By Sara Pikofsky and Nicholas Curabba
On September 11, 2006, the St. Louis, Missouri-based personal injury law firm of Schlichter, Bogard, and Denton filed six lawsuits in four federal district courts challenging a widely-used practice of compensating 401(k) plan service providers. The suits all were brought against large U.S. corporations and alleged violations of the fiduciary duty provisions in the Employee Retirement Income Security Act of 1974 ("ERISA"). The Schlichter firm followed its initial wave of complaints with additional lawsuits, and other plaintiffs' firms subsequently lodged similar complaints.
All told, as of June 2007 there were no less than 14 similar cases currently pending in eight federal district courts.1 This report discusses the background for the complaints, the allegations in the complaints, defenses raised, and court decisions related to these cases. It concludes with a discussion of the likely trends for the future and practice tips for plan sponsors and service providers.
Background
Although the individual cases differ slightly, all represent a fundamental attack on a compensation arrangement commonly referred to as "revenue sharing." Although not defined in ERISA or other applicable law, "revenue sharing" describes an increasingly prevalent compensation practice in which investment providers—usual mutual fund companies—allocate a portion of their fees to other plan service providers. In one fairly common passage from the Schlichter complaints, revenue sharing is defined as "the transfer of asset-based compensation from brokers or investment management providers (such as mutual funds, common collective trusts, insurance companies offering general insurance contracts, and similar pooled investment vehicles) to administrative service providers (record-keepers, administrators, trustees) in connection with 401(k) and other types of defined contribution plans."2
A typical (but by no means exclusive) example of a revenue sharing payment is a 12b-1 fee charged by mutual fund companies to cover the cost of share distributions and other shareholder services. Proponents of revenue sharing arrangements tout resulting market efficiencies that drive down the overall cost of services charged to the plan. Detractors see such payments as little more than illegal kickbacks, a quid pro quo fund companies pay for shelf space on a plan provider's pre-packaged investment platform.
While the timing, scope, and individual defendants involved in these revenue sharing controversies may not have been foreseen, the fact that they were filed could hardly be called a surprise. Plan consultants and practitioners have been talking about the "coming storm" of fee litigation for several years.3 Indeed, the plaintiffs filed their initial round of lawsuits against a backdrop of increasing scrutiny of § 401(k) fee levels and disclosure by Congress, the regulatory agencies, the media, and the general public.
The new Democratic majority in Congress wasted no time in focusing on the issue of 401(k) plan fees. Even before he took control of the gavel, Chairman George Miller (D-CA) of the House Education and Labor Committee commissioned the General Accountability Office to perform an industry-wide study of 401(k) plans. That report, released in November 2006, served as the centerpiece of the committee's March 6, 2007, hearing entitled "Are Hidden 401(k) Fees Undermining Retirement Security?" If the chairman's opening statement can be viewed as a blueprint for future action, the committee—and perhaps the entire Congress—will consider legislation that not only will enhance fee disclosure and transparency, but question whether "all these fees are necessary" in the first place.4
The Department of Labor has also been in the vanguard on this issue, signaling its intention to regulate the way revenue sharing arrangements are to be disclosed to the government, plan sponsors, and plan participants. In a three-pronged regulatory initiative, the DOL has promised to revise required fee disclosures on the annual Form 5500, propose new fee disclosure rules as part of the primary statutory prohibited transaction exemption relied on by plan service providers, and require new fee disclosures to plan participants. In addition, the DOL has teamed up with the Securities and Exchange Commission on at least two projects related to fee disclosure issues. In June 2005, the DOL and the SEC jointly released guidance on the selection and monitoring of pension consultants, including a suggested review of fee arrangements.5 And in April 2007, SEC Chairman Christopher Cox announced the commission will, in cooperation with the DOL,"re-evaluate" rules permitting mutual funds to charge distribution-related fees to shareholders (i.e., 12b-1 fees).6
By the time the first suits were filed in September 2006, there was already an air of inevitability about them. The question was not whether such cases would be filed, but when. In fact, many of the issues presented in the complaints had already been preliminarily tested in court. On March 7, 2006, the U.S. District Court for the District of Connecticut denied Nationwide Financial Services' summary judgment motion in a case challenging a revenue sharing arrangement that is similar to those challenged in the Schlichter suits. In that case, Haddock v. Nationwide Financial Services, 419 F. Supp.2d 156 (D. Conn. 2006), the plaintiffs were the trustees of five separate defined contribution plans sponsored by the Flyte Tool & Dye Company who sued Nationwide for violations of ERISA's fiduciary and prohibited transactions provisions.
Each of the plans was participant-directed and offered various investment options from which participants could choose to invest their contributions. The plans contracted with Nationwide to provide those investment options, which included variable annuity contracts through which participants could direct their contributions to individual mutual funds.7 As part of the plans' arrangement with Nationwide, Nationwide also performed administrative services in connection with the participants' investments in the mutual funds.
According to the court, in the mid-1990s, Nationwide began entering into contractual arrangements with the mutual funds that required the fund companies to pay Nationwide amounts based on the percentage of participant investments in the funds.8 Plaintiffs challenged Nationwide's practice of retaining the amounts the mutual fund companies paid to them, alleging that the arrangements amounted to a breach of Nationwide's fiduciary duties and a prohibited transaction. Nationwide argued that the arrangements with the fund companies were "service contracts" under which it would receive payments from the fund companies in exchange for performing administrative and shareholder services. Siding with the plaintiffs, the court held a fact-finder could conclude that the contracts were merely "a guise for making payments to Nationwide or that Nationwide provided only nominal services and that the payments were not in consideration for those services."9 Rather than bona fide service contracts, the court held that the revenue sharing arrangement between the fund companies and Nationwide could be a prohibited transaction.
The court's decision was predicated on two important issues that will likely be central battlegrounds in future litigation: 1) whether a plan's investment provider can be an ERISA fiduciary by retaining some control over the investment options offered to plans; and 2) whether the funds used for revenue sharing payments constitute "assets of a plan." In Haddock, the court held that Nationwide's ability to select, remove, and replace the mutual funds available in the plans could constitute fiduciary conduct, even though Nationwide alleged that the plaintiffs retained the right to terminate the contract if they did not approve of Nationwide's actions.10 The court's ruling appears to be in tension with a DOL advisory opinion, AO 97-16A ("Aetna Opinion"), in which the Department indicated that an insurance company would not be exercising fiduciary discretion "solely as a result of deleting or substituting a fund from a program of investment options and services offered to plans, provided that the appropriate plan fiduciary in fact makes the decision to accept or reject the change."
Perhaps even more troubling for defendants, the court went on to hold that a reasonable fact-finder could conclude that the mutual fund revenue sharing payments to Nationwide came from "plan assets," and therefore could be per se illegal under ERISA's prohibited transactions rules. To reach that conclusion, the court constructed a novel, two-pronged "functional" test under which plan assets "include items a defendant holds or receives: (1) as a result of its status as a fiduciary or its exercise of fiduciary discretion or authority, and (2) at the expense of plan participants or beneficiaries."11
According to the court, a reasonable fact-finder could determine that the revenue sharing payments met both prongs of that test. First, as the court previously held, Nationwide was a fiduciary with respect to the plan and Nationwide received the revenue sharing payments as a result of its status as a fiduciary. Second, the court held that the plaintiffs adequately alleged that the revenue sharing payments were made "at the expense of " the plan and its participants. Specifically, the court pointed to language in the fourth amended complaint alleging that the fund companies set the revenue sharing payments at a level "to cover not only the fees they would have normally charged, but also the amount of the revenue-sharing payments they had to make to Nationwide."12 Against this backdrop, the Schlichter firm filed its complaints.
The Complaints
The plaintiffs' bar appears to have taken note of the Haddock decision. The recent spate of class action suits all raise issues similar to the ones discussed in Haddock, and some of the complaints include language very similar to that employed by the court in that case, particularly with regard to the court's characterization of revenue sharing arrangements as being made "at the expense of" the plan. Boiled down to their essence, the complaints contain two basic allegations: that the plans at issue failed to disclose the full extent of the fees paid, as well as the ultimate recipients of those fees; and that the fees themselves are excessive. Plaintiffs generally break these allegations down into several discreet sections, many of which appear in more than one complaint. These include allegations based on: the hidden and excessive fees involved in revenue sharing including both hard and soft dollar payments; the fees associated with employer stock funds; use of mutual funds; and the application of ERISA §404(c), 29 U.S.C. §1104(c). Each of these is discussed below.
Revenue Sharing Allegations
Most of the complaints pick up and expand on the themes explored by the plaintiffs in the Haddock case—namely that the compensation arrangement described as "revenue sharing" violates one or more provisions of ERISA. Unlike the Haddock case, however, the defendants in most of these newer cases are not the service providers receiving revenue sharing payments, but the plan sponsors who allowed the revenue sharing to happen, allegedly without telling the plans' participants about it. That is not to say service providers got a free pass. In two of the cases, two divisions of Fidelity, Inc. that provided investment and trust services to plans were sued along with the plan sponsors for similar fiduciary breaches.13 In addition, one of the suits was brought against Principal Financial Group in a complaint that raised nearly identical issues raised in the Haddock case.
Unlike Haddock, which focused primarily on fiduciary self-dealing charges, these more recent lawsuits have generally challenged revenue sharing as a violation of ERISA's general fiduciary obligations. First, most of the complaints allege that revenue sharing arrangements resulted in the plans paying excessive fees to plan service providers. Second, nearly all of the complaints allege that the plan sponsors violated their fiduciary duties by failing to disclose to participants the existence of the revenue sharing arrangements.
Excessive Fees.
In nearly all of the cases, plaintiffs describe a dichotomy between so-called "hard dollar" payments, on the one hand, and "soft dollar," or "revenue sharing" payments, on the other. Hard dollar fees are described as "direct disbursements from the Plans to individuals or entities providing services to the Plan."14 Typical hard dollar expenditures purchase administrative services, such as recordkeeping, plan auditing, and other professional services. When plans pay hard dollar expenses, they also must report those amounts on the annual Form 5500. In those cases in which plans paid hard dollar costs, the plaintiffs were able to recite just how much and to whom payments flowed by accessing the plans’ Form 5500. Plaintiffs used that information in at least two complaints to document reported plan expenses paid as hard dollar fees to various plan service providers.15None of the complaints expressly alleges that the hard dollar fees, standing alone, were excessive. Rather, the plaintiffs suggest that those hard dollar fees, when considered together with the revenue sharing payments, amounted to unreasonable compensation paid to service providers. According to many of the complaints, revenue sharing arrangements require that "the Plan and Fund agree upon an asset-based fee that is not the true price for which the Fund will provide its services. Instead, the Fund's agreed asset-based fee includes both the actual price for which the Fund will provide its service and additional amounts that the Fund does not need to cover the cost of its services and to make a profit."16
Without clearly setting a hard maximum on the profit an investment provider is permitted to earn, it is difficult to determine how much of the agreed asset-based fee is offensively "additional." Notwithstanding that lack of clarity, the plaintiffs describe two separate but related implications of revenue sharing arrangements that result in the plan paying excessive fees. First, for those plans that also pay hard dollar fees, plaintiffs complain that service providers are essentially being paid twice for the same job. These allegations are particularly present in the two cases in which Fidelity is a co-defendant. Since Fidelity allegedly received both hard dollar payments directly from the plan for providing recordkeeping and other administrative services, and soft-dollar revenue sharing payments from its mutual fund affiliates, plaintiffs allege it was compensated "far in excess of reasonable fees."17
Plaintiffs' second, and perhaps more nuanced, argument against revenue sharing suggests that service providers should be prohibited from retaining such payments at all. Instead, plaintiffs imply that ERISA requires that the "additional amounts" of the fund's asset-based compensation be used to benefit the plan. In the words of the plaintiffs, to the extent that these revenue sharing payments were not "captured" by the plans, but retained by service providers, they represented payments that were "far in excess of reasonable fees for the administrative and/or investment services provided to the Plan...and far in excess of what a plan of this type must pay for similar services or investment options."18
To prevail on these lines of argument, plaintiffs will have to successfully demonstrate that the revenue sharing payments from fund companies came from "plan assets" and that the defendants were acting in a fiduciary capacity when entering into those arrangements. These issues have already proven to be contentious. Indeed, the Fidelity defendants have filed motions to dismiss that defend revenue sharing payments on the grounds that they are not plan assets, citing the express exemption from ERISA coverage afforded the assets of registered investment companies. Plaintiffs have responded to that argument by relying heavily on the Haddock decision, employing the functional plan asset test to argue that the revenue sharing payments that Fidelity retained were excessive and unreasonable. In addition, in order to establish violations of ERISA §§404 or 406(a), plaintiffs will have to prove that the revenue sharing fees were unreasonable or more than "adequate consideration."
Inadequate Disclosure.
The second charge the plaintiffs lodge against revenue sharing payments is more straightforward, although it leads to a potentially much less significant remedy as the losses associated with it are unclear. They argue that plan sponsors, acting as fiduciaries, did not adequately disclose the compensation arrangements to participants, in violation of their fiduciary obligations. The revenue sharing payments, in turn, obfuscated the "true cost" to the plan of providing investment and administrative services.The defendants that have addressed this allegation in motions to dismiss have pointed out that nothing in ERISA currently requires plan fiduciaries to disclose the existence of revenue sharing arrangements. Defendants ABB, Bechtel, United Technologies and CIGNA, take the issue head-on by arguing that their respective plans disclosed everything required by ERISA. CIGNA, for instance, points out that currently, "ERISA requires plan fiduciaries to disclose only direct costs plans pay to service providers out of plan assets. Tellingly, the DOL has issued proposed regulations to broaden ERISA's disclosure obligations to include indirect forms of compensation, like revenue sharing, because undeniably there is no current disclosure requirement that includes indirect forms of compensation."19
In addition, the plaintiffs in the International Paper case allege that the use of a "master trust" resulted in the disclosure of direct, hard dollar payments becoming "incomplete, unclear, inaccurate and/or misleading."20 According to the plaintiffs, payments from the master trust to pay for services provided to individual plans confuses the disclosures of hard dollar payments because the plan administrator must report the payment only on the Form 5500 associated with the master trust, and not the Forms 5500 associated with the individual plans. When plan participants look to the individual plan Form 5500, therefore, they will not get the full picture of the fees being paid from that plan's assets unless they also refer to the Form 5500 for the master trust. The International Paper defendants did not directly challenge this assertion, filing instead a motion to dismiss the complaint based on improper venue.
Employer Stock Fund Allegations
Many of the complaints also contain allegations related to the option (or in some cases mandate) of investing 401(k) assets in an employer stock fund.21 Each of the employer stock funds contains both stock and cash. This cash is necessary in order to manage the liquidity needs of the stock fund. Rather than purchasing shares of the stock on the open market, the investors in the employer stock fund purchase units of the fund. Each unit essentially consists of employer stock with a small (typically 1-3 percent) amount of cash. Plaintiffs assert that employer stock funds inherently present problems. They allege that they are not sufficiently diversified and therefore unreasonably risky. They also allege that they increase the participant's dependence on her employer by making both the participant's livelihood and retirement rely on the success of the employer, going so far as to allege that were the employer to become insolvent it would financially devastate most participants.22
Plaintiffs claim that the company stock funds should not need any investment management and therefore should have minimal, if any, fees. The plaintiffs attempt to compare the returns of a participant in the stock fund with the returns of an individual investor who purchases the same stock on the open market. Plaintiffs allege that the investor who purchase shares on the open market will realize a better return because he will not be assessed fees on the investment and will not have a small cash component that will not realize any gains. Plaintiffs therefore conclude that the defendants in these actions breached their fiduciary duties by charging unreasonable and excessive fees and by maintaining excess cash in the employer stock fund.
With one exception, the motions to dismiss filed by various defendants have not specifically tackled the issues raised with respect to employer stock funds. In the United Technologies case, the defendants argue that the employer stock fund allegations should be dismissed because the fees on the stock fund are paid to UTC, not to Fidelity. Because Fidelity's fees appear to be the focus of the complaint, UTC seems to argue that charges related to fees accepted by other entities are inappropriate for the complaint. As plaintiffs do not seem to limit their claims specifically to the fees received by Fidelity, the basis for this argument is not entirely clear.
General Dynamics provides the only other indication of how the defendants might respond to these allegations. General Dynamics did not file a motion to dismiss, but asserted in its answer to the complaint that the employer stock fund does not charge fees. It further asserted that because it had disclosed the percentage cash that the employer stock fund could hold, it could not have breached its fiduciary duties.
Plaintiffs' claims suffer from several problems. First, many of the complaints do not allege that the particular employer stock fund charges fees. Second, in comparing the potential return on the employer stock fund with the return by an individual investor, they ignore the effect of the fees that one must pay simply to buy stock on the open market. Third, they ignore the realities of an employer stock fund which must retain a small amount of cash in order to adequately handle purchases and sales within the stock fund. Fourth, they ignore the fact that many, if not all, of the employer stock funds disclose the allowable percentage of cash holdings in the prospectus for the stock fund. Fifth and finally, plaintiffs ignore the fact that ERISA permits, and some would even argue, encourages, investment by participants in the stock of their employer. Given all of these factors, it seems unlikely that plaintiffs will ultimately prevail on their claims that the fees charged by employer stock funds are excessive and that the cash positions are unreasonable.
Mutual Fund Allegations
Plaintiffs offer several versions of allegations regarding the mutual funds in which 401(k) plans invest. In the Boeing complaint, plaintiffs allege that Boeing offers investment alternatives that include Advisor class fund shares rather than the cheaper Institutional class fund shares. Boeing, however, disputes this claim in the answer it filed. In the Caterpillar complaint, plaintiffs include allegations relating to Caterpillar's interest in a group of mutual funds sponsored by Caterpillar Investment Management Ltd (CIML).23 The master trust for the plans invested mainly in funds sponsored by CIML until October 2005 according to the complaint. The complaint further alleges that Caterpillar reaps prohibited profit through from the Plans through CIML. The Caterpillar complaint includes lengthy discussions of shadow or closet index funds, benchmarks, and active versus passive management, among other things. Plaintiffs' complaint appears to boil down to the general allegation that the participants paid CIML for actively managing funds that performed as shadow funds and should therefore have incurred, at a maximum, passive management level fees. Plaintiffs do not add separate allegations to the counts of their complaints based on the availability, fees or performance of CIML funds, nor do they include a count of the complaint alleging self-dealing.
The International Paper complaint, similarly, contains allegations that the defendant's use of benchmarks was misleading. According to plaintiffs, the International Paper plan communicated to participants that plan fees were up to 70 percent lower than "comparable retail mutual fund fees" without disclosing that the plan would qualify to invest in the "lowest fee" institutional investor shares.24 Plaintiffs' suggestion, stated another way, is that the plan fiduciary did not provide its participants with a meaningful way to determine if the plan fees were too high. Instead, it used mismatched benchmarks, making the fees appear lower than they actually were.
Prohibited Transactions
Most of the complaints hint at allegations of fiduciary self-dealing or conflicts of interests that bear a resemblance to an allegation that the fiduciary caused the plan to enter into a transaction prohibited by ERISA §406 without actually alleging a violation of §406. Two complaints in particular, however, include more focused allegations of prohibited transactions. In the case against Principal Financial Group, plaintiffs argue—precisely as the Haddock plaintiffs did—that the very act of entering into revenue sharing arrangements constituted a prohibited transaction.25 Principal opted to file an answer to the complaint, rather than file a motion to dismiss, in which it denied the allegations that it engaged in a prohibited transaction.
The CIGNA case also presents direct allegations of a prohibited transaction, albeit in a somewhat unique fact pattern. The complaint against CIGNA focuses, in part, on the sale of its retirement plan business to a division of Prudential Financial in April 2004. According to the plaintiffs, CIGNA artificially inflated the amount of the plan's assets that were invested in CIGNA-provided investment options in order to increase the sale price to Prudential.26 In other words, since the price Prudential would pay for CIGNA's retirement plan business was based in part on the amount of plan assets CIGNA had under management, CIGNA allegedly pushed as many as possible of its own plan participants into CIGNA-provided investments. CIGNA allegedly did so by using its own fixed income investment fund as the plan's default investment option, and by offering an employer stock fund as an investment option. Plaintiffs claim that the resulting gain from CIGNA's sale of its retirement plan business to Prudential, at least in part, should have benefited the plan. In its motion to dismiss, CIGNA argued that the sale of its business was not a fiduciary decision, and therefore cannot be a violation of ERISA.
The Defenses
Defendants in these cases have elected a wide variety of defenses to the allegations in the complaint, including those mentioned above. In some cases, including General Dynamics and Principal, the defendants have not yet offered a defense, apparently foregoing the option of filing a motion to dismiss. Defendants in the other cases have filed either motions to dismiss for failure to state a claim upon which relief may be granted or a motion to dismiss for failure to comply with Rule 8 of the Federal Rules of Civil Procedure.
Rule 8 requires that a complaint contain a short and plain statement of the claim that shows that the pleader is entitled to relief. Two defendants—Lockheed and Caterpillar—have argued solely that the complaints should be dismissed because plaintiffs fail to meet this criterion, while defendants in Kraft primarily (but not solely) based their motion to dismiss on Rule 8. Defendants point out that a number of nearly identical complaints were filed almost simultaneously against other large corporations.27
Defendants argue that the "Complaint is replete with extraneous arguments, unnecessary facts, statutory provisions, legal conclusions, and supposed expert commentary that serve no function but to confuse the reader and cloud the issues."28 Defendants further assert that the nature of the complaint does not allow for the required admission or denial of each allegation.
Defendants argue that these deficiencies are so severe as to warrant the dismissal of the entire complaint. The courts have not yet ruled on either of these motions but it is unlikely that the motions will prevail, particularly in light of the outcome of the Kraft case on a similar issue. As will be discussed in more detail below, the Kraft court rejected defendant's Rule 8 arguments, holding that although the complaint is "a bit garrulous perhaps...it is eminently possible for persons of reasonable intelligence to discern" the nature of the claims alleged.29
The motions to dismiss for failure to state a claim illustrate a number of different approaches. One defense is for certain of the defendants, most likely the corporation itself, to argue that it is not a fiduciary and therefore cannot be sued for breach of fiduciary duty. This is a particularly fact-based defense and requires that the corporation or plan sponsor not be identified in the plan documents as the named fiduciary of the plan. This defense has been raised in three cases: Boeing, Bechtel, and ABB.
Boeingargued in its motion to dismiss that it was not a fiduciary because the complaint only alleged that Boeing served as plan sponsor and contained no allegations that Boeing exercised any of the discretionary authority necessary to render one a fiduciary. Because it faced a slightly different factual situation, Bechtel took a moderately different approach, arguing that even if Bechtel had fiduciary duties with respect to monitoring and appointing members of the administrative committee, it did not have fiduciary duties beyond that, including with respect to the actions alleged in the complaint. Bechtel further explains that any plan design issues for which it might have responsibility are purely settlor functions and cannot be the basis for a breach of fiduciary duty.
Another common defense focuses on the duplicative nature of the counts or claims contained in the complaints. Count 1 generally relies on the enforcement mechanism provided in ERISA§502(a)(2), while Count 2 requests slightly different relief for the same alleged bad acts, but relies on ERISA §502(a)(3). Defendants argue that based on case law going back to Varity v. Howe, a plaintiff cannot maintain a §502(a)(3) claim when §502(a)(2) provides adequate relief.
Some defendants point out that in order to plead an actionable breach of fiduciary duty, one must allege a breach, a loss and causation of the loss by the breach.30 Plaintiffs' complaints generally do not include direct allegations of loss or of causation. Without both causation and loss, the claims should be dismissed as legally insufficient.
The United Technologies defendants offer several unique defenses at this early stage of the litigation. United Technologies asserts that plaintiffs fail to allege a breach of fiduciary duty with respect to the fees paid to Fidelity, because plaintiffs allege only that the fees are not commensurate with the services performed. According to United Technologies, this cannot be a breach of fiduciary duty since the decision to retain Fidelity was prudent and it is insufficient for plaintiffs to simply second-guess the outcome of the decision. United Technologies claims reliance on the regulations to ERISA §404 which address investment duties and require consideration of appropriate facts and circumstances when making decisions regarding investments. 29 C.F.R. §2550.404a-1. Based on this regulation, United Technologies argues that it considered all appropriate facts and circumstances when it hired Fidelity and therefore did not breach any fiduciary duties.
United Technologies further argues that the fees themselves cannot be imprudent because they comport with the industry standard. As long as revenue sharing is common in the industry, the practice itself cannot be per se unreasonable according to this defense.
United Technologies also argues that the revenue sharing information is not material to participants' investment decisions and therefore need not be disclosed. Defendants take the argument a step further stating that "the allegedly misrepresented or undisclosed information is immaterial as a matter of law."31 This is because a court may dismiss a claim for failure to disclose if the information that has not been disclosed would be insignificant. United Technologies argues that the amount paid to Fidelity would not influence participants' investment decisions and that "investment returns are not affected by whether a mutual fund retains the entire fee or pays a portion of it to Fidelity." Boeing puts forth a similar argument, stating that Plaintiffs fail to claim that the participants would have invested their money differently if they were aware of the potential for revenue sharing, thus rendering the disclosure immaterial.
With respect to the allegations of inadequate disclosure, perhaps the most straightforward defense employed by several defendants is that ERISA simply does not compel the kind of fee disclosures plaintiffs' demand. In ABB, CIGNA, United Technologies, and Bechtel, the defendants point to two sections of ERISA that they argue are the statute's exclusive fee disclosure requirements.32 Pointing to recent reports by the Department of Labor's ERISA Advisory Council and the General Accountability Office recommending changes in the law, defendants essentially concede that "ERISA's current fee disclosure requirements are insufficient to capture the full cost of plan operation."33 The fact that regulatory agencies are paying attention to this issue, and have begun to propose changes to enhance ERISA's disclosure requirements demonstrates that "ERISA's current disclosure scheme does not now require plan fiduciaries to provide participants and beneficiaries with the kind of comprehensive information about service fees, such as revenue sharing arrangements, upon which Plaintiffs' breach of fiduciary duty claims are predicated."34
The CIGNA and ABB defendants also challenge plaintiffs' assertions that ERISA's fiduciary obligations include an implied duty to disclose fee information to plan participants. Citing the U.S. Supreme Court case of Curtiss-Wright Corp. v. Schoonejongen, 514 U.S. 73, 84 (1995) the defendants argue that ERISA's specific disclosure provisions in §§ 104(b)(3) and 104(b)(4) "are not subject to further judicial expansion" under the general fiduciary rules found in section 404(a). In response to those arguments, plaintiffs relied in part on the holding in Variety v. Howe that ERISA requires fiduciaries to avoid providing "any misleading information to participants."35The ABB plaintiffs further alleged in their opposition to defendants' motion to dismiss that by failing to disclosure the "fact and amount of" revenue sharing payments, the defendants in essence provided misleading information to plan participants.36
As was mentioned above, plaintiffs sued two separate divisions of Fidelity, both of which provide services to the defendant plans. Fidelity Management and Research Company (FMR) is a registered investment advisor to Fidelity mutual funds and in that capacity provided investment services to the plans sponsored by ABB and John Deere. Fidelity Management Trust Company (FMTC) provided custodial and recordkeeping services to the plans. In the ABB and John Deere cases, plaintiffs sued both Fidelity divisions for allegedly breaching their fiduciary obligations by entering into revenue sharing arrangements with the plan.
Fidelity has filed motions to dismiss in those cases, disputing the legal sufficiency of the complaints on two basic grounds.37 First, Fidelity argues that neither of its divisions acted as a fiduciary with respect to the challenged conduct. With respect to FMR, Fidelity argues that the revenue sharing payments it received were not plan assets, but assets of a registered mutual fund company that are expressly exempt from ERISA regulation.38 Fidelity makes no attempt, however, to distinguish the Haddock case or to explain how the revenue sharing payments do not fall into the two-pronged functional test the court used to define "plan assets." Second, similar to the Bechtel defendants, Fidelity argued that the complaint impermissibly requests relief under both ERISA §§ 502(a)(2) and 502(a)(3). With respect to FMTC, Fidelity argues that the trust company did not exercise fiduciary discretion with respect to the challenged conduct.
The Relevance or Irrelevance of ERISA §404(c)
Defendants' responses to plaintiffs' allegations regarding § 404(c) understandably reflect confusion as to the purposes of these allegations. Plaintiffs include in every complaint a discussion of §404(c) and the disclosure it requires. ERISA §404(c) provides some insulation from fiduciary liability in a participant-directed plan if certain requirements are met. As several defendants point out, it typically serves as an affirmative defense, rather than as part of a complaint. Plaintiffs do not allege that the defendants do not meet the requirements of § 404(c) nor do they allege that defendants claim the protections of §404(c) in the relevant plan documents. Instead, plaintiffs appear to use regulations that accompany §404(c) as a benchmark for the disclosure they claim ERISA requires, quoting from the regulations certain disclosures that are necessary for §404(c) protection.
The motions to dismiss run the gamut with respect to §404(c) with some essentially ignoring it. Some, such as United Technologies, argue that plaintiffs fail to state a claim by invoking §404(c) and that failure to comply with §404(c) cannot serve as the basis for a breach of fiduciary duty. Others, including Bechtel, argue that §404(c) does not require any of the disclosures that plaintiffs complain about, including hard dollar payments, revenue sharing and the calculation of administrative expenses at the participant level.
The CIGNA and ABB defendants used § 404(c) as a basis for their motions to dismiss. CIGNA, for instance, argued in its motion to dismiss that since it met its "investment-specific fee disclosure requirements in exactly the manner" the § 404(c) regulations require, it is protected by the statute's safe harbor. Therefore, CIGNA argues, "(e)ven if Defendants had breached their fiduciary duty in selecting certain funds that carried high fees in light of the services rendered, (which Defendants dispute), Section 404(c) ‘allows a fiduciary who is shown to have committed a breach of fiduciary duty in making an investment decision, to argue that, despite the reach, it may not be held liable because the alleged loss resulted from a participant's exercise of control’."39
The Decisions
Only a small handful of courts have reached the point of issuing decisions on any of the motions that have been filed.40 These include Bechtel, Boeing, Kraft, and Exelon. Each decision is summarized below.
The court in the Bechtel case addressed head-on defendants' arguments that the complaint against them must be dismissed because ERISA simply does not require the type of disclosure demanded by plaintiffs. In short, the court was "unpersuaded" by Bechtel's argument and flatly rejected it. The court held instead that if the fiduciary requirements in ERISA are to mean anything, they must require something more than "mere compliance" with separate disclosure mandates. In other words, the scope of an ERISA fiduciary's obligation to provide information to plan participants goes beyond that which is required by the statute and regulations. Moreover, because the allegations in the complaint charged defendants with manipulation and misrepresentation of fee information, holding otherwise would be inconsistent with ERISA, the court indicated. If the defendants' position prevailed, the court said, then "any amount of misrepresentation or dishonest dealing on behalf on the Plan, at least with respect to the fees and expenses charged against the Plan, cannot provide the basis for a cause of action so long as such fees and expenses are disclosed in the manner prescribed by ERISA and the Department of Labor's regulations."
The court also rejected Bechtel's attempt at ERISA jujitsu by ruling that its § 404(c) defense was premature. Although the court acknowledged the general rule that a defendant may test the validity of a defense that is raised in a complaint, it went on to hold somewhat cryptically that such a test is "only appropriate where the merits of the defense, as opposed to merely the possibility of the defense, appears in the face of the complaint." The court offered no further analysis or any authority for that proposition, nor did it offer insight into how the distinction between the merits of a defense and the possibility of a defense is to be made in practice.
Bechtel could take solace, however, in at least one portion of the decision. The court strongly hinted that Bechtel Corp. was not exercising the type of fiduciary discretion with respect to the plan that would give rise to liability. While not yet dismissing Bechtel from the case prior to development of a factual record, the court did opine that "it appears unlikely that Bechtel has an independent fiduciary obligation to Plaintiffs." If this inclination of the court holds, it would remove a "deep pocket" source of recovery, which would undoubtedly alter plaintiffs' calculus about continuing or settling the lawsuit.
The Boeing court denied the defendants' motion to dismiss on several different grounds. The court addressed three different arguments: that plaintiffs did not allege that Boeing (and one of the individual defendants) were fiduciaries; that a §502(a)(2) claim precludes the availability of a §502(a)(3) claim; and that claims of nondisclosure were inadequate.
With respect to whether the complaint sufficiently alleged fiduciary status, the court began with an analysis of what the statute and regulations say with respect to the definition of a fiduciary and acknowledged that the exercise of discretion of some sort is necessary to qualify as a fiduciary. The court finds, however, that the issue of whether a person or entity exercises discretion is purely factual and therefore cannot be addressed on a motion to dismiss. The court does not consider that plaintiffs do not allege that Boeing performed any acts that could be considered fiduciary acts, instead simply finding that one cannot determine fiduciary status on a motion to dismiss. The broadness of this holding could have a significant impact if other courts follow it as it essentially allows plaintiffs to skate by motions to dismiss simply be alleging fiduciary status with nothing more.
Despite the court's finding that "it is not wholly clear that the relief requested" in the §502(a)(3) claim is equitable, the court allows the §502(a)(3) claim to proceed. It bases its opinion on the strictures of Rule 8 which allow a party to maintain alternate claims or defenses.
The court interprets defendants' argument regarding the materiality of nondisclosures to impact only "Defendants' ability to maintain a defense under ERISA §404(c)." The court summarily dismisses Boeing's argument with respect to nondisclosure by stating that §404(c) is an affirmative defense and therefore inappropriate as a basis for a motion to dismiss. Boeing's motion to dismiss does not discuss the §404(c) requirements. Instead it argues that plaintiffs had not shown that the failure to disclose revenue sharing was meant to deceive participants, was material to their decision-making, or caused any losses to the plan. For whatever reason, the court chose not to directly respond to those arguments.
Similarly, the Kraft court rejected defendant's Rule 8 arguments. As described by the court, the "chief ground for Defendants' motion is the supposed prolixity of Plaintiffs' complaint...." The court noted that, while there is precedent for using Rule 8 as a "sword for those pleaded against" as opposed to a "shield for pleaders," it has been done rarely, and only in the unusual case of an excessively lengthy complaint that is "so confusing and disjointed as to warrant dismissal for failure to comply with Rule 8."41 The complaint, while lengthy, "easily withstands scrutiny under Rule 12(b)(6)."42
The Kraft defendants also attacked plaintiffs' invocation of ERISA§404(c) in the complaint. The court noted that a §404(c) defense is an affirmative defense, and that it "is unclear to the Court why Plaintiffs have chosen to plead such matters in their complaint." Rather than striking the offending paragraph, however, the "Court will simply disregard the allegation at issue."43
The court in the Exelon case took stronger action against the §404(c) arguments, granting the defendants' partial motion to dismiss on that issue. The defendants in that case had taken a somewhat unorthodox position of acknowledging that both counts in the plaintiffs' complaint state a claim upon which relief can be granted. Notwithstanding that acknowledgment, defendants requested that the court dismiss plaintiffs' prayer for recovery of investment losses because "the Complaint fails to allege a nexus between the administrative fees charged by (sic) participants and their market-based losses," as required by ERISA §409. The court agreed and dismissed the plaintiffs' prayer for relief that was based on alleged investment losses suffered by plaintiffs as a result of allegedly undisclosed or excessive fees. Because of the narrow scope of the motion to dismiss, the remainder of the case against Exelon challenging the direct losses allegedly resulting from excessive fees continues.
Trends
How these cases ultimately will be resolved is unclear, and any prediction about which side will prevail is premature. The one thing that can be said with a degree of certainty is that these types of cases are not going away any time soon. As discussed above, as of mid-2007 two courts had already held that the complaints survive scrutiny under a motion-to-dismiss standard of review, meaning that if all the factual allegations in the complaints are true, the defendants will be found to have breached their fiduciary duties. The ability of the cases to so far withstand motions to dismiss makes it all the more likely that plaintiffs' firms will continue to bring these lawsuits. The ability to get past a motion to dismiss increases the likelihood that defendants will settle, particularly to avoid litigation costs when intensive fact discovery is needed. Thus plaintiffs' firms have an incentive to bring these cases in the hopes of a payout for their clients and themselves. Indeed, it has already been widely noted that the plaintiffs' law firm responsible for many of the so-called "stock drop" cases brought since the Enron implosion is actively "investigating" several large financial services corporations for possible fee-related ERISA violations.44
Given the vagaries and expense of litigation, particularly given the fact-intensive nature of these disputes, we suspect many of these cases will settle prior to full-blown decisions on the merits, thus leaving the state of the law somewhat unsettled. In a statute like ERISA, which is expressly based on concepts of common law and which provides federal courts with a role in shaping the law, this type of unsettled legal atmosphere is fertile ground for plaintiffs to test new theories of liability and to attempt to expand the boundaries of fiduciary duties.
Practice Tips
Employers can take several prophylactic steps to reduce the chances of being sued, or at a minimum, to mitigate the amount of losses plaintiffs will try to claim. Fiduciaries should consider that there are really two separate disclosure issues: what must be disclosed to the fiduciary and what the fiduciary must disclose to plan participants. While we recommend both types of disclosure, given the complaints and the state of the law, disclosure to plan fiduciaries is even more critical than disclosure to participants.
A central aspect of the lawsuits against plan sponsors is that, as plan fiduciaries, they breached their obligation by causing the plan to pay excessive fees. The first step for fiduciaries, therefore, is to review their contractual arrangements with service providers and be sure they are fully aware of all of the fees the plan is paying, and all the ways in which their service providers may be receiving third-party compensation through revenue sharing payments. If the fiduciary does not know what fees it is paying, the fiduciary has no way of determining whether the fees are reasonable.
One place plan sponsors can look to for additional information in the Department of Labor, which has published several pieces of guidance plan fiduciaries might find helpful, including:
- "A Look at 401(k) Plan Fees"45
- "Understanding Retirement Plan Fees and Expenses," March 200446
- "Study of 401(k) Plan Fees and Expenses," submitted to the Department by Economic Systems, Inc., April 199847
- "401(k) Plan Fees Disclosure Form," developed by financial services trade associations in 200148
In order to determine the fees, a fiduciary should request a breakdown in writing from its service providers of all fees paid. The fiduciary should insist on a written answer from the service providers. If the service provider refuses, the fiduciary would be wise to look for another service provider. Once the fiduciary is aware of all fees the plan plays, it is advisable that they routinely compare those fees to what is charged in the marketplace for the same products and services. ERISA does not require that the fiduciary retain the cheapest service provider. Instead, fiduciaries must compare the cost of the services with the value provided in determining whether the fees are reasonable. Plan fiduciaries may wish to consider engaging an independent fiduciary or consultant to assist in this comparison.
If revenue sharing arrangements are part of the service provider compensation mix, and they do not represent unreasonable or excessive compensation, any such arrangement should only be entered into pursuant to very clear contractual language regarding the source of those payments. Specifically, there should be no doubt from reading the contracts that the revenue sharing payments are not coming from "plan assets," but from the general operating assets of the registered investment company providing the investments options to the plan.
Fiduciaries may also wish to take an aggressive posture regarding disclosure to participants. While there may be merit to the legal arguments discussed above regarding ERISA's limited statutorily-required disclosures, the state of the law is in enough flux that may be wise to err on the side of over-disclosure. In particular, participant communications should not only disclose the existence of any revenue sharing arrangements, but also explain how the arrangement works.
If done correctly, plan sponsors and fiduciaries may actually have an opportunity to better understand and communicate the positive aspects of revenue sharing arrangements. Provided that the relationship between a participant's investment in a particular fund and the revenue sharing payment that fund may pay to a service provider is properly and fully disclosed, such arrangements have had the effect of driving down overall costs for plan administration, as was apparently the result of Nationwide's revenue sharing contracts in the Haddock case.
Endnotes
1 In two cases—Beary v. Nationwide and Beary v. ING—the same named plaintiff brought similar charges against service providers to an Internal Revenue Code §457 plan. Because ERISA does not apply to those plans, the suits alleged violations of state fiduciary laws. This report does not discuss those cases, but instead is limited to cases brought pursuant to ERISA.
2 International Paper Complaint, ¶ 104; see also ABB Complaint, ¶ 64; CIGNA Complaint, ¶ 88.
3 "Advisors Selling DC Plans Must Improve Fee Disclosure," INVESTMENT NEWS, November 1, 2004 ("The threat of class actions that could hinge on non-disclosure of fees is a real one that hangs over the retirement plan market."); "Excessive 401(k) Plan Fees and Costs: The Coming Storm in ERISA Litigation?" Joe Faucher, ERISA CONTROVERSY REPORT, February 2005 ("With plan fiduciaries facing greater scrutiny than ever in the wake of the employer stock cases, what is the next ERISA litigation trap for corporate officers and directors that preside over their companies' retirement plans? The answer may be claims relating to payment of excessive fees and expenses.").
4 A Web cast of the entire hearing, and full text of Chairman Miller's opening statements, are available on the committee's website:
http://edworkforce.house.gov/hearings/fc030607.shtml.5 More information is available on the DOL's Web site at
http://www.dol.gov/ebsa/newsroom/pr060105.html.6 Chairman Cox discussed the initiative in a speech to the Mutual Fund Director's Forum Seventh Annual Policy Conference on April 13, 2007. The full text of Chairman Cox's speech is available on the SEC Web site at http://www.sec.gov/news/speech/2007/spch041207cc.htm.
7 As the court noted, the participants did not, technically speaking, invest in the mutual fund they chose. Rather, they invested in a Nationwide variable account, which is a unitized, pooled investment trust holding contributions from multiple plans sponsored by other Nationwide clients. Each of Nationwide's variable accounts are, in turn, divided into various "sub-accounts" each of which correspond to a particular investment option, which typically are mutual funds. 419 F. Supp.2d at 161.
8 419 F. Supp.2d at 162.
9 Id.
10 Id. at 166.
11 Id. at 170.
12 Id.
13 See, e.g., Complaints in John Deere, ABB.
14 International Paper Complaint, ¶ 90; CIGNA Complaint, ¶ 85.
15 International Paper Complaint, ¶ 90; Kraft Complaint ¶ 57.
16 Deere Complaint, ¶¶ 64-65; International Paper Complaint, ¶¶ 106-107; ABB Complaint ¶¶ 66-67; CIGNA Complaint ¶¶ 91-92.
17 Deere Complaint, ¶ 79; CIGNA Complaint, ¶ 81; ABB Complaint ¶ 82.
18 Deere Complaint, ¶ 79.
19 CIGNA Memorandum of Law in Support of Their Motion to Dismiss, pp. 2-3.
20 International Paper Complaint, ¶ 93.
21 The complaints in Lockheed Martin, General Dynamics, Boeing, Caterpillar, United Technologies, CIGNA, Kraft and International Paper contain these general allegations.
22 E.g., Boeing Complaint, ¶ 111.
23 Caterpillar Complaint, ¶¶ 41 and 106-113.
24 International Paper Complaint, ¶ 149.
25 Principal Complaint, ¶ 12.
26 CIGNA Complaint, ¶ 60.
27 This statement may come back to haunt defendants. Although it is true that plaintiffs filed several other similar complaints, in no other case did the defendants bring up Rule 8 as a defense. Many of them filed motions to dismiss on a host of issues, while in a few cases the defendants simply answered the complaint. The court in the Kraft case did not refer to the other cases, but if other defendants were able to answer the complaint, the Caterpillar and Lockheed courts may find the arguments about inability to answer the complaint somewhat disingenuous.
28 Lockheed Mem. of Points and Authorities in Support of Motion to Dismiss at 4. Defense counsel in Caterpillar states the same thing in the motion similar motion filed in that case.
29 Kraft Memorandum Order, p. 7.
30 See Boeing, Bechtel, and UTC motions to dismiss.
31 United Technologies, Brief in Support of Defendants' Motion to Dismiss, p. 21.
32 ERISA §104(b)(3) requires plan administrators to make automatic annual disclosures to participants in the form of a summary annual report. In addition, ERISA § 104(b)(4) permits participants and beneficiaries to request additional plan documents.
33 CIGNA, Memorandum of Law in Support of Their Motion to Dismiss, p. 14; Suggestions of Law in Support of ABB Defendants' Motion to Dismiss, pp. 9-14.
34 Id.
35 ABB Plaintiffs' Opposition to Defendant's Motion to Dismiss, p. 10.
36 Id. pp. 12-13.
37 Fidelity's pleadings in the John Deere case are not available online. This discussion, therefore, is limited solely to the ABB case.
38 ERISA § 401(b)(1).
39 CIGNA, Memorandum of Law in Support of Their Motion to Dismiss, p. 20, quoting Meinhardt v. Unisys, 74 F.3d 420, 445 (3d Cir. 1996).
40 Defendants in the John Deere case filed a motion for summary judgment, setting up the U.S. District Court for the Western District of Wisconsin to rule on the merits of the complaint. Because that court does not make court papers available online, however, an analysis of defendants' summary judgment motion was not possible for this report.
41 Kraft Memorandum Order, p. 6.
42 Id. p. 9.
43 Id.
44 The firm, Keller Rohrback, appears to be targeting only large insurance companies who provide investments and services to 401(k) and 403(b) plans. They have already filed related litigation against ING over alleged improper endorsement arrangements with the New York State teachers' union. More information is available on the firm's Web site at
http://www.erisafraud.com/Default.aspx?tabid=1543.
45 Available on the DOL Web site at http://www.dol.gov/ebsa/publications/401k_employee.html
.46 Available on the DOL Web site at http://www.dol.gov/ebsa/publications/undrstndgrtrmnt.html.
47 Available on the DOL Web site at http://www.dol.gov/ebsa/pdf/401kRept.pdf.
48 Available on the DOL Web site at http://www.dol.gov/ebsa/pdf/401kfefm.pdf.
Copyright 2007 by The Bureau of National Affairs, Inc.
(800-372-1033). Reproduced with permission from the Benefits Practice Center, ERISA Compliance & Enforcement Library, ERISA Compliance and Enforcement Strategy Guide.This article is published as an information service for clients and friends. Please recognize that the information is general in nature and must not be relied upon as legal advice. We would be pleased to discuss the information in this article, and its application to your specific situation, in greater detail. We welcome your comments and suggestions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
