Litigation reform – investment management fees

This is the second article in our series on the issues ERISA fiduciary litigation presents for plan sponsors – litigation over plan fees for investment management services. The remarks we made in our earlier article on the preliminary issues applicable to ERISA fiduciary litigation – the ERISA prudence standard with respect to fees, who gets sued and why, and the importance of and rules with respect to the motion to dismiss – will also apply to litigation with respect to investment fees.

What’s different about investment fees?

Why are we treating investment management fees separately from administrative fees? The ultimate fiduciary obligation is the same as for administrative fees – fiduciaries have “a continuing duty to monitor plan expenses and ‘incur only costs that are reasonable in amount and appropriate’ with respect to the services received.”

The fundamental problem for plaintiffs’ attorneys in ERISA fiduciary litigation is proof – in fee litigation, “how do you prove that the fees the plan paid are too high?” With respect to administrative services, many courts see willing to accept the idea that, e.g., recordkeeping services are something like a commodity, so that a comparison of costs can be made between two similarly-sized but otherwise totally different plans, like the Texas employee retirement system’s “Texa$aver Plan” used as a comparator in Tussey v. ABB.

This approach does not work as well for investment management services for several reasons:

• Most obviously, with respect to actively managed funds (at least), the services aren’t a commodity. Every active manager is pursuing its own (theoretically unique) strategy.

• Investment management services are often “bundled with” other services or involve revenue sharing arrangements or, e.g., securities lending, making it unclear what fees are being paid for what services.

• There is a conceptual problem about whether investment management fees – rather than net returns – matter at all.

Broad outline of the courts’ position on these issues

The courts struggled for some time with how to handle these issues, as plaintiffs’ attorneys threw everything at the wall to see what would stick. Here is (more or less) where they have come out:

Actively managed funds: With a couple of exceptions, courts have generally not allowed fee suits targeting actively managed funds (in a plan fund menu), accepting the idea that these services are in effect unique. Thus they have generally rejected comparisons to lower costs for “cheaper strategies” (e.g., comparing fees for an actively managed US large cap fund to fees for a passively managed S&P 500 index fund) or “cheaper formats” (e.g., comparing the plan’s actively managed mutual fund to the “same strategy” in an allegedly cheaper collective trust).

Index funds: Courts have (in some cases) been willing to compare costs for index funds (e.g., comparing the expense ratios of the plan’s S&P 500 index fund to the expense ratio on other available S&P 500 index funds). These cases have in recent years, however, become much less common.

Share class/retail vs. institutional. Courts have been willing to allow (past the motion to dismiss stage) claims based on the plan’s use of a more expensive share class (especially, a retail share class rather than an institutional share class). Often, courts will defer mitigating issues – e.g., where the retail share class is, because of revenue sharing, on-net a better deal – until after discovery.

Emerging issue: prohibited transaction exemption requiring reasonable-ness

There is an emerging line of cases in which plaintiff’s claim is not based on prudence but on ERISA’s prohibited transaction (PT) rules. One version of this sort of claim is based on ERISA’s identification of the provision of services as (read literally) a prohibited transaction. There is an exemption for this PT that requires that the compensation for the services be reasonable. InBugielski v. AT&T the Ninth Circuit held that, based on this analysis, plan fiduciaries must review for “reasonableness” payments to service providers, including payments by third parties. (At issue in Bugielski were payments (related to the AT&T plan) made by Financial Engines to the plan’s recordkeeper.) The viability of these sorts of claims is currently before the Supreme Court in Cunningham v. Cornell University.

Once again: would you please just tell us what to do?

To repeat (in the context of litigation with respect to investment management fees) what we said with respect to administrative fees, what is really missing in all is clarity about what the law requires.

If it is the case that mitigation (via revenue sharing or other rebates) of the “sticker price” for services can only be taken up after the motion to dismiss and discovery stages, then sponsors and the industry can restructure fee arrangements to avoid possible litigation. Although, there may be advantages to plans entering into these sorts of arrangements that some policymaker – e.g., a regulator or Congress – should at least consider.

If fiduciaries are to examine all third-party payments with respect to the plan received by any service provider, some policymaker – e.g., a regulator or Congress – should say so, in so many words.

And some policymaker should comprehensively address the fundamental conceptual issue here – why, and under what circumstances, should investment management fees, as opposed to net returns, matter at all to a plan fiduciary?

More broadly: we all accept that a fiduciary “shouldn’t do stupid things with participants’ money.” But the law and the courts should recognize that fiduciaries should be allowed some latitude in this regard. Again, to repeat what we said with respect to administrative fees: shouldn’t the test be “is it possible that some prudent fiduciary might agree to this fee arrangement?” rather than “is there some other fiduciary somewhere in the world that got a better deal?”

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We will continue to follow this issue.