District Court dismisses Chevron fee complaint

September 08, 2016

On August 29, 2016, the United States District Court for the Northern District of California dismissed plaintiffs’ complaint in White v. Chevron. The court rejected (among other things) plaintiffs’ argument that the plan’s fiduciaries’ inclusion in a 401(k) plan fund menu of “high-priced share classes of mutual funds, instead of identical lower-cost share classes of those same mutual funds” constituted a breach of ERISA’s prudence standard.

In this article we discuss the court’s analysis and holding with respect that issue.

Background

In a number of recent 401(k) fee complaints, plaintiffs’ lawyers have argued that the inclusion in a fund menu of a higher-cost fund, when there was “an identical lower-cost fund” available, constitutes a breach of ERISA’s prudence standard. The Anthem complaint provides an extreme example: in that case, plaintiffs alleged that the use of an S&P 500 index fund with an expense ratio of 4 basis points violated ERISA where there was an identical fund available for only 2 basis points.

The Chevron complaint contains a similar (if somewhat less extreme) allegation: that Chevron fiduciaries “selected high-priced share classes of mutual funds, instead of identical lower-cost share classes of those same mutual funds which were readily available to the Plan.” (Emphasis in the original.) In Chevron (as in, e.g., Anthem) this allegation is made with respect to the use of (i) retail vs. (cheaper) institutional funds/share classes and (ii) higher-priced vs. lower-priced institutional funds. Plaintiffs also assert that identical investment results could be achieved by the use of less expensive “non-mutual fund alternatives, such as collective trusts and separately managed accounts.”

The court’s decision

In dismissing plaintiffs’ complaint, the court rejected these arguments, holding that:

Plaintiffs’ contention that the Plan fiduciaries should have offered cheaper share classes of the funds actually included in the Plan's investment lineup is based on the assumption that the mere inclusion of a fund with an expense ratio that is higher than that of the lowest share class violates the duty of prudence. This claim, standing alone, is insufficient to state a claim that fiduciaries imprudently failed to consider lower cost options.

To survive a motion to dismiss, plaintiffs would have to show “facts supporting the inference that the fiduciaries’ process for selecting the fund options was flawed.” In this regard the court cited as an example Tussey v. ABB, “where an outside consulting firm advised the administrator it was overpaying for Plan recordkeeping services and cautioned that the revenue sharing the recordkeeper received under the Plan might have been subsidizing other corporate services the recordkeeper provided to the administrator.” No such additional facts were alleged in this case.

Retail funds/share classes may have features that justify their use

In rejecting plaintiffs’ argument, the Chevron court held that: “Fiduciaries have latitude to value investment features other than price (and indeed, are required to do so), as recognized by the courts. … ERISA does not require fiduciaries to ‘scour the market to find and offer the cheapest possible funds (which might, of course, be plagued by other problems).’” (Quoting Hecker v. John Deere.)

With respect to the use of retail vs. institutional share classes, the court stated:

In Hecker, the Seventh Circuit found “nothing in the statute that requires plan fiduciaries to include any particular mix of investment vehicles in their plan,” and rejected the argument that a plan administrator is required to offer only institutional-class funds, noting that retail-class funds, being open to the public, give participants the benefits of competition. … In Loomis, the Seventh Circuit repeated this point, explaining that because retail funds are offered to investors in the general public, their expense ratios are necessarily set against the backdrop of market competition, which benefits participants; in addition, they are highly liquid, unlike institutional vehicles.

With respect to the (possible) use of collective trusts and separate accounts, the court quoted Tibble vs. Edison: “[a] pension plan that directs participants into privately held trusts or commingled pools . . . lacks the market-to-market benchmark provided by a retail mutual fund.”

A wide range of funds may include some higher-priced funds

The court also argued that the existence of some lower-cost funds may justify the inclusion of some higher-cost funds:

Plan fiduciaries provided a diverse mix of investment options and expense ratios for participants. The breadth of investments and range of fees the Plan offered participants fits well within the spectrum that other courts have held to be reasonable as a matter of law.

This analysis is explicitly adopted (again) from Hecker. The Seventh Circuit, in Hecker, held that a fiduciary could not be faulted for providing a fund menu that included a “wide range of expense ratios,” with the implication that it was, in effect, “OK” to provide some higher-priced funds (which “were also offered to investors in the general public, and so the expense ratios necessarily were set against the backdrop of market competition”) so long as the fund menu included lower-priced alternatives.

The Department of Labor, in an amicus brief, took issue with the latter holding, and, in a somewhat elliptical decision denying a request for a re-hearing en banc, the Seventh Circuit “clarified” its decision:

The Secretary [of Labor] also fears that our opinion could be read as a sweeping statement that any Plan fiduciary can insulate itself from liability by the simple expedient of including a very large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them. She is right to criticize such a strategy. It could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It also would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives. The panel's opinion, however, was not intended to give a green light to such “obvious, even reckless, imprudence in the selection of investments” (as the Secretary puts it in her brief). Instead, the opinion was tethered closely to the facts before the court. Plaintiffs never alleged that any of the 26 investment alternatives that Deere made available to its 401(k) participants was unsound or reckless, nor did they attack the BrokerageLink facility on that theory. They argued – and especially in their Petition for Rehearing they continue to argue – that the Plans were flawed because Deere decided to accept “retail” fees and did not negotiate presumptively lower “wholesale” fees. The opinion discusses a number of reasons why that particular assertion is not enough, in the context of these Plans, to state a claim, and we adhere to that discussion.

How much comfort can fiduciaries take from this decision?

Some observations: In Chevron, the court is, in effect, allowing an explicit price difference – that is, allowing plan fiduciaries to require participants to pay a higher price (by using a retail rather than an institutional share class) for an “identical fund.” It is not requiring the defendant fiduciaries to provide any evidence that the price difference is justified – the benefits of using a higher priced share class are simply assumed.

How much comfort can plan fiduciaries take from this decision?

First, with respect to retail vs. institutional share classes of the identical fund, is the court’s assumption – that retail mutual funds include benefits that offset their higher costs – reasonable? In some places, the court seems to blur the issues presented by the use of different funds with the issues presented by the use of different share classes.

And, is the court’s description of the alternative – fiduciaries having to “scour the market to find and offer the cheapest possible funds” – reasonable? What about a case like Tibble v. Edison, in which the fiduciary did not even make a phone call to find out if a cheaper fund was available? In this regard, might it not be reasonable to argue that a fiduciary should be expected to prove some justification for the higher price?

Second, will plaintiffs’ lawyers (who have thus far proved themselves both persistent and creative) find a way to challenge the court’s assumption, by (i) proving (somehow) that retail funds/share classes do not provide additional benefits, (ii) proving that whatever benefits they do provide are not worth the additional cost or (iii) or shifting the burden of proof back on the plan fiduciary (so that the fiduciary would have to justify the additional cost)?

Finally, is it possible that, whatever the case today, innovations and competition will change the facts the Chevron court is assuming?

What is the standard?

As we noted at the beginning of this article, plaintiffs in one high-profile lawsuit (Anthem) have alleged that it is a fiduciary breach to include an S&P 500 index fund in a plan’s fund menu with an expense ratio of 4 basis points where an identical fund is available for 2 basis points.

On the other hand, the Chevron court describes the fiduciary as having “latitude to value investment features other than price (and indeed, are required to do so).” In this context, many plan fiduciaries are asking: exactly what is the standard?

The answer is: we do not know. But we are, over the next couple of years, going to find out, as these two very different theories of a fiduciary’s duty with respect to fund menu construction battle it out in the courts.

We will continue to follow this issue.

October Three Consulting, LLC is a full service actuarial, consulting and technology firm that is a leading force behind the reemergence of defined benefit plans across the country. A primary focus of the consultants at October Three is the design and administration of comprehensive retirement benefits to employees that minimize the financial risks and volatility concerns employers face.

Through effective plan design strategies October Three believes successful financial outcomes are achievable for employers and employees alike. A critical element of those strategies is the ReDB® plan design. The ReDefined Benefit Plan® represents an entirely new, design-based approach to retirement and to the management of both the employer’s and the employee’s financial risk, focusing on maximizing financial efficiency and employee value.

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