In February, 2009, the Seventh Circuit handed down its decision in Hecker v. Deere. The case involves a number of claims, but critical to plan sponsors are plaintiffs’ allegations that Deere, as sponsor of two 401(k) plans, violated ERISA by failing to disclose certain revenue sharing arrangements and including in the plans’ fund menus funds that (allegedly) charged excessive fees. The court ruled in favor of Deere on these issues, and in this article we focus on those rulings.
The case involves two 401(k) plans sponsored by Deere & Company, to which both Deere and its employees contributed. Both plans provide a menu of investment funds from which participants choose. Fidelity Management & Research Company was the investment advisor to mutual funds offered under both plans, although both plans also provided for a “brokerage window” that allowed access to about 2,500 additional funds. A Fidelity affiliate was trustee.
The case comes up on a defendant motion to dismiss plaintiffs’ claims. Motions to dismiss must meet a high standard. Generally, for purposes of this sort of motion, all plaintiffs’ allegations are taken as true, and the court decides whether those allegations constitute a violation of the law. Following the court, for purposes of this article we also will generally take plaintiffs’ facts as alleged.
Three key issues
For sponsors, the case involves three key issues: First, does ERISA require that sponsors generally disclose information about revenue sharing arrangements? Second, does a sponsor have a general obligation under ERISA to make sure that each fund offered as part of the plan’s fund menu does not charge excessive fees? And, third, is ERISA section 404(c) a general defense to allegations that funds in a fund menu charge excessive fees?
We address each of these issues in turn.
Obligation to disclose revenue sharing
Deere and Fidelity had an evolving arrangement that involved, to one or another extent, Fidelity using a portion of its fund management fees to offset the cost of administrative and trust fees. Plaintiffs alleged that Deere failed to disclose this revenue sharing arrangement and in doing so breached an affirmative fiduciary obligation under ERISA.
The Deere court found that, under current rules at least, Deere had no obligation to disclose this information.
Critical to plaintiffs’ case is the proposition that Deere and Fidelity had a duty to disclose the revenue-sharing arrangements that existed between Fidelity Trust and Fidelity Research. … The Hecker group’s case depends on the proposition that there is something wrong, for ERISA purposes, in that arrangement. The district court found, to the contrary, that such an arrangement (assuming at this stage that the Complaint accurately described it) violates no statute or regulation…. [T]he participants were told about the total fees imposed by the various funds, and the participants were free to direct their dollars to lower-cost funds if that was what they wished to do. … The later distribution of the fees by Fidelity Research is not information the participants needed to know to keep from acting to their detriment. The information is thus not material, and its omission is not a breach of Deere’s fiduciary duty.
There is, of course, a current regulatory project and proposed legislation that would impose an obligation to disclose revenue sharing arrangements in certain circumstances. Until one or the other of those initiatives are made law, however, in the Seventh Circuit at least there is no general ERISA obligation to describe these sorts of revenue sharing arrangements to participants.
General fiduciary obligations with respect to fund menu construction
The plaintiffs’ next claim was that, in effect, Deere, as plan fiduciary, had an obligation to make sure that each fund offered under the plan did not charge “excessive fees.” Let’s note that, with respect to a plan that offers more than 2,500 investment choices, such a responsibility would clearly be unmanageable. It’s worth quoting the court on this issue at length:
We turn next to plaintiffs’ contention that Deere violated its fiduciary duty by selecting investment options with excessive fees. In our view, the undisputed facts leave no room for doubt that the Deere Plans offered a sufficient mix of investments for their participants. Thus, even if, as plaintiffs urge, there is a fiduciary duty on the part of a company offering a plan to furnish an acceptable array of investment vehicles, no rational trier of fact could find, on the basis of the facts alleged in this Complaint, that Deere failed to satisfy that duty. As the district court pointed out, there was a wide range of expense ratios among the twenty Fidelity mutual funds and the 2,500 other funds available through BrokerageLink. At the low end, the expense ratio was .07%; at the high end, it was just over 1%. Importantly, all of these funds were also offered to investors in the general public, and so the expense ratios necessarily were set against the backdrop of market competition. The fact that it is possible that some other funds might have had even lower ratios is beside the point; nothing in ERISA requires every fiduciary to scour the market to find and offer the cheapest possible fund (which might, of course, be plagued by other problems).
The fundamental problem
The court, the plaintiffs, Deere and the Department of Labor (which filed an amicus brief siding with the plaintiffs) are all wrestling with the same problem. If your plan has only three funds, you could understand a rule that required that the fiduciary make sure that each fund bear a “non-excessive” expense ratio (however that might be determined). But to impose that rule where you have 2,500 funds seems a little ridiculous.
There has been no formal guidance from DOL on this issue. Informally, and in various amicus briefs, however, DOL has made it clear that it is not prepared to surrender its position that a plan’s fiduciary has an affirmative obligation to make sure that every fund offered meets ERISA’s prudence standard. But, even more informally, DOL has indicated that where the participant is offered a choice from what is, in effect, “the market as a whole” (e.g., as would generally be the case where a broad brokerage window is offered), no fund-by-fund prudence examination is required. Oversimplifying, the DOL position seemed to be, more or less, if you only offer 50 funds, each must pass a prudence test; if you offer thousands, then this rule would not apply. But — in any case, your “core funds” must each pass the prudence test.
If you find this confusing, so do most practitioners. The Deere court, in resolving this issue, takes a different approach. To restate in brief what the language quoted above says: if you have offered enough funds that do pass ERISA’s prudence test (including that they do not charge excessive fees), the fact that some other funds offered might not pass that test, strictly applied, does not violate ERISA.
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This finding by the court was adequate to dispose of the case in favor of Deere. But the court went on to consider, assuming that there was a general obligation under ERISA to examine the prudence of each fund, whether ERISA section 404(c) was a defense to a claim that that general obligation was breached. Again, the court ruled for Deere.
ERISA section 404(c) defense
ERISA section 404(c) provides that, if a participant controls the investment of assets in his or her account, then no fiduciary will be liable for any loss resulting from the participant’s exercise of control and the participant him- or herself will not be a fiduciary. Thus, in a 404(c) plan, fiduciaries are generally off the hook for the negative consequences of participant investment choices.
Generally, in order to use 404(c) a plan must provide a broad group of investment choices (at least three funds with meaningfully different risk/return profiles), participants must be given the ability to move assets back and forth between investment funds at least quarterly (and more frequently if the volatility of the investment warrants it) and participants must be given information sufficient to make an informed choice between available investments (generally, a summary of each fund’s risk/return characteristics and certain fee information, and with respect to mutual funds a prospectus upon the first investment by the participant in the fund). In addition, participants must be notified that the plan is a 404(c) plan.
Was the 404(c) defense available to Deere?
Plaintiffs claimed that the ERISA section 404(c) defense was not available to Deere because Deere failed to disclose the Fidelity revenue-sharing arrangement and provide “complete knowledge of the fees and expenses that were being charged to the Plans and that were reducing [participant] account balances.” As discussed above, the court rejected this claim that there is an obligation to disclose this sort of revenue sharing arrangement, and therefore found that an ERISA section 404(c) defense was available to Deere.
If an ERISA section 404(c) defense was available, did it extend to the construction of the fund menu?
Turning to the substance of the ERISA section 404(c) defense, we are back at the same issue discussed above with respect to an employer’s general fiduciary obligation: Does a sponsor fiduciary have an obligation to review the “prudence” of every fund offered in a fund menu? The plaintiffs, and DOL, say yes, citing the preamble to the 404(c) regulations. Here’s language from that preamble cited in DOL’s brief to the court: “the act of designating investment alternatives . . . in an ERISA section 404(c) plan is a fiduciary function to which the limitation on liability provided by section 404(c) is not applicable.”
As discussed above, this sort of rule may make sense in some circumstances, but it’s application to a plan offering 2,500 investment alternatives is clearly problematic. The Deere court, again, takes a different approach. Rejecting plaintiffs’ and DOL’s interpretation, it states:
Plaintiffs would like us to decide whether the [404(c)] safe harbor applies to the selection of investment options for a plan, but in the end we conclude that this abstract question need not be resolved to decide this case. Even if [ERISA section 404(c)] does not always shield a fiduciary from an imprudent selection of funds under every circumstance that can be imagined, it does protect a fiduciary that satisfies the criteria of [ERISA section 404(c)] and includes a sufficient range of options so that the participants have control over the risk of loss.
This sounds pretty much like a restatement of the general rule described above: so long as a sponsor complies with ERISA section 404(c) generally (e.g., 404(c)’s information and participant control rules) and provides a “sufficient range of options,” the fact that some other option might flunk ERISA’s prudence standard does not trigger sponsor liability.
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Clearly, the court’s decision in Deere is controversial. As we understand it, DOL regards the decision as a rejection of its (DOL’s) interpretation of the application of ERISA’s prudence requirements to 404(c) plans. Plaintiffs have petitioned for a rehearing of the case en banc (that is, by all the judges in the Seventh Circuit and not just the three-judge panel that decided the case in February). There may also be efforts to change the law, as interpreted by the Seventh Circuit, either by legislation or by regulation.
There are a number of other cases in other courts, making the same allegations as the plaintiffs in Deere. We will continue to update you as this issue develops.