By Daniel Aronowitz
Euclid Fiduciary
The sequel is often not as good as the original, and so it is with the Sixth Circuit’s recent excessive fee rulings. The June 21, 2022 decision by the Sixth Circuit Court of Appeals in Smith v. CommonSpirit Health was a masterpiece. The Sixth Circuit ruled that ERISA is a law of process and does not allow hindsight second-guessing of fiduciary decisions without proof of a process-based defect. It further ruled that it is not imprudent to offer active funds in an institutional plan, and to properly plead fiduciary imprudence under ERISA, you must do more than just compare active funds to passive funds or “simply pointing to a fund with better performance.” Both Amway and Humana have already moved for reconsideration based on the CommonSpirit appellate decision of two excessive fee cases in which district courts in the circuit had denied motions to dismiss.
Nevertheless, we noted in our analysis of the CommonSpirit decision [see The Sixth Circuit Vindicates That ERISA is a Law of Process, and Does Not Allow Hindsight Second-Guessing of Fiduciary Decisions – Euclid Fiduciary (euclidspecialty.com)] that plaintiffs in that case somehow failed to allege that it was imprudent to offer higher-fee Fidelity K shares in a large institutional plan [the plan had moved to lower-fee K6 shares in 2018]. Consequently, we warned that “there is still the lingering issue of whether a claim of investing in an improper share class meets the Sixth Circuit’s higher pleading standard of a process-based defect.” The July 13, 2022 decision by the Sixth Circuit in Forman v. TriHealth, Inc. addresses this critical issue that was missing in the CommonSpirit case, concluding affirmatively that it does state a plausible claim under ERISA to allege that plan fiduciaries invested in more expensive mutual fund shares when shares with the same investment strategy were available at lower costs. This is a common issue for many plans, and remains the single most important priority for fiduciaries of large defined contribution plans as long as investment providers keep pushing higher-fee share classes on unsuspecting institutional plans.
The TriHealth Plan
The $457 million TriHealth plan is smaller in asset size than many plans sued in excessive fee cases, but it has 12,168 participants, which qualifies as a large plan. This is a plan with many small account holders that is more expensive to administer. While it may not be material to the ruling, it is interesting to note that the original TriHealth Complaint did not allege that the plan fiduciaries failed to offer the lowest available fee share classes for the plan’s investments. Instead, the crux of the complaint was that the plan’s all-in fee ranged from 1.05% to .86% from 2013 to 2017. Plaintiffs alleged that the .86% all-in fee in 2017 was higher than 90% of comparator plans greater than 10,000 participants and in plans between $250 to $500 million in assets. This sounds really authoritative until you read their footnote in which plaintiffs disclose that this is a comparison of just twenty-three plans, and plaintiffs do not disclose anything about these purported comparison plans. It is just a bald allegation that the plan fees are too high without any primary source to validate the malpractice claim. This all-in fee claim is reiterated in the Amended Complaint that was reviewed by the lower court and the Sixth Circuit, only this time the purported “peer group” was twenty-two unnamed comparator plans.
The Amended Complaint added the claim that for seventeen of the twenty-six offered mutual funds in the plan, the plan failed to offer cheaper institutional shares instead of the more expensive retail shares. The difference is stark: for example, the plan QDIA appears to be T. Rowe Price Adv shares that ranged from 79 to 97 bps when the plan allegedly could have qualified for the I share class with fees between 39 and 59 bps. According to the complaint, the fee differential had a direct impact of a lower three-year return. For example, the three-year return for the higher fee Adv shares of the 2005 T. Rowe Price target date glide path was 5.26% versus a 5.61% return for the lower fee I share class. Another example alleged in the Amended Complaint was the Janus Henderson Balanced T fund with a 82 bps fee versus the I shares class of 64 bps. The 18 bps fee differential translated almost directly to a lower three-year return of 7.58% v. 7.75%. The complaint also alleged that the remaining investments in the plan were more costly and performed worse than the alternatives.
For perspective, even though this is not a mega-sized plan like CommonSpirit [the CommonSpirit plan was $3.2B in assets with 105,590 in participants], it is not a low-fee plan. Neither was CommonSpirit. CommonSpirit had a .55% all-in fee, making it one of the higher-fee mega plans. The TriHealth plan at .86% for close to $500m in assets also means that the plan has higher fees than most plans of its size. Even though plaintiffs presented weak evidence of this fact, they are mostly right as to how the investment fees compare to other plans. While we are not in any way agreeing with plaintiffs that the plan fiduciaries committed malpractice, plaintiffs are largely correct that the investment fees are much higher than most plans of the same size. The question is whether this constitutes fiduciary malpractice.
The Sixth Circuit’s TriHealth Opinion
The TriHealth Opinion starts with a review of the CommonSpirit ruling, reiterating that “[i]n assessing the prudence of a plan administrator’s decision-making process, context often is destiny.” The Court summarized that “[d]isappointing performance in the near term and higher costs do not by themselves show ‘deficient decision-making, especially when we account for competing explanations and other common sense aspects of long-term investments.’” In addition, plaintiffs need to consider the “distinct objectives” of plan investments when alleging imprudence, because “each fund has distinct goals and distinct strategies.” The court then applied these principles to the claims of: (1) overall high plan fees; (2) high costs and performance of other investments; (3) breach of duty of loyalty; and (4) different/lower-fee share classes available.
Overall plan fees: Plaintiffs had alleged that the TriHealth’s average plan expenses were almost twice as high as the other comparator plans they had identified [but not named in the complaint]. The Court ruled that “this overall attack on the plan’s expense ratios” did not satisfy the pleading standards because plaintiffs never alleged that these fees were high in relation to the services that the plan provides. “Allowing such bare allegations to proceed, devoid of all context for the services provided, would effectively create liability whenever a plan chooses actively managed funds over passively managed ones – an approach that CommonSpirit rejected.” The other problem, according to the Court, is that plaintiffs never alleged that the fees could not be justified by the plan’s strategic goals relative to their selected comparators. The reason is that a “plan fiduciary might prudently seek value in actively managed funds – whether aggressively bullish or highly defensive.” The value of this part of the opinion is that it underscores that the higher fees for investing in actively managed investment options does not constitute imprudence under ERISA, and any such imprudence claim is plausible only if placed into proper context of investment objectives.
Costs and performance of other investments: For eight of the twenty-six investment options offered in the plan, plaintiffs identified available alternatives in the same investment style that charged lower fees and performed better over a three-year period. The Court held that this does not meet the plausibility standard because plaintiffs failed to plead that these available alternatives were “otherwise equivalent” to the selected funds, a common excessive fee claim that was rejected in CommonSpirit, because “[p]lan administrators . . . have considerable discretion in choosing their offerings and do not have to pick the lowest-cost fund of a certain type . . .” Again, the Sixth Circuit’s excessive fee or under-performance pleading standard requires a comparison to an equivalent investment that has the same distinct investment objectives. Most excessive fee lawsuits fail under this standard.
Breach of duty of loyalty: Another common claim alleged in TriHealth was that the plan fiduciaries violated their duty of loyalty by choosing investments that would unduly profit third-party investment managers. The Court rejected this claim as well because plaintiffs failed to make any allegations suggesting that “the fiduciary’s operative motive was to further its own interests.” This holding is important for two reasons. First, nearly every excessive fee case alleges malpractice without any evidence that plan fiduciaries took illegal gratuities or somehow improperly sought personal benefit. This gets lost in the onslaught of cases, but it is important to remember that these cases are about relative expenses and performance. Unlike fraud cases, participants have not suffered any actual investment losses. Instead, it is a question of plaintiff firms alleging lost opportunity cost relative to something else. And the Sixth Circuit has held that the relative benchmark must be meaningful and within a proper context of distinct objectives. Second, the Sixth Circuit cites to the First Circuit’s opinion in Brotherston v. Putnam Invs, LLC, 907 F.3d 17, 40 (1st Cir. 2018). The key point from the First Circuit in Brotherston is the suggestion that only way for fiduciaries to avoid liability from excessive fee lawsuits is to offer low-cost index funds:
“Moreover, any fiduciary of a plan such as the Plan, in this case, can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these are not matters concerning which ERISA fiduciaries need to cry ‘wolf.’”
But the fact that the Sixth Circuit cited Brotherston shows (1) that they were not ignoring the decision when issuing the holding in CommonSpirit that it is not imprudent to offer active funds in institutional retirement plans; and (2) that the Brotherston case is distinguishable because it involved proprietary investments from the plan sponsor with inherent breach of loyalty issues – i.e., the case was about Putnam sponsoring a plan that offered Putnam investments. Why is this important? Because if we are heading back to the Supreme Court on the basis that the Sixth Circuit ruling in CommonSpirit conflicts with other circuits on the issue of whether active funds can be compared to the fees and results of lower-fee index funds, then the decision in Brotherston should not represent a split in the circuits because CommonSpirit and TriHealth did not involve proprietary investments, but rather garden-variety Fidelity and T. Rowe Price investments. The cases are distinct, as Brotherston should only apply to proprietary investments from the plan sponsor. But this argument is far from foolproof, and the warning from the First Circuit that fiduciaries offering active funds should not cry “wolf” when they are sued for excessive fees on actively managed investment options continues to haunt excessive fee jurisprudence.
Lower-fee share classes available: The crux of the TriHealth case is the claim that TriHealth fiduciaries violated the duty of prudence by offering pricier retail shares for 17 of the 26 mutual funds offered in the plan when the same investment management companies offered less expensive institutional shares of the same funds to other retirement plans. As the Court recast the claim, “why . . . didn’t TriHealth take advantage of – indeed just ask for – these lower-priced mutual fund shares for the same investment team and the same investment strategy when this retirement plan has nearly half a billion dollar in assets?” This alleged failure to take advantage of cheaper share classes and exploit the advantage of a large retirement plan to leverage its scale “materially decreased the value of their retirement savings.” The Court held that this states a claim under the common law of trusts and ERISA.
Importantly, the Court does not assume retail share classes are automatic evidence of malpractice. The Court notes that there are “equally reasonable inferences” of prudence that could exonerate TriHealth once all of the facts come in. For example, it is possible that the plan is not large enough or does not have enough participants interested in a particular investment style to qualify for less expensive share classes. Also, it is possible that the plan has a revenue-sharing arrangement that makes the retail share classes less expensive or that benefit plan participants on the whole. The Court simply held that it is “too early” at the pleading stage to make judgement calls as to whether the use of retail share classes is prudent. The Court cited the Washington University case in the Eighth Circuit, New York University in the Second Circuit, University of Pennsylvania in the Third Circuit, and Trader Joe’s Co. in the Ninth Circuit, to support its decision on the share-class issue. No circuit court has ruled for the defense on the share-class issue at the pleading stage.
TriHealth argued that plaintiffs had failed to allege a meaningful benchmark for the retail-share class claim. The Court stated that plaintiffs “must do the work of showing that the comparator investment has sufficient parallels to prove a breach of fiduciary duty.” But the Court warned first that if plaintiffs are correct that the less expensive share class has the same investment strategy, portfolio and management team, then “this claim has a comparator embedded in it.” Second, “a claim premised on the selection of a more expensive class of the same fund guarantees worse returns.” In other words, it is difficult to justify paying more for the same exact investment option.
The final issue was whether revenue sharing would explain the use of retail share classes. Curiously, this was raised only by the Chamber of Commerce in its amicus brief. Nevertheless, the Court held that this alternative explanation for the use of higher-fee share classes would not change the outcome in this case, because it would only provide a competing or plausible inference, but not the only one, for why TriHealth offered retail-share classes. Revenue sharing would be a process-based inquiry, and the Court opined that an “attentive district court judge ought to be able to keep discovery within reasonable bounds given that the inquiry is narrow and ought to be readily answerable.” A nice sentiment, but we have not seen any district judge streamline an excessive fee case to keep discovery costs reasonable.
How and When to Justify Retail Share Classes
Based on our daily underwriting, we believe that the fact pattern of large plans over $500 million in assets using revenue sharing as the primary method of paying for plan administration costs is dwindling. Most large plans have moved to recordkeeping charged on a per-participant asset basis. Except for some university plans, and some plans under $500m in assets, the days of using revenue sharing for every investment option is nearly over. So the TriHealth fact pattern of plans with many retail-share class investments should become rarer. But we continue to see many plans with a handful of retail-share class investments, mixed in with other lower-cost, often passive-based investments. The open question is whether a small minority of retail-share class investments is enough to plead a plausible claim of imprudence. We hope not, but we would not bank on it.
The TriHealth Court ended the opinion by stating that “mere allegations that a retirement plan chose retail over institutional share classes – or failed to utilize other volume-based discounts – does not provide a universal golden ticket past a motion to dismiss.” The Court said the “inquiry is as always ‘context-sensitive.’” But the Court was persuaded that the plan had nearly one-half a billion dollars in assets and a chart showing 17 funds with lower-fee alternatives. The key in TriHealth was that the amended complaint alleged that “the only difference between share classes was that the lower-cost share class were available only to Plans that had larger investments.” The take-away for plan fiduciaries is that it is very hard to justify the use of retail-share classes, and it most likely will be a claim that survives a motion to dismiss. If you think ahead to the Northwestern remand to the Seventh Circuit, which is nearly fully briefed, that case had 129 mutual funds in retail share classes. If it was not obvious before, it is now crystal clear that Northwestern is going to lose on at least the share class issue.
The two types of potential justifications for retail-share classes are (1) that the plan was not big enough to be eligible for lower cost shares; and (2) that the plan employed revenue sharing, a defense that is stronger if the plan rebated revenue sharing back to participants. Taking the issue of size first, we do not consider a sub-$500m asset plan to possess sufficient leverage against large investment managers like T. Rowe Price and Fidelity, but this Court does. It thus brings many more smaller plans into the crosshairs of excessive fee litigation. For perspective, the TriHealth plan is one-sixth the size of the CommonSpirit plan. At what size does a plan grow large enough to gain sufficient leverage? The Court does not say. Another unclear issue is that the Court did not address what level of proof is necessary for plaintiffs to hit the plausibility hurdle in alleging whether institutional share classes were even available. Most of these complaints fail to show how much is invested in each investment option, and then fail to compare it against the minimum required to be eligible for the lower fee share class. For example, the T. Rowe Price Adv shares were 30 bps+ more expensive than the I shares, but we do not know how much was invested in the T. Rowe Price target-date suite, nor what T. Rowe Price requires to move to the I share class. This is not hard to allege, but surely that is the bare minimum to meet the pleading standard. The Court strangely ignores this. We are also concerned by the argument that the Schlichter law firm has long used in the Northwestern and other university cases that large plans can simply ask for lower fees even if they are not technically eligible for lower fees. Participants obviously have no proof that plan fiduciaries did not ask for lower fees, and any such claim is pure conjecture. But any standard that large plans can get lower fees than the published fee schedule allows represents a slippery slope that could allow more claims of imprudence, even when the facts would show it was unjustified. And it is also hard to disprove a negative after the fact in hindsight.
We are also concerned that now both the Ninth and Sixth Circuits have ruled that plan fiduciaries cannot justify revenue sharing at the pleading stage. We fully understand that a generic defense that revenue sharing justifies retail investment fees may need a more complete factual record, but in the Trader Joe’s case, the defense lawyers gave actual proof that the revenue sharing was rebated back to plan participants. There was proof on the record that participants were not harmed by the revenue sharing, but it was ignored by the appellate court. We continue to believe that rebating evidence is the type of context-specific proof that should be sufficient to render a complaint implausible. The Sixth Circuit did not have sufficient facts to get this far, and we hope that this avenue of defending revenue sharing with proof that it is rebated to participants remains open.
The Euclid Perspective: Holding Investment Managers Accountable
The TriHealth opinion raises the question as to who is at fault when plans have retail share classes. When plaintiff firms serve as Monday-morning quarterbacks, it is easy to make plan fiduciaries look negligent for over-paying for plan investments. But most of these plans have third-party investment advisors, and they share in the responsibility. Where are the investment advisors in these cases? And more significantly, what is the role of T. Rowe Price in selling retail share classes to institutional investors? T. Rowe Price will take the position that it is not a fiduciary, and likely has a fiduciary disclaimer in its contract. But it is irresponsible for an investment advisor to sell target-date funds at 79 to 97 basis points when it offers the same funds at 30 basis points lower. These fees are five years out-of-date and have come down, but we continue to believe any investment manager who wants to serve institutional investors should share in liability if and when a court rules that the fees were excessive. T. Rowe Price and other institutional investment managers like Fidelity should have a duty to treat institutional investors differently, because they know they are putting plan fiduciaries in harm’s way when they overcharge them. That is exactly what T. Rowe Price did here to the TriHealth plan fiduciary committee. The damages model in a retail-share class imprudence claim is the amount of overpayment to the investment manager. Simply put, investment managers should indemnify their clients for claims of excessive fees even when the contract does not require it, or be willing to defend the case to demonstrate that the fees were prudent. If not, institutional investors need to move their considerable assets to companies whose goal is not to overcharge them.
The holding of TriHealth is that share class claims are plausible excessive fee claims. But the real lesson of TriHealth is that plan fiduciaries need to hold investment managers accountable for excessive fees. It is time to change the paradigm and demand that investment managers take responsibility for fees charged to institutional plan fiduciaries: when lower fees are available, investment managers need to offer the lower fees or rebate the difference – not take advantage of their clients by charging the highest possible fee. It is time for the paradigm to change in which plan fiduciaries bear sole liability when investment managers charge higher fees than are available to institutional investors.
