The June 21, 2022 decision by the United States Court of Appeals for the Sixth Circuit in Smith v. CommonSpirit Health is the most helpful decision for plan sponsors in the hundreds of excessive fee and imprudent investment cases that have been filed since the lawsuits first started in 2006. The reason is that it refutes the entire genre of lawsuits claiming that active fund management is per se proof of fiduciary malpractice. It effectively disposes of the persistent and repetitive claims of fiduciary imprudence asserted in most excessive fee lawsuits in which plaintiffs are asking the court to infer fiduciary malpractice based on circumstantial evidence of what participants consider an undesirable outcome. The CommonSpirit Court instead rules that participants need more than a disfavored outcome to plead imprudence – they need proof of a negligent process. The Court stated that “ERISA for short, does not give the federal courts a broad license to second-guess the investment decisions of retirement plans.” But plaintiff lawyers have been largely successful in doing just that in hundreds of cases.
We consider this case a vindication that ERISA fiduciary law is based on process and, notwithstanding the many courts that have diluted the pleading standard for fiduciary imprudence cases, that ERISA does not allow hindsight claims based on disappointing outcomes. We assume that many law firms will write blogs on this case given its favorable ruling for plan sponsors, so we will limit our analysis to five key points that apply to all excessive fee and investment imprudence cases.
POINT #1: IT IS NOT IMPRUDENT TO OFFER ACTIVE FUNDS IN A DEFINED CONTRIBUTION PLAN. IN FACT, IT MAY BE IMPRUDENT NOT TO OFFER SOME ACTIVE FUNDS.
The crux of the CommonSpirit complaint was the claim that has been alleged in dozens of cases that the plan fiduciaries committed fiduciary malpractice by imprudently choosing the actively managed K shares (and later in 2018 K6 shares) of the Fidelity Freedom target-date funds. Although not filed by the Capozzi Adler law firm, the Miller Shah law firm used a copycat version of the Capozzi complaint template that alleges that Fidelity Freedom actively managed target-date funds are “high risk and unsuitable for plan participants,” that the active suite has “considerable cost” [42 to 65 bps for K shares; and 37 to 49 bps for K6 share], that “investors have lost faith in the active suite,” and that the Freedom Funds have suffered “inferior performance” compared to Fidelity’s index target-date funds [offered at a lower fee of 8 bps]. The complaint also alleged that the plan committee “saddled participants” with two additional “objectively imprudent investment options” that have “consistently and significantly underperformed” the Russell 1000 Value Index on a five- and ten-year basis [the American Beacon Large Cap Value Fund and the AllianzGI NFJ Small Cap Value Fund].
The Court held that the plaintiff had not plausibly pleaded that the CommonSpirit plan acted imprudently “merely by offering actively managed funds in its mix of investment options.” “[S]uch investments represent a common fixture of retirement plans, and there is nothing wrong with permitting employees to choose them in hopes of realizing above-average returns over the course of the long lifespan of a retirement account.” To the contrary, the Court noted that “[i]t is possible indeed that denying employees the option of actively managed funds, especially for those eager to undertake more or less, would itself be imprudent.” The Court went on to say that “[w]e know of no case that says a plan fiduciary violates its duty of prudence by offering actively managed funds to its employees as opposed to offering only passively managed funds.” Amen to that.
This principle alone is grounds to dismiss many of the pending excessive fee cases that assert imprudence of a handful of actively managed funds in plans that offer both index and active investment options. It is also relevant to the many cases that challenge actively managed target date options as allegedly imprudent choices for retirement plans. Plaintiff law firms are attempting to act as the de facto regulators of retirement plans in America by claiming that actively managed funds are imprudent and evidence of fiduciary malpractice. But it is the job of Congress or the Department of Labor, and not plaintiff lawyers or the courts, to decide whether actively managed funds belong in retirement funds. This is an obvious point, but it is helpful for a court to issue such a definitive ruling on the prudence of actively managed funds.
POINT #2: CLAIMS OF INVESTMENT UNDER-PERFORMANCE ARE NOT PLAUSIBLE BASED ON SIMPLY POINTING TO A FUND WITH BETTER PERFORMANCE – PLAUSIBLE CLAIMS REQUIRE A DEFICIENT PROCESS AND SIGNS OF SERIOUS DISTRESS.
The Court next explained that fiduciaries can violate ERISA by imprudently offering specific actively managed funds. “ERISA, in other words, does not allow fiduciaries merely to offer a broad range of options and call it a day.” Plan fiduciaries must ensure that all fund options remain prudent options. That is the lesson from the Supreme Court’s decisions in Tibble v. Edison and Hughes v. Northwestern. But the CommonSpirit Court held that plaintiff had failed to plausibly plead that the plan fiduciaries had violated the obligation to monitor the prudence of the active investment options. The Court noted that “there is still room for offering an actively managed fund that costs more but may generate greater returns over the long haul. Nor does a showing of imprudence come down to simply pointing to a fund with a better performance.”
The Court explained that it may be necessary to show that another fund in which the plan may have invested performed better, but that “factual allegation is not by itself sufficient.” Nevertheless, this is what nearly every excessive fee complaint purports to do. The Court instead offered that “[i]n addition, these claims require evidence that an investment was imprudent from the moment the administrator selected it, that the investment became imprudent over time, or that the investment was clearly unsuitable for the goals of the fund based on ongoing performance.” This is what excessive fee and underperformance complaints allege. But the Court said that merely pointing to a five-year snapshot of the fund “does not plausibly plead an imprudent decision that breaches a fiduciary duty because it is “largely a process-based inquiry.” “Any other rule would mean that every actively managed fund with below-average results over the most recent five-year period would create a plausible ERISA violation.”
The Standard to Allege Under-Performance is “Significant Signs of Distress”: The key ruling is that “disappointing performance by itself does not conclusively point towards deficient decision-making, especially when we account for ‘competing explanations’ and other ‘common sense’ aspects of long-term investments.” Mere performance comparisons typical of excessive fee lawsuits lack the “proper foresight-over-hindsight perspective.” Indeed, an “after-the-fact performance gap between benchmark comparators” does not violate “the process-driven duties imposed on ERISA fund managers.” So what evidence would be needed for a purported excessive fee complaint to move from possible and conceivable to plausible and cognizable as required under the pleading standard? The Court states that “[w]e would need significantly more serious signs of distress to allow an imprudence claim to proceed.” (emphasis added). Under the CommonSpirit test, most pending investment imprudence cases should be dismissed or proven to yield no damages.
POINT #3: PLAINTIFFS ARE NOT EXEMPT FROM PLEADING PROCESS BECAUSE THEY LACK PROCESS INFORMATION – THEY MUST USE REGULATORY FEE DISCLOSURES AND OTHER PUBLIC INFORMATION
A key argument that plaintiffs make in excessive fee cases is that they cannot be required to plead process because they do not have access to the fiduciary decision-making of plan fiduciaries. The Court acknowledges that requiring the pleading of a process-based defect puts participants in a “deep hole” in gaining sufficient information. But the court preempts this argument with two responses. First, Congress, and not the courts, established a cause of action premised on proving a process-based defect. It is not the role of the courts to changes the rules. Second, ERISA’s extensive disclosure requirements ease the burden because plans are required to disclose a range of information about costs and performance. Participants and their lawyers also have access to publicly available information that “may show sufficiently dismal performance that this reality, when combined with ‘allegations about methods,’ will successfully allege that a prudent fiduciary would have acted differently.”
Euclid made this same argument in our amicus brief to the Supreme Court in the Northwestern case. Like plaintiff lawyers, fiduciary underwriters do not have access to plan minutes and other original sources of plan fiduciary decisions. But underwriters use plan disclosures and publicly available financial information to make an informed judgment as to whether plans have complied with best practices and met their fiduciary responsibilities. Plaintiff lawyers should not be allowed to allege the serious offense of fiduciary malpractice without reviewing plan fee disclosures required by regulators. The CommonSpirit standard requires a higher level of due diligence before a case can be filed.
POINT #4: CLAIMS OF EXCESS RECORDKEEPING MUST BE PROVEN IN PROPER CONTEXT, AND NOT BY COMPARISONS TO A FEW OTHER PLANS TAKEN OUT OF CONTEXT
The recordkeeping claim in the CommonSpirit complaint was not the typical Capozzi or Walcheske chart that compare the challenged plan’s recordkeeping fees to five to seven purportedly low-cost plans. The recordkeeping fee allegation was even weaker than that. It instead alleged that Fidelity received a flat fee between $30 and $34 per participant. Anyone with knowledge of recordkeeping fees knows that this is a very reasonable fee, but the complaint purports to compare the CommonSpirit recordkeeping fee to a plan example in the 401k Averages Book with 100 participants and $5m in assets that paid $35 per participant. The complaint alleges that the CommonSpirit Plan with $3.2 billion in assets and 105,590 participants should have paid “significantly lower than $30 per participant” given that one small plan purportedly paid $35. We have written an entire whitepaper debunking the credibility of any claim based on the 401k Averages book. The statistics in the book are misrepresented by the plaintiff law firm in this case because the citation is to direct recordkeeping fees and omits the significant indirect revenue sharing that most small plans pay. In other words, the average small plan participant pays well over $35 in recordkeeping fees because the plan administration fees are usually based on a percentage of plan assets, and high-balance participants often pay several hundred dollars in plan administration costs. We firmly believe that any excessive recordkeeping fee claim against a large plan based on the 401k Averages Book with small-plan fee samples should be laughed out of court and the plaintiff firm should be sanctioned. The simple fact remains that nearly every large plan sued for purported excessive recordkeeping fees have lower fees than small plans.
Judge Sutton was much kinder than our prescription, but still dismissed the excessive fee claim for failing to “give the kind of context that could move this claim from possibility to plausibility.” Like in most excessive fee cases, plaintiff had failed to plead that the services the CommonSpirit’s fee covers are equivalent to those provided by the plans comprising the average in the 401k Averages Book. The fees are taken out of context, which is a common defect, but finally called out by the Sixth Circuit judges. The Supreme Court stated in Hughes v. Northwestern that imprudence is a “context-specific” inquiry. How refreshing for a court to follow the Supreme Court’s ruling.
POINT #5: PLAN CHANGES ARE PROOF OF PRUDENT MANAGEMENT, AND DO NOT SUPPORT IMPRUDENCE CLAIMS
A common playbook of the excessive fee bar is to find plans that have made changes to their investment lineup when they hire new investment advisors, and then claim that the changes are both “too little, too late,” and proof that the plan fiduciaries knew or should have known that the plan investments or recordkeeping arrangement was somehow imprudent. For example, in the Northwestern case, the Schlichter law firm alleges that the plan committee admitted malpractice by taking major actions in 2016 to reduce its investment lineup from 242 to 42 investments, and by consolidating recordkeepers with reduced recordkeeping fees. In CommonSpirit, the plan moved to lower-fee K6 shares of the Fidelity Freedom Funds and removed the AllianzGI Fund in 2018, which was one of the two other investment options that plaintiffs claimed were imprudent. The Court explained that this “simply shows that CommonSpirit fulfilled its ‘continuing duty to monitor trust investments and remove imprudent ones’” under Supreme Tibble precedent. More courts should follow this ruling.
The Euclid Perspective
The CommonSpirit decision is a breath of fresh air in excessive fee jurisprudence. A court finally got it right on all accounts. The Court correctly rules that ERISA is a law of process and does not allow second-guessing of fiduciary decisions without proof of a process-based defect. But that is exactly what excessive fee lawsuits attempt to do. It is the decision that plan sponsors needed and deserved from the Supreme Court in Hughes v. Northwestern. Instead, we got a limited opinion that has been misinterpreted by many district judges. Hopefully the CommonSpirit decision is influential to other courts in reestablishing a proper pleading standard.
On a more specific note, germane to the actual case facts, it is important to note that the CommonSpirit plan was not a low-fee plan. Plaintiffs alleged that the plan had all-in fees of .55%. That is more than double the average for $1b+ asset plans. It is a higher all-in fee than many cases filed in the last two years. By simple logic, if the CommonSpirit plan fiduciaries did not violate their fiduciary duties, then over 90% of the purported excessive fee complaints filed in the last two years are also not plausible. We have always believed that only egregious plan fees that are way outside a reasonable range merit damages for fiduciary malpractice. The CommonSpirit decision validates that viewpoint.
Finally, we have written extensively on the many cases alleging that Fidelity Freedom active target-date funds are not suitable for retirement plans. The CommonSpirit case refutes this unsupported claim, and hopefully disposes it once and for all. But there is still the issue of whether the plan fiduciaries chose the correct fee share class. The CommonSpirit plan was in the K share class for several years, and then switched to the K6 shares with slightly lower fees. There is still an issue as to whether it is reasonable for Fidelity to charge K and K6 share fees when they offer lower fees to other institutional plans. We do not understand how the defense in this case somehow skirted the issue of the prudence of higher-fee share classes. It is not addressed anywhere in the Sixth Circuit’s opinion. We assume it is because the plaintiff law firm did a poor job pleading this case, as the complaint is a weak copycat version of the Capozzi excessive fee complaint template. [We assume that Miller Shah somehow partners with the Capozzi law firm, because their respective complaints are nearly identical, but we have not verified that.] Maybe they failed to explicitly allege the magic words that the plans were in the wrong share class, but they do allege that the Freedom funds have excessive cost. The point is that while we relish in the Sixth Circuit’s opinion that vindicates ERISA as a law of process that prevents hindsight second-guessing, 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 process-based defect. Many cases allege investments in improper share classes, even if it was not alleged in this case. Again, we are not trying to rain on the parade when plan sponsors finally got a great decision, but it is a reality check that this is one key issue that is not addressed in the Sixth Circuit’s decision.
