds). See, e.g., Mehling v. New York Life Ins. Co., 2007 WL 3145344 (E.D. Pa. 2007); see also, Leber v. Citigroup Inc. 2010 WL 935442 (S.D.N.Y. 2010) (discussing the prohibited transaction class exemptions that apply in connection with such claims).
H.
Other
Issues. The discussion below
does not include mainly procedural issues (such as class certification and
standing) raised in the plan expense cases. This outline also generally does not
address the unique issues raised in the fee litigation cases brought solely
against service providers (sometimes by plans). See, e.g., Haddock v. Nationwide Financial Services, Inc., 419 F.Supp. 2d 156
(D.C.
III.
Key Decisions
A.
Hecker v. Deere & Co.
1.
Background. The defendants in the case are Deere
& Company (“Deere”), in its capacity as sponsor and
administrator of two 401(k) plans, Fidelity Management Trust Company
(“Fidelity Trust”), as trustee of the plans, and Fidelity
Management and Research Company (“Fidelity Research”), as
investment advisor and/or manager of the Fidelity mutual funds offered as
investment options under the plans.
Fidelity provided turnkey recordkeeping and investment services to the plan pursuant to a 1990 agreement
(the agreement was modified over the following years to add services and
generally to decrease the administrative fees paid by Deere). Deere was responsible for selecting all
investment options, and agreed to limit the available plan investment options
to funds offered, managed, or advised by Fidelity Research. In addition to 23 Fidelity retail mutual
funds (with retail expenses), the plans offered an employer stock fund, two
proprietary/separate account funds (one a stable value fund) managed by
Fidelity Research, and a “brokerage window” pursuant to which the
participants could invest in any of 2,500 other mutual funds. Deere paid all plan administrative and
trustee costs directly to Fidelity.
The retail investment costs of each investment option were deducted from
fund returns, and thus were paid from plan assets. The summary plan descriptions for the
plans disclosed that participants paid fund-level expenses, including management
fees, 12b-1 expenses, and other fund expenses, the same as other fund
investors. Fidelity Research shared
12b-1 fees with Fidelity Trust, and that revenue sharing was not specifically
disclosed in the SPDs or fund prospectuses.
2.
Claims. The plaintiffs alleged that Fidelity
Trust and Fidelity Research were functional fiduciaries with respect to the
selection of investment options, the investment management of plan assets in
the proprietary funds, and the sharing of mutual fund 12b-1 fees. The plaintiffs then claimed that the
Fidelity defendants and Deere breached their fiduciary obligations by providing
investment options with excessive fees and by failing to adequately disclose
the sharing of fees between Fidelity Research and Fidelity Trust. Although not discussed by the court, a
finding that the Fidelity defendants were fiduciaries with respect to the
selection of investment options would have required offsetting Fidelity
Trust’s administrative and trustee fees by the shared 12b-1 fees for the
arrangement to have complied with the DOL position regarding section 406(b) set
forth in Op. Ltr. 97-15A.
3.
District Court Decision. The District Court granted the
defendants’ motions to dismiss the case for failure to state a claim for
the following reasons. 496
F.Supp.2d 967 (W.D. Wis. 2007).
a.
Fidelity Trust and Fidelity Research were not
plan fiduciaries with respect to the selection of funds because the trust
agreement specifically provided that Deere was responsible for the selection of
investment options.[3]
b.
The disclosures made by the plans in the SPDs
and annual reports accurately reflected the actual investment expenses charged
to the plans (no misrepresentation occurred). ERISA does not presently require the
disclosure of how the expenses were shared after collection by the funds,[4]
and the general fiduciary obligations of ERISA cannot be construed to require
disclosure that is not required by the detailed statutory disclosure
provisions.
c.
Even if Deere violated its fiduciary obligations
by selecting some investment options with excessive expenses (e.g., retail
expenses rather than wholesale expenses), it was relieved of liability under section
404(c) because the plans satisfied the disclosure obligations of section 404(c)
(i.e., section 404(c) only requires the disclosure of aggregate expenses and
not revenue sharing) and because any investment losses caused by the alleged excessive
fees were caused by the participants’ own elections given the large
number of available funds (more than 20 in the plan and more than 2,500 through
the brokerage window).
Not only did Deere and Fidelity
win decisively, the District Court also awarded them costs of over $200,000! Note that the District Court decision
does not address the possible limitations period issues that were decisive in
other cases even though the arrangement with Fidelity dated back to 1990.
4.
7th Circuit Decisions. The 7th Circuit affirmed the
District Court decision and denied a motion for rehearing for the following
reasons (disregarding procedural issues).
556 F.3d 575 (7th Cir. 2009), rehearing denied, 569 F.3d 708.
a.
In an amicus brief, the DOL argued that the claim
that Fidelity was a “functional fiduciary” could not be dismissed
pursuant to a 12(b)(6) motion because the inquiry necessarily required an
analysis of the facts rather than solely the terms of the trust document. The court rejected this argument because
the complaint only alleged that Fidelity “played a role” in selecting
the investment options and did not dispute the provisions of the trust
agreement that gave Deere the final authority to select the funds. The court ruled that “playing a
role” or providing advice could not have made Fidelity a fiduciary if
Deere retained the final authority and discretion to select the investment
options (just as providing advice does not make lawyers or accountants plan
fiduciaries). The complaint would
have had to assert that Fidelity in fact had the final authority to select the
funds to state a claim that Fidelity was a functional fiduciary.
b.
Any discretion exercised by Fidelity Research in
deciding how to split the 12b-1 fees with Fidelity Trust did not make Fidelity
Research a plan fiduciary because the fees, once paid, were not plan
assets. In accordance with the
“plan asset” regulations applicable to mutual funds and other
investments subject to the Investment Company Act of 1940, the plan’s
only assets were the shares of the mutual funds, not the underlying fund
assets.[5]
c.
Deere did not violate its fiduciary obligations
by not disclosing the revenue sharing.
Such a violation requires proving an intentionally misleading statement
(Varity) or a material omission. Deere’s disclosure of the
investment fees actually paid by the participants was accurate (not misleading),
and the failure to disclose that a portion of those fees was shared with
Fidelity Trust (to effectively pay some of the costs of plan administration)
was not a material omission because only the total cost was relevant for
purposes of a participant evaluating the cost of a particular investment.
d.
Even if Deere had a fiduciary obligation to
offer funds with reasonable expenses, Deere satisfied that obligation by offering
a wide array of funds (more than 2,500 after taking into account the brokerage
window) with varying levels of expenses.
ERISA does not require fiduciaries to offer only the cheapest available
funds (which might have other problems).
Note that this conclusion does not depend upon the section 404(c)
defense, it is a substantive reason why Deere did not violate any fiduciary
obligation even if some available funds had relatively high expenses. In denying the motion for rehearing the
court added that another defect in the complaint was its failure to address whether
the plan received additional services in exchange for paying the relatively
higher retail investment fees (such as additional investment assistance or
other services not available to other retail investors).[6]
e.
Deere did not violate a fiduciary obligation by
only offering Fidelity managed funds as the principal investment options for
the plan. ERISA does not require a
plan to offer funds from more than one mutual fund family if diversification is
possible within the family.
Moreover, the decision in the trust agreement to limit the primary
available options to Fidelity funds was more in the nature of a settlor
decision than a fiduciary decision (but the decision did not constitute a
fiduciary breach in any event).
f.
Deere was relieved of liability under section
404(c). Section 404(c) does not
require the disclosure of revenue sharing.[7] More importantly, the court specifically
ruled that section 404(c) provides a defense to a claim regarding fund
selection (a ruling that was implicit in the District Court opinion and that is
contrary to the longstanding DOL position on that issue) as long the fiduciary
asserting the defense includes sufficient range of investment options so that
participant have control over the risk of loss. Hecker
at 13, citing Langbecker v. Electronic
Data Sys. Corp., 476 F.3d 299, 310-11 (5th Cir. 2007) and In re Unisys Savings Plan Litigation, 74
F.3d 420, 446 (3d Cir. 1996). That
is, section 404(c) provides a defense to a claim by a participant who has
invested in a fund, even if the claim is that the fiduciary inappropriately
selected or retained the fund in the plan, as long as other, reasonable
investment options were available. In
this case, the plaintiffs could not reasonably state a claim that no other
reasonable investment options were available given the broad range of available
options with varying levels of investment expenses.[8] In its denial of a motion for rehearing
and in response to an amicus brief
filed by the DOL, the court specified that provisions to the contrary in the
preamble to the section 404(c) regulations and in DOL opinion letters were not
entitled to Chevron deference.[9]
The 7th Circuit also
upheld the cost awards in favor of Deere and Fidelity.
B.
Braden v. Wal-Mart Stores, Inc.
1.
Background. The defendants in this case are Wal-Mart
Stores, Inc. in its capacity as plan administrator of its 401(k) plan, four named
members of the compensation committee of the board of directors of Wal-Mart who
had oversight responsibility for the “Retirement Plans Committee” (the
“RPC”) which was a named fiduciary of the 401(k) plan, three human
resources officers of Wal-Mart who had oversight responsibility for the RPC,
and the RPC and its members. The
RPC selected the investment options offered under the plan. Merrill Lynch was the trustee of the
401(k) plan and allegedly received revenue sharing payments from some of the
mutual fund invest options offered under the plan. However, Merrill Lynch was not named as
a defendant in the case. The
plaintiff was hired in 2002 and became eligible to participate in the plan in
late 2003.[10] During the period covered by the lawsuit
(starting in early 2002 before the plaintiff was hired, but within the six-year
limitations period from the filing of the suit), the plan had 12 investment
options (not all options were available at all times): a proprietary stable value fund, an
employer stock fund, a Merrill Lynch index fund structured as a
common/collective trust, and nine retail mutual funds.
2.
Claims. The Braden
case includes almost all of the claims described above. The plaintiff claimed that Wal-Mart and
the RPC violated their fiduciary duties by selecting (and not appropriately
monitoring) retail funds with excessive fees (including 12b-1 fees), rather
than institutional or proprietary funds; by selecting more expensive actively
managed funds rather than index funds; by permitting Merrill Lynch to receive excessive
revenue sharing payments from the funds that did not reduce other fees paid to Merrill
Lynch; and by not adequately disclosing the excessive fees and revenue
sharing. Much of the complaint is
devoted to charts comparing the mutual fund investment options in the plan to
institutional shares of the same funds, to alternative index funds with lower
fees, and to alternative actively managed funds with lower fees and no 12b-1
fees. In addition, the plaintiff
claimed that the compensation committee of the board and the HR officers with
oversight responsibility for the RPC failed to monitor the RPC and had
co-fiduciary liability for the fiduciary breaches. The plaintiff also claimed that the
fiduciaries engaged in prohibited transactions under section 406 by paying
excessive fees to Merrill Lynch and by allowing Merrill Lynch to receive
revenue sharing payments from the plan investment options that were not used to
offset the other fees paid to Merrill Lynch. The plaintiff’s complaint also
claimed that the 404(c) defense did not apply to the alleged breaches of
fiduciary duty, but that issue was not discussed in the motion to dismiss
decisions.
3.
District Court Decision. The District court granted the
defendant’s motions to dismiss all claims. 590 F.Supp.2d 1159 (W.D. Mo. 2008). On the substantive claims,[11]
the court ruled as follows.
a.
The fiduciary breach claims relating to the
selection and monitoring of investment options were dismissed because the court
ruled that the plaintiff had not plead any facts substantiating his claim that
the defendants had not engaged in prudent process in selecting and monitoring
the investment options. That is,
merely pointing to the outcome of the fund selection process (funds with relatively
higher fees in comparison to other funds) is not sufficient to state a claim of
fiduciary breach based on excessive plan expenses.
b.
The
fiduciary breach claims relating to the failure to disclose revenue sharing and
alleged excessive fees were dismissed because the court ruled that the plan
participants could have made their own fund expense comparisons with other
retail funds and because the fiduciary provisions of ERISA cannot be construed
to mandate the disclosure of revenue sharing when the detailed disclosure
requirements of ERISA do not require such disclosure.
c.
The court dismissed the prohibited transaction
claims because the complaint did not allege the that the total fees paid to
Merrill Lynch (including the fees received from mutual funds) were excessive
compared to the services rendered.
d.
Because the substantive claims failed, the
derivative failure to monitor and co-fiduciary liability claims also failed.
4.
8th Circuit Decision. The 8th Circuit vacated the entire
lower court decision and remanded the case for further proceedings. Much of the decision is based on the
court’s conclusion that the lower court simply misapplied the relevant
standard for evaluating a motion to dismiss on the pleadings. 588 F.3d 585 (8th Cir. 2009).
a.
The court ruled that the lower court ignored
reasonable inferences supported by the facts alleged by the plaintiff and impermissibly
drew inferences in favor of the defendants. Thus, the court ruled that it was
reasonable to infer defects in the process of selecting and monitoring the
investment funds based on the alleged facts (of relatively high fund expenses). In footnotes, the court explained that it agreed with the 7th
Circuit decision in Hecker that ERISA
does not require a fiduciary to select only the cheapest possible investment
options, but that in this case the reasonableness of the inference was
bolstered by the fact that the Wal-Mart plan had a “far narrower range of
investment options” compared to the more than 2,500 available to
participants in the Deere plan.[12] The court explained that the Wal-Mart
defendants would have an opportunity to rebut these inferences by providing
additional facts regarding the selection process, but that it was not
appropriate to dismiss the claims on the pleadings prior to the development of
those facts, particularly because ERISA is a remedial statute and the
defendants, rather than the plaintiffs, hold most of the factual information
needed to determine the validity of the claims.
b.
The court ruled that the plaintiff’s
fiduciary disclosure claims also should not have been dismissed. The court explained that the existence
of revenue sharing could be material because it calls into question whether
funds were selected because of the payments to the trustee rather than on the
basis of performance. The court
reached the same conclusion regarding the other alleged disclosure failures
(the failure to disclose that the plan investment options had higher expenses
than other, comparable funds; that institutional funds could have been selected
instead; and that the RCP did not evaluate funds on the basis of the fees
charged to participants). Again,
the court stated that it was only deciding that the claims could not be
dismissed at this stage of the proceedings (i.e., that the allegations could be
“material omissions” supporting a fiduciary breach claim) not that the
fiduciaries had a per se duty to disclose revenue sharing or other fee
information not otherwise required by law.
c.
The most important procedural decision
made by the court was its reason for deciding that the plaintiff’s prohibited
transaction claims should not have been dismissed. The court’s procedural decision is
so important that it represents a substantive victory for the plaintiff. The court ruled that the plaintiff had
stated a claim for violations of section 406 because the defendants had the
burden of proving that the 408(b)(2) prohibited transaction exemption was
applicable. Thus, the plaintiff
only had to claim that the plan had engaged in transactions in which Merrill
Lynch received revenue sharing payments.
The plaintiff did not have to show that the total compensation paid to
Merrill Lynch was unreasonable given the services rendered. In response to the defendants’
argument that this would make any business between a plan and a service
provider a prima facie prohibited transaction and require ERISA fiduciaries to
defend the reasonableness of every service provider transaction, the court
simply stated that the conclusion was mandated by the terms of ERISA and
binding precedent regarding the allocation of pleading responsibility and by
traditional principles of trust law.
The court also explained that its conclusion was supported because a
contrary ruling would require the plaintiff to plead facts to which he did not
have access (the trust agreement between Merrill Lynch and the plan required
that the amount of revenue sharing be kept confidential).
C.
Martin v. Caterpillar. Although usually cited as a
“significant case” in articles regarding the ERISA fee litigation,
the significance mainly relates to the fact that it represents a rare victory
for the plaintiffs and not because of the legal significance of any particular
decision. Civ. Action 1:07-CV-01009
(C.D. Ill. 2008). Caterpillar
agreed to pay a total of $16.5 million to settle the case. Although the reasons for the settlement
are not entirely clear, one distinguishing factual circumstance compared to the
other employer cases is that Caterpillar started its own, for-profit mutual
fund company, and most of the assets invested in the Caterpillar affiliate mutual
funds were from Caterpillar plans. Therefore,
the case against Caterpillar more closely resembled the cases against financial
institution plan sponsors rather than ordinary employers. Moreover, Caterpillar removed all of the
Caterpillar fund options from the plan after selling its mutual fund affiliate
to T. Rowe Price (allowing the plaintiffs to more persuasively argue that
the funds were only included in the plan for so long as Caterpillar could profit
from them).
IV.
The Surprising Developments
A.
404(c)
Defense.
1.
Section 404(c) Applies to Fund
Selection Claims (at least in the 7th and 3rd Circuits). As described above, the court in Hecker held that section 404(c) provides
a defense to a claim regarding fund selection as long the fiduciary asserting
the defense includes in the plan a sufficient range of investment options so
that participant have control over the risk of loss. Although the court was careful to state
that it was not deciding whether section 404(c) was a defense to an imprudent
selection of funds in every instance, the case has already been cited to
support the application of the section 404(c) defense in the most meaningful context
for employer-fiduciaries: the
“stock drop” case brought with respect to an employer stock
fund. Lingis v. Motorola, Inc., 649 F.Supp.2d
861 (N.D. Ill. 2009) (citing to Hecker
in holding that section 404(c) was a defense to a claim that the Motorola stock
fund was an imprudent investment option because the Motorola plan offered eight
other diversified investment funds that offered participants a wide range of
investment options with varying risk exposure and potential for return). Moreover, another court has held that the
decision by the court in In re Unisys
Savings Plan (section 404(c) applies even when a fiduciary selects an
imprudent investment option) was based on the “plain language” of
section 404(c),[13] and therefore DOL regulations to the contrary are not
entitled to Chevron deference. Renfro
v. Unisys Corp., 2010 WL 1688540 (E.D. Pa. 2010) (citing In re Unisys Savings Plan, 74 F.3d 445
(3rd Cir. 1996). The court also cited legislative history
supporting its conclusion. That
conclusion is more sweeping than the Hecker
court’s conclusion that the preamble and DOL opinion letters are not
entitled to deference because it would also apply to the DOL’s proposed
amendment to the 404(c) regulations described above. Note however, that several courts have
expressly disagreed with the Hecker ruling
on this issue and have held that section 404(c) does not apply to fund
selection claims. See Kanawi
v. Bechtel Corp. 590 F.Supp.2d 1213 (N.D. Cal. 2008) (citing the DOL
preamble to support its holding that section 404(c) does not provide a defense
to claims of imprudent selection of plan investment options); Tibble v. Edison Int’l, 2009 WL
2382340 (C.D. Cal. 2009); Tussey
v. ABB, Inc., 2008 WL 379666 (W.D. Mo. 2008) (citing DiFelice v. U.S. Airways, Inc., 497 F.3d 410 (4th Cir.
2007) and distinguishing the Langbecker
and In re Unisys cases relied upon by
the lower court in Hecker – the
court explains that if “revenue sharing agreements are not disclosed, a
reasonable fact finder could conclude that losses to the Plan as a result of
revenue sharing were not caused by the Plan participant who was ignorant of the
revenue sharing arrangement when he or she chose the investment.”).
2.
Motion to Dismiss Based Upon Section 404(c). In Hecker,
the 404(c) issue was decided on the pleadings even though the defendants
typically have the burden of proof on affirmative defenses. The court permitted the resolution on
the pleadings because the plaintiffs, anticipating the section 404(c) defense,
had specifically plead that it did not apply because the failure to disclose
revenue sharing had corrupted participant investment directions. As a result, the court did not require
the defendants to prove all of the elements of the section 404(c) defense, but
only those disputed by the plaintiffs.
See also, Lingis v. Motorola, Inc.;
Abbott v Lockheed Martin Corp., 2009 WL 839099 (S.D. Ill. 2009) (deciding
on summary judgment that defendants only had to prove compliance with those
404(c) requirements disputed by plaintiffs in their pleadings). Other courts have declined to follow
this procedural aspect of the ruling and have held that because section 404(c)
is an affirmative defense, plaintiffs are not required to negate the defense in
their pleadings, and defendants must generally prove all elements of the
defense.[14] Tussey
v. ABB, Inc.
B.
Statute
of Limitations. The next
surprising issue is the extent to which some courts have construed the statute
of limitations defense to dramatically decrease exposure in plan expense
cases. Courts in the 9th
Circuit have held that “there is no ‘continuing violation’
theory to claims subject to ERISA’s limitation period.” Kanawi
v. Bechtel Corp.; Tibble v.
C.
New
Pleading Standards (the Motion to Dismiss is the New (and Better) Summary Judgment). The large number of plan expense cases
decided on the pleadings (upon a motion to dismiss under Rule 12(b)(6) of the
Federal Rules of Civil Procedure) is a result of two recent Supreme Court cases
regarding the pleading standards of Rule 8(a) of the Federal Rules of Civil
Procedure. Bell Atlantic Corp. v. Twombly, 550
D.
Functional
Standard for Plan Assets. In
one of the plan expense cases brought by a plan sponsor, the sponsor argued
that the defendant service provider Nationwide engaged in section 406(b) prohibited
transactions when it received revenue sharing payments from mutual funds. Haddock
v. Nationwide Financial Services Inc., 419 F.Supp.2d 156 (D.
E. Diversification of Investment Funds. In Young v. General Motors Investment Management Corp., the plaintiffs alleged not only that plan expenses were excessive,[16] but also that the plan fiduciaries had retained several “single equity” funds that were not diversified in violation of the fiduciary duty under section 404(a)(1)(C). 2009 WL 1230350 (2nd Cir. 2009). These funds related to securities received by the various GM 401(k) plans in respect of GM stock in connection with spin-off and other transactions and included an “EDS Fund,” a “DIRECTV Fund,” a “Raytheon Fund,” a “Delphi Fund,” and a “News Corp. Fund.” The funds had been retained in the plans for some time, and no longer constituted “qualifying employer securities” for purposes of the section 404(a)(2) exception to section 404(a)(1)(C). Nevertheless, the 2nd Circuit ruled that the plan fiduciaries had not violated any fiduciary duty because the plaintiffs had only alleged that individual funds were undiversified, and section 404(a)(1)(C) is violated only “when a plan is undiversified as a whole.”
F. Functional Fiduciary Status. As described above, the 7th Circuit in Hecker rejected the DOL position that the claim that Fidelity was a “functional fiduciary” could not be dismissed pursuant to a 12(b)(6) motion because the inquiry necessarily required an analysis of the facts rather than solely the terms of the trust document. The court rejected the argument because the complaint only alleged that Fidelity “played a role” in selecting the investment options and did not dispute the provisions of the trust agreement that gave Deere the final authority to select the funds. The court ruled that “playing a role” or providing advice could not have made Fidelity a fiduciary if Deere retained the final authority and discretion to select the investment options (just as providing advice does not make lawyers or accountants plan fiduciaries). The court explained that the complaint would have had to assert that Fidelity in fact had the final authority to select the funds to state a claim that Fidelity was a functional fiduciary. Such a pleading requirement would have required the plaintiff to prove not only that Fidelity influenced fund selection, but that it effectively made the fund selections notwithstanding the terms of the trust agreement.
G. Prohibited Transaction Exemption Pleading. If the 8th Circuit opinion in Braden is upheld, the burden shifting to treat section 408(b)(2) as an affirmative defense could dramatically increase plan expense prohibited transaction claims against plans and plan service providers (including plan fiduciaries). Rather than requiring plaintiffs to demonstrate that a particular fee arrangement is unreasonable, the burden shifting requires defendants to prove that fee arrangements are reasonable. This makes every plan transaction subject to a valid prohibited transaction claim unless the plan sponsor can demonstrate the reasonableness of the arrangement. Given the fact intensive nature of the demonstrations (likely relying upon expert testimony), the burden shifting would greatly increase the cost of defending plan expense cases.
[1] Of course, to the extent plan services
providers are paid directly by the plan sponsor without any charge to the plan,
the payment cannot violate either section 406(a) or 406(b) without regard to
any underlying revenue sharing. Kanawi v. Bechtel Corp., 590 F.Supp.2d
1213 (N.D.
[2] Courts have disagreed as to whether the regulations are correct given that the text of section 408(b)(2) and 408(c)(2) do not limit the exemption to section 406(a). Cf. Kanawi v. Bechtel Corp. (summarizing the law and stating that the section 408 exemption does not apply to section 406(b) prohibited transactions) and Harley et. al. v. Minnesota Mining and Manufacturing Company, 284 F3d 901 (8th Cir. 2002) (holding that section 408(c)(2) applies to section 406(b) transactions).
[3] See Tussey v. ABB, Inc., 2008 WL 379666 (W.D. Mo. 2008) for the opposite conclusion on this same issue. The court ruled that additional factual development was necessary to determine the fiduciary status of Fidelity Management even though the trust agreement delegated sole authority to select investment options to a committee appointed by the plan sponsor.
[4] As evidence of the fact that ERISA did not currently require disclosure of revenue sharing, the court cited the DOL’s own proposals for amending the disclosure regulations and the Form 5500 to expressly require such disclosure. The court noted that the proposals would not have been required if disclosure were already required by the existing statute and regulations.
[5] As described below, other courts have
held that the plan asset regulation is not dispositive of the status of revenue
sharing payments as plan assets and that such payments can be considered plan
assets using a “functional approach.” See Haddock
v. Nationwide Financial Services Inc., 419 F.Supp.2d 156 (D.
[6] In Braden, described below, the court rejected the use of such reasoning at the motion to dismiss phase because a comparison of the services received to the fees paid requires additional factual development.
[7] The plaintiffs also argued that satisfaction of the many 404(c) requirements cannot be resolved at the motion to dismiss phase. However, the court ruled that the plaintiffs’ pleadings were sufficiently detailed regarding the reasons why section 404(c) did not apply, so that any failure to plead specific failures constituted a waiver.
[8] In its denial of the motion for rehearing and in response to an argument raised in the DOL amicus brief, the court clarified that a plan fiduciary cannot necessarily insulate itself from liability by offering a large number of funds, only some of which are reasonable, and requiring participants to choose from among those funds. The court explained that those were not the facts of the case. The plaintiffs did not claim that the available funds were selected recklessly without regard to quality or reasonableness of fees, but only that the acceptance of retail mutual fund fees was not proper, and that Deere should have negotiated wholesale or institutional pricing instead.
[9] Note that the proposed disclosure regulations under section 404 include amendments to the section 404(c) regulations that would move the preamble statement to the text of the regulations. However, the 7th Circuit decision, unlike the District Court decision, did not rely entirely upon section 404(c) but instead independently dismissed the fiduciary breach claim (the 404(c) defense was an alternative reason for dismissing the claim). Moreover and as described below, the court in Renfro v. Unisys Corp., has ruled that the conclusion in Hecker and Langbecker is mandated by the clear terms of the statute, and that any interpretation to the contrary by the DOL would not be entitled to Chevron deference in any event. 2010 WL 1688540 (E.D. Pa. 2010).
[10] Although not discussed in the court decisions, the fact that the plaintiff was a new participant presumably avoided the limitations period issues that have proved important in other cases. However, if a class were certified, presumably the limitations period issues would be raised by the defendants and could substantially restrict the size of the class.
[11] The court also made a procedural ruling that the plaintiff lacked standing to challenge practices before he became a plan participant. That decision was also vacated on appeal (the 8th Circuit ruled that the plaintiff had standing to bring the claim on behalf of the plan even though he was not a participant during the entire time covered by the suit).
[12] These notes certainly validate the DOL’s stated concern in its amicus brief to the court in Deere: that plans will simply make a large number of funds available to avoid fiduciary breach claims.
[13] The In re Unisys decision was issued prior to the promulgation of the current section 404(c) regulations.
[14] The courts disagreeing with this aspect
of the decision included two lower courts in the 7th Circuit which
issued decisions prior to the Hecker
decision on appeal. See, Martin v. Caterpillar, 1:07-CV-01009
(C.D. Ill. 2008); Spano v. Boeing Co.,
2007 WL 1149192 (S.D.
[15] The decision regarding “attached documents” was not material to the Caterpillar decision because, even without the documents, the court had already ruled in favor of the defendants’ motion to dismiss claims regarding the disclosure of revenue sharing. It appears that the court was merely being conservative regarding the basis of its ruling to provide one less issue for challenge on appeal.
[16] On a motion to dismiss on the pleadings, the lower court ruled that the excessive fee claims were barred by the three-year statute of limitations because all fees had been adequately disclosed to participants more than three years before the suit was filed. 2008 WL 1971544 (S.D.N.Y. 2008). The 2nd Circuit affirmed that decision on other grounds (holding that the plaintiffs had failed to allege that the fees were excessive relative to the services rendered (the standard for similar claims under the Investment Company Act) and had failed to allege any facts relevant to determining whether a fee is excessive under the circumstances).