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In an August 4, 2023, decision, the Ninth Circuit Court of Appeals reversed and remanded a lower court decision for defendants in Bugielski v. AT&T. The court held that: (1) when AT&T plan fiduciaries amended the plan’s contract with Fidelity (the plan’s recordkeeper) to incorporate Fidelity’s brokerage window service (BrokerageLink) and Financial Engines’ participant advice service, they caused the Plan to engage in a prohibited transaction; (2) that the available exemption for that prohibited transaction required that the plan fiduciaries scrutinize/evaluate third-party compensation arrangements (in this case, an arrangement between Fidelity and Financial Engines under which Financial Engines would remit to Fidelity part of the fee paid by the plan to Financial Engines) for “reasonableness;” and (3) with respect to that third-party arrangement, the exception to the 5500 reporting requirement otherwise applicable to the compensation that Fidelity received from Financial Engines did not apply.
In this article, we are going to discuss issues (1) and (2) – once there is clarity on those two issues, issue (3) is both more technical and simpler – it’s just a reporting issue.
Our discussion of the case is going to be linear – facts, plaintiffs’ arguments, defendants’ arguments, decision. We’ll begin, however, with the bottom line – the key position the Ninth Circuit is taking with respect to sponsor fiduciaries’ legal obligations and why it matters to sponsors.
Bottom line
Plaintiffs in this case are claiming that sponsor fiduciaries have an obligation to review the third party arrangements between recordkeepers (here, Fidelity) and participant investment advice providers (here, Financial Engines), under which the advice provider pays a share of the fees it gets from the plan/plan participants to the recordkeeper. These are sometimes called pay-to-play arrangements.
The innovation in this case is that the plaintiffs are claiming – and the court agrees with them – that because the plan-recordkeeper relationship is a per se prohibited transaction, it must comply with the exemption available for that specific prohibited transaction, which (among other things) requires that the recordkeeper’s compensation, both direct and indirect, be “reasonable.” And, in determining whether it is reasonable, plan fiduciaries must take into account/review the indirect compensation the recordkeeper is receiving from the participant advice provider.
In reaching this holding, the Ninth Circuit has declined to follow the holdings of at least two other circuits (the Third and the Seventh). Those courts argue that reading ERISA to say that a plan’s relationship with a recordkeeper (or any other service provider) is a per se prohibited transaction is “absurd” and “nonsensical.”
In view of this decision, sponsors will want to consider (1) determining whether any of their service providers (especially, their recordkeeper) are, with respect to the plan, receiving indirect compensation from other parties (e.g., the plan’s advice provider) and (2) if they are, reviewing with counsel what action they should take.
Sidebar: Bugielski and DOL’s recently proposed “Retirement Security Rule: Definition of an Investment Advice Fiduciary:” The issue highlighted in Bugielski – the obligation of sponsor fiduciaries to review the reasonableness of third-party fees received by service providers – is identical to one critical sponsor issue in DOL’s recently proposed “Retirement Security Rule: Definition of an Investment Advice Fiduciary.” That proposal explicitly conditions the availability of the applicable Prohibited Transaction Exemption (PTE 2020-02) on the fiduciary advisor’s compensation – direct or indirect – being reasonable. The sponsor fiduciary’s obligation to review/monitor indirect compensation that is at the heart of Bugielski would also apply to fiduciary advisors. Although, in addition to monitoring the reasonableness of the advisor’s indirect compensation, there are a number of other conditions in that proposal (e.g., related to the impartial conduct standards) that may also require review/monitoring.
Facts
Plaintiffs are former participants in an AT&T defined contribution plan (apparently, a 401(k) plan). They are suing AT&T (as plan administrator) and the AT&T Benefit Plan Investment Committee (the plan’s fiduciary).
The plan’s recordkeeper is Fidelity Workplace Services. In 2014, AT&T added optional advice services from Financial Engines to the plan. This transaction and payments under it are the key facts of the lawsuit. The court describes them as follows:
AT&T contracted with Financial Engines … to provide optional investment advisory services to Plan participants. … [T]o do so, Financial Engines needed access to participants’ accounts. Accordingly, AT&T amended its contract with Fidelity to provide Financial Engines with this access. And in its contract with Financial Engines, AT&T authorized Financial Engines to contract directly with Fidelity to secure the requisite access. Financial Engines and Fidelity then entered into a separate agreement under which Fidelity received a portion of the fees Financial Engines earned from managing participants’ investments. The compensation Fidelity received from Financial Engines was significant; in some years, Fidelity received approximately half of the total fees that Financial Engines charged participants, resulting in millions of dollars in compensation for Fidelity.
Plaintiffs’ theory of the case
Plaintiffs’ argument for their claims runs as follows:
In 2014 (and prior thereto) Fidelity was, as the plan’s recordkeeper, a “party in interest” under ERISA. This is black letter law – under ERISA, service providers are parties in interest.
The 2014 contracts/contract amendments constituted a prohibited transaction under ERISA section 406(a)(1)(C), which prohibits the “furnishing of goods, services, or facilities between the plan and a party in interest.”
There is an exemption for that sort of prohibited transaction, the “service provider exemption,” the key requirements of which relevant to this case are that (1) the contract for the services is reasonable and (2) “no more than reasonable compensation is paid therefor.”
To meet those two reasonableness requirements, the service provider (here, Fidelity) has an obligation to disclose any indirect compensation (e.g., from Financial Engines) it is receiving to the plan fiduciary, and the plan fiduciary must determine that the total amount of direct and indirect compensation the service provider receives is reasonable.
Neither of those two things – disclosure by Fidelity of the compensation it was receiving from Financial Engines in connection with the plan and a review by plan fiduciaries of the reasonableness of that compensation – happened. That failure to disclose/failure to review means that the plan fiduciaries have (1) caused the plan to enter into a prohibited transaction (the plan-recordkeeper relationship) and (2) breached their duty of prudence in failing to review the reasonableness of the (indirect) compensation Fidelity received.
Defendants’ counter arguments
While defendants raise a number of substantive and technical arguments, the most significant one is that the 2014 contracts/contract amendments do not constitute a prohibited transaction, and therefore the reasonableness of those contracts and of Fidelity’s compensation under them is not an issue for plan fiduciaries. In support of this they cite a line of cases that holds that ERISA’s prohibited transaction language should not be read as literally as plaintiffs claim. Here is the court’s description of the reasoning of one of these cases, Sweda v. University of Pennsylvania (in the Third Circuit):
In Sweda, the Third Circuit … recognized that “it is possible to read [ERISA section 406(a)(1)(C)] to create a per se prohibited transaction rule forbidding service arrangements between a plan and a party rendering services to the plan.” … Nevertheless, the court “declined” to follow that reading …, and instead established a requirement that a plaintiff plead “factual allegations that support an element of intent to benefit a party in interest” to state a prohibited-transaction claim. … The court reasoned that because … 406(a)(1)(C) was “designed to prevent ‘transactions deemed likely to injure the . . . plan’ and ‘self-dealing,’” it seemed “improbable” that [it] “would prohibit ubiquitous service transactions and require a fiduciary to plead reasonableness as an affirmative defense.” … The court also reasoned that reading … 406(a)(1) “as a per se rule” would “miss the balance that Congress struck in ERISA” by “expos[ing] fiduciaries to liability for every transaction whereby services are rendered to the plan.” … Finally, the court noted that … interpreting 406(a)(1) “to prohibit necessary services would be absurd.”
The Seventh Circuit, in Albert v. Oshkosh Corp., took a similar line, finding, e.g., that a literal reading of 406(a)(1)(C) would be “nonsensical.”
Are third party arrangements relevant to “reasonable compensation?”
Defendants also make the (less theoretical/more practical) argument that, if the exemption’s “reasonable compensation” standard does apply, it “encompasses only the compensation Fidelity received directly from the Plan and its participants for recordkeeping” and not payments Fidelity receives from someone else (here, Financial Engines).
This line of reasoning was taken by another California Federal District Court, in Marshall v. Northrop Grumman Corp. That court held that:
“ERISA does not require, as a matter of law,” that fiduciaries monitor “the type of third-party fees at issue here” because those fees “are not subject to fiduciary control, the fees are not paid out of plan assets, and [the fees] are for services [the recordkeeper] provides to Financial Engines out of an independent business arrangement.”
The court’s decision
The court agreed with the plaintiffs and did not agree with the defendants.
The prohibited transaction
With respect to whether the 2014 contracts/contract amendments constituted a prohibited transaction, the court read 406(a)(1)(C) literally and saw no reason not to do so.
In addition to parsing the statutory language, the court also found persuasive the following language in the preamble to DOL’s 2012 fee disclosure regulation:
The furnishing of goods, services, or facilities between a plan and a party in interest to the plan generally is prohibited under section 406(a)(1)(C) of ERISA. As a result, a service relationship between a plan and a service provider would constitute a prohibited transaction, because any person providing services to the plan is defined by ERISA to be a ‘‘party in interest’’ to the plan. However, section 408(b)(2) of ERISA exempts certain arrangements between plans and service providers that otherwise would be prohibited transactions under section 406 of ERISA.
In reaching this decision, the court (as discussed above) declined to follow the position taken by at least two other circuits.
Third party arrangements and “reasonable compensation”
With respect to whether third-party arrangements under which the plan/plan participants make no payments are relevant to a fiduciary’s “reasonable compensation” determination, the court again found DOL’s preamble language in its 2012 fee disclosure regulation particularly persuasive:
[DOL] stated explicitly that the information the party in interest must disclose to the fiduciary about the compensation it expects to receive “in connection with” the services provided “will assist plan fiduciaries in understanding the services and in assessing the reasonableness of the compensation, direct and indirect, that the [party in interest] will receive.” … (emphasis added). Put differently, the regulation contemplates that the fiduciary will assess the reasonableness of the compensation that the party receives “directly from the covered plan,” … and “from any source other than the covered plan.”
Holding
As noted, plaintiffs made three claims. (1) That the 2014 contracts/contract amendments constituted a prohibited transaction. (2) Because they constituted a prohibited transaction, the AT&T fiduciaries had a duty to review for reasonableness Fidelity’s compensation under its third party fee arrangement with Financial Engines. And (3), absent disclosure and review of the compensation Fidelity received from Financial Engines, the exception to 5500 fee disclosure does not apply to that compensation.
The court sent issues (1) and (2) back to the lower court to “correctly apply the relevant substantive law” (as described in its decision). With respect to issue (3), it held that AT&T had failed to comply with its 5500 disclosure requirement with respect to the payments made by Financial Engines to Fidelity.
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Repeating what we said at the top: in view of this decision, sponsors will want to consider (1) determining whether any of their service providers (especially, their recordkeeper) are receiving indirect compensation from other parties (e.g., the plan’s advice provider) and (2) if they are, reviewing with counsel what action they should take.
In its decision on remand, it is entirely possible that the lower court may find that Fidelity’s (indirect) compensation from Financial Engines was reasonable. Or not. It’s unclear what standard might be applied here.
We will continue to follow this issue.