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By Brian J. Lamb
Given the prevalence of ERISA fee litigation, 401(k) plan sponsors are very concerned about identifying and implementing best fee practices to insulate themselves from liability against such claims. Over 50 so-called “fee cases” have been filed to date, with the vast majority pursued as class actions.
The numbers are staggering. Plaintiffs prevailed in the Tussey trial and received tens of millions of dollars in damages and attorneys’ fees (Tussey v. ABB Inc., 746 F.3d 327 (8th Cir.), cert denied, 135 S.Ct. 477 (2014)). Many fee cases settle short of trial, with at least one settlement exceeding $60 million.
In 2017 alone, ERISA class action settlements reached almost $1 billion. In one recent fee case, the complaint seeks to certify a class of “over 300,000 members.” Thus, the anxiety of plan sponsors and their fiduciaries over these potential fee claims is understandable. Like most fiduciary benefit claims, however, the liability risk can be substantially mitigated through preventive practices.
One thorny variety of fee litigation involves bundled services. When hiring 401(k) service providers, there are two basic approaches. In the “bundled services” approach, a single vendor provides all investment, recordkeeping, administration, and education services for the plan; while in the “unbundled services” approach, the plan sponsor chooses a separate vendor to provide each of those distinct services to the plan. There are hybrids, colorfully described as the alliance method or the full-service custom co-bundled platform and the like, which combine features of the unbundled and bundled models (The advice in this article applies equally to such hybrids). For the plan sponsor, the upside of bundled services includes the convenience of one-stop shopping and the opportunity for volume discounts inuring to the benefit of the plan.
But bundled services come with downsides, too: complexity and opacity of pricing, difficulty with comparison shopping, and the potential for hidden or impermissible cross-subsidized fees (where the bundle includes services for the company that sponsors the plan, as opposed to services for the plan itself). The best practice is for the fiduciary to unpack the bundle and scrutinize its contents. If the fees for one service (say, recordkeeping) appear to be below market, does that divert the fiduciary’s attention from what may be higher, unreasonable fees for other services in the bundle? Does it tempt the fiduciary not to question other aspects of the bundled services that might be less favorable to the plan?
There is nothing inherently wrong with bundled services. But the law requires fiduciaries to act prudently. This article advises that the best practice is for fiduciaries to atomize bundled fee proposals: scrutinize the fee for each and every individual service to ensure that it is reasonable on a stand-alone basis. A detailed review is particularly critical with bundled service arrangements, which can require additional effort to parse, understand, and evaluate. Until a granular review is undertaken, a plan sponsor may not fully understand whether bundled services are, relative to the plan’s other options, beneficial or burdensome. If only overall aggregate expenses are reviewed, a fiduciary may fail to uncover unreasonable, excessive or impermissibly cross-subsidized components. Plan sponsors should not wait for the plaintiffs’ lawyers to unpack the bundle for them: the time for close scrutiny is before contracting with service providers, and at least annually thereafter, not after receiving a summons to court.
Although fee issues occasionally surfaced as a tangential part of the long-running company stock cases, plan fee litigation became a primary fiduciary liability concern only recently. In 2006, a St. Louis law firm filed 16 putative class actions against large plan sponsors and a few service providers. The actions initially focused on fees and soft compensation, including revenue sharing, before morphing into attacks on plan menu investment options. The focus later returned to fees. Plaintiffs’ strategies have been adaptive throughout this complex litigation odyssey, and courts have increasingly accepted plaintiffs’ arguments, especially over subsidization of fees in an impermissible manner.
Initially, the cases focused upon plaintiffs’ claims that soft compensation, such as revenue sharing, constituted illegal kickbacks and that plan fees overall were excessive. Early in the fee litigation, courts began rejecting these soft compensation claims. In the Hecker case, the district court granted a Rule 12(b)(6) motion to dismiss, holding that all fees were disclosed consistent with then-existing ERISA requirements; that defendants complied with the requirements of §404(c); that the safe harbor applied; and that plaintiffs could have avoided excessive fees because they had a choice of over 2,500 investments, for which fees were disclosed, through the brokerage window. The district court rejected the argument that defendants had a separate obligation, apart from the fee disclosure requirements, to disclose soft compensation. Thus, the revenue sharing claims were not tenable and the plan’s brokerage window shielded fiduciaries from liability under ERISA §404(c).
The Seventh Circuit affirmed this dismissal on appeal, holding that the fiduciary breach allegations failed to state a claim. (Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009), cert denied, 558 U.S. 1148 (2010)). The Seventh Circuit noted that the Hecker plan offered twenty primary mutual funds with expense ratios ranging from .07% to 1% and that plaintiffs could access thousands of additional investment options at various cost levels through the plan brokerage window.
The costs of these investments were fully disclosed. Faced with this array of options, the Court held that the excessive fee allegations did not state a plausible claim. The court commented that the plan offered a “sufficient mix of investments for their participants” and that “all of the funds were offered to the general public and so the expense ratios necessarily were set against the backdrop of market competition.” The Seventh Circuit noted that a plan sponsor and fiduciary is not obligated “to scour the market to find and offer the cheapest possible fund.” The Seventh Circuit also affirmed the district court’s finding that the fiduciaries were entitled to rely upon the §404(c) safe harbor defense, noting that fees were fully disclosed and participants were offered a sufficient array of investment options. The Seventh Circuit also held that the revenue sharing allegations—that such payments to record-keepers were “kickbacks”—did not state a claim because total fee expense ratios were disclosed. (The DOL has long asserted the position that such payments do not constitute plan assets and reaffirmed its view in DOL Adv. Op. 2013-03A).
In the initial aftermath of the Hecker case, plaintiffs’ fee claims failed to garner much traction. Several courts granted motions to dismiss fee complaints outright. (Renfro v. Unisys Corp., 671 F.3d 314 (3d Cir. 2011); Loomis v. Exelon Corp., 658 F.3d 667 (7th Cir. 2011)). No court ever accepted pure soft compensation claims involving revenue sharing. Plaintiffs’ excessive fee claims morphed slightly, moving from revenue sharing and soft compensation claims to investment prudence contentions. These modified investment claims generally contended that the plan’s menu of options was flawed either because the investments were imprudent or were excessively priced.
By 2008, the litigation had exposed that ERISA and the existing regulatory scheme contained few requirements for fee disclosure. Most fee disclosures were voluntary or contained in fund prospectuses issued under other statutes. But that changed in 2008, when the Department of Labor’s Employee Benefit Security Administration (“EBSA”) promulgated regulations that required new detailed fee disclosures. These disclosure regulations, which became effective in 2012, required service providers to disclose all compensation, including soft compensation amounts, to plan fiduciaries and plans, including the disclosure of fee levels and charges to participants. In addition, plans were required to disclose, in regulatory filings that were publicly available, all compensation paid to service providers.
In guidance to plan sponsors, EBSA has coupled its description of the differences between bundled and unbundled services with this admonition: “Fees need to be evaluated keeping in mind the cost of all covered services.” As it relates to bundled services, EBSA has urged fiduciaries: “Compare all services to be provided with the total cost for each provider. Consider whether the estimate includes services you did not specify or want. Remember, all services have costs.” Plan sponsors are advised to make “meaningful comparisons” among service provider proposals and to request sufficient information to “assist you in understanding the services, assessing the reasonableness of compensation (direct and indirect), and determining any conflicts of interest that may impact the service provider’s performance.”
The information provided by service providers “should include a description of all compensation related to the services to be provided that the service providers expect to receive directly from the plan as well as the compensation they expect to receive from other sources.” Together with litigation developments, these increased regulatory requirements served notice upon plan fiduciaries that they carry an obligation to gain an “understanding of the fees and expenses you will pay and a review of those charges as they relate to the services to be provided and the investments you are providing.” In short, scrutinize closely service provider contracts, examine all tranches of services and sources of compensation, and ensure that plan is not subsidizing corporate expenses.
In 2012, after six years of litigation, the Tussey case came to trial in Kansas City. Plaintiffs charged the fiduciaries with failing to monitor the recordkeeping fees paid to the vendor—which they claimed were excessive and effectively used to subsidize the vendor’s other services provided to the corporation—and with making imprudent investment selections for the menu of options provided to plan participants. (Tussey v. ABB, Inc. (W.D. Mo., Mar. 31, 2012)). Plaintiffs further alleged that plan fiduciaries selected the vendor’s mutual funds, which carried higher cost expense ratios, in order to reduce the plan sponsor’s expenses rather than benefit plan participants and beneficiaries. On the fee claims, the vendor was paid two ways by the plans. Initially the vendor was paid through a separate per participant fee. Over time, the vendor was increasingly paid by revenue sharing. Plaintiffs contended that the vendor’s compensation was unreasonably high and that plan fiduciaries had not adequately monitored the fees.
Following a lengthy trial, the district court found the fiduciaries liable for their failure to monitor plan fees. The court found that the fiduciaries had never calculated the amount that the vendor was receiving through revenue sharing even though an outside consultant had raised concerns about the amount of compensation being paid to the vendor. In fact, the same consultant raised concerns that the vendor was using the payments to subsidize other services being provided to the plan sponsor. The district court also found that the plan sponsor failed to consider how the plan’s size, over $1.4 billion in assets by 2000, could be used to reduce plan expenses through leveraging its purchasing power. Specifically, the district court found that plan sponsor could have negotiated rebates from the vendor. The district court held that the plan’s investment policy statement required plan fiduciaries to explore using the plan’s size to obtain service provider rebates in order to reduce plan expenses. The court also found $40 million in liability arising from an alleged fiduciary breach involving mapping of investments from a predecessor plan. This finding was reversed and remanded for retrial on appeal).
The district court found that the defendants’ failure to monitor recordkeeping fees violated their duty of prudence under ERISA §404(a)(1)(B). The court also held that defendants’ failure to follow the investment policy guideline constituted a breach of their obligation to administer plans in accordance with their written documents. The court held that the plan suffered losses of $13.4 million, which the defendants were obligated to restore to the plan.
In a separate finding, which is highly relevant to the discussion below, the district court held in the alternative that the plan sponsor breached its fiduciary duty to act solely on behalf of the interests of plan beneficiaries and participants when it knowingly permitted a service provider to use excessive fees charged to the plan to cross-subsidize its corporate expenses. The service provider performed other services for the plan sponsor, in its corporate capacity, and charged below-market compensation for such services.
On appeal, the Eighth Circuit affirmed the fiduciaries’ liability for failure to monitor the service provider’s recordkeeping costs. The Court of Appeals commented that the district court had accepted the concept of revenue sharing as commonplace in the industry and was not predicating its liability findings on such fee practices, but found other failings. (746 F.3d at 337). The Court of Appeals held that the finding of excessive fees was amply supported by the record and affirmed the finding. The Eighth Circuit did vacate separate liability for investment selection and remanded the case.
If the Seventh Circuit’s decision in Hecker constitutes the high water mark for the defense of these claims, the Eight Circuit’s decision in Tussey represents the nadir. Following the district court’s decision in Tussey, several cases first filed in 2006 settled for substantial sums, including Bechtel, Boeing, International Paper, Cigna, and Lockheed Martin.
With these settlements, fee actions against defined contribution plans have become engrained in the fiduciary litigation and liability landscape. During the period 2014 through 2017, plaintiffs have filed at least 30 fee actions against defined contribution plans, including 403(b) arrangements involving colleges and universities. The U.S. Department of Labor has also filed fee cases against plan fiduciaries and sponsors and has obtained substantial relief in several actions. The case law has developed substantial deference to plaintiffs’ fee claims. Although a motion attacking the complaint’s viability is filed in most fee cases, courts have declined to grant relief except in isolated occasions. (In 2017, Chevron Corporation obtained relief, at least preliminarily, with the district court dismissing the complaint because it contained such generalized allegations that it lacked plausibility under Twombly. White v. Chevron Corp., No. 4:16-cv-000793 (N.D. Cal., May 31, 2017) (appeal pending)).
Overall, the case law and the regulatory developments have trended toward higher fiduciary prudence standards concerning fees, which should motivate plan fiduciaries to carefully scrutinize bundled fee arrangements.
Although the parameters of fee liability are not firmly established, and plaintiffs are pressing the outer scope of liability in light of apparent judicial receptivity to these claims, the case law has established some guidelines. One can reasonably anticipate that plaintiffs will be testing new theories and seeking to expand the types of claims asserted in fee litigation in unanticipated ways. These predictions do not necessarily mean that fiduciaries are hopelessly exposed to litigation claims. Like most fiduciary benefit claims, fee claims can be mitigated or avoided through appropriate preventive practices.
Plan fiduciaries taking a plan action are obligated to act, of course, solely in the interests of plan participants and beneficiaries and for the exclusive purpose of providing benefits to participants. (ERISA §404(a)(1)(a)). Fiduciaries also have the duty of acting prudently, which is defined as acting with the skill, care, prudence and diligence of a person acting in a like capacity. (ERISA §404(a)(1)(B)). Based upon these two tenets of fiduciary responsibility, plan fiduciaries face liability for excessive plan expenses paid by the plan to a service provider. (Santomenno v. John Hancock Life Ins. Co., 768 F.3d 284 (3d Cir. 2014)).
Furthermore, any transaction involving payment of plan assets must also satisfy ERISA’s and the Code’s prohibited transaction provisions, which are prophylactic in nature. (ERISA §§406 & 408). These provisions basically bar transfers between a plan and a party in interest unless one of their provisions are satisfied, the chief one being that the fees are reasonable. (ERISA §§406(a)(1)(c); 408(b)(2)). As noted above the Department has promulgated extensive regulations under §408(b)(2) that come into play. The §408(b)(2) regulations detail two requirements which are required to satisfy the necessary and reasonable compensation standard. A service provider to a 401(k) plan is generally deemed to be providing a necessary service; the issue is whether the compensation is reasonable. While such an inquiry is dependent upon the facts and circumstances of each situation, the regulation imposes a duty upon fiduciaries to understand and critically consider a service provider’s fees and services and compare them to other alternatives in the marketplace. (29 CFR §2550.48b-2).
The duty here is a high one, and the case law does not provide clear and unambiguous guidance. The Seventh Circuit has suggested that a fiduciary needs to conduct a request for proposals to determine if the service provider’s proposal is reasonable. (George v. Kraft Foods Global, Inc., 641 F.3d 786 (7th Cir. 2011)). Even if an RFP is not conducted, a fiduciary clearly has to demonstrate that it considered other service providers in addition to the one providing the bid. There has been some dispute over whether a fiduciary is obligated to review the overall fees produced by a bundled arrangement or review each tranche independently to determine whether the fee for that particular service is reasonable. (Compare Hecker, 556 F.3d at 585-86 (focus is on bundled overall fee) with Tussey, 746 F.3d at 336 (each tranche of service, even in bundled arrangement, must be reasonable)).
Fiduciaries are also obligated, under the current regulatory maze, to make cost allocations across a plan. In Field Assistance Bulletin 2003-03, the Department held that such allocations must be part of a deliberative fiduciary process. There, the Department stated, “A plan fiduciary must be prudent in the selection of the method of allocation. Prudence in such instances would, at a minimum, require a process by which the fiduciary weighs the competing interests of various classes of the plan’s participants and the effects of various allocation methods on those interests.”
Given these regulatory requirements, cost allocations become more difficult when a fiduciary does not understand each tranche of service, but only sees the overall cost. For example, a fiduciary will lack the requisite information to effectively weigh the competing interests of various classes of plan participants if the plan’s service providers or their affiliates receive, or plan to receive, more ancillary streams of income from plans, such as income from in-kind IRA rollovers, that the fiduciary may not know about.
These fiduciary obligations may be amplified by ongoing regulatory efforts to expand the definition of fiduciary investment advice. The SEC, on April 18, 2018, issued a proposed package of rulemakings and interpretations to enhance the quality and transparency of retail customers’ relationships with investment advisors and broker-dealers, including requiring broker-dealers to disclose key facts about their relationship with the customer, act in the best interests of the retail customer, and maintain policies to identify and address material conflicts of interest. Also, some individual states (e.g., Nevada) are pursuing their own fiduciary rules, which raises the specter of patchwork regulation.) Any recommendation concerning plan distributions, including IRA rollover solicitation, may now (or in the future) constitute fiduciary investment advice, and plan fiduciaries may be responsible for monitoring service providers’ rollover marketing and solicitation to plan participants. This monitoring responsibility may be more difficult given that the service providers’ rollover income may not be captured under the §408(b)(2) disclosures.
Increasingly, some service providers have also sought to provide a commoditized service below cost, typically recordkeeping, in order to gain a competitive advantage in providing another service. Some service providers, for example, have offered deeply discounted bundled service arrangements, such as in-plan advisory and related services, knowing of advantages that it will have in securing IRA rollovers for participants and beneficiaries who sever their relationship with the plan sponsor or otherwise leave the plan. Through the IRA rollovers, the service providers may more than recover any loss in offering the recordkeeping or other plan service discount. It has often been believed that participants can benefit from such arrangements, too, for example by being permitted to conduct an in-kind rollover without having to convert a distribution to cash. The point is that a fiduciary should factor this arrangement into its analysis of the reasonableness of the provider’s fees. A fiduciary who accepts such an arrangement without discernment is taking on liability risk. Both plaintiffs’ counsel and the Department have this arrangement in their sights. The DOL is examining whether a bank has been pushing participants in low-cost corporate 401(K) plans to roll their holdings into more expensive IRAs. The GAO issued a report that expresses concern about programmed rollovers especially regarding the accuracy of communications provided to participants. (See GAO Report to Congressional Requesters, 401(k) Plans Labor and IRS Could Improve the Rollover Process for Participants (March 2013) 29, 37-38)). Additional revenue sources such as rollover income could become subject to fiduciary scrutiny.
Finally, the case law makes clear that the §404(c) defense does not provide a defense to a fiduciary’s contracting with a service provider or agreement over plan architecture or investment options, including IRA rollovers. Many of these claims have arisen from plaintiffs’ claims that the plan presents a closed architecture of investment options heavily weighted to one service provider’s funds or imprudent plan options. The selection of plan investment options is a fiduciary function that is not shielded by ERISA § 404(c).
These principles could impose fiduciary liability upon fiduciaries and plan sponsors that facilitate targeted or anticipated rollovers to a service provider. In short, service providers’ income from all sources should be examined as part of the determination whether a proposal is reasonable.
In today’s litigation environment, virtually any 401(k) plan could face a fee claim. To mitigate the fiduciary liability, a plan sponsor should consider these best practices.
First, a plan sponsor must ensure that there is a documented record of the fiduciary’s procedural and substantive prudence. Procedural prudence requires a demonstration that fiduciaries methodically met and reviewed plan matters in an organized manner. “Good old-fashioned ‘kicking of the tires’” is how one court recently put it. Sacerdote v. New York Univ., Case No. 1:16-cv-06284-KBF (S.D.N.Y., July 31, 2018 opinion and order entering judgment for defendant). With regard to service provider engagements, fiduciaries undoubtedly would be required to demonstrate that they evaluated/monitored the service provider before and after contracting, including while the provider was discharging its contractual obligations.
Second, prior to contracting, each service provider proposal should be scrutinized for the cost of each distinct service, as well as overall costs. Especially with bundled proposals, fiduciaries should price each level of service, ensure that it is reasonably priced, and beware of any impermissible cross-subsidization of fees within the plan, or, impermissible cross-subsidization of the plan sponsor. If the fees set for a particular service appear too low—for example if the recordkeeping fees drop 25% from the prior year for the same level of service—but other fees appear high or the service provider requires provision of additional services, the service provider may be cross-subsidizing fees. Plan sponsors should raise the issue with the service provider and demand a documented explanation for the discrepancy. Whose ox is being gored? Are certain classes of participants benefitting, to the detriment of others? Fiduciaries who ask such questions should mitigate the risk of exposing themselves to a fee claim.
Third, fiduciaries, with the assistance of fee consultants, should attempt to benchmark each level of service to other marketplace fees and proposals. In some cases, this may require a request for proposal (RFP) or a more limited request for information (RFI). The fiduciaries should ensure that each service is benchmarked and that independent diligence is conducted in an unbundled manner for each service.
Fourth, plan fiduciaries should consider the pros and cons of unbundling recordkeeping services from other distinct services. Most of the fee claims to date have arisen from recordkeeping service charges, either claiming that the soft compensation from revenue sharing is excessive or the total fees are excessive. Certainly the task of examining each level of service is more easily satisfied if the plan service model is unbundled and each fee is separately benchmarked.
Fifth, plan fiduciaries should be sensitive to any proposals that demand that the plan close its architecture by concentrating investments on the service providers’ investment products. Numerous claims have arisen based upon allegations that a plan’s architecture was closed and offered for the most part only the service provider’s investment products. If those proprietary investments perform poorly (viewed with the benefit of hindsight, which is not supposed to be relevant), plaintiffs’ lawyers may sharpen their pencils.
Sixth, the DOL is scrutinizing aggressive tactics by some service providers regarding IRA rollovers. Plan sponsors should be cognizant of structural elements that position the service providers to facilitate IRA rollovers to themselves. For example, a service provider might allow 401(k) participants to make in-kind rollovers only to IRAs operated by that provider, not to ones operated by competitors. Perhaps this kind of structural advantage is good for participants, and is not the kind of aggressive tactic that will be challenged in litigation. But fiduciaries are in a better position to defend their own conduct and the conduct of those they engage to serve the plan if they ask questions and actively consider the merits. “I wasn’t aware of this practice” is not a good starting point for mounting a defense of the practice once challenged.
Finally, plan sponsors and fiduciaries should carefully review their existing policies with service providers to determine if the service providers solicit rollovers from the plan. If so, the plan sponsor should scrutinize the service providers’ practices with respect to rollovers, and demand information for audit purposes on an ongoing basis from the provider with regard to frequency, asset base from the rollovers, and anticipated compensation from the rollovers. If the service provider declines to provide information, fiduciaries should make their own estimate of these factors. Fiduciaries should determine whether such targeted or anticipated rollover solicitations into a proprietary product are in their participants’ best interest and must take corrective action to ensure that participants are afforded some competitive choice if they determine that a favored rollover is not serving their participants’ best interest, especially when the service provider may be willing to deeply discount in-plan services such as recordkeeping in order to achieve preferred positioning of the IRA rollover and other retail services.
In conclusion, plan sponsors and fiduciaries are on notice that plaintiffs’ lawyers and regulators are hyper-focused on fees – a fact that is not likely going to change anytime soon. Preventive measures are a fiduciary’s best friend.
Brian J. Lamb is a partner at Thompson Hine LLP in Cleveland, Ohio. His practice focuses on representing companies and their directors and officers in complex business disputes, including ERISA litigation, securities and shareholder litigation, and other fiduciary disputes. He is the practice group leader of the firm’s business litigation group, which has more than 80 lawyers in seven offices.
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