By Daniel Aronowitz, Euclid Fiduciary
Note: This article first appeared on Wednesday February 2, 2022, in The D&O Diary. Thank you to Kevin M. LaCroix for publishing this as a guest post on his site. You can see a full copy of the post (here).
The fiduciary liability insurance market has been upended in the last five years by the increase in the number of excessive fee cases. The surge of cases started in 2016 with lawsuits against university and other plans with high recordkeeping and investment fees, but has now morphed into a plaintiffs’ business model challenging many plans with reasonable fees and investments. Over fifteen percent of all plans with assets over $250 million have already been sued [350+ out of 2,371 plans] – a ratio similar, if not higher than securities class actions against public companies. One of the first university cases ended up before the United States Supreme Court in Hughes v. Northwestern University, and the Court issued a short, six-page decision on January 24, 2022 remanding the case back to the Seventh Circuit (here)
We are reading many articles and law firm blogs trying to find a silver lining in the Supreme Court’s short decision, for example, here. But the Northwestern fact pattern of 242 predominately active investment options, uncapped revenue sharing, and 129 retail share class funds was always problematic, and the risk of bad facts making bad law has likely come to fruition. Even if Northwestern can somehow prevail again in the Seventh Circuit, we believe that plaintiff law firms will be emboldened in their efforts to sue based on isolated plan investments, even against plans with low-cost index offerings. In any event, plan sponsors are now clearly on notice that there is no justification for offering retail share classes in defined contribution plans.
But we offer a larger point for ERISA defense counsel to consider. The decision underscores that defense lawyers can no longer categorically argue that all excessive fee cases are unfair. The tactic of filing motions to dismiss in all cases – even in cases like Northwestern with problematic fact patterns – has not worked. The Northwestern case demonstrates that the defense of excessive fee cases must now distinguish legitimate from illegitimate excessive fee cases based on actual plan expenses. When a case like Northwestern has high fees that exceed industry benchmarks, defense lawyers need to refrain from filing motions to dismiss and litigating on a limited record. That is how we ended up with a high-fee plan before the Supreme Court. The excessive fee battle is far from over, but the defense bar must change its tactics if we are going to win the war.
The Court’s Decision: The district court granted Northwestern’s motion to dismiss the Amended Complaint for failure to state a claim on which relief could be granted, and denied leave to file an amended complaint. The Court of Appeals for the Seventh Circuit affirmed, holding that the claim for excessive recordkeeping fees failed as a matter of law because ERISA does not require a flat-fee structure as opposed to revenue sharing; “does not require a sole recordkeeper”; and did not require the plans “to search for a recordkeeper willing to take $35 per year per participant” – the amount that plaintiffs alleged would have been reasonable recordkeeping fees. The court noted the allegations that using multiple recordkeepers and failing to solicit competitive bids imposed higher costs on participants, but the court concluded that the plan had “explained it was prudent to have this arrangement so [the Plans] could continue offering” the TIAA Traditional Annuity, given that TIAA had required the Plans to use TIAA as the recordkeeper for all TIAA funds in the plan. The court also found that the participants had not identified an “alternative recordkeeper that would have accepted” a lower fee than the one paid by the Plans while still providing the same level of service. And “[a]t any rate,” the court reasoned, “plan participants had options to keep the expense ratios (and, therefore, recordkeeping expenses) low,” by choosing to “invest in various low-cost index funds.” As to the claim that the plans offered imprudent investment funds with unnecessary management fees and inferior investment performance, the court of appeals stated that it understood the participants’ “clear preference for low-cost index funds were and are available” in the plans. The court also declined to endorse a “blanket prohibition on retail share classes,” and it stated that “plans may generally offer a wide range of investment options and fees without breaching any fiduciary duty.”
The Supreme Court ignored most of the basis for the Seventh Circuit’s opinion, and instead homed in on what Justice Thomas in oral argument had called “the entire menu defense.” The Court held that allegations of high recordkeeping and investment fees cannot be ignored, even if the plan has a few low-cost investments from which investors can choose. The Court did not even feel the need to address the pleading standard, likely because the Amended Complaint alleged so many high cost investments. From our perspective, Northwestern would have lost under even the strictest pleading standard that the Court could have espoused. The point is that the Northwestern investment and recordkeeping fees were so problematic that the Court held that the Seventh Circuit could not ignore these allegations. The last paragraph of the opinion did state that the Seventh Circuit needs to review the case under the Iqbal and Twombly pleading standard. And there is even a reference to the “context specific” inquiry required under Dudenhoeffer, as well as the helpful instruction that “circumstances facing an ERISA fiduciary will implicate difficult tradeoffs, and courts must give due regard to the range of reasonable judgments a fiduciary may make based on her experience and expertise.” Many ERISA lawyers are trying to find a silver lining in this helpful language. But these pleading-standard cases are cited in every dismissal of a motion to dismiss, as district courts largely have failed to enforce these rules rigorously.
Bad Facts: Too much pre- and post-decision analysis has failed to analyze the actual fees and investments of the Northwestern plan. But without these facts, you cannot make an informed analysis as to whether the Northwestern case is a legitimate sheep or an illegitimate goat under the Dudenhoeffer standard. As alleged in the operative amended complaint, Northwestern’s main plan had the following issues: (1) 242 investments, which was alleged to be too confusing [for example, 32 fixed income investments; 48 large cap domestic equity investments; and 15 mid cap domestic equity investments]; (2) high recordkeeping fees of $153-$243 per participant with uncapped revenue sharing; and (3) 129 retail-share class investments in which identical investments were offered to large plans at a lower fee. The Seventh Circuit held that the plan offered some low-cost index funds, but it never did the math in the opinion: the index funds represented just 7 out of 242 investments, and even some of those 7 index funds were alleged to be in high-cost retail share classes, like the Fidelity 500 Index Fund at 10 instead of 7 bps [obviously 2016 outdated pricing, as these are now available at 1-2 bps]. Based on this fact pattern, the Supreme Court essentially held that you cannot maintain 129 investments that are available at a lower price, just because you have a small fraction of the plan investments in index funds. The Seventh Circuit may ultimately on remand find other reasons to dismiss the case, but the damage of this ruling has already been done.
Is this a Roadmap to Sue on Isolated Plan Investments?: The decision could easily be construed by plaintiff lawyers to be a license to sue based on one or two investments in a plan as allegedly imprudent. This happens often, as just this month the $1.7 billion Milliman plan was sued over three plan investments out of twenty available investments, representing less than 15% of overall invested assets and invested in by less than 10% of plan participants. The risk is that plaintiff lawyers will now sue more frequently, alleging that any active fund in a retirement plan is imprudent or underperforms some purported benchmark. We think this is the risk of bad facts making bad law. The Court is saying that you have to remove all imprudent investments. We continue to believe that the only way to judge whether an individual investment is imprudent is by looking in context at the total investment lineup [i.e., an active fund makes sense when combined with low-cost index options]. The decision did not articulate this principle, and that is a problem for plan sponsors facing open-ended liability.
But again, you have to look at the bad facts of the Northwestern plan to understand the decision. Northwestern had only 7 out of 242 investments in index funds, and even those funds were allegedly not the cheapest share class available to a large plan that should be levering its size. The point is that the Northwestern plan is an anomaly – it is different than nearly every large plan existing today. It is an obsolete fact pattern, because most current mega plans have one recordkeeper; most plans have less investment options [20-40 on average]; well over 95% of all large plans offer a low-cost S&P 500 index fund at one or two basis points; and most large plans do not allow revenue sharing, and have low, per-participant recordkeeping fees. In a normal plan that offers one or more higher-cost active funds, whether those active investment choices are imprudent can only be judged in the context of the entire lineup which includes low-cost investments. But this defense is now likely lost to plan sponsors at the pleading stage.
The Seventh Circuit tried to allow a meaningful investment choice defense – that participants have a choice to choose low-cost investments in the plan – but essentially the Supreme Court is saying that the Northwestern plan cannot rely on participants to choose because there are so many high-cost investments that overwhelm any reasonable option to choose. But as noted above, most current plans are not like the Northwestern plan – and even the Northwestern plan has changed its entire lineup to streamline investments and lower fees. Northwestern should have argued that the plan previously had higher fees, and that is why they made radical changes as the fiduciary duty standard evolved and industry fees become lower. Instead, they tried to defend high fees, and there just is no good justification for 129 retail share class funds when lower cost investments are available. You cannot explain that away [especially when revenue sharing is uncapped], and that is why Northwestern lost, and was always destined to lose. Too many commentators have stubbornly ignored these facts.
The Lesson for Defense Counsel is that Plan Sponsors Must Distinguish the Northwestern Facts in Order to Win Future Excessive Fee Cases: Up to now, most cases are being defended the same way, without distinguishing the investment fees between plans. The defense bar is essentially arguing by filing a motion to dismiss in every case that all excessive fee cases are unfair. But the Northwestern fees were high under any benchmark. Defense counsel failed to acknowledge the bad facts. We did not see any admission prior to the case by any commentor on the plan sponsor side (except Euclid) that the Northwestern facts were problematic. This lacked credibility. But now there is no alternative. Plan sponsors must defend excessive fee cases by distinguishing that the Northwestern facts are different from what most plans currently offer. The Northwestern facts are obsolete and anomalous. The fact that the Supreme Court said it is likely to be a legitimate excessive case must be cast and construed as a reasonable proposition, because most plans have lower investment and recordkeeping fees. In other words, there are some legitimate excessive fees cases, and Northwestern might be one of them, but plans with low fees should not be allowed to be sued. Most cases fall into this category, and should be defended differently. This may mean that defense counsel should not file a motion to dismiss in cases in which the record is incomplete. More importantly, defense lawyers must distinguish between plans with high and low fees. That has not been done in most cases previously, and that is how we ended up with a high-fee case before the Supreme Court creating bad law from bad facts.
Is there a Silver Lining in the Decision? We noted above that smart lawyers are commenting that there is a silver lining in that the Court ended the decision by reminding lower courts that the excessive fee complaints must be judged under the Iqbal and Twombley standard with a “context-specific” scrutiny. The best analysis we have seen is here from Groom lawyers. But the Court did not apply a context-specific analysis, so we view this as less than helpful in that it leaves district courts to their own discretion, and most of these courts want to help plan participants get their day in court. Our take is that this is a just a recitation of the law as it always has been.
The problem is not the law. Rather, the problem is how the law is being applied. Every dismissal of an excessive fee motion to dismiss starts with citations to the Iqbal and Twombley standard. As we told the Supreme Court in our amicus brief, the problem is that most courts only give lip service to this heightened standard, but then allow complaints based on weak circumstantial evidence and insufficient benchmarks to proceed to discovery and high-settlement pressure. The problem is not the law: it is how to apply the law, which is working in plaintiff’s favor.
The Impact on the Fiduciary Insurance Market: We would remiss if we did not comment on how the Court’s decision will impact fiduciary liability insurance. In short, fiduciary insurance will continue to be more expensive and require plan sponsors to self-insure more of the risk with higher retentions. The reason is that the decision gives no reason to believe that the volume of cases will recede. Plaintiffs continue to file illegitimate cases against plans with low fees and good investments, and the Northwestern decision did nothing to stop that. In a world in which low-fee plans are being sued and courts treat them as legitimate, it is becoming harder for fiduciary insurers to remain profitable and provide reliable coverage. Fiduciary insurance is now similar to directors and officers’ liability insurance in which public companies face constant securities lawsuits that are often illegitimate, but cost millions of dollars to defend and then settle when courts fail to dismiss unfair lawsuits. The pressure on the fiduciary market has not changed, and likely has gotten worse.
Advice to Plan Sponsors: Plan sponsors need to learn from the Northwestern facts what is already well known: plan fiduciaries must ensure that plan recordkeeping and investment fees are as low as possible. Most lawyers advise that fiduciaries must document the process, and that is correct, but plaintiff lawyers sue in excessive fee cases without any knowledge of the documented process.
The Northwestern case amplifies the basic principles of controlling plan costs:
(1) ensure that all plan investments are in the lowest share class – this was the most obvious flaw of the Northwestern plan;
(2) ensure that recordkeeping fees include no revenue sharing and are charged on a low, per-participant basis;
(3) ensure that the plan offers low-cost index funds in every investment category; and
(4) review the investment performance of all investments to ensure that the investments are tracking appropriate benchmarks.
Whether plans can maintain active funds is more concerning after the Supreme Court’s decision, because now all higher-cost active funds increase the fiduciary risk of plans. We recommend that the QDIA consists of index target-date funds. But if a plan has active target-date funds, they must ensure that the funds are meeting the appropriate performance benchmark and are in the lowest possible share class.
Conclusion:
While we are more sober in our analysis, both before and after the case, than most commentators we have reviewed, we believe that a realistic analysis of the case is imperative. Defense counsel in these cases need to change tactics: (1) use the motion to dismiss more sparingly; (2) find ways to give the district court more context of the plan fees and investments, which the motion to dismiss does not always allow; (3) but anchor any defense on distinguishing most plans being sued from the problematic and obsolete facts in the Northwestern case. The key point is that the Northwestern case is likely a legitimate excessive fee case, but only because it has a fee and investment structure that is not offered in most large plans being sued across the country. Only by distinguishing these facts can plan sponsors win the war on the many illegitimate excessive fee cases being filed every week.
