By Daniel Aronowitz, Euclid Fiduciary
Anyone hoping for a clear indication as to how the Supreme Court will rule in the Hughes v. Northwestern case will be disappointed. The arguments were scattered and convoluted. The analogies made little sense. Thus, there is no way to predict how they will rule. Most disappointing was the failure to conduct an in-depth analysis of the proper context and standard to judge excessive fee complaints. The Justices spent most of their time asking factual questions specific to the Northwestern plan, which misses the larger context of the meritless claims being filed against defined contribution plans when courts apply a low pleading standard. This was always the risk with a case that presented problematic facts. But we must still hope that the bad facts do not create bad law. The following are our takeaways from the oral argument and better answers to the questions presented.
Does a “Meaningful Mix and Range of Investment Options” Insulate A Fiduciary from Liability?
The argument began with a misrepresentation of the Seventh Circuit’s ruling. Petitioner’s counsel stated in just his third sentence that “[t]he Seventh Circuit erred by announcing a new rule that immunizes ERSIA fiduciaries from suit for including imprudent options so long as the plan options are prudent.” Transcript 3 (emphasis added). This was the same premise of the Department of Labor’s (DOL) amicus appearance in the case – that the Seventh Circuit had somehow tolerated imprudent investments, or what one of Petitioners’ amici labeled “contaminated oysters.” There was opportunity to correct the record, but counsel arguing the case did not bite. For example, Justice Thomas asked Northwestern’s counsel to comment on what he called the “Seventh Circuit’s focus on the large menu defense.” Transcript 60. And Justice Sotomayor pressed Northwestern’s counsel as to whether a “rule as broad as the Seventh Circuit has [legitimacy] without harming the beneficiaries.” Transcript 76. But Northwestern’s counsel inexplicably avoided this key issue at every turn. This failure to correct the record is a missed opportunity to help the plan sponsor community facing capricious excessive fee liability.
It is important to understand exactly what the Seventh Circuit ruled, because it was misrepresented by Petitioners and DOL as condoning imprudent investments. To the contrary, the Seventh Circuit noted that “plaintiffs rely on the Third Circuit’s holding in Sweda v. Univ. of Pa. [citation omitted], to find ‘a meaningful mix and range of investment options [does not] insulate[] plan fiduciaries from liability for breach of fiduciary duty.’” The Seventh Circuit analyzed that the Third Circuit had not disregarded the mix of offered investment options, but “would consider that range [of options] in the context of the fiduciary’s overall performance.” The Seventh Circuit quoted from the Sweda decision that any “breach claim must be examined against a backdrop of the mix and range of available investment options.” The Seventh Circuit thus concluded that the Third Circuit’s approach was not inconsistent with its own, “that plans may generally offer a wide range of investment options and fees without breaching any fiduciary duty.” Citing Hecker and Loomis. The court concluded that Northwestern fiduciaries had not breached their fiduciary duties because “[n]ot only did Northwestern provide the plans with a wide range of investment options, it also provided prudent explanations for the challenged fiduciary decisions involving alleged losses or underperformance.”
There is nothing in the Seventh Circuit’s opinion about condoning imprudent investments as Petitioners and DOL misrepresented. This is a key point. The question was whether Northwestern offered imprudent investments, i.e. whether the investments were imprudent. And the way to judge or evaluate whether the investment options are imprudent is by evaluating the entire menu of investment options in context of the entire plan – what Justice Thomas aptly characterized as the “entire menu defense.” Nowhere does the Seventh Circuit justify or tolerate “imprudent” investments.
If the mischaracterization of the Seventh’s Circuit opinion had been addressed, then the Court could have held a constructive discussion as to how a proper pleading standard could be used to decide this and other cases alleging investment imprudence. For example, in the Northwestern case, the Amended Complaint alleges that there were seven index funds out of 242 total investment options, most of which were alleged to be higher cost versions of identical investments. Justice Sotomayor said that “I don’t know . . . that we can say a rule as broad as the Seventh Circuit has [legitimacy] without harming beneficiaries . . . there has to be a happier medium. . .” Transcript 76.
But what is the “happier medium”? And how do you fashion an appropriate pleading standard to prevent plaintiff law firms from second-guessing the investments choices of every plan in the country, which is what is happening now. Let’s do the analysis that was missing from the Northwestern argument and briefing. In Northwestern, there were seven index funds out of 242 total investment choices. The Seventh Circuit ruled that it was a meaningful mix, because participants could choose the seven low-cost index funds to avoid revenue sharing and high investment fees. Participants could fashion a low-cost lineup if they chose. It did not condone “imprudent investments”; rather it found that the higher-fee investments were not imprudent because of a meaningful mix overall. On similar facts in the University of Pennsylvania case, however, the Third Circuit found the same type of imbalanced investment lineup to be an imprudent mix. Most other appellate courts have agreed. The Northwestern case is further problematic because it had 129 retail share class funds, and even some of the seven index funds were alleged not to be in the proper share class.
We readily admit that seven index funds out of 242 is not an ideal mix, and it might not be a meaningful mix. Justice Sotomayor correctly noted that “it is hard” with the institutional-versus-retail share class allegations of 129 of the 242 funds. This is why it is important, for credibility purposes, to admit that the Northwestern facts are problematic.
But as we have noted previously, the Northwestern plan is not structured like most large defined contribution plans. Most large plans have less investment options – 20 to 28 on average, including target-date funds – and nearly every plan [at least 94% according to the most recent ICI BrightScope survey of 2018 plans] has at least one low-cost index fund, and most have several index funds. So large participants have nearly universal access to low-cost investments. Given this important distinction, how should a happy medium work when applied to most plans that have low-cost index options?
Petitioners’ argument was not honest because they misrepresented the court’s decision as condoning imprudent investments. But a more honest argument would have tested the limits of the decision. For example, if seven out of 242 options is not a meaningful mix, what would be? What about four out of 20, like most plans with active target-date funds? Does the access to low-cost S&P 500, large-cap, mid-cap and small-cap index funds provide a meaningful or prudent mix when combined with some actively managed funds? Or what about plans with index target date funds, but three to eight higher-cost active funds? Many cases challenge a few cherry-picked active investments. For example, in Reichert v. Juniper Networks, Inc., Case 3:21-cv-06213 (N.D. Calif.), participants claim that two of the active plan investments in the plan are imprudent, but ignore the meaningful mix of forty-four low-cost index funds.
These fact patterns based on actual cases show how quickly courts become micro-managers of the investment choices that fiduciaries make, under a statute that is designed to give fiduciary discretion. It also shows how important it is to judge whether an individual investment is imprudent by evaluating the entire portfolio of investment options. In other words, you cannot, as the Department of Labor wrongly advocated, absent unique circumstances, judge whether an individual investment is imprudent by looking at it in isolation. When fiduciaries have a duty to diversify investments, the prudence of an individual investment can only make sense in the context of the entire, diversified portfolio. That is the crux of the “meaningful mix” or “large-menu defense.”
Finally, the allegations of 129 retail-share class investments in the Northwestern case are problematic. Petitioners’ counsel was correct to say the case is about “brand name sodium chloride and whether you charge $1 or $2 for the same bottle of sodium chloride.” Transcript 93-94. The debated analogy to brand versus non-brand name products is not what this case is about. For credibility purposes, plan sponsors need to be honest about that. Northwestern’s lawyer had the difficult assignment of trying to argue that the institutional investments were somehow not identical. His argument is only persuasive to the extent that some of the revenue sharing paid for plan expenses, but what he did not say is that the revenue sharing was not capped, and the $150+ dollars in recordkeeping fees is well beyond any reliable benchmark [although the Amended Complaint never bothered to give an honest benchmark to judge whether $150 – or even their standard of $35 – was justified]. The Northwestern plan may not provide a prudent mix of investments given that so many of the investments are duplicative and not the lowest cost available. But the fact that the Northwestern complaint may present a legitimate excessive fee case should not change the fact that most excessive fee cases are not legitimate, and should be dismissed.
What is the proper benchmark? – Not the lowest fee possible like most excessive fee complaints attempt to allege
The biggest disappointment in the oral argument was the failure to discuss the proper standard to allow courts to dismiss meritless or implausible cases. If the Justices want to create a proper balance, then they need a workable standard. The Chamber of Commerce, American Counsel on Education, and Euclid provided the Court in amicus briefs with proposed standards to divide the plausible sheep from the goats, but none of these ideas were discussed. Justice Roberts tried a line of questioning that should have gotten there, but his questions got deflected by Petitioners’ counsel. Justice Roberts asked what the ERISA prudent standard requires: “does that mean you go and look at the average . . . I don’t know that they should be held to the highest – highest standard. I mean, is the fiduciary duty average, or is it the highest standard?” Transcript 23-25. Justice Roberts gave the analogy of a fiduciary buying gas, needing to find the lowest price in the neighborhood, but not having to drive ten miles out of the way to get a lower price. Transcript 25. Petitioners’ counsel weakly answered that the test is a “band of objective reasonableness.” But that is open season to second-guess every fiduciary decision.
Justice Roberts is right. To allege fiduciary duty, you cannot be judged by other plans that achieved the lowest possible price in the entire country. Then nearly every fiduciary would be guilty of imprudence. To the contrary, the test has to be the average for similar-sized plans in similar circumstances. We call that a meaningful benchmark.
Let’s give a live example to illustrate the point. The most recent excessive fee case was filed by the Capozzi Adler law firm on December 8, 2021 against Advance Auto Parts in Riaz v. Advance Stores Company, Inc., Case 7:21cv-00619 (W.D. Va.). They employ the new tactic used by plaintiff law firms to allege excessive recordkeeping fees. They first take the direct recordkeeping number from the plan’s Form 5500 filing and divide by the number of participants with account assets, which is alleged to have been $58.34 to $74.58 for the six years in the complaint. This overstates the amount of recordkeeping, because it includes a significant amount of transaction costs from loans, QDROs and other transactions, so it is not the correct recordkeeping amount. Plaintiffs will argue that you have to accept their allegations as true, even if they are unreliable. But the only reliable evidence of the true recordkeeping amount is on the quarterly DOL-mandated rule 404(a)(5) participant disclosure provided to all participants suing in the case. Plaintiffs have this disclosure, but fail to disclose it, because it would reduce the amount of alleged excessive fee damages. We have argued that courts must use DOL-mandated disclosures to validate any fee claims in complaints. But even if you assume that their recordkeeping allegation is correct – which it certainly cannot be – they then compare the inflated Advance Auto direct recordkeeping fees to a chart of five random plans of similar size that allegedly have lower recordkeeping fees: Sutter Health – $35; Fortive – $35; Texas Children’s Hospital – $30; DHL – $33; and Dollar General — $18. Out of the hundreds of plans with nearly one billion in assets, petitioners try to meet the pleading standard by alleging that five plans had lower fees between $18 and $35 per participant. This fact pattern is repeated in dozens of excessive fee cases, many of which courts allow to proceed to discovery and the threat of an in terrorem settlement.
In the Northwestern case, petitioners failed to allege lower fees by any comparable plans or benchmark. Even Justice Sotomayor seemed to find this deficient, as the only evidence of a lower fee than the $155+ alleged was the evidence that Northwestern reduced plan fees to $42 in 2016 with plan changes. But there was no allegation of any plan with the asserted $35 target. [Transcript 31: Justice Sotomayor: “But I don’t know how – in a complaint, how you could plausibly allege a price unless you allege why that’s the market rate.”] There were allegations that five universities had allegedly consolidated recordkeepers, but there was no allegation of what these plans were paying for recordkeeping fees. Petitioners relied on an alleged deficient process – a failure to do a RFP or supposedly ask for lower fees. Whereas the investment claim might have been sufficiently pled, even the liberal justices were concerned the recordkeeping fees had not been sufficiently pled.
But most cases are like the Advance Auto Parts case. In most cases, plaintiffs allege misleading statistics from small plans in the 401k Averages Book (omitting indirect revenue sharing), or more recently allege four to six large plans with super low fees. This goes to Justice Roberts’ question: what is the fiduciary standard – is it failure to achieve the absolutely lowest fee, or is it the average fee that other fiduciaries in like circumstances have achieved? No one gave him the answer, but it is obvious: the fiduciary standard is the average of what other fiduciaries under like circumstances have achieved. You cannot be judged – as plaintiffs try to do in Advance Auto and nearly every recent excessive fee case – by the absolute lowest price that a few plans achieved. That is why a meaningful benchmark must be required to meet the pleading standard when you are alleging fiduciary negligence based on circumstantial evidence. See the Euclid Fiduciary Amicus Brief and Chamber of Commerce Amicus Brief. Otherwise, every plan can be sued and courts will be micro-managing the investment decisions of fiduciaries who are granted discretion under ERISA.
To finish this point, if a proper benchmark of comparable plans had been alleged, the $155+ recordkeeping fees allegations that included uncapped revenue sharing may have been enough to meet the proper pleading standard. But no meaningful benchmark was alleged – just references to five universities who supposedly lowered their fees. But a proper benchmark is not alleging the fees of the lowest-cost plans in the industry. Cases like Advance Auto should not be deemed to meet the proper pleading standard without providing a meaningful benchmark to judge whether the recordkeeping fees were within a reasonable range of the entire industry. Just because these plans did not achieve the lowest possible fees in the entire universe of plans, that does not mean the plan fiduciaries had a deficient process, or otherwise 95%+ plans in the country can be sued for excessive fees – and that is not a “happier medium.”
What about Plans that have lowered their fees – are you still liable if you have lowered your fees?
The most interesting question from the oral argument is whether plans that have made changes to lower fees should be subject to fiduciary litigation. Many excessive fee cases allege a six-year damages model of allegedly high fees, and acknowledge that the plan fiduciaries have recently switched to lower-cost investments, or reduced recordkeeping fees. But the cases typically allege that this is “too little, too late.” In Northwestern, petitioners try to use the plan changes to a reduced 40-investment lineup and reduced $42 recordkeeping fees against them as proof of fiduciary malpractice. This is a line of questioning that needed a better response. If the goal is to reduce fees, then we do not understand how courts can apply a damages model of individual liability against fiduciaries who have made changes. The real point is that the standard of care is changing. The excessive fee plaintiffs’ bar can take some credit for the industry-wide fee reductions, and they do. But the reality is that in 2016, many plans, if judged by 2021 current standards, still had high recordkeeping and investments fees. If Northwestern made changes by then, they were responding to the changing standard of care. They should not be liable for higher fees in the prior era.
Litigation Abuse with a Low Pleading Standard
Petitioners’ counsel started the argument by misrepresenting the Seventh Circuit decision, and then ended it by misrepresenting how excessive fee cases have affected plan sponsors. He concludes the argument with some real whoppers.
- Higher Rate of Excessive Fee Cases: First, he argues that “the fees have decreased so much that there are almost no new cases being filed in this area.” Transcript 95. This same lawyer cited statistics in his Reply Brief from Euclid’s amicus brief to show that 350 cases have been filed in the last five years. The litigation may have branched out to 401k plans and other industries beyond just university 403b plans, but with 150 cases in the last two years alone, it is becoming more prolific, not less. The 2020 volume is twice as high as 2021, but that is only because the Capozzi Adler law firm filed 40+ cases in 2020, and appears to be taking a temporary time out to digest their portfolio. The representation to the Court that the cases have diminished is a serious misrepresentation.
- 15% of large plans have been sued: Second, he claims that the evidence of the disruption in the fiduciary insurance market should be disregarded and that the litigation is not a problem, because more people are invested in defined contribution plans, and more plans have been established in the last five years. As we have noted previously, however, based on Plan Sponsor statistics from 2020, there are only 2,371 plans with assets over $250 million, which is the size at which most plans are at risk for legitimate excessive fee exposure [under the theory that excessive fee lawsuits are premised on the alleged failure to leverage size]. This means that as many as 15%+ of large plans have already been sued. This is hardly a de minimis impact.
- Good Plans Are Being Sued – Not Just “Rotten Apples”: Petitioners represented to the Court that only “rotten apples” like the Northwestern plan are being sued, but that is patently false. The main reason why Euclid filed an amicus brief was to demonstrate that plaintiff law firms are taking advantage of the low pleading threshold to sue plans with low fees based on misleading and often false claims. For example, the AT&T plan was sued for excessive recordkeeping based on false facts of an inflated fee, when discovery showed that it had a super low $20 recordkeeping fee with a contractual guarantee from Fidelity to match any other customer who received a lower fee. The Kroger plan was recently sued for having a $30 recordkeeping fee. The Walgreens plan settled after it lost a motion to dismiss claiming that its super low-fee .06% Northern Trust target date funds were underperforming when the funds had a more conservative stock investment mix. The litigation abuse is real. Even if the Northwestern plan is a legitimate excessive fee case, a rigorous pleadings standard is needed to prevent the many implausible and meritless cases that are being filed.
Conclusions and Predictions
Even though plan sponsors have very few positives to take away from the oral argument in the Northwestern case, we can only hope that the Supreme Court did not take this case just to settle factual disputes in one university excessive fee case. From the arguments, it appears that at least three justices think that the retail v. institutional share class claim was properly pled, but the excessive recordkeeping claim, including the claim of duplicative recordkeepers, may not be sufficient.
But the big picture – how this case will apply to other excessive fee cases – is what matters. It only makes sense that the Supreme Court took this case to pronounce a pleading standard to direct district courts handling the deluge of excessive fee cases. Even Justice Sotomayor wants a proper “balance.” The justices asked how many of these cases survive a motion to dismiss, and the lawyers had no answer. Well, we know the number – over two-thirds – and that is not a proper balance. And most cases involve two to four amended complaints, which involves significant defense fees. Too many meritless cases are going to full discovery, which allows plaintiffs to leverage settlements. Hopefully the Justices read the amicus briefs and settle on a more rigorous standard to vet the many implausible cases based on circumstantial evidence. That is what justice demands.
Finally, we want to reiterate the point that noted fiduciary expert Larry Fine of Willis articulated in his recent post in the D&O Diary blog to ensure proper context. The retirement plans being sued in purported excessive fee cases provide quality and safe investment options from reputable providers. The onslaught of excessive fee lawsuits is not a warning that retirees’ savings are in jeopardy. In fact, the opposite is true: in nearly every case, the asset size of many of these plans being sued has increased — often by billions of dollars — in the long bull market of the last ten years. Nor do these cases allege or proffer evidence that any plan fiduciaries took illegal gratuities, that any plan fiduciary personally benefited from the alleged decision, or made any fiduciary decisions based on improper pressure. To the contrary, the plan sponsors being sued have an incentive to offer employees the best possible options to save for retirement — and many plans offer matching contributions to help them do so. Excessive fee cases are not like employee-stock drop cases in which all or most of an employee’s life savings were lost. In fact, we have seen no case in which there are any actual investment losses. Rather, in every case, all of the plan participants have made money in the long bull run. The cases are just allegations of simple negligence, based on circumstantial evidence, that participants did not make as much as the plaintiff lawyers claim they should have made. They are lawsuits generated in a plaintiffs’ lawyer business model. With rare exceptions, most of these cases are improper second-guessing of valid fiduciary decision-making, and should be dismissed. Only a rigorous pleadings standard will restore the proper balance to this litigation.
