Issuing a much anticipated opinion, the U.S. Court of Appeals for the Seventh Circuit held that a 401(k) plan sponsor, a mutual fund investment advisor and an affiliated trustee were not subject to suit for providing investment options with allegedly excessive and unreasonable fees and failing to disclose revenue-sharing arrangements between the mutual fund investment advisor and the plans’ directed trustee and recordkeeper. See Hecker v. Deere, Case Nos. 07–3605, 08–1224, 2009 WL 331285 (7th Cir. Feb. 12, 2009). The benefits community has intently monitored the Deere case because it was the first of the recent 401(k) fee disclosure class action lawsuits to have been dismissed by a trial court with prejudice in its entirety — a dismissal which has now been affirmed by an appellate court. The Seventh Circuit’s decision strikes a blow to participant-plaintiffs at a time when the Department of Labor’s regulations on fee disclosures by service providers and plan fiduciaries, proposed under the Bush administration but never finalized, appear to have been tabled (at least temporarily) due to the change in Presidential administration.
Plans Offered Broad Selection of Investment Options; Fee Sharing Not Disclosed
Equipment manufacturer Deere & Co. sponsors and serves as plan administrator for two 401(k) plans. Together, the plans held more than $2.5 billion in assets as of the end of 2005, more than half of which was invested in twenty-three Fidelity mutual funds that were also available on the open market to individual investors. Besides these retail mutual funds, the other investment options offered to participants were a Deere company stock fund, a Fidelity-operated brokerage window called BrokerageLink, and two investment funds managed by Fidelity Management Trust Company (“Fidelity Trust”). The BrokerageLink option offered participants their choice of approximately 2,500 additional funds managed by different companies. All participants were free to choose the particular funds — among the available options offered — in which they wished to invest their plan account balances.
Deere appointed Fidelity Trust as directed trustee and record-keeper to the plans and together they agreed that Deere would select Fidelity funds as investment options under the plans. Fidelity Trust, as trustee, received no direct compensation from the plans themselves. A related corporate entity, Fidelity Management and Research Company (“Fidelity Research”), served as the investment advisor for the Fidelity mutual funds offered by the plans. Fidelity Research received an asset-based fee (ranging from .07% to 1.01% based on the particular fund) from the assets of the mutual funds for which it served as investment advisor and shared some of the fee revenue it received with Fidelity Trust. The total fee, and the itemization of that total fee into management fee, service fee and other expenses, was disclosed to plan participants in fund prospectuses and the fees charged to the Deere Plans were the same as those charged to retail fund customers. The existence and amount of fee sharing between Fidelity Trust and Fidelity Research were not known by Deere or disclosed to plan participants.
Hecker Plaintiffs Alleged Breaches of Fiduciary Duty Regarding Provision of Investment Options and Disclosure of Fee Information
Three plan participants, individually and on behalf of a class of similarly situated participants, sued Deere, Fidelity Trust and Fidelity Research. They alleged that Deere and the Fidelity entities were fiduciaries who violated their duties under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) in providing investment options that required the payment of excessive fees and costs (that were ultimately borne by participants) and by failing to adequately disclose information about the fees and costs to participants. The plaintiffs alleged that a lack of transparency in the fee structure arose from Fidelity Research sharing its fees with Fidelity Trust because some expenses reported as incurred for fund management were actually used for trustee and administrative expenses. The plaintiffs faulted Deere for allegedly failing to properly monitor Fidelity Trust’s actions and to inform participants of the revenue sharing arrangements.
The defendants moved to dismiss the complaint for failure to state a claim.
The District Court Dismissed the Claim in its Entirety
Granting dismissal with prejudice, the U.S. District Court for the Western District of Wisconsin held, with respect to Deere’s fiduciary obligations regarding disclosure of fees, that Deere complied with all applicable disclosure requirements. It found that nothing in ERISA or applicable regulations directly required disclosure of the revenue sharing between Fidelity Research and Fidelity Trust. The fact that the Department of Labor was in the process of formulating regulations regarding fee disclosures signaled to the district court that the existing statute and regulations did not already require such disclosures. Moreover, the court held that, in light of the lack of a specific requirement under ERISA to disclose revenue sharing arrangements, it would not impose an obligation under ERISA’s general fiduciary rules to make such disclosures. Acknowledging that the plaintiffs alleged that the same fees were charged to retail fund customers, the district court held that the reports and prospectuses furnished to participants accurately reflected the expenses actually paid by the plans.
With respect to the defendants’ alleged fiduciary breach for selecting investment options with unreasonably high fees, the district court held that the defendants had met the burden of establishing an affirmative defense under ERISA § 404(c), under which plan fiduciaries are not liable for any losses or breaches resulting from participants’ exercise of control over their accounts in self-directed plans which meet certain requirements. The district court found it significant that the plans offered more than 2,500 investment funds through the self-directed brokerage accounts that, because they were also offered to investors in the general public, had expense ratios that were meant to attract investors. Because plan participants had access to the relevant expense ratios for each investment fund and could take those into consideration when choosing their portfolio of investments, the court held that to the extent participants incurred excessive expenses their losses resulted from the participants’ exercise of control over their investments within the meaning of ERISA § 404(c). The district court further held that neither of the Fidelity defendants functioned as a fiduciary with regard to the selection and/or provision of investment options or the disclosure of information to plan participants.
Following an unsuccessful motion for reconsideration of the district court’s ruling, the Hecker plaintiffs appealed the decision to the Seventh Circuit Court of Appeals.
Seventh Circuit Delivers a Wide Ranging Victory for the Defendants
On appeal, the substantive issues addressed by the Seventh Circuit were:
- whether the Fidelity defendants were fiduciaries under ERISA; and
- whether Deere or the Fidelity defendants breached any fiduciary duties, and if so whether ERISA § 404(c) provided an affirmative defense.¹
The appeals court agreed with the district court on all issues.
Fidelity not a Fiduciary
The Seventh Circuit rejected the plaintiffs’ argument that Fidelity Trust exercised the control necessary to confer fiduciary status on it by limiting Deere’s selection of funds to those managed by Fidelity Research. The Seventh Circuit held that even if Fidelity Trust did limit Deere’s selection of funds to those managed by its related corporate entity, that act did not necessarily confer fiduciary status. The court cited cases holding that a service provider was not a fiduciary with respect to the terms contained in its service agreement where it exercised no control over the negotiation and approval of the terms by the plan’s named fiduciary. Under the Trust Agreement between Deere and Fidelity Trust, Deere had ultimate decision-making authority to choose the investment options for the plans. The court held that Deere’s discussion of its decision, or negotiations, with Fidelity Trust did not mean that Fidelity Trust had discretion to select the plans’ investment options. Moreover, the court found it significant that the plaintiffs had admitted in the complaint that Deere had “final authority” over the selection of the investment funds and that Fidelity Trust merely “played a role” in that selection. By so alleging in the complaint, the court held that the plaintiffs could not thereafter argue, in opposition to a motion to dismiss, that Fidelity Trust exercised de facto control over the selection of funds and that Deere “rubberstamped” Fidelity Trust’s recommendations, because the plaintiffs had not put the defendants on notice of the actual claim against which they would need to defend. The court stated that merely playing a role in a decision or furnishing professional advice was not enough to confer fiduciary status on Fidelity Trust.
The Seventh Circuit also rejected the plaintiffs’ argument that Fidelity Research and Fidelity Trust exercised discretion over the disposition of plan assets by determining the amount of revenue Fidelity Research shared with Fidelity Trust, because the fees paid to the Fidelity entities were drawn from the assets of the mutual funds. Under ERISA § 401(b)(1), where a plan invests in any security issued by registered investment company, the assets of the plan include the security in the mutual fund but do not include the underlying assets of the mutual fund. Once Fidelity Research collected fees from the mutual fund’s assets, they became Fidelity assets and were not plan assets. The Seventh Circuit held that Fidelity Trust and Fidelity Research were not “functional fiduciaries” and the Plaintiffs’ claims could not be brought against these defendants.
No Breach of Duty in Non-Disclosure of Revenue Sharing and in Fund Selection
The court then addressed the Plaintiffs’ claims against Deere. The Seventh Circuit rejected the claim that Deere breached its fiduciary duty by not disclosing the revenue sharing arrangement between Fidelity Trust and Fidelity Research. It agreed with the district court that the revenue-sharing arrangement did not violate any statute or regulation. Based on the allegations of the complaint and confirmation by Deere and Fidelity, participants were informed of the total fees imposed by the available investment options and had the ability to select lower cost funds from the available investment options.
The plaintiffs argued that the Summary Plan Description supplements gave the misleading impression that Deere was paying the plans’ administrative costs even though Fidelity Trust recovered its costs, not by direct compensation from Deere, but from sharing in a portion of the asset-based fees that Fidelity Research assessed against the various mutual funds. The Seventh Circuit found that the non-disclosure of the revenue sharing must either be an intentionally misleading statement or a material omission in order to be a breach of fiduciary duty. It noted that the complaint alleged that Deere’s statement in the SPD supplement was an intentional misrepresentation. The record, however, showed that this was not the case — the plaintiffs had submitted evidence showing that Deere believed that Fidelity Trusts’ services were free and thereby had undermined their own allegation that Deere had intentionally misrepresented the facts. The Seventh Circuit also held that the alleged omission of the fee-sharing arrangement was not material, and therefore not actionable as a fiduciary breach, because it was the total fee that influenced a participant’s choice whether to invest in a particular fund, not how the fee was distributed once it was collected from the investor.
Having decided the disclosure issue, the court turned to the matter of the fund selections and found that Deere did not violate its fiduciary duty in selecting the investment options. The plans offered a wide range of investment vehicles that had varying expense ratios and were available to the general public on the open market for the same fee and, therefore, the setting of those fees would be influenced by market competition. The Seventh Circuit held there is no ERISA duty or requirement that every fiduciary must find and offer the cheapest possible fund or include any particular mix of investment vehicles in their plan. Alluding to the settlor function doctrine (a concept borrowed from trust law where the basic structuring of a plan is not a fiduciary act), the court questioned whether Deere’s selection of investment choices for its plans was even a fiduciary function.
Broad Interpretation of the ERISA Section 404(c) Defense
The Seventh Circuit then analyzed the district court’s ruling that the defendants, even had there been a fiduciary breach, were not liable because they had established an ERISA § 404(c) safe harbor defense. Dispensing with an initial procedural issue, the Seventh Circuit held that it could determine, on a motion to dismiss, whether the § 404(c) affirmative defense warranted dismissal of the complaint because the plaintiffs “put it in play” by extensively discussing in the complaint how the plans allegedly failed to meet § 404(c) requirements. While acknowledging there were at least nine or more requirements to qualify for the § 404(c) safe harbor, the court sided with Deere’s position that, because of the complaint’s allegations regarding § 404(c), the plaintiffs had waived the right to complain about the plans’ non-compliance with all but two criteria — the obligation to disclose fees charged and the level of expenses. The Seventh Circuit held that fee sharing by a fund’s management company after the fees are collected from the investor is not one of the types of fees that must be disclosed under the regulations implementing ERISA § 404(c). It also noted again that the revenue sharing arrangement between Fidelity Trust and Fidelity Research was not material with regard to a participant’s decision as to how to invest his or her plan benefits.
The Plaintiffs argued, with the support of the Department of Labor (which filed a brief and appeared at oral argument as amicus curiae), that the § 404(c) safe harbor does not shield a fiduciary from the imprudent selection of mutual funds with excessively high fees. However, the Seventh Circuit declined to decide the issue. Instead, it held that § 404(c) protects a fiduciary who satisfies the criteria of § 404(c) and includes a sufficient range of investment options so that participants retain control over the risk of loss. The court looked to the requirements for investment options in the § 404(c) implementing regulations and noted that the § 404(c) defense is available only if the plan offers “a broad range of investment alternatives.” According to the regulations, this broad range exists if the available investment alternatives provide participants with a reasonable opportunity to:
- materially affect potential return and degree of risk in his or her portfolio;
- have a choice from at least three investment alternatives each of which is diversified and has materially different risk and return characteristics; and
- have the ability to diversify sufficiently so as to minimize the risk of large losses.
The Seventh Circuit held that it is implausible that the plans — whose investment options included the BrokerageLink, with its 2,500 mutual funds with a range of expense ratios — did not provide the participants with a reasonable opportunity to accomplish the three goals required by the § 404(c) regulation. The defendants had established a defense under § 404(c) and could not be held liable for losses related to participants’ investment choices. The Seventh Circuit affirmed the district court’s ruling.
Important Decision for Fee Lawsuits
Because the Deere case has long been viewed as the front-runner (in terms of progress from start to finish) of the several 401(k) fee lawsuits filed against large companies, pending fee lawsuits will most likely be impacted by the Seventh Circuit’s decision. Notably, the Seventh Circuit joins the Third and Fifth Circuit Courts of Appeal² in rejecting the Department of Labor’s interpretation of ERISA § 404(c) as not shielding a fiduciary’s selection of the investment options available under a self-directed plan. It can be anticipated that defendants in pending or future 401(k) fee lawsuits will rely with greater confidence on the § 404(c) safe harbor as an affirmative defense and plaintiffs will likely frame their complaints to exclude allegations that would permit defendants to establish an ERISA § 404(c) affirmative defense on a motion to dismiss.
The district court and the Seventh Circuit in Deere very candidly pointed out the flaws they perceived in the plaintiffs’ complaint, and we are likely to see plaintiffs in the future streamline their allegations to avoid the mistakes noted in Deere. The district court had remarked that the Deere complaint was a “rambling 38 page collection long on legal argument, public policy rhetoric and repetition, but vague in its allegations of facts.” In the Seventh Circuit’s decision, it is clear that the Deere plaintiffs were disadvantaged by the allegations of their own complaint in at least a couple of instances — in its expansive discussion of the § 404(c) safe harbor and in its admission that Deere had “final authority” over selection of the plans’ investment choices while Fidelity Trust “played a role” in that selection. No doubt plaintiffs in other pending fee lawsuit are taking notes and learning from these failures.
¹ The Seventh Circuit also addressed the procedural issues of whether the district court erred by considering documents outside the complaint in determining the motion to dismiss, whether the district court abused its discretion in denying plaintiffs’ motion for reconsideration of its ruling, and whether the district court erred in awarding costs to defendants in excess of those authorized by statute. The Seventh Circuit affirmed the district court in all respects.
² See Langbecker v. Electronic Data Sys. Corp., 476 F.3d 299, 310-11 (5th Cir. 2007); In re Unisys Sav. Plan Litig., 74 F.3d 420, 445 (3d Cir. 1996). The Fourth Circuit has come out on the other side of this issue. See DiFelice v. U.S. Airways, Inc., 497 F.3d 410, 418 n.3 (4th Cir. 2007).