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On June 19, 2017, the US District Court for Massachusetts handed down a decision for the defendant in Ellis v. Fidelity. Plaintiffs were two participants in the Barnes & Noble 401(k) plan, representing a class including all participants in defined contribution employee pension benefit plans investing in the Fidelity Group Employee Benefit Plan Managed Income Portfolio (“Portfolio”) (a stable value fund (SVF) managed by Fidelity), beginning January 1, 2010.
The decision was a summary judgment: a decision by the court based on facts agreed upon by both parties.
Plaintiffs claimed that defendant Fidelity breached its ERISA duties of loyalty and prudence by managing the SVF to an overly conservative standard with the result that the Fidelity SVF underperformed peer SVFs.
In 2009, two of the wrap providers for the Fidelity SVF exited the wrap business. At that time, and in response, Fidelity aggressively sought additional wrap capacity and, among other things, agreed to “stringent” investment guidelines in order to obtain capacity from JP Morgan. (As a general matter, more conservative SVF investments decrease the wrap provider’s exposure.)
Plaintiffs claimed that Fidelity breached ERISA’s duty of loyalty by agreeing to those “overly stringent wrap insurance guidelines that sacrificed the competitiveness of the Portfolio while allowing Fidelity to grow its AUM [assets under management].” The basic theory of this claim is that Fidelity sacrificed return for additional capacity. (The parties more or less agreed that the wrap insurance guidelines had the effect of lowering Fidelity’s returns versus competitors who were not subject to those guidelines, although Fidelity argued that this was knowable only in hindsight.) Plaintiffs also argued that the only reason Fidelity sought additional capacity was to increase its AUM and thus its total (asset-based) fees.
There appears to have been no question that during the relevant period Fidelity’s SVF investment policy was relatively conservative. During the class period, Fidelity managed the SVF to a Barclay’s Government/Credit Bond Index 1- 5 A (“1-5 G/C Index”) benchmark. Plaintiffs’ expert stated that such a benchmark is “not very common.”
In 2010, “Fidelity stated that a best practice was consistent emphasis on capital preservation and that integrity of the underlying assets took priority over crediting rate.” In presentations to potential wrap providers, subsequent to 2009, “Fidelity portrayed the Portfolio as desirable to wrap providers, due in part to low probability of withdrawals …, its conservative approach, and a ‘portfolio structure [that] minimizes risk to issuers.’”
Nevertheless, during the period, “[t]he Portfolio also outperformed its stated benchmark,” and “and its crediting rate improved relative to the median SVF’s crediting rate from 2010- 2014.” In holding for Fidelity, the court found that:
Wrap insurance is a core feature of SVFs. … The Portfolio was at risk of losing wrap coverage from two of its providers, … until its eventual replacement in 2012 …. Thus, the Portfolio faced a potential gap in wrap coverage until 2012. The Plaintiffs submit that Fidelity’s alleged single-minded pursuit of increased wrap capacity ran from 2009 to 2012, … the same time period during which Fidelity was searching for replacement wrap insurance. The Plaintiffs fail, however, to explain how Fidelity’s obtaining replacement wrap coverage would put Fidelity’s interests ahead of the Plaintiffs’.
The court found that the plaintiffs did “not set forth evidence that any of the Portfolio’s wrap guidelines were unreasonable,” however conservative they might be. Although plaintiffs claimed their position was supported by a 2011 Fidelity email characterizing the guidelines as “overly stringent,” there was an understanding at the time (2009) that the wrap provider would make them its “industry standard.” Moreover, plaintiffs did not claim “that Fidelity had other wrap insurance options with less stringent guidelines.”
Plaintiffs claimed that Fidelity violated ERISA’s prudence requirement “by structuring and managing the Portfolio with the intention that it underperform competing stable value funds, as particularly evidenced by Fidelity’s chosen benchmark and delay in addressing the Portfolio’s underperformance.”
In holding for Fidelity on the benchmark issue, the court described Fidelity’s evaluation process as “exhaustive,” using a “detailed analytical process … in continually assessing the Portfolio’s benchmark.” The court found that plaintiffs did not “submit evidence that Fidelity acted unreasonably by retaining [the benchmark],” citing a statement by plaintiffs’ expert “that economic circumstances could have occurred during the class period in which a conservative investment approach like the Portfolio’s would have outperformed SVFs with less conservative approaches.”
With respect to the allegations of Fidelity’s “delay in addressing the Portfolio’s underperformance,” the court found this claim was “negated by the undisputed facts that the Portfolio’s crediting rate improved from 2010 to 2014.”
It’s hard not to see plaintiffs’ prudence argument as anything other than another version of its loyalty argument. Thus, the plaintiffs “generally argue that the investment management process was guided by Fidelity’s overarching desire to grow its wrap capacity” and that Fidelity’s “process and motives were self-interested and thus the process was not prudent.”
With respect to their prudence claim, plaintiffs made no argument that Fidelity’s SVF was “mis-priced” – that Fidelity was somehow providing a product that was not priced at the market. Plaintiffs’ argument seems to be simply that Fidelity should have taken on more risk and that if it had done so participants would have gotten a greater return.
In a footnote, the court stated: “Fidelity also argues that the Plaintiffs’ claim is impermissibly based on hindsight. … The Court disagrees with this characterization and declines to address the argument further herein.” But, given that plaintiffs’ own expert admitted that if economic events subsequent to 2009 had been different, “the Portfolio’s would have outperformed SVFs with less conservative approaches,” it’s hard for us reading the opinion to see how this is not a hindsight claim.
From one point of view, plaintiffs’ prudence claim in Ellis is the same as the money-market-funds-are-imprudent claim being brought against plan fiduciaries in 401(k) plan fee litigation. With regard to both of these sorts of cases, we would observe that (1) there is no obligation to have any capital preservation fund in a 401(k) plan, (2) much less one that provides a mix of risk/reward that produces a higher return than that produced by a money-market fund or, as in this case, a very conservative SVF.
The prudence claim in this case, thus, seems to boil down to a complaint about where on the risk frontier this particular investment fund was located. In that regard, you would think it would be significant that this was just one of many different investment options on offer in the Barnes & Noble 401(k) plan, all with different positions on the risk frontier, and that the plaintiffs chose voluntarily to invest in this one. That issue was not discussed in court’s decision in Ellis.
The duty of loyalty claim is more curious. The court, in an aside, remarks that “although the Portfolio’s taking on of excess wrap coverage would almost certainly raise doubts as to whether Fidelity acted in the investors’ best interests.” Of course, the court found that Fidelity did not take on “excess wrap coverage” and in fact had a clear need for more wrap capacity.
But what exactly would “excess wrap coverage” look like and how would it be in Fidelity’s interest? Certainly, as, in effect, a middleman between wrap providers (e.g., insurance companies and banks) and wrap “consumers” (participants who want to invest in SVFs), what is in Fidelity’s best interest is to find the “price point” that best reflects the tradeoff between market supply and demand. In 2009, obviously, the market was suffering from what economists might call a supply shock, and Fidelity made a decision to lock down capacity rather than chase returns. That any of that is analyzable as an ERISA duty of loyalty issue seems like a stretch. It would seem that the only viable claim of fiduciary breach against Fidelity would be to argue (if possible on the facts) that participants were somehow forced to over-pay for the particular risk/return mix they got. But, again, such claim was not part of this decision.
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We end with one note of caution. Plaintiffs sued the provider in this case. Having lost, it is conceivable that in the next suit of this sort they will (as in the money-market-funds-are-imprudent cases) look for a way to sue the sponsor and sponsor-fiduciaries.
We will continue to follow this issue.