401(k) Fiduciary Litigation – “Underperformance” – Current Issues
On November 16, 2021, the United States District Court for the Northern District of California rendered its decision in In Re Linkedin ERISA Litigation, granting in part/denying in part defendants’ motion to dismiss.
Among other issues, Linkedin involves a claim that Linkedin plan fiduciaries breached their duty of prudence by selecting/retaining an “underperforming” target date fund. This sort of claim is being brought more frequently by plaintiffs’ lawyers in 401(k) breach-of-duty-of-prudence litigation.
In what follows, we discuss the court’s decision on this issue, finding, with respect to the target date fund, that plaintiffs’ allegations are sufficient to survive defendants’ motion to dismiss. We begin, however, with an extensive discussion of the litigation framework that gives this issue significance: the importance of the “motion to dismiss” stage of litigation; the general standard plaintiffs in 401(k) fiduciary prudence litigation must meet to survive a motion to dismiss; and the specific standard they must meet in underperformance litigation. And we conclude with takeaways for plan sponsors.
401(k) fiduciary litigation framework
As a general matter, the plaintiffs’ lawyer’s first challenge in 401(k) fiduciary prudence litigation is, what sort of facts must be alleged in the complaint to survive a motion to dismiss? This stage of litigation is critical – if the plaintiff can survive a motion to dismiss, then it can begin discovery (e.g., deposing plan fiduciaries) and often force a settlement.
This challenge (surviving the motion to dismiss) presents (for plaintiffs’ lawyers) a significant threshold problem. Axiomatically, ERISA prudence is a question of process – what was the procedure by which the plan fiduciary reached the allegedly imprudent decision? But, as courts have recognized, plaintiffs’ lawyers don’t have access to that information before discovery, and discovery doesn’t happen until after defendants’ motion to dismiss is ruled on.
To compensate for this information disadvantage, courts are willing to allow plaintiffs to make “circumstantial factual allegations” from which imprudence can be inferred. Much of the litigation has turned on this issue – what sort of circumstantial factual allegations must a plaintiffs’ lawyer make to survive a motion to dismiss. And, as a consequence, the fiduciary takeaways turn on these issues.
Characteristic fee claim allegations
401(k) fiduciary litigation started with a focus on allegedly “excessive” fees. Challenges based on “underperformance” – selection or retention of a fund with “substandard” performance – have emerged more recently. And the circumstantial factual allegations needed to survive a motion to dismiss with respect to an underperformance claim are different from those needed to survive a motion to dismiss a fee claim.
Briefly, and by way of review, 401(k) fiduciary fee litigation began with a focus on two areas: (1) Recordkeeping fees. Here, the argument by plaintiffs’ lawyers was that recordkeeping services were generic, and that (to survive a motion to dismiss) it was sufficient to allege that defendant-fiduciaries “paid too much” by comparing fees in the targeted plan with fees paid by other, similar plans. (2) Investment management fees with respect to a fund for which there was an “identical” lower cost investment alternative. The easy version of this was use of a higher-fee retail share class instead of an (available) institutional share class. But plaintiffs’ lawyers have been creative, claiming that fees in the fund they are targeting could, e.g., be compared to fees on a similar fund in a collective trust.
Characteristic underperformance claim allegations
With respect to a claim alleging that the fiduciary was imprudent in retaining an “underperforming” fund, as we discussed in our article on the Home Depot litigation, some courts have accepted as adequate to survive a motion to dismiss allegations of (1) underperformance vs. a benchmark plus (2) some additional facts that indirectly show an imprudent process. With respect to the “additional facts” element, in Reetz v. Lowe’s, plaintiffs pointed to the targeted fund’s limited track record, negative rate of return, “novel” investment strategy, and lack of a consistent benchmark. In Anderson v. Intel, plaintiffs pointed to the novelty of the fund’s investment strategy (significant allocations to hedge funds and private equity), the generic problems presented by those hedge fund and private equity investments (e.g., lack of liquidity), and the relatively high fees. In Pizarro v. The Home Depot, the court cited a poor Morningstar rating with respect to one fund and alleged “legal troubles” (that is, lawsuits) with respect to another.
One critical point to take away from the foregoing is, in avoiding underperformance litigation: benchmarks matter (and in much of what follows we will be discussing the issue “what is the right benchmark?”).
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With this background, let’s now turn to Linkedin, and how the court in that case handled these issues.
Linkedin involves a suit by former Linkedin employees, who are either current or former participants in the Linkedin participant directed 401(k) plan, against plan fiduciaries alleging (among other things) that they breached their ERISA duty of prudence by offering the actively managed Fidelity Freedom Funds (the “Active Suite”). Plaintiffs claim the plan fiduciaries that should instead “have offered the Freedom index funds (‘the Index Suite’), which are less risky, less expensive, and better performing.”
Plaintiffs’ claim with respect to the Active Suite illustrates nicely the issues in underperformance litigation we discussed above, and in the remainder of this article we are going to focus exclusively on the court’s treatment of that claim.
Allegations in Linkedin with respect to the Active Suite
With respect to the Active Suite claim, plaintiffs in Linkedin alleged that:
(1) [T]wo of the Active Suite’s top three domestic equity funds underperformed their benchmark indices by 2.99% and 3.69% over their lifetimes.
(2) The Active Suite has a significantly higher expense ratio than the Index Suite, despite underperforming the Index Suite based on three- and five-year annualized returns. … [T]he Active Suite “underwent a strategy overhaul” in 2013 and 2014 that granted its managers discretion to deviate from the glide path allocations to “time market shifts in order to locate underpriced securities,” which Plaintiffs say was an unnecessary risk. After the 2014 changes, a March 2018 Reuters special report described how investors had lost confidence in the Active Suite “because of their history of underperformance, frequent strategy changes, and rising risk.” In 2018 alone, the Active Suite experienced an estimated $5.4 billion in net outflows, and investors withdrew nearly $16 billion from the Active Suite between 2014 and 2018.
Is the benchmark selected by plaintiffs an “adequate comparator?”
Many courts have recognized that the question “what is the appropriate benchmark?” presents a number of difficulties. It invites manipulation/cherry picking of “comparators” by plaintiffs (and, for that matter, by defendants).
With respect to plaintiffs’ chosen benchmark in Linkedin, comparing the Active Suite to the (so-called) Index Suite, defendants argued that a number of courts have rejected this sort of comparison between actively managed funds and index/passively managed funds. Thus, the Linkedin defendants argued that comparison of Fidelity’s “actively managed Active Suite to the passively managed Index Suite is an improper ‘apples to oranges’ comparison.”
In this case, however, the Linkedin court found persuasive plaintiffs’ arguments that “all TDFs are actually inherently actively managed” (presumably because they use a manager-chosen glidepath) and that “the Index Suite is a ‘perfect comparator’ for the Active Suite because the two share the same investment management firm, management team, and a nearly identical glide path.”
Different decision with respect to a single fund
Underlining the distinction it was making with respect to the Fidelity TDF, the court found that plaintiffs’ allegations with respect to a separate fund – the American Funds AMCAP Fund Class R4 and R6 (“the AMCAP Fund”), which it benchmarked against the S&P 500 Index – were inadequate.
With respect to this allegation, the court held that “Plaintiffs have … pled nothing more than the conclusory underperformance of an actively managed fund as compared to a market index benchmark, which is insufficient on its own to state a claim for breach of prudence.”
The distinction – underlying the court’s decision to allow the claim with respect to the Fidelity Freedom Funds but deny the claim with respect to the AMCAP Fund – being that the comparator for the Fidelity TDF “share[d] the same investment management firm, management team, and a nearly identical glide path.”
Some observations on benchmarks/comparators in underperformance litigation
This certainly is a way of distinguishing Linkedin from cases in which courts have rejected the comparison of unrelated actively managed and passive funds.
But a feature of litigation involving the evaluation an underperformance claim is that, often, the court (and indeed sometimes the litigants) do not seem to understand how alleged underperformance may simply be the result of a different funds/fund types’ investment strategy. Given the over-10-year bull market in US large cap equities, most actively managed funds have had a difficult time “beating,” e.g., the S&P 500 Index. That does not mean that the selection of a fund pursuing, e.g., a more defensive strategy, is imprudent.
Thus, in one of the leading cases (discussed by the Linkedin court), Davis v. Salesforce.com, Inc., the court found that “Passively managed funds, however, ordinarily cannot serve as meaningful benchmarks for actively managed funds, because the two types of funds ‘have different aims, different risks, and different potential rewards that cater to different investors.’” And, even the though two fund “suites” in Linkedin “share the same investment management firm, management team, and a nearly identical glide path,” they may have fundamentally different investment strategies.
Additional facts that indirectly show an imprudent process
In Linkedin, the court found that, together with the “demonstrated” underperformance, the Fidelity Freedom Funds alleged a “history of underperformance, frequent strategy changes, and rising risk” (etc.) was enough to satisfy the requirement that a plaintiff show “circumstantial factual allegations” of imprudence sufficient to survive a motion to dismiss.
Takeaways for plan sponsors
We are seeing a number of cases involving claims by 401(k) participants that fiduciaries violated their ERISA fiduciary duty of prudence because they chose or retained an underperforming fund/funds. Especially underperforming target date funds – because, (to apply Willie Sutton’s maxim), that’s where the money is.
With regard to the risk of this sort of claim being brought, plan fiduciaries will want to pay close attention to two critical issues.
What is the right comparator? If possible, fiduciaries should identify, ideally before an investment fund is selected for inclusion in the plan’s fund menu, a benchmark against which they are prepared to judge it. With the understanding that, if the selected fund consistently underperforms that benchmark, then they should reconsider selection of that fund.
What are the sorts of information that will raise questions about an underperforming fund? Obviously, there’s a wide array of “information that raises questions” (about a given fund), but unpopularity (e.g., the Fidelity Freedom Funds’ “net outflows” cited in Linkedin) and novelty (as in Intel) are on the list here.
This is not to say that there may not be good reasons to retain an underperforming fund, but fiduciaries should be prepared to prove that they had good reasons for doing so, with evidence (such as committee minutes) that can be produced in court.
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We will continue to follow this issue.