On April 11, 2011, the U.S. Court of Appeals for the Seventh Circuit issued an opinion in George v. Kraft Foods Global, Inc.¹ which calls into question common and seemingly non-controversial practices in the administration of ERISA plans. In doing so, the Court’s opinion threatens to increase the administrative burdens on ERISA plan fiduciaries, increase the costs of litigation, or both. Though the Court’s holding specifically applies to unitized stock funds (which most employer stock funds are) and fees paid to plan recordkeepers from plan assets, it may have broader impact on the level of decision-making documentation and service provider fee-shopping that plan fiduciaries will be required to do in order to avoid having to defend their actions in court.
In 2010, the U.S. District Court for the Northern District of Illinois held that the fiduciaries of Kraft Foods Global, Inc.’s (“Kraft”) Section 401(k) Plan (the “Plan”) did not breach their fiduciary duties by maintaining a unitized stock fund for employer stock, and did not breach their fiduciary duties by continuing to use Hewitt as the Plan’s recordkeeper without requesting competitive bids. The plaintiffs appealed the district court’s decision, and a panel of the Seventh Circuit reversed the district court’s holding on these two points. The panel consisted of three judges, one of whom authored a strong dissent. The Appellees filed a petition for a rehearing and, on May 13, 2011, four employee benefit industry groups filed an amicus brief in support of the Appellees’ petition. On May 26, 2011, the same three judge panel of the Seventh Circuit denied the Appellees’ petition for rehearing with no comment and with the same judge dissenting.
Following the Seventh Circuit’s opinion in Kraft, it is likely that ERISA plan fiduciaries will face an increase in participant lawsuits challenging what would otherwise be considered noncontroversial elements of plan administration.
MAINTAINING UNITIZATION OF COMPANY STOCK FUNDS: Plan Fiduciaries May Need to Thoroughly Document Common Administrative and Investment Decisions, Even if the Decision is Simply to Maintain the Status Quo
In 2006, a class of current and former participants in the Kraft Plan filed an action in an Illinois district court against the Plan’s fiduciaries alleging that they breached their fiduciary duties to the Plan’s participants by, among other things, continuing to maintain the Plan’s company stock funds (which held stock of Kraft and its then-parent Altria) as “unitized funds” and by paying excessive fees to Hewitt, the Plan’s recordkeeper.
The unitized nature of the company stock funds (“CSF”) meant that instead of owning shares of company stock directly through the Plan, participants owned units of the CSF. Although the CSFs invested almost exclusively in common stock of Kraft and Altria, they also held approximately 5% of the overall value of the fund in cash. Unitization offers several benefits to participants:
- Unitization allows participants to quickly sell their interests in the fund rather than wait the three days a normal stock sale would take to complete (distributions or transfers to another Plan investment are made out of the cash buffer).
- Unitization allows the Plan to save transaction costs by “netting” participant transactions. Absent unitization, every time a participant initiates either a purchase or sale of stock, the Plan has to enter the market and pay a brokerage commission and other fees on the transaction. Unitization enables a Plan to offset a participant’s request to purchase with another participant’s request to sell, and the Plan only needs to enter the market and pay transaction costs to meet a net inflow or outflow of investment in the fund.
The plaintiffs attacked the perceived downsides of unitization. The plaintiffs complained that because of the funds’ cash holdings, participants who invested in the CSFs did not recognize as great a return on their investment as investors who purchased Kraft and Altria stock directly. Because the CSFs held 5% of fund assets in cash, the funds did not recognize the rate of return that a 100% stock fund would recognize. Of course, the inverse is true too — when company stock is declining in value, the cash held by the CSF reduces the total loss to the fund. The plaintiffs called this effect of holding cash in the funds “investment drag.” The plaintiffs also complained about “transactional drag”, or the alleged increased transaction costs resulting from charging transaction fees (i.e. brokerage commissions, SEC fees and other costs associated with the trade) against the fund as a whole, rather than to the specific buying or selling participant. The plaintiffs argued that since transaction fees were spread across participants based on their pro rata share of the fund, all participants were incentivized to trade frequently, which in turn resulted in higher transaction costs for the fund.
The plaintiffs alleged that the Plan lost millions due to the unitized structure of the funds and that the Plan fiduciaries breached their duties by maintaining the funds’ unitized structure. The district court dismissed the plaintiffs’ claims but, on appeal, the Seventh Circuit panel reversed. The Seventh Circuit held that there was no evidence in the record that the defendants actually made a decision about whether to continue the unitized structure. Apparently, there was ample evidence that the defendants had considered the costs and benefits of the unitized structure and the CSFs had remained unitized. However, there was no specific document or communication that the defendants could point to as evidence that an affirmative decision was made.
What the Seventh Circuit’s Holding Means for Plan Fiduciaries
The Seventh Circuit’s holding is startling because unitization is an extremely common practice, reportedly used by an estimated 90% of all employer stock funds. The Kraft Plan fiduciaries may not have seriously considered an alternative fund structure and may have believed, rightfully so, that their continued use of unitized funds was quite non-controversial. As the amici argue in their brief, plan fiduciaries do not typically, and are generally not required to, document a decision not to make a change to a plan. The Seventh Circuit’s holding opens the door for participants to challenge a wide range of decisions made by Plan fiduciaries on a daily basis. After Kraft, plan fiduciaries may be required to document even decisions to maintain the status quo, particularly once alternatives are considered. Such an interpretation of ERISA’s fiduciary requirements may discourage plan fiduciaries from considering administrative or investment changes at all for fear of future litigation regarding the choice to maintain the status quo.
In a strongly worded Dissent, Circuit Judge Cudahy questions the panel’s decision and the notion that a plan fiduciary must produce “a reasoned decision on the record about such a universally accepted investment practice as unitization.” 2011 WL 1345463 at *14. As Judge Cudahy notes, unitization of employer stock funds is an extremely common practice, present in the “overwhelming majority of managed fiduciary funds investing in employer stock.” Id. at *14 (citing a text indicating the prevalence of unitized stock funds may be as high as 90%). “This is part of the ABC’s of investing — not some sort of esoterica. What the trustees did here is well within their discretion, both from an administrative and an investment standpoint and should not become the subject of a federal lawsuit.” Id. at *14.
While the Seventh Circuit’s holding certainly appears to rock the boat regarding a plan fiduciary’s obligation to document its exercise of discretion regarding administrative and investment decisions, it may also be read more narrowly. In a footnote, the panel emphasized that on remand, the district court might find that the issues of unitization were “so trivial that a prudent fiduciary would have ignored them” in which case “the failure to make a decision will not result in liability.” Id. at *10, fn.9. That is, if a prudent fiduciary would not have rendered a formal decision on the matter, the Kraft Plan fiduciaries should not be found to have breached their fiduciary duties by failing to make such a determination. Of course, the Seventh Circuit’s holding leaves open the question of what decisions are “so trivial a prudent fiduciary would have ignored them” and appears to require that all other decisions (even decisions to maintain the status quo) must be thoroughly documented and recorded in order to avoid liability.
CONTRACTING WITH PLAN SERVICE PROVIDERS: Must Fiduciaries Obtain RFPs Every Three Years to Avoid Litigation Regarding Fees Paid to Plan Service Providers?
The second element of the Seventh’s Circuit’s holding relates to the plaintiffs’ claim that the Plan paid excessive fees to Hewitt, the Plan’s recordkeeper. Hewitt had been the Plan’s recordkeeper for over ten years when the plaintiffs’ filed their lawsuit. Though the Plan requested bids from various recordkeepers before hiring Hewitt, the Plan had extended Hewitt’s contract a number of times without soliciting bids from other providers. The Plan did engage various consultants for advice as to the reasonableness of Hewitt’s fees and negotiated fees during each extension of Hewitt’s contract.
The plaintiffs argued that it was a breach of the fiduciaries’ duty of prudence to extend Hewitt’s contract without soliciting competitive bids on a periodic basis — once every three years. According to the plaintiffs, the defendants’ failure to solicit competitive bids resulted in the Plan overpaying for Hewitt’s services. The district court ruled in the defendants’ favor, holding that the Plan fiduciaries had not breached their fiduciary duties by extending Hewitt’s contract without soliciting competitive bids, and that the Plan’s reliance on its consultants was prudent. On appeal, the Seventh Circuit panel reversed.
The Seventh Circuit relied on the testimony of an expert presented by the plaintiffs in the district court, who opined that it was imprudent for the Plan fiduciaries to extend Hewitt’s contract without first soliciting bids from other recordkeepers. The district court had essentially ignored the expert’s testimony because his experience involved working with the retirement plans of mid-sized companies rather than the plans of large companies such as Kraft. On appeal, the Seventh Circuit held that the testimony of the plaintiffs’ expert created an issue of material fact as to whether the defendants acted prudently which was enough to defeat defendants’ motion for summary judgment. The Seventh Circuit also held that the defendants’ reliance on the advice of their consultants was not sufficient to entitle defendants to judgment as a matter of law.
Following the Seventh Circuit’s opinion and its denial of the Appellees’ petition for rehearing, the case will now be remanded to the district court. If the parties do not settle, there will be a trial to determine whether the Plan fiduciaries breached their fiduciary duties by failing to obtain competitive bids, and by relying on consultants for determining whether Hewitt’s fees were reasonable.
What the Seventh Circuit’s Holding Means for Plan Fiduciaries
The Seventh Circuit’s holding is disturbing because it flies in the face of what is a commonly accepted practice in today’s world of large ERISA plans. The Kraft Plan is a large plan with over 37,000 participants and over $2.7 billion in assets (at its lowest). Large plans routinely rely on consultants and other outside experts in determining pricing for plan service providers. Most large plans do not solicit RFPs on a regular basis, and for good reason. Engaging in a competitive bidding process is an extremely time consuming and expensive process. Moreover, such costs of administration generally may be paid from plan assets and therefore reduce participant investment returns. Converting a plan to a new recordkeeper also requires significant leg work, and detailed and expensive employee communications. Moreover, it is disruptive to plan participants, whose investment options will change, and who will be locked out of their plan accounts entirely for a period of time while the plan transitions to the new provider.
As Judge Cudahy states in his dissenting opinion:
The Seventh Circuit’s decision in Kraft means that plan fiduciaries may face increased litigation challenging basic administrative and investment decisions. We will have to wait and see if other courts follow the Seventh Circuit’s lead, or if courts outside of the Seventh Circuit will continue to give plan fiduciaries deference in their administrative decisions regarding the plan. As the amici concluded, the Seventh Circuit’s holding unfortunately may “subject fiduciaries to costly ‘make-work’ requirements and the threat of litigation that Congress sought to avoid.”²
¹ —F.3d.—, No. 10-1469, 2011 WL 1345463 (7th Cir. Apr. 11 2011).
² Brief of Amici Curiae in Support of Appellees’ Petition for Rehearing En Banc, at *2.