Last week, Justice Diane Woods of the federal 7th Circuit Court of Appeals decided on Hecker v. Deere in favor of the Deere defendants.Â The decision deals a major blow to Schlichter, Bogard & Denton, the St. Louis law firm with 13 other ERISA lawsuits pending against some of the largest 401k plan sponsors in the country. While lead attorney Jerome Schlichter will argue that each of his cases are unique, the fact of the matter is that most of the suits will be affected significantly by the Deere decision.
I won’t discuss this decision in granular detail, but I would like to address three major implications of the Deere decision. The first is the broad immunization that 404(c) was deemed by the courts to offer the Deere fiduciaries. Second is the court’s heavy reliance on access to lower-cost funds through a brokerage window, in defeating claims of excessive investment fees within the core options of the investment menu.Â Finally, the courts took the view that fee disclosure, and particularly disclosure of revenue-sharing payments, is completely irrelevant to the investment decisions of participants.
First, when it comes to 404(c) I believe that it is fairly clear that the court’s understanding of 404(c) is very different from that of the Department of Labor.Â In point of fact, the Department of Labor submitted an Amicus Curiae in support of the plaintiffs that made it very clear where the DOL stands on the 404(c) issue:
” (T)he statutory safe harbor in section 404(c) does not immunize the Plans’ fiduciaries to the extent they acted imprudently in offering investment options with excessive fees. The Secretary’s regulation interpreting section 404(c), issued after notice and comment pursuant to an express delegation of authority, reasonably interprets 404(c) as providing no defense to the imprudent selection or retention of an investment option by the fiduciary of an individual account plan that otherwise provides for participant-directed investments. The Secretary’s contemporaneous interpretation to that effect is expressed in the preamble to her regulation, in briefs, and in Department of Labor Opinion Letters, and is therefore entitled to the highest level of deference under controlling Supreme Court precedent. This interpretation has effectively ensured for fourteen years that plan fiduciaries retain responsibility â€“ and accountability â€“ for the prudent selection and monitoring of plan investment options in accordance with ERISA’s stringent fiduciary obligations. The court’s decision to disregard this interpretation sharply limits the liability of fiduciaries that have imprudently selected or maintained investment options in individual account plans, gives insufficient deference to the Secretary’s determination of an issue expressly delegated to her by Congress, and threatens to deprive participants in individual account plans of adequate remedies for fiduciary misconduct. The court thus erred in dismissing the plaintiffs’ claims based on its misconception about the scope of ERISA section 404(c).” Department of Labor, Amicus Curiae.
The DOL’s interpretation of section 404(c) offers a more limited safe harbor to plan fiduciaries than the court’s interpretation. Under the court’s interpretation plan fiduciaries can seemingly offer “imprudently and disloyally selected investment options with excessive fees” and still be offered protection from liability under 404(c).Â Until the differences between the court’s interpretation and the DOL’s interpretation ultimately get resolved, for the sake of prudence I imagine most plan sponsors will continue to subscribe to the DOL interpretation. I want to make it clear that I am offering no analysis of the prudence or imprudence of Deere’s investment menu, only an analysis of the potential effect of the Deere decision on fiduciary obligations under ERISA.
Second, in this decision the court placed a high value on access to a brokerage window and to retail mutual funds to shield fiduciaries from claims of excessive fees. Both U.S. District Court Judge Shabaz and Justice Woods were impressed by the volume of funds in Deere’s brokerage window.Â Both Justices felt that because all of Deere’s retail mutual fund investment options were “offered to investors in the general public,” their expense ratios were “set against the backdrop of market competition” and therefore must be reasonably priced.Â I find this to be a curious defense.Â By this logic, a mutual fund manager could open a fund with a 5% expense ratio and provided it was available to the “general public” it would be acceptable under this definition – which is hardly compelling logic.Â While it is most certainly true that ERISA does not require fiduciaries to “scour the market to find and offer the cheapest possible fund,” the law does impose duties of loyalty and prudence.Â The true question of prudence is not how many funds are offered, nor whether or not these funds are offered to the public, but rather, whether a prudent investor “acting in a like capacity and familiar with such matters” would select the same retail mutual funds in the core funds as well as the brokerage window as those selected by the Deere fiduciaries.Â To me, “in a like capacity” does not mean that the Deere fiduciaries must think like a prudent individual “in the general public”, but rather they must think like a prudent investor in control of the design of a $4 billion investment menu.Â Hypothetically an attorney could make the argument that a prudent investor in control of this $4 billion investment menu would be aware of the scale of the Deere plans and seek to use that leverage to obtain investments at a fraction of the current cost. In fact, the Deere fiduciaries may have even been able to use the exact same investment managers in their new lower-cost investment vehicles thus avoiding claims of inferior performance. If the same exact investment managers, and thus the same investment performance, could be obtained for a lower price I think a prudent investor in this situation would pursue this alternative.Â This exact approach has been used by numerous plan sponsors to successfully lower fees and obtain the full benefit of their scale. Again, I do not know whether or not the Deere fiduciaries were in fact in breach of their fiduciary obligations.Â The court thinks they are not, but I think the case here is thinner for the Deere fiduciaries than in other places. In general prudent fiduciaries should always seek to eliminate unnecessary fees, as it is generally both good for participants and good for limiting fiduciary risk.Â On a more practical note, BrightScope has analyzed the percentage of assets in the brokerage window in plans that it has rated and the percentage is ordinarily quite low.Â The core funds are clearly the funds that participants are “nudged” towards, and plan fiduciaries following the DOL’s guidance would likely seek to construct a prudent core menu regardless of whether a brokerage window is offered.
The third and final implication of this decision relates to fee disclosure and particularly disclosure of revenue-sharing payments.Â On one point I agree with the courts.Â There is “nothing in the statute or regulations that required Deere to disclose the fact that Fidelity Research was sharing part of the fees it received with its corporate affiliate, Fidelity Trust.”Â The Department of Labor and Congress are working on improving disclosure of revenue-sharing payments, but right now these payments are generally undisclosed.Â However, the court claims that other than the statutory reporting and disclosure requirements no other disclosures are required under ERISA’s general fiduciary provision.Â In his opinion Justice Shabaz said that any reporting other than the statutory disclosure “would instead require judicial expansion of the detailed disclosure regime crafted by Congress and the Department of Labor pursuant to its statutory authority.”Â Justice Woods did not disagree. The Department of Labor believes that although not laid out in the letter of the law, if a disclosure is material to participant decisions it still needs to be disclosed:
“(T)he Secretary disagrees with the district court to the extent that it dismissed this claim based on its erroneous conclusion that, if a fiduciary satisfies ERISA’s express statutory reporting and disclosure requirements, it can never have additional disclosure duties under ERISA’s general fiduciary provisions. This Court and others have held that ERISA’s duties of prudence and loyalty not only forbid fiduciaries from misleading plan participants, but may, under some circumstances, also require fiduciaries to disclose information that participants need to protect their interests, even if the disclosure is not specifically requested or otherwise mandated in ERISA’s reporting and disclosure provisions.” Department of Labor, Amicus Curiae.
So if additional disclosures may be required under ERISA’s general fiduciary provisions, how do we determine the materiality of these disclosures?Â I would argue these disclosures would include information that materially affects participants’ retirement outcomes.Â I believe that Fred Reish does a great job of explaining why revenue-sharing payments are material:
“If a recordkeeper is receiving $50,000 in revenue sharing, and if a reasonable charge for its services is $50,000 – the same amount – there is no conflict.Â However, if the plan grows with time and the revenue sharing grows to $85,000, but a reasonable charge only increases to $60,000, the fees have become excessive.Â At that point, the responsible fiduciaries have three jobs: to know about the amount of the revenue sharing, to know the reasonable cost of the recordkeeper’s services, and to reclaim the difference for the plan and the participants.”
Fred makes it clear that revenue-sharing is material to fiduciaries, but must it be disclosed to participants? Justice Woods had something very specific to say about the materiality of revenue-sharing to participants.Â Namely, that “the total fee, not the internal, post-collection distribution of the fee, is the critical figure” participants needed to “keep from acting to their detriment.”Â The fundamental difference in thinking here is that the court views only the total fee as being material to the participant, whereas many others view materiality as knowing whether each fee being paid is reasonable.Â They would argue that allowing participants to overpay for something, even if its full price is disclosed, is not acting with loyalty and prudence. The only way to verify that payments are fair is to break out each major category of service and understand how much is being paid for each.Â BrightScope believes that plan fiduciaries should be doing this analysis right now and in the name of prudence they should probably disclose what they find to participants.Â Participants deserve to know if the plan is paying significantly more than other plans of similar size, and if so they deserve an explanation.Â As another benefit, to paraphrase Stephen Rosenberg, this added level of fee transparency which is not currently required by law may actually serve to reduce lawsuits.Â Read more about this argument here.
Now, on to the practical implications of this decision on the other lawsuits filed by Schlichter.Â If a plan is 404(c) compliant and it offers a brokerage window, the Deere decision makes it more difficult to pursue an argument of an imprudently constructed, high-fee menu.Â So let us ask the following two questions of the other companies that face a Schlichter case:
- Is the plan, or any part of it intended to meet the conditions of 29 CFR 2550.404c-1?
- Are participant-directed brokerage accounts provided as an investment option under the plan?
- General Dynamics
- Savings & Stock Investment Plan:Â 1. Yes, 2. No.
- General Dynamics has 9 other 401k plans.
- Northrop Grumman
- Savings Plan: 1. Yes, 2. Yes.
- United Technologies
- Employee Savings Plan – 1. Yes, 2. No.
- Represented Employee Savings Plan – 1. Yes, 2. No.
- Lockheed Martin
- Salaried Savings Plan: 1. Yes, 2. Yes.
- Lockheed Martin has 4 other 401kÂ plans.
- 401k Plan: Yes, Yes.
- ABB Inc.
- Personal Retirement . . . Plan for Employees: Â 1. Yes, 2. No.
- Personal Retirement . . . Plan for Certain Represented Employees:Â 1. Yes, 2. No.
- Voluntary Investment Plan: 1. Yes, 2. No.
- International Paper Company
- Salaried Savings Plan: 1. Yes, 2. Yes.
- Hourly Savings Plan: 1. Yes, 2. Yes.
While this list represents only a handful of the Schlichter cases some trends jump right out at us.Â First, almost every single plan is established in such a way as to be 404(c) compliant.Â In addition it looks like roughly two thirds of the plans on this list do not have a brokerage window.Â Provided each properly complies, the 404(c) hurdle will be tough for Schlichter to overcome.Â If Schlichter does break through without knowing anything else about the plans I would suppose that those plans without brokerage windows might be marginally more vulnerable than those with brokerage windows.Â In the coming weeks I will do a more thorough analysis of the remaining cases and post what I find right here on the BrightScope Blog.
In closing, this is a critically important decision not only because it affects the rest of the Schlichter cases in a meaningful way, but also because of the failing health of Supreme Court Justice Ruth Bader Ginsburg.Â As it stands, Justice WoodsÂ is considered by many to be a front-runner on the Obama administration’s list of nominees to replace Justice Ginsburg.Â While the impact of this decision is large now it could have a much larger impact if Justice Woods became a Supreme Court Justice, a role she appears qualified to hold.
Disclaimer:Â This post is not intended by legal advice.Â BrightScope is not a law firm and is not a fiduciary under ERISA.Â Please contact your legal counsel with legal questions.