Pay to play lawsuits — issues for plan sponsors

Recently, in two separate lawsuits, plaintiffs sued Fidelity, alleging ERISA fiduciary violations in connection with an “infrastructure fee” it charges certain funds that participate in its FundsNetwork mutual fund “supermarket.” In a series of lawsuits going back at least to 2016, plaintiffs have also sued recordkeepers (including Fidelity, Aon Hewitt, and Voya) over fees they have charged Financial Engines to be included as an advice provider on their platforms. The defendant platform providers have generally won these cases.

Why this matters to plan sponsors

Most current litigation in this area is focusing on providers. In the typical case that has (thus far) been decided, courts have dismissed plaintiffs’ claims, finding that the platform provider is not a fiduciary and/or that the transaction has been approved by the sponsor fiduciary. In that context, do these arrangements pose an ERISA prudence challenge for sponsor fiduciaries? After briefly reviewing current “pay to play” litigation, we take up that issue. Bottom line: as with other 401(k) fee litigation, the key question is likely to be, is the plan overpaying for these services? And the answer to that question is likely to turn on the issue of fair market value and the cost of alternative solutions.

Financial Engines cases

In the Financial Engines (FE) litigation, the arrangements between FE and platform providers vary. Under some arrangements, FE is hired by the plan and pays a portion of the fees that it receives to the platform provider. In others, the platform provider contracts directly with the plan and then subcontracts with FE to provide the actual advice services. Either way, some portion of the advice fee goes (it is alleged) to the platform provider, while all advice services are provided by FE. Plaintiffs in these suits are claiming that the fee paid to (or retained by) the platform provider with respect to advice services violates ERISA, typically characterizing it as an illegal “kickback.”

Plaintiffs have lost all of these cases that have thus far been decided. Generally, the courts have found (1) that the recordkeeper (and where relevant its affiliates) was not fiduciary, at least not with respect to the receipt of payments from FE, and (2) that the terms of the FE arrangement were ultimately approved by the plan fiduciary.

Plaintiffs’ prohibited transaction claims generally fail because (1) there is no fiduciary (with respect to the recordkeeper/FE arrangement), (2) the payments do not involve plan assets, and/or (3) no proper allegation is made that the compensation paid by the plan to FE for advice services was unreasonable.

Reasonable compensation

Any payment by a plan to a service provider, e.g., a payment to an advice provider, must generally comply with ERISA’s service provider exemption (ERISA section 408(b)(2)). Among other things, that exemption requires that the amount paid be no more than “reasonable compensation.” Often, in these cases, plaintiffs will argue that since FE is paying part of its compensation to the platform provider, it must be overcharging for its services.

Thus, in Scott v. Aon Hewitt Financial Advisors, et al. (2018), plaintiff argued that “‘a significant portion of the total fees were being syphoned to pay off Hewitt for performing no work and providing no value,’ thus making the total fee paid ‘too high by at least the amount of the [alleged] kickback.’” The District Court for the Northern District of Illinois dismissed this argument as “mere ‘labels and conclusions.’” The court found that plaintiff had failed to “include any factual allegations that challenge the fees paid as not consistent with the fair market value of the services provided or some other acceptable metric for a reasonable fee.” (Emphasis added.)

The Illinois’ courts emphasis on a market value test of reasonable compensation, rather than “who is getting paid by whom,” is an important point that we will come back to.

Supermarket “infrastructure” fee

Fidelity has, since 1989, maintained an open architecture mutual fund “supermarket,” the FundsNetwork, which makes thousands of third-party mutual funds available to Fidelity investors. According to the Wall Street Journal, beginning in 2016 Fidelity began charging some of these third-party funds an “infrastructure fee” to participate in the FundsNetwork.

In February and March 2019, participants in plans for which Fidelity was recordkeeper filed two lawsuits – Wong v. FMR and Summers v. FMR – claiming that this fee violated ERISA’s self-dealing and anti-kickback prohibitions and that Fidelity did not comply with applicable ERISA fee disclosure regulations.

Precise information on how this fee works is sketchy. 

According to the Wong complaint, mutual funds participating in Fidelity’s FundsNetwork pay the fee “in the event that otherwise disclosed 12b-1 fees, administration fees, service fees, sub-transfer agent fees and/or similar fees … fall below a certain level.” The funds pay the fee “in return for [Fidelity] providing the mutual funds with access to its retirement plan customers, including its 401(k) plan customers,” via the FundsNetwork. The Summers complaint alleges, however, that Fidelity “set[s] the Fee amount by reference to each… mutual fund’s industrywide assets, as opposed to its assets held by Fidelity customers.”

We will have to wait for a further development of the facts to get a better idea exactly how this program works, but at this point Fidelity’s infrastructure fee appears to be a charge for access to Fidelity’s mutual fund supermarket and related services. According to the Wall Street Journal, the fee is 15 basis points of total (industrywide) assets, presumably net of certain other fees the funds pay Fidelity.

Purported ERISA violations

The Wong and Summer  plaintiffs claim that Fidelity’s arrangement violates ERISA prohibitions on fiduciary self-dealing and was not properly disclosed. Critical elements of this claim are at this point up in the air:

Is Fidelity an ERISA fiduciary with respect to this fee?   Given how the courts have handled the FE cases, and the rule under ERISA that mutual fund assets are not plan assets, persuading a court to agree that Fidelity is acting as a fiduciary with respect to this fee is probably the toughest issue for plaintiffs in these cases.

Are these fees covered by ERISA (whether Fidelity is a fiduciary or not)?  If they are, did Fidelity comply with its disclosure obligations under DOL’s 408b-2 regulation?

Are these fees “unreasonable?”   And what standard should apply to determine reasonability?

For sponsors

The “pay to play” lawsuits we’ve discussed were all brought against providers – against the platform operator and (in some cases) the advice provider. Do these cases raise issues for plan sponsor fiduciaries?

Prudence and market value

401(k) fee litigation has made clear that sponsor fiduciaries will be held accountable, under ERISA’s prudence rule, for overpaying providers. In this regard, a lawsuit – Pizarro v. Home Depot – filed last year in the United States District Court for the Northern District of Georgia is instructive. Plaintiffs in that case alleged that “Home Depot … allowed participants to pay unreasonable fees to the Plan’s ‘investment advisors,’ first Financial Engines and later AFA [Alight Financial Advisors]. It also constructed a plan with far too many layers of fees, and turned a blind eye to a kickback scheme between Financial Engines and the Plan recordkeeper Aon Hewitt.”

In support of their claim that Home Depot plan fiduciaries imprudently caused the plan to overpay for advice services, plaintiffs alleged that FE’s fees (according to the complaint, 30-50 basis points) “are exorbitant compared to similar investment products.” They alleged that, based on limited user input, FE only provides “cookie-cutter portfolios,” services that are “no more complicated than a [less expensive] standard target date fund.” And, although these services are tantamount to robo-advice, FE charges more than other robo-advisers.

These are, of course, merely allegations, but they go to what is likely to prove the key point – especially for plan fiduciaries (like Home Depot): is the plan overpaying for the advice services being provided? And that issue is – as we have seen in other 401(k) fee litigation, e.g., Tussey v. ABB– likely to be adjudicated based on a comparison with the cost of similar services provided to other plans. Thus, in Tussey, the cost of recordkeeping services for the ABB plan was compared with the cost of recordkeeping services for the 401(k) plan for Texas state employees.

The existence of third-party payments – e.g., from the advice provider to the platform provider – might be an element in plaintiffs’ argument in these cases (as it is in Pizarro). But in the end, if the provider, notwithstanding such payments, is charging less for its services than its (comparable) competitors, the existence of those payments should not be an issue. The plan is still getting the best deal available.

Prudence and the “infrastructure fee”

Similar principles should apply to evaluation of Fidelity’s “infrastructure fee.” The analysis is somewhat complicated by the issue of whether a fund selected from the FundsNetwork (and possibly paying Fidelity an infrastructure fee) is part of the plan’s core investment menu, or the FundsNetwork is simply offered as a “brokerage window.”

While courts seem to allow some latitude with respect to fees charged on funds in a brokerage window, they also seem prepared (at least in some jurisdictions) to hold sponsor fiduciaries to a “best deal” standard for funds in the core menu. (We review these issues in our article Fee litigation: sponsor fiduciary vulnerabilities.)

Fee disclosure

While compliance with fee disclosure requirements under the 408b-2 regulation is primarily the responsibility of the provider, violation of the regulation may result in a prohibited transaction, and the responsible plan fiduciary, by causing the transaction (e.g., retention of the advice provider), may have violated ERISA. The regulation provides an exemption, in certain cases, for such a violation, provided, among other things: (1) the plan fiduciary did not know that provider failed to make required disclosures; (2) upon discovering the disclosure failure, it requests in writing that the provider make disclosure; (3) in certain cases, it files a notice with DOL; and (4) if the provider does not comply with the disclosure request, it “determine[s] whether to terminate or continue the contract or arrangement consistent with its duty of prudence.”

Discussion with providers

Sponsor fiduciaries will want to discuss with the plan’s provider(s) the existence of “pay to play” fee practices generally and, in particular, those practices of which the fiduciaries have notice. It is possible that those fees are not subject to 408b-2 regulation disclosure, but sponsor fiduciaries will want to review the issue.

Documentation

Finally, sponsor fiduciary deliberations with respect to service provider selection, fund menu construction, and service provider disclosure should be thoroughly documented – with a view to the possible production of that documentation in litigation.

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We will continue to follow these issues.