Litigation with respect to in-house funds

March 16, 2017

There have been a number of recent lawsuits brought against financial services companies alleging prohibited ERISA “self-dealing” with respect to the use of proprietary funds and services for plans they maintain for their own employees. Those self-dealing issues are, generally, unique to financial services company in-house plans. But (and, it turns out, more significantly) these cases also typically involve allegations of breaches of ERISA’s loyalty and prudence standards, and those sorts of claims are also at the heart of “non-financial services company” 401(k) plan fee litigation.

In this article we review the issues presented by these cases for plan fiduciaries – both fiduciaries of financial services company in-house plans and “regular” plan fiduciaries. We illustrate these issues by considering the recent (February 27, 2017) decision by United States District Court for the Western District of Missouri denying defendants’ motion to dismiss in Wildman v. American Century.

Wildman prohibited transaction/self-dealing issue

In Wildman, plaintiffs’ complaint included a claim that the revenue sharing arrangement between the plan and American Century affiliates constituted a prohibited transaction (self-dealing) under ERISA. There are class exemptions available for the use by financial services companies of proprietary products in in-house funds. Relevant here, Prohibited Transaction Exemption 77-3 provides an exemption for mutual fund in-house plan investment in a proprietary fund. And defendants asserted PTE 77-3 as a defense to plaintiffs’ PT claim.

These exemptions are, however, subject to certain conditions – for instance, PTE 77-3 requires (among other things) that the plan get as favorable a deal with respect to in-house funds as other (non-plan) shareholders. And some of the financial services company litigation includes allegations by plaintiffs that, e.g., one of these conditions has not been satisfied and that therefore the in-house plan investment constitutes (non-exempt) prohibited self-dealing.

In Wildman, “the amended complaint alleges American Century introduced a lower-cost share class for several of its funds and that share class was available to other employer-sponsored plans, but Defendants failed to timely convert Plan assets to this lower-cost share class.” The court, in denying defendants’ motion to dismiss on this claim, found that that allegation was sufficient to raise an issue of fact about whether American Century had complied with the requirements of PTE 77-3.

Fiduciaries of financial services company in-house plans that use proprietary products/services will want to familiarize themselves with available exemptions and assure themselves that all necessary requirements have been met.

Other companies (non-financial services companies) will generally not have this issue – that is, they generally will not be providing investment or recordkeeping services to their plan. (Some companies may bill certain direct expenses to the plan. In a follow-on article we will discuss that issue.)

Critically, though – even if there is an exemption available for the ERISA prohibited transaction presented by the use of proprietary funds or services – plan fiduciaries must still meet ERISA’s general loyalty and prudence standards. And as we’ll see, plan fiduciaries of in-house plans are, if anything, more vulnerable to those sorts of claims than “regular” plan fiduciaries.

Breach of duties of loyalty and prudence issue

Those familiar with 401(k) plan fee cases brought against non-financial services companies will already be aware of the sorts of loyalty and prudence claims raised by plaintiffs in the in-house funds cases (see our article Fee litigation – sponsor fiduciary vulnerabilities).

Generally, these cases involve either or both of: claims that plan recordkeeping fees are high relative to what plans of comparable size pay; and claims that investment fees are high relative to allegedly “identical” or “comparable” funds.

Recordkeeping fees

As we have discussed in prior articles, the former claim, with respect to recordkeeping fees, has generally been easier for plaintiffs to credibly allege. Some courts are prepared to regard recordkeeping fees as to some extent generic and to judge whether plan fiduciaries acted prudently by comparing fees paid by the defendant plan to fees paid by other, similarly sized plans. The classic case on this issue is Tussey v. ABB, in which the court, in finding that plan fiduciaries had violated their duty to prudently “shop” for recordkeeping services, accepted plaintiffs’ comparison of the fees paid by the ABB plan with the (lower) fees paid by a 401(k) plan for Texas state employees.

Another typical feature of these claims: the defendant plan often pays for recordkeeping with an assets-under-management revenue sharing arrangement which is then compared to an alleged “standard” per-participant recordkeeping fee.

Thus, in Wildman, plaintiffs claimed that:

Tussey appeal decided by Eighth CircuitBased on … the Plan’s investments, the nature of the administrative services provided, and the Plan’s participant level (roughly 2,000 to 2,300 during the statutory time period), and the recordkeeping market, the outside limit of a reasonable recordkeeping fee for the Plan from 2010 to the present would have been between $50 and $60 per participant. … But the [revenue sharing-based] recordkeeping fees paid by the Plan greatly exceeded this amount.

The court found plaintiffs’ allegations on this issue sufficient to survive defendants’ motion to dismiss.

Investment fees

Plaintiffs have generally had a harder time proving that investment fees are “imprudently excessive.” Courts seem to be less willing to view investment services, particularly with respect to actively managed funds, as “generic,” permitting a simple comparison between higher-priced and lower-priced funds.

To meet this challenge, plaintiffs’ attorneys have gotten creative. They have challenged the use of retail vs. institutional share classes, the use of institutional vs. lower-priced institutional share classes and the use of higher-priced passive funds where “identical” lower-priced funds are available. They have also claimed that courts should consider comparing plan investments to lower-priced funds using an “identical strategy” or using the same “style.” And they have alleged (quoting the Department of Labor) that the use of collective trusts or separate accounts will “‘commonly’ reduce ‘[t]otal investment management expenses’ by ‘one- fourth of the expenses incurred through retail mutual funds.’”

The Wildman plaintiffs make some of these arguments, e.g., they compare the American Century plan’s funds with less expensive “alternatives in the same investment style.” They also “compare 2010 and 2013 Plan costs with the average cost of similarly-sized plans in 2009 and 2013 … [alleging that] fees within the Plan were 38% more expensive in 2010 and 48% more expensive in 2013 than the average similarly-sized plan.” (Emphasis added.) It will be interesting to see whether, when the court gets to the merits of this case, it finds this sort of average cost argument persuasive – it seems much broader and vaguer than the arguments plaintiffs in other (non-financial services company) cases have made.

Self-dealing as part of loyalty and prudence claims in in-house plan cases

Another element in the in-house plan cases is consideration of the self-dealing as evidence of a breach of the ERISA duties of loyalty and prudence. Even where the self-dealing itself is exempt from ERISA’s prohibited transaction rules, plaintiffs allege that it may be taken as the (implicit) explanation of, e.g., why average fees are higher than comparable plans.

Thus, in Wildman, the court – in considering whether plan fiduciaries have gotten the best deal for plan participants, and looking at a plan that (with a couple of exceptions) has a fund menu made up of American Century funds with a relatively high expense ratios – seems disposed to buy the plaintiffs disloyalty/imprudence argument:

Plaintiffs are not complaining that Defendants failed to find the lowest cost funds, rather, they allege Defendants acted in their own self-interest by following a process that failed to consider lower-cost funds in favor of higher-cost American Century funds. These specific allegations regarding the excessive fees support an inference that the Plan’s fiduciaries’ process was deficient.

With respect to plaintiffs’ claim that plan fiduciaries disloyally and imprudently caused the plan to pay excessive recordkeeping fees, the court, in finding that plaintiffs had “pled sufficient facts to raise an inference of a deficient decision-making process for recordkeeping services,” noted that “Plaintiffs claim the relationship between American Century and the recordkeeper together, with the allegations of excessive fees, establishes an inference of disloyalty and imprudence.”

Thus, for financial services companies, the exemption from the prohibited transaction rules for the use of proprietary products/services in in-house plans may be a “trap.” It gives plan fiduciaries a pass on one set of ERISA fiduciary rules, with respect to prohibited transactions. But it provides evidence for a breach of another set of ERISA fiduciary rules – ERISA’s loyalty and prudence standards.

All plan fiduciaries, whether or not a financial services company, have a myriad of fiduciary duties to follow. As more lawsuits alleging violations of their duties under ERISA seem to be filed, each with a slightly new nuanced accusation of a violation of fiduciary duties, it is crucial now more than ever for fiduciaries to follow written procedures in all decisions made regarding the plan. It might also be beneficial for fiduciaries to perform a self-audit, and if there is a sense that a prior action or decision might even remotely trigger liability should they be sued by a class of participants, then they should seek out an appropriate alternative dispute resolution venue outside of the federal courts.

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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