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ERISA Fiduciary Duties When Offering Retail Mutual Funds as 401(k) Investments

In recent years, 401(k) plan sponsors, administrators and serviceproviders have become targets for ERISA class actions asserting breach of fiduciary duty claims based on the fees charged by the funds offered in the plan as investment options. Some of the so-called ERISA "excessive fees" cases challenge the use of revenue-sharing arrangements between the mutual fund providers and other service providers to the plans, and the potential circuit split that developed in 2009 on the issue of whether the Employee Retirement Income Security Act requires fiduciaries to disclose revenue-sharing arrangements to plan participants has been discussed previously.1

Some recent excessive fee cases have focused on whether a fiduciary's decision to offer retail mutual funds as investment options in a 401(k) plan, when investment options with supposedly lower expenses may be available to the plan, such as institutional share classes, collective trusts, and commingled pools, constitutes a breach of ERISA's fiduciary duty requirements. On Sept. 6, 2011, the U.S. Court of Appeals for the Seventh Circuit in Loomis v. Exelon, —F.3d—, 2011 WL 3890453 (7th Cir. Sept. 6, 2011), held that neither the decision to offer retail mutual funds as investment options in a 401(k) plan, nor the decision to require plan participants, rather than the plan, to bear the costs of those retail funds, constitutes a breach of fiduciary duty.

While this decision represents a significant victory for plan sponsors and administrators, the issue continues to be actively litigated, with one case presently pending before the U.S. Court of Appeals for the Ninth Circuit. In this article, we will discuss the Exelon case and offer some advice for defined contribution plan fiduciaries charged with responsibility for adding and removing plan investment options, given the uncertain and rapidly changing state of the law.

Background

Exelon Corporation sponsored a defined contribution 401(k) plan, which offered participants a choice of 32 investment options, 24 of which were "no-load" retail mutual funds open to the public. Id. at *1. These funds did not charge investors a fee to buy or sell shares, but instead covered their expenses by deducting them from the assets under management. Id. The expense ratios of the 32 investment options available under the plan ranged from three to 96 basis points. Id.

A group of plan participants filed an action in the U.S. District Court for the Northern District of Illinois, alleging that Exelon and the plan administrator violated their fiduciary duties under ERISA by (1) offering retail mutual funds, in which participants receive the same terms and bear the same management fees as the general public, rather than by securing access to allegedly less expensive institutional investment vehicles; and (2) requiring plan participants to bear the costs of the mutual fund fees themselves, rather than having the plan bear those costs. Id.

On Dec. 9, 2009, the district court dismissed the complaint, holding that under the Seventh Circuit's decision in Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009), 401(k) plans are not required to offer solely institutional funds, and asset-based revenue sharing arrangements, pursuant to which participants bear the cost of their investment options through a lower return on investment, are permissible. Loomis v. Exelon Corp., No. 06-CV-4900, 2009 WL 4667092, at *4 (N.D. Ill. Dec. 9, 2009).

The participants appealed the district court's dismissal of their claims to the Seventh Circuit. The U.S. Department of Labor submitted an amicus curiae brief in support of the participants' appeal, arguing that in dismissing the participants' fiduciary duty claims, the district court required an "unduly high pleading standard" not contemplated by ERISA, and misread the Seventh Circuit's decision in Hecker. According to the Labor Department, the Seventh Circuit dismissed the complaint in Hecker because the complaint "did not expressly allege that the price [the plan] paid as a large institutional investor was excessive in relation to the services received," and "[b]y continually returning to the point that the panel's opinion was limited to the particular facts as alleged, Hecker clearly and deliberately left the door open for other cases like [Loomis] in which the allegations about fees are tied directly to allegations about services."2

Seventh Circuit Decision

On Sept. 6, 2011, Judge Frank H. Easterbrook, writing for the three-judge panel, affirmed the district court's dismissal of all claims.

The court rejected the plaintiffs' first theory that the plan should have offered institutional mutual funds or other non-public investment options. The court refused to accept the plaintiffs' premise that because the terms of an investment in an institutional investment vehicle would be negotiated by the fund and the plan, the terms necessarily would be more favorable to participants than those of retail funds. Loomis, 2011 WL 3890453, at *2. As in Hecker, the court observed that the fact retail funds are open to the public means that their fees are set by market competition, and there is no guarantee that negotiations between the plan and institutional investment vehicles would produce lower expenses. Id. at *2, 4. Indeed, the court cited an amicus brief submitted by the Investment Company Institute, according to which the average expense ratio of institutional-share classes in equity funds was higher than that of any of the retail funds offered in Exelon's plan. Id.

Even if there were funds theoretically available with lower expense ratios than the funds offered in Exelon's plan, the court held, consistent with Hecker, that "nothing in ERISA requires every fiduciary to scour the market to find and offer the cheapest possible fund." Id. at *2. Further, the court noted that institutional investment vehicles have drawbacks that may outweigh the benefit of lower expenses, such as a lower level of liquidity than retail funds and the inability to make daily withdrawals. Id. at *4.

The court was unpersuaded by the plaintiffs' argument that the fiduciaries should have used the plan's $1 billion size to bargain for lower fees with "the same retail services (such as daily transfers) for which mutual funds charge their normal expenses." Id. The court observed that unlike a rental car company that may receive a "fleet discount" by purchasing cars en masse, fiduciaries of a participant-directed plan cannot guarantee that participant accounts will be invested en masse in any specific investment, and even if the fiduciaries could negotiate a flat per capita fee, as the plaintiffs suggested, that fee structure would benefit some participants at the expense of others, depending on the size of each participant's account. Id.

The court distinguished the Loomis case from Jones v. Harris Associates, L.P., 130 S.Ct. 1418 (2010), and Branden v. Wal-Mart Stores Inc., 588 F.3d 585 (8th Cir. 2009), both of which involved conflict of interest allegations. Jones "dealt with the fiduciary duties of investment advisors, which...have a conflict of interest when seeking management fees from mutual funds under their effective control." Id. at *2. Branden was an ERISA excessive fees case in which the U.S. Court of Appeals for the Eighth Circuit held that, at the pleading stage, allegations that the plan's fiduciary failed to use the supposed purchasing power afforded by the plan's size to negotiate cheaper institutional share classes for mutual funds were sufficient to state a claim for breach of fiduciary duty under ERISA.

In that case, however, the plaintiffs had alleged that the revenue-sharing arrangement between the plan's mutual fund provider and trustee was not intended to compensate the trustee for services rendered to the plan, but was intended as kickbacks for including the mutual funds in the plan. 588 F.3d at 590. In contrast, the Loomis plaintiffs did not allege that Exelon suffered from any conflict of interest in selecting the funds offered in the plan or that Exelon in fact "chose those funds to enrich itself at participants' expense." Id.

As to the plaintiffs' second theory—that Exelon should have borne the expenses charged by the retail funds—the court held that the decision to have participants bear the investment expenses was a question of plan design and was not, therefore, susceptible to challenge as a breach of fiduciary duty. Id. at 83. Citing long-standing Supreme Court precedent, the court reasoned that ERISA does not create any obligation to "make retirement plans more valuable to participants," and "[w]hen deciding how much to contribute to a plan, employers may act in their own interests." Id. (citing Hughes Aircraft Co. v. Jacobson, 525 U.S. 432 (1999), and Lockheed Corp. v. Spink, 517 U.S. 882 (1996)). The plaintiffs' argument was, in essence, that Exelon should have contributed more to the participants' accounts by covering mutual fund expenses. The court held that ERISA did not support plaintiffs' theory of relief.

Advice for Fiduciaries

The Loomis decision represents a significant victory for defined contribution plan sponsors and fiduciaries. As noted above, the use of retail mutual funds as 401(k) plan investment options is a common industry practice, and the Seventh Circuit not only rejected the claim that that practice violates ERISA, but also offered a strong justification for that practice.

Notwithstanding the victory in Loomis, fiduciaries should continue to exercise caution in selecting retail funds as investment options for defined contribution plans. Plaintiffs may endeavor to use the Seventh Circuit's effort to harmonize its decision with the Eighth Circuit's decision in Branden as grounds to argue that while Exelon held that offering retail mutual funds is not a per se breach of fiduciary duty, the court left the door open for claims that the offering of retail mutual funds, plus some other conduct (such as acting based on a conflict of interest), constitutes a breach of fiduciary duty.

Fiduciaries also should be mindful that the closely watched case, Tibble v. Edison International, is currently pending before the U.S. Court of Appeals for the Ninth Circuit. See Case Nos. 10-56406, 10-56415 (9th Cir.). On Aug. 9, 2010, the U.S. District Court for the Central District of California, in the first judgment after a trial in an ERISA excessive fees case, ruled in favor of the defendants on several claims, but also held that plan fiduciaries breached their ERISA fiduciary duty of prudence by failing to investigate the merits of offering retail share classes, rather than institutional share classes of the same funds, when such an investigation would have revealed that "the institutional share classes offered the exact same investment at a lower cost to the Plan participants" and there was no other advantage offered by the more expensive retail share classes to justify the greater expense. Id. at *1747.

It remains to be seen how the Ninth Circuit will rule in the Tibble case, and several circuit courts have not yet had occasion to rule in an ERISA excessive fees case. Notwithstanding the Seventh Circuit victories, as the law in this area continues to develop in other circuits, fiduciaries should continue to scrutinize plan expenses and ensure that they engage in a procedurally prudent process for selecting investment options. In particular, when fiduciaries have a choice between retail and institutional share classes of the same fund, fiduciaries should ensure that there is some advantage offered by the more expensive retail shares in the event that they do not choose to offer the institutional share class.

Jeffrey S. Klein and Nicholas J. Pappas are partners at Weil, Gotshal & Manges.

Endnotes:

1. See, e.g., Employer Update January-February 2010, Fiduciary Duty to Disclose Fee Sharing Arrangements Between 401(k) Plan Trustees and Investment Managers, (discussing Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009), which held that ERISA does not require a plan sponsor to disclose to participants that the plan's investment advisor shares revenue with the plan's other service providers, versus Branden v. Wal-Mart Stores Inc., 588 F.3d 585 (8th Cir. 2009), which held that ERISA plan fiduciaries may be required to disclose revenue-sharing arrangements, if such information would be "material" to plan participants' investment decisions).

2. See Brief of the Secretary of Labor, Hilda L. Solis, as Amicus Curiae in Support of Plaintiffs-Appellants, Loomis v. Exelon Corp., No. 09-4081 (7th Cir. Feb. 2, 2010), available at http://www.dol.gov/sol/media/briefs/loomis(A)-03-10-10.htm.

Reprinted with permission from the December 7, 2011 edition of the New York Law Journal © 2011 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382, reprints@alm.com or visit www.almreprints.com.

This article also appeared in the September-October 2011 Employer Update.

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