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ERISA Liability from 401(k) Plan Revenue Sharing

Employers design and administer 401(k) plans in a variety of ways with the objective of providing employees with investment vehicles to save for retirement, while at the same time maximizing investment returns. One arrangement many 401(k) plans use is called “revenue sharing.” While popular for many reasons, these arrangements have been a magnet for class action litigation, and teachings from recent cases (and the accompanying sizable settlements), suggest that employers should review their 401(k) plans in an effort to stay out of the litigation “line of fire.”

“Revenue sharing” refers to an arrangement where a mutual fund, offered as an investment option in a 401(k) plan, pays either the plan’s sponsor (usually the employer) or a plan service provider (a third-party vendor) a fee for performing administrative or record-keeping services for the plan. This concerns plan participants because mutual funds typically pay such revenue sharing fees to the employer or service provider by periodically deducting the fees from the retirement plan’s invested assets. Although plan sponsors usually have a choice in whether to self-manage or delegate 401(k) plan administrative or record-keeping services, neither option absolves employers of the fiduciary duties to monitor the plan, as mandated by the Employee Retirement Income Security Act of 1974 (“ERISA”).

Plaintiffs in revenue sharing lawsuits typically assert two types of ERISA claims. In the first type of claim, plan participants allege that employers breach their fiduciary duties by collecting, or allowing a third-party vendor to collect, “excessive” revenue sharing fees for administrative and record-keeping services. In the second type of claim, plan participants allege that employers, administering their own 401(k) plans, engage in revenue sharing schemes for their own benefit, rather than the benefit of plan participants, and thereby engaged in a “prohibited transaction.” A number of these class actions have resulted in significant settlement payments, including a $415 million settlement by ING and a $140 million settlement by Nationwide Life Insurance. 

In this month’s column, we analyze two recent cases where plaintiffs challenged revenue sharing arrangements under ERISA. We also provide recommendations for employer to reduce the risk of costly litigation involving revenue sharing arrangements.

Background

ERISA requires that a fiduciary carry out its duties with “the exclusive purpose” of “providing benefits to participants” and “defraying reasonable expenses of administering the plan.” 29 U.S.C. § 1104(a)(1). Although properly executed revenue sharing arrangements comply with law, plan participants have accused employers of breaching their fiduciary duty where the plan sponsor receives, or allows a third-party vendor to receive, “excessive” or “unreasonable” revenue sharing fees. 

Additionally, when employers manage their own 401(k) plans, under certain circumstances, acceptance of revenue sharing payments may provide the basis for liability because such payments constitute “prohibited transactions.” ERISA mandates that a fiduciary shall not “deal with the assets of the plan in his own interest or for his own account.”  29 U.S.C. §§ 1106(b)(1) and (2). When a plan sponsor receives revenue sharing payments in excess of actual administrative or record-keeping costs, plaintiffs have argued that such an arrangement constitutes a prohibited transaction.  

City National

Because most revenue sharing lawsuits are resolved through settlements, very few courts have decided cases involving revenue sharing based on a full factual record. However, in Perez v. City National Corporation, 176 F.Supp.3d 945 (C.D. Cal. 2016), the U.S. District Court for the Central District of California granted partial summary judgement, finding that an employer’s revenue sharing arrangement violated ERISA. In City National, the U.S. Department of Labor filed an action against City National Bank which managed its own 401(k) plan. The DOL claimed that City National violated ERISA by receiving revenue sharing payments from a mutual fund provider both by breaching its fiduciary duty of prudence and by engaging in a “prohibited transaction” with the plan.

The court’s reasoning in City National suggests that plan fiduciaries accepting revenue sharing payments must carefully evaluate the reasonableness of those fees and ensure that they comply with ERISA’s rules governing record keeping and the use of plan assets by fiduciaries. Initially, the DOL established a prima facie case that City National breached its duty of prudence based on evidence of its “failure to track direct expenses, acceptance of fees from the Plan without any review or independent investigation into the reasonableness of the fees, and the failure to reimburse the Plan upon discovery of the unreasonably high fees.” City National sought to rebut this prima facie case by arguing that its administrative fees were reasonable, because they were lower than those of one outside vendor from which it solicited a quote. The court rejected this argument, stating that ERISA’s fiduciary duties are the “highest known to the law” and that a “prudent fiduciary would have done more.”  Id. at 948. The court suggested that City National could have “shopp[ed] administration of the Plan to additional vendors or appoint[ed] a non-conflicted fiduciary” to assess the reasonableness of administrative fees charged to the plan.

City National’s second holding indicates that employers collecting revenue sharing payments in excess of actual administrative expenses engage in prohibited transactions. City National received compensation from the plan “in a mostly automated process without tracking direct expenses or knowing how much direct expenses were required for the Plan’s operation.” Id. at 948. City National justified revenue sharing fees “based on estimates and averages, rather than evidence of direct expenses actually incurred.” Although City National argued that an ERISA exemption, contained in 29 U.S.C. § 1108(c)( 2), allowed for “reasonable compensation,” the court held that this exemption does not apply to fiduciary self-dealing. Therefore, the court found that City National’s use of “averages and estimates,” rather than directly tracked expenses, established “that the Plan's fiduciaries were acting on behalf of City National, rather than Plan beneficiaries.” Id. at 947.

Chevron

While City National states that employers managing their own 401(k) plans must limit revenue sharing payments to actual administrative costs, the same limitations do not apply to third-party plan service providers. Courts have held that third-party service providers can collect revenue sharing fees without regard to actual expenses, as long as the fees are “reasonable.” In White v. Chevron Corp., Case No. 16-cv-0793-PJH (N.D. Cal. 2016), plan participants brought a class action against Chevron which sponsored a 401(k) plan with more than $19 billion in assets and over 40,000 participants. Plan participants alleged that Chevron breached its fiduciary duties by allowing Vanguard, as plan service provider, to collect excessive revenue sharing fees in exchange for administrative and record-keeping services. In August 2016, the U.S. District Court for the Northern District of California dismissed the case without prejudice, holding that Chevron took reasonable steps to monitor plan expenses, despite plaintiffs’ allegations that Chevron did not compare lower cost options or limit revenue sharing fees to actual costs.

In Chevron, the court held that ERISA did not require Chevron to ensure that a third-party service provider limit revenue sharing fees to actual expenses, particularly when Chevron was prudently monitoring costs for reasonableness. Over a two year period, in which plan assets rose exponentially, Vanguard collected revenue sharing payments based on a percentage of plan assets, rather than a fixed per-participant fee. Under these circumstances, plaintiffs claimed this method of calculating fees was inherently excessive and unreasonable. They argued that a prudent fiduciary would have renegotiated Vanguard’s administrative fees. However, because Chevron ended the revenue sharing arrangement after the fees increased for two years, the court concluded that this “plausibly suggest[ed] that defendants were monitoring recordkeeping fees to ensure that they did not become unreasonable.”

Practice Suggestions

Given the recent litigation regarding revenue sharing arrangements, employers should reexamine the extent to which 401(k) plans pay for their administration and record keeping functions using revenue sharing arrangements with mutual funds. The simplest way for employers to avoid this type of liability would be to avoid revenue sharing arrangements altogether. However, because revenue sharing eliminates the need for up-front administration fees, this could foreclose potentially advantageous options for plan participants. Whether employers choose to self-manage our outsource plan administration or record keeping, employers should periodically monitor revenue sharing fees to satisfy themselves that they remain reasonable, or alternatively, consider periodically shopping 401(k) plan administration or record keeping services to compare costs.

Employers administering their own 401(k) plans should track actual record-keeping and administrative costs. In City National, the court stated that the employer “should have kept contemporaneous time records so that it could calculate actual costs of administering the Plan,” rather than relying on “averages and estimates.”  176 F.Supp.3d at 949. ERISA does not necessarily required plans to use fixed, per-participant fee structures, but employers should maintain records to ensure that revenue sharing fees do not exceed actual administrative expenses. Employers also could implement a process for fees to be returned to or “recaptured” by the plan when revenue sharing fees exceed the cost of services provided.

Employers should also consider developing a process to evaluate the reasonableness of fees deducted from plan assets to pay third-party service providers for plan administration or record keeping services. After City National, the court ordered City National to retain an independent, third-party fiduciary to calculate the reasonableness of revenue sharing fees. While retaining an independent fiduciary is certainly not required in every case, courts typically will consider what a neutral, non-conflicted party would decide in determining the reasonableness of revenue sharing fees. Independent fiduciaries, or even outside consultants, might help employers demonstrate the reasonableness of fees and perhaps determine whether to outsource plan administration and record keeping.

Finally, employers should consider comparing fee structures by shopping the administration of their plans to outside vendors. Chevron indicates that there is no requirement to “scour the market” for the cheapest option, but City National suggests that comparing fee structures from multiple vendors is a best practice. Such “comparison shopping” could demonstrate that the employer took affirmative steps to fulfill its ERISA fiduciary obligation to monitor fees.

The area of ERISA revenue sharing litigation is still developing, with large employers, such as Safeway and Edward Jones, currently facing pending lawsuits. See Lorenz v. Safeway, Inc., N.D. Cal., No. 4:16-cv-04903 (complaint filed 8/25/16); McDonald v. Edward D. Jones & Co. L.P., E.D. Mo., No. 4:16-cv-01346 (complaint filed 8/19/16); Schultz v. Edward D. Jones & Co. L.P., E.D. Mo., No. 4:16-cv-01762 (complaint filed 11/11/16). Thus, employers should recognize the risk of ERISA liability and evaluate their revenue sharing arrangements accordingly.

Reprinted with permission from the December 5, 2016 edition of the New York Law Journal © 2016 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

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