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In January 2022, in Hughes v. Northwestern, the Supreme Court vacated a 2020 Seventh Circuit decision for defendants in an ERISA fee case, remanding the case to the Seventh Circuit for further consideration.
On March 23, 2023, the Seventh Circuit handed down its decision in this litigation, siding with plaintiffs on the issues of recordkeeping fees and the selection of retail share classes. Most significantly, the court articulated a set of rules for consideration of these cases that could prove useful both for plaintiffs bringing lawsuits and for plan fiduciaries wishing to avoid being sued.
In this article, we begin with a brief summary of the background on this case and then review the court’s theory of how motions to dismiss in ERISA prudence litigation involving participant-directed individual account plans (like, e.g., 401(k) plans) should be handled and discuss the court’s decision with respect to the two issues the plaintiffs won on – recordkeeping fees and the use of retail share classes.
Background
Northwestern University maintains two ERISA-covered 403(b) plans, the Voluntary Savings Plan and the Retirement Plan. Before October 2016, the Voluntary Savings Plan offered 187 options and the Retirement Plan offered 242 investment options. Both plans’ fund menus included investments through Teachers Insurance and Annuity Association of America and College Retirement Equities Fund (TIAA-CREF) and Fidelity Management Trust Company. TIAA-CREF was the recordkeeper for the TIAA-CREF offerings; Fidelity was recordkeeper for other plan offerings.
Among other claims, plaintiffs alleged that Northwestern plan fiduciaries breached their ERISA fiduciary duty of prudence by (1) including the TIAA-CREF Stock Account and certain other funds (including certain retail mutual funds) in the plan’s fund menu and (2) allowing TIAA-CREF to serve as a recordkeeper for its funds (and using two different recordkeepers), claiming that the fees charged by TIAA-CREF for investment and recordkeeping services were excessive.
As is typical of 401(k) fee litigation, plaintiffs alleged that there were “otherwise-identical alternative investments,” and comparable, lower-cost recordkeeping, available.
The Supreme Court’s decision
The Seventh Circuit had (in 2020) dismissed plaintiffs’ claims on the basis of (among other things) its “categorical rule” that “the inclusion of low-cost investment options in the plan mitigated concerns that other investment options were imprudent.” The Supreme Court rejected this rule, holding instead that courts must apply a “context-specific inquiry” taking into account the sponsor fiduciary’s “duty to monitor all plan investments and remove any imprudent ones,” citing its decision in Tibble v. Edison.
On that basis, the Court instructed the Seventh Circuit that “On remand, the Seventh Circuit should consider whether petitioners have plausibly alleged a violation of the duty of prudence as articulated in Tibble, applying the pleading standard discussed in Ashcroft v. Iqbal, 556 U. S. 662 (2009), and Bell Atlantic Corp. v. Twombly, 550 U. S. 544 (2007).” Iqbal and Twombly are Supreme Court cases defining the standards for consideration of a motion to dismiss.
Perhaps the most significant element of the Seventh Circuit’s decision on remand is its further articulation of (1) just what is “the duty of prudence articulated in Tibble” and (2) how the standards for a motion to dismiss under Iqbal and Twombly are to be applied in ERISA prudence litigation.
Substance of the ERISA duty of prudence in 401(k) litigation – “the duty of prudence articulated in Tibble”
In its decision on remand, the Seventh Circuit first addressed the substance of the ERISA prudence standard in the context of a participant directed account-based plan (such as a 401(k) plan or, as in this case, a 403(b) plan). In this regard, it identified two broad standards:
First, the duty of prudence requires a plan fiduciary to systematically review its funds both at the initial inclusion of a particular fund in the plan and at regular intervals to determine whether each is a prudent investment.
Second, the duty of prudence requires a plan fiduciary to “incur only costs that are reasonable in amount and appropriate to the investment responsibilities of the trusteeship.”
The court then went on to consider how this substantive standard is to be applied in the procedural context of a motion to dismiss.
The pleading standard on a motion to dismiss in ERISA prudence litigation
The motion to dismiss for failure to state a claim has generally been the battleground over which 401(k) prudence litigation has been fought. Defendants’ motion to dismiss is (basically) an attempt to throw plaintiffs’ claims out of court based simply on the pleadings. Many (if not most) cases in which the plaintiffs win the motion to dismiss (and thus, prevent dismissal on pleadings) are settled by defendants, who are reluctant to undertake the cost of discovery and trial.
While the Supreme Court understood the significance of the motion to dismiss in ERISA prudence litigation, in Northwestern it gave only general guidance on how to handle it:
“Because the content of the duty of prudence turns on ‘the circumstances . . . prevailing’ at the time the fiduciary acts, … the appropriate inquiry will necessarily be context specific.” [Citing Fifth Third Bancorp v. Dudenhoeffer] At times, the circumstances facing an ERISA fiduciary will implicate difficult tradeoffs, and courts must give due regard to the range of reasonable judgments a fiduciary may make based on her experience and expertise.
The Seventh Circuit in its decision provides much more detail on just what this pleading standard involves.
The standard generally
Quoting the court: “To plead a breach of the duty of prudence under ERISA, a plaintiff must plausibly allege fiduciary decisions outside a range of reasonableness.” That is probably the best one-sentence explanation of how to think about these issues.
More specifically, the court explained:
Plausibility is the basic test for pleadings on a motion to dismiss. A plaintiff’s “[f]actual allegations must be enough to raise a right to relief above the speculative level on the assumption that all allegations in the complaint are true.” … Plaintiffs must provide “some further factual enhancement” to take a claim of fiduciary duty violation from the realm of “possibility” to “plausibility.” … “A claim has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.” … So for [the recordkeeping and fund claims being considered by the court], plaintiffs must have alleged enough facts to show that a prudent fiduciary would have taken steps to reduce fees and remove some imprudent investments. [Citations omitted.]
Treatment of “alternative explanations”
One issue that, in 401(k) prudence litigation, often comes up is the possibility of an “alternative explanation.” Defendants will assert that, rather than fiduciary imprudence, there is another, perfectly prudent reason why the fiduciary, e.g., selected a particular fund or recordkeeper.
In Northwestern, this issue comes up with respect to both plaintiffs’ recordkeeping and fund claims: (1) With respect to the recordkeeping claim, defendants argued that comparisons to other, lower-cost recordkeeping arrangements do not, e.g., take into account the differing quality of services provided. And (2) with respect to the retail share class claims, defendants argued that an institutionally priced share class may not actually have been available (e.g., because of investment minimums).
Before dealing with the specifics of the parties’ arguments, the Seventh Circuit took the time to articulate a set of general rules for evaluating these sorts of “alternative explanation” arguments.
Generally, the court stated that “something ‘more’ … is necessary to survive dismissal when there is an obvious alternative explanation that suggests an ERISA fiduciary’s conduct falls within the range of reasonable judgments a fiduciary may make based on her experience and expertise.” (Emphasis added.) In applying this rule, however, there is no requirement that “a plaintiff must conclusively rule out every possible alternative explanation for a defendant’s conduct, no matter how implausible. Only obvious alternative explanations must be overcome at the pleadings stage, and only by a plausible showing that such alternative explanations may not account for the defendant’s conduct. Accordingly, whether a claim survives dismissal necessarily depends on the strength or obviousness of the alternative explanation that the defendant provides.” (Emphasis added.)
Finally (and crucially) ties go to the plaintiffs – “[w]here alternative inferences are in equipoise – that is, where they are all reasonable based on the facts – the plaintiff is to prevail on a motion to dismiss.”
The foregoing general discussion by the court of the standards to be applied in ERISA 401(k) plan prudence litigation provide a meaningful advance over the somewhat chaotic 20+ years of previous decisions.
Now, let’s turn to how the court applied them in this case.
Recordkeeping claim
The court, stated, as a general matter, that while a fiduciary has no duty to “constantly solicit quotes for recordkeeping to comply with his duty of prudence with respect to plan expenses, … a fiduciary who fails to monitor the reasonableness of plan fees and fails to take action to mitigate excessive fees may violate the duty of prudence.”
Plaintiffs argued that the Northwestern fiduciaries “incurred unreasonable recordkeeping fees by failing to monitor and control those expenses. Per plaintiffs, the university should have reduced its fees by soliciting bids from competing providers, negotiating with existing recordkeepers for fee reductions, and consolidating to a single recordkeeper.”
In support of this claim, plaintiffs alleged that the Northwestern plans, through “uncapped revenue-sharing arrangements,” paid $4-$5 million in recordkeeping fees annually while comparable plans were paying at an annual rate (based on a flat $35 per participant fee) of $1 million.
A critical issue in litigation over recordkeeping fees has been comparability. Thus, as the court notes, defendants were able to win motions to dismiss in two Sixth Circuit cases, Smith v. CommonSpirit Health and Forman v. TriHealth, based on plaintiffs’ failure to allege that “the fees [paid by the plan] were excessive in relation to the services provided.”
In this case, however, the court found that plaintiffs had addressed this issue, having alleged that “[t]here are numerous recordkeepers in the marketplace who are equally capable of providing a high level of service to large defined contribution plans like the Plans.” Further, plaintiffs alleged that “because recordkeeping services are ‘commoditized … recordkeepers primarily differentiate themselves based on price, and will aggressively bid to offer the best price in an effort to win the business, particularly for jumbo plans like the Plans.’” Finally, plaintiffs also alleged that many other plans, including those of many high-profile universities, had “successfully reduced recordkeeping fees by soliciting competitive bids, consolidating to a single recordkeeper, and negotiating rebates.” These allegations, in effect, defeated defendants “alternative explanation” argument (at least in the context of a motion to dismiss).
The court’s analysis here may also be considered a roadmap for future recordkeeping prudence claims.
Retail share class claim
While plaintiffs alleged generally that Northwestern plan fiduciaries “selected and retained for years as the Plans’ investment options mutual funds and insurance company variable annuities with high expenses and poor performance relative to other investment options that were readily available to the Plans at all relevant times,” the court focused only on plaintiffs’ allegation that the plans included “mutual funds and variable annuities with retail expense ratios far in excess of other lower-cost options available to the Plans.”
As we have noted, while courts have been sympathetic to defendants’ argument that it is inappropriate to compare funds with different investment objectives (see, e.g., Smith v. CommonSpirit Health), they have generally allowed plaintiffs’ claims based on the use of retail share classes where institutional share classes are available. In Northwestern,the Seventh Circuit followed this line, quoting with approval the observation of the court in Forman v. TriHealth that “Different ERISA claims have different requirements, to be sure. But this claim [based on the use of a retail instead of an institutional share class] has a comparator embedded in it.”
And, on this issue, the court (again) rejected defendants’ “alternative explanations”: Defendants argued that because of inadequate investment levels an institutional share class might not have been available. But (quoting the court): “under Twombly and Iqbal, a plaintiff is required to show only that such cheaper institutional shares were plausibly available. Northwestern has contended that the institutional shares are only possibly unavailable.” Defendants argued that a retail-plus-revenue sharing arrangement may be better because it “encourages small plan participants to invest.” The court found that “this explanation [for the fiduciaries’ selection of the retail funds] is not so much more obvious than plaintiffs’ account [that that selection was simply imprudent] that this issue can be resolved on the pleadings.”
As noted above – on these issues, in a motion to dismiss, ties go to the plaintiff.
We are beginning to get a little better idea – based on appellate court decisions following the Supreme Court’s decision in Hughes v. Northwestern – of what the “rules” are for 401(k) ERISA prudence litigation. Courts are prepared to look at “comparability” more closely, especially with respect to fund/investment management fees. Although – following this decision in Northwestern – plaintiffs may be able to argue that recordkeeping is a “commodity” and (therefore) fees are strictly comparable between similar-sized plans.
With respect to fund fees and investment performance, the biggest sponsor/sponsor fiduciary vulnerability appears to be the use of retail share classes. Challenges to the use of other “mainstream” fund options (that don’t involve retail share classes) have been failing recently based on defendant arguments that the comparator funds aren’t really comparable – that the funds being compared have different investment objectives. All of this is well illustrated in the two Sixth Circuit decisions cited in this case – Smith v. CommonSpirit Health and Forman v. TriHealth.
We will continue to follow these issues.