Narrowing of Available Class Actions in 401(k) Fee Cases

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By Marcia S. Wagner, Esq.  

The Wagner Law Group, a Professional Corporation, Boston, MA

Numerous lawsuits have been filed challenging the fee structures of investments and revenue sharing practices in connection with 401(k) plans. At one point, certification of these cases as class actions seemed almost routine. However, the U.S. Supreme Court's 2011 decision in Wal-Mart Stores v. Dukes, __ U.S. __, 131 S. Ct. 2541, 180 L.Ed. 2d 374, 2011 BL 161238 (2011), and other recent cases have led to a more rigorous application of the rules for establishing a bona fide class. This has likely contributed to the waning of new excess fee cases and may have been a factor in recent settlements.

Federal Rule of Civil Procedure 23. Federal Rule of Civil Procedure 23(a) requires that one or more members of a class may sue on behalf of all class members only if: (1) the class is so numerous that joining all its members would be impracticable; (2) the case involves questions of law or fact common to the class members; (3) the claims of the class representative are "typical" of the claims of the class; and (4) the class representative will "fairly and adequately protect the interests of the class."

In addition to these four criteria, a class must also pass one of three tests in Rule 23(b). The first test is met if the prosecution of separate actions by members of the class creates a risk of varying or inconsistent adjudications and, consequently, incompatible standards of conduct for the defendants. Alternatively, the test under Rule 23(b)(1) can also be satisfied if it can be shown that individual adjudications carry the practical risk that claims of non-parties would be disposed of, impaired or impeded. A class meets the test under Rule 23(b)(2) if the action is for final injunctive or declaratory relief respecting the class. Finally, Rule 23(b)(3) requires a case in which questions common to the class members predominate over questions affecting only individual members. Unlike the classes under Rules (b)(1) and (b)(2), a class certified under Rule 23(b)(3) must be afforded procedural protections by receiving notice of the class and having the opportunity to opt out of the class action.

Wal-Mart Case. In the Supreme Court's Wal-Mart decision, employees of Wal-Mart sought injunctive and declaratory relief, punitive damages and backpay stemming from claims that Wal-Mart's practice of allowing local managers to exercise discretion over pay and promotions led to discrimination against women.  Relying on Rule 23(b)(2), the appellate court had affirmed class certification, including the claims for backpay. However, the Supreme Court vacated the class certification, not being able to find a single common question of law or fact for purposes of Rule 23(a)(2), given the lack of any uniform employment practices by Wal-Mart other than allowing discretion to local management.

As a separate matter that has consequences for excess fee cases, the Court also held that claims for backpay were improperly certified under Rule 23(b)(2). According to the Court, individualized monetary claims, such as backpay, belong under Rule 23(b)(3) with its notice and opt out features, not under Rule 23(b)(2).  Because it lacks the procedural protections of Rule 23(b)(3), a (b)(2) case only applies in the narrow circumstances where injunctive and declaratory relief are sought. The court rejected the plaintiffs' argument that claims for backpay could be brought under (b)(2) if they do not "predominate" over requests for injunctive and declaratory relief and held that the proper standard for allowing a claim for individualized monetary damages under (b)(2) is whether the monetary relief is "incidental" to the injunctive or declaratory relief. As to the contention that backpay claims are appropriate under (b)(2), because they are equitable in nature, the Court noted that this was irrelevant, because "The Rule does not speak of "equitable" remedies generally, but of injunctions and declaratory judgments."

Application of Rule 23 in Revenue Sharing Cases. The Wal-Mart decision's reading of Rule 23(b)(2) was recently applied to vacate the district court's class certification in Nationwide Life Insurance Company v. Haddock, 2012 BL 28710, 52 EBC 1161 (2d Cir. 2012). The claims in the Nationwide case involve the provider of an investment platform that has been sued by the trustees of several §401(k) plans over its receipt of revenue sharing from mutual funds offered as plan investment options.  Nationwide is an insurance company and the mutual funds are offered under its variable annuity contracts. The trustees sought to certify a class under Rule 23(b)(2) or Rule 23(b)(3) consisting of over 24,000 plans that had held or continue to hold such annuities. Certification under Rule 23(b)(2) was granted by the district court in November 2009, but the certification was appealed to the Second Circuit Court of Appeals.

The plan trustees in Nationwide sought a declaratory judgment that Nationwide's receipt of revenue sharing payments violated ERISA, an injunction prohibiting the further receipt of such payments and disgorgement of the payments already received by Nationwide. The Second Circuit held that Wal-Mart's interpretation of Rule 23(b)(2) precluded certification under that rule, noting that "if plaintiffs are ultimately successful in establishing Nationwide's liability on the disgorgement issue, the district court would then need to determine the separate monetary recoveries to which the individual plaintiffs are entitled from the funds disgorged." This would have required non-incidental individualized proceedings that Wal-Mart held were inconsistent with Rule 23(b)(2).

The Second Circuit remanded Nationwide to the district court to determine whether certification under Rule 23(b)(3) would be proper. Nationwide will, in all likelihood, argue that a class cannot be certified pursuant to Rule 23(b)(3) because individualized questions of fact will predominate over common questions. As noted below, similar arguments have been effective in other cases. However, the district court in Nationwide has in the past shown receptiveness to plaintiffs' theories for establishing fiduciary status that seem to bypass traditional analysis examining a fiduciary's actual conduct in favor of allowing a fact-finder to determine that the power of a platform provider to extract revenue sharing from mutual funds on the platform confers fiduciary status on the platform provider.  Given the court's willingness to look at such issues in a new light, it is difficult to predict the outcome of a Rule 23(b)(3) analysis in Nationwide.

Nationwide is an example of a revenue sharing case brought against a financial service provider in which the class that the plaintiffs seek to certify consists of plan sponsors or trustees. However, it is not the first of its kind and in Ruppert v. Principal Life Insurance Company, 44 EBC 2727 (S.D. Iowa 2008), the plaintiff brought an action on behalf of a class of all retirement plans to which the defendant life insurer was a service provider. The plaintiff sought certification under Federal Rules of Civil Procedure 23(b)(1), 23(b)(2) and 23(b)(3) for claims that Principal had received revenue sharing "kickbacks." However, the district court decided that the claim did not meet the threshold requirements of Rule 23(a) relating to commonality and typicality, thereby making it unnecessary to address the other three parts of the rule. The failure to meet the commonality requirement arose from the fact that the mutual funds offered to plan sponsors varied from plan to plan, as did the marketing materials and the amounts of revenue sharing received by Principal. Thus, Principal's fiduciary status, on which its liability would have been predicated, would also have had to be determined on a plan-by-plan basis.

Excess Fee Cases against Plan Sponsors. Beginning in 2006, more than three dozen lawsuits have been brought against some of the nation's largest employers claiming that they breached their fiduciary duties by failing to negotiate reasonable fees for administrative and investment services in connection with retirement plans that they sponsored. The plaintiffs in these cases typically allege that the defendants failed to understand, monitor and control hard dollar and revenue sharing payments to service providers made directly or indirectly by plans. The cases against plan sponsors have generally sought to certify a class consisting of a broad group of plan participants.

The Seventh Circuit Court of Appeals initiated what may be a trend by giving closer attention to class certification previously granted in the excess fee case of Spano v. The Boeing Company, 633 F.3d 574, 2011 BL 16204 (7th Cir. 2011). As originally constituted, the class in Spano included all participants or beneficiaries who were or may have been affected by the defendants' conduct, as well as future participants and beneficiaries.  This definition met the requirements of Rule 23(a) relating to numerosity of the class members and common factual and legal questions, but the Seventh Circuit held that the putative class failed the typicality requirement since many of its members would not have held investments in the funds that were subject to the complaint. As noted by the court, "a class representative in a defined contribution case would at a minimum need to have invested in the same funds as the class members."

The Seventh Circuit also ruled that the class failed the adequacy of representation requirement given the potential for intra-class conflict arising from the fact that, "A fund that turns out to be an imprudent investment over a particular time for one participant may be a fine investment for another participant who invests over a slightly different period." Thus, it is not sufficient to base membership in a class only on participation in a plan, and those participants who might be harmed by the requested relief must be excluded from the class.

A reaction to Wal-Mart and Spano can be seen in George v. Kraft Foods Global, Inc., 2011 BL 286770, 51 EBC 2793 (N.D. Ill. 2011). In Kraft, the district court had vacated its previous grant of class certification based on the Spano decision to which the plaintiffs responded by proposing modified class definitions. The newly defined class would only have contained members who invested in one of the two actively managed mutual funds subject to the complaint. Further, the class definitions were amended to include only those participants who had invested in these funds between specified dates. Accordingly, not every past, present and future plan participant would have been a class member, as had been problematic in Spano. Finally, in an attempt to meet the Seventh Circuit's criticism in Spano that membership in a class should not include those who had no complaint with the funds at issue, only those participants whose investments in the complained of funds underperformed a prudent alternative were to be covered by the class. The two funds chosen for making this comparison were specifically identified Vanguard mutual funds which were passively managed and provided a better investment result during the specified period.

The district court in the Kraft case thought that the redefined classes were an improvement in that they sought to include only participants who had been harmed by the defendants.  Nevertheless, the court held that the redefined classes still did not meet the class certification tests as interpreted by Spano.  The problem with the new definitions lay with the use of the Vanguard funds as comparators.

To state a claim for fiduciary breach, the plaintiffs were required to show that the defendants' alleged breach of fiduciary duty resulted in harm to the plaintiffs. In the court's view, an underlying assumption of the proposed class definitions was that all of the class members would have invested in the Vanguard funds in place of the actively managed funds subject to the complaint if the Vanguard funds had been available as a plan investment option. The court thought that this was "less than obvious" and ruled that class certification resting on this assumption was not appropriate for the loss and causation issues.

The court was also troubled by the implication that a class certification relying on references to the Vanguard funds would mean that a comparison with those funds would be appropriate for purposes of measuring loss. Since the appropriate calculation of damages was an unresolved issue, the court warned against using class certification as a backdoor way of resolving this matter. Although the Kraft plaintiffs were allowed to amend their motion for class certification, they ultimately chose to settle the case in February 2012.

Conclusion. Until recently, district courts overseeing revenue sharing and excess fee cases have routinely granted class certification without rigorous attention to Rule 23 of the Federal Rules of Civil Procedure. The basis for granting certification has frequently been the offhand observation that commonality can be found in the fact that the defendants' conduct affected all the plaintiffs, be they plan trustees or plan participants. The recent cases discussed above indicate that, while class certification remains possible in cases involving §401(k) plans, the potential conflict between various categories of plaintiffs requires narrower definitions of the class that align the interests of the class representative and the class members.

For more information, in the Tax Management Portfolios, see Wagner, Bianchi, and Marathas, 374 T.M., ERISA - Litigation, Procedure, Preemption and Other Title I Issues,  and in Tax Practice Series, see ¶5560, Specialized Retirement Plans.