Chapter 23
Fiduciary litigation
Beginning in 2006, several complaints were filed against very large 401(k) plan sponsors alleging that plan fiduciaries had breached their ERISA duty of prudence “by providing investment options with excessive and unreasonable fees and costs.” (Quoting the Seventh Circuit’s decision in Hecker v. Deere.)
In the prototype 401(k) fee lawsuit, participants sued plan fiduciaries claiming that plan fees—either investment fees or recordkeeping fees or both—were too high, that plan fiduciaries knew it or should have known it, and that because they didn’t do anything about it, they breached their ERISA duty of prudence.
In the first round of litigation, some of these cases were settled; in those that went to judgment, defendant plan fiduciaries often won.
The Problem of Proof
In 401(k) fee litigation, plaintiffs’ lawyers trying to make an ERISA prudence claim face a fundamental challenge: how do you prove that investment fees are too high? This problem is acute with respect to (sometimes high-priced) actively managed funds, in which “star” managers may assemble a “unique” portfolio based on some “unique” expertise (or a special gift). How do you objectively price that value-claim? There is nothing to compare it to.
This problem stymied much 401(k) fee litigation in its early days. Over time, however, plaintiffs’ lawyers have developed effective attacks in several areas:
“Identical Lower Cost Investments”
One of the easiest solutions to this proof problem plaintiffs developed was simply to claim that there was a cheaper version of the exact same fund the plan used. One of the first (if not the first) examples of this “Identical lower cost investment” line of attack was Tibble v. Edison (2010), a case in which the court found that the plan had used a higher-priced retail share class when there was a lower-priced institutional share class of the same mutual fund available.37 The court found:
Plan fiduciaries simply failed to consider the cheaper institutional share classes when they chose to invest in the retail share classes of the William Blair, PIMCO, and MFS Total Return funds. Defendants have not offered any credible explanation for why the retail share classes were selected instead of the institutional share classes. In light of the fact that the institutional share classes offered the exact same investment at a lower fee, a prudent fiduciary acting in a like capacity would have invested in the institutional share classes. [Emphasis added.]
Extending the “Identical Lower Cost Investments” Argument
The key element of the Tibble decision for current litigation is the “identical lower cost investments” line of argument. Plaintiffs’ lawyers have seized on the concept of an alternative share class providing “the exact same investment at a lower fee” and extended it to situations beyond the retail vs. institutional share class at issue in Tibble –
Institutional vs. lower-priced institutional. The complaint in Bell v. Anthem (filed at the end of December 2015) includes a claim that the inclusion of an institutional fund in a plan’s fund menu violates ERISA where there is an identical even-lower-priced alternative institutional fund available. In that case (according to the complaint) the plan included a fund with an expense ratio 4 basis points. Plaintiffs are arguing that ERISA is violated because there was an identical fund available that charged only 2 basis points.
Mutual fund vs. separate account or collective trust. The Anthem and White v. Chevron cases also include a claim that ERISA is violated when a plan menu includes a mutual fund where there is a lower-priced investment vehicle, e.g., a separate account or collective trust, available for the identical investment strategy.
Lower priced alternatives with a similar investment strategy or “style.” This argument has been made (again, in Anthem and Chevron) with respect to actively managed funds—that it was imprudent to select a high-priced actively managed fund of a particular style (e.g., small cap value) when there were lower-priced alternatives pursuing the same style. This claim is given added credibility when the higher-priced alternative underperforms the lower-priced one or the relevant benchmark.
Just to be clear, these are arguments in plaintiffs’ complaints, not court decisions—we do not know whether courts will agree with them.
“Generic Services”—Recordkeeping
While it is (still) a challenge to argue that, e.g., fees for an actively managed fund may be compared to the fees of some other fund managed by different active managers, the courts have been more open to the argument that recordkeeping services are, in effect, a commodity and may be subject to such comparisons. Thus, in Tussey v. ABB, the court compared the per capita recordkeeping costs of defendant ABB’s plan with those of the employee retirement system for employees of the State of Texas, finding on that basis that the recordkeeping fees for the ABB plan were excessive.
Revenue Sharing as a Target
As in many of the lawsuits challenging 401(k) plan recordkeeping fees, the ABB plan used revenue sharing to pay for recordkeeping. Critically, rather than being compensated based on a per capita fee, the ABB plan recordkeeper was compensated by an “assets under management” fee, paid out of the assets in the fund. This practice, while recognized as not per se illegal, presents several problems.
Plaintiffs’ generally claim (and courts seem to agree) that the reasonableness of recordkeeping fees should be determined (and compared) on the basis of something like a flat per participant fee. Quoting a lawsuit filed against BB&T Corporation (Smith v. BB&T Corporation):
The cost of providing recordkeeping services depends on the number of participants, not on the amount of money in participants’ accounts. … For this reason, prudent fiduciaries set recordkeeping fees on the basis of a fixed dollar amount for each participant in the plan, instead of a percentage of plan assets. Otherwise, as plan assets increase (such as through participant contributions and gain on investments), recordkeeping compensation increases without any change in recordkeeping services.
Plaintiffs often focus on increases in assets under management fees resulting from a significant increase in asset values that is not associated with any increase in the number of participants. Some sponsors (and sponsor fiduciaries) have developed strategies to deal with this problem, but those who do not may have some vulnerability to this sort of claim.
The “Best” versus a “Good Enough” Deal
Plaintiffs in these 401(k) plan fee cases seem to believe that ERISA imposes an obligation—with respect to fees for both investment and administration—to get the best available deal for participants. Consider Anthem, the complaint in which participants alleged that sponsor fiduciaries violated ERISA prudence standards by including in the fund menu a fund with an expense ratio of only 4 basis points (0.04%), because an (allegedly) identical fund was available for only 2 basis points (0.02%).
Pushing back on these claims, defendants often cite language from one of the early 401(k) plan fee cases, Hecker v. Deere, that “nothing in ERISA requires every fiduciary to scour the market to find and offer the cheapest possible fund (which might, of course, be plagued by other problems).” Those “other problems” here include (especially) search costs—the expense of finding, and vetting, lower cost alternatives.
There have been cases that, in some version, accept this argument, e.g., the United States District Court for the Northern District of California decisions in White v. Chevron.
The Motion to Dismiss—A Critical Stage in Fee Litigation
The question for a court considering these arguments is: is the mere allegation that there was a cheaper, “identical” (or in some cases, very similar) investment available enough to get plaintiffs past a motion to dismiss? If plaintiffs can survive such a motion, and get to the discovery stage, they can develop more facts and impose litigation costs on defendants—increasing plaintiffs’ chances of a favorable settlement or victory in an ultimate trial on the merits.
In this ongoing argument, the Chevron court sided with the defendants, finding that plaintiffs’ “sole basis for [their ERISA prudence] claim is the assertion that there were allegedly lower-cost institutional-class funds available that could have been substituted for certain higher-cost retail-class funds that defendants selected,” and that that does not constitute “facts sufficient to create a plausible inference that Chevron failed to investigate the merits of the retail-class funds allegedly included in the Plan lineup, or failed to engage in a reasoned decision making process in selecting the funds.”
How Much Fiduciary Effort Will Courts Require?
As of this writing (2018) the courts are, in effect, still struggling over the issue of where to draw the line. If all fiduciaries had to do to find a lower cost, identical fund was to pick up the phone and ask, then not having done so is likely to be significant proof of fiduciary imprudence. How much more—how much greater a search effort—courts will require is an open question.
This issue is particularly acute with respect to recordkeeping, where searching for, vetting and taking on a new recordkeeper involves significant effort. The position plaintiffs are staking out is that recordkeeping should be regularly re-bid—the complaint in Smith v. BB&T Corporation claims that “prudent fiduciaries of large 401(k) plans … put plan recordkeeping and administrative services out for competitive bidding at regular intervals of around 3 years.” Again, it is an open question whether courts will impose such a requirement.
The Vulnerability of Generic Funds and Services to Attack
Finally, an observation. As we said at the top, the greatest challenge for plaintiffs is how to prove that fees are too high. For sponsor fiduciaries, that does not mean that low fees equal safety. The complaint in Anthem demonstrates that plaintiffs are perfectly prepared to attack very low fees if they can demonstrate that there is an identical fund available with even lower fees.
At this stage (at least) in 401(k) fee litigation, the risk is with respect to those funds and services that can be characterized as generic, as commodities, facilitating A vs. B comparisons. The court in Tussey compared the ABB 401(k) plan’s recordkeeping costs with a plan maintained by the state of Texas. The Anthem fiduciaries are being sued with respect to (among other things) the use of a (relatively) low cost index fund.
Special Issue: Company Stock
The other area of significant defined contribution plan litigation risk—besides 401(k) plan fees—is company stock. Oversimplifying somewhat, ERISA exempts DC plan investments from ERISA’s diversification requirements. Many publicly traded companies, typically motivated by Tax Code incentives,38 include a company stock investment option in their 401(k) plans, in some cases initially investing sponsor contributions in company stock.
These investments present a special risk. Because they are not diversified—they are holdings in a single stock—performance can be much more volatile. When a company’s stock drops significantly in value, participants investing in the company stock fund can lose a lot of money. And not infrequently, they look for someone to sue.
Courts have struggled to develop an appropriate standard to apply in these cases.
Fifth Third Bancorp et al. v. Dudenhoeffer
In 2014, in Fifth Third Bancorp et al. v. Dudenhoeffer, the Supreme Court overturned the “presumption of prudence” rule that many courts had applied to these “stock drop” cases. In its place, the Court articulated what might be called a “market price” presumption. Oversimplifying somewhat, the court held, among other things, that a plaintiff cannot sue a fiduciary on the premise that the fiduciary should know, based on public information, that a publicly traded stock is overvalued, absent special circumstances. Quoting the court:
In our view, where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances. ... [A] fiduciary usually “is not imprudent to assume that a major stock market . . . provides the best estimate of the value of the stocks traded on it that is available to him.” [Emphasis added.]
The Court left open the question of what those “special circumstances” might be.
It also left open the possibility of a claim based on an allegation that plan fiduciaries had (or conceivably should have had) non-public (“inside”) information on the basis of which they “knew” (or should have known) that the market was overpricing company stock. In this regard, however, the Court stated:
To state a claim for breach of the duty of prudence on the basis of inside information, a plaintiff must plausibly allege an alternative action that the defendant could have taken that would have been consistent with the securities laws and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it. [Emphasis added.]
Since the Supreme Court’s decision, stock drop litigation has focused on these two issues—the possibility that in a given case there were either “special circumstances” or plan fiduciaries had inside information. Defendants have won most, but by no means all, of these cases, and the courts are clearly still working on the exact scope of these exceptions to a general “market price = prudence” rule.