Implications of the Deere Decision
Last week, Justice Diane Woods of the federal 7th Circuit Court of Appeals decided on Hecker v. Deere in favor of the Deere defendants. The decision deals a major blow to Schlichter, Bogard & Denton, the St. Louis law firm with 13 other ERISA lawsuits pending against some of the largest 401k plan sponsors in the country. While lead attorney Jerome Schlichter will argue that each of his cases are unique, the fact of the matter is that most of the suits will be affected significantly by the Deere decision.
I won’t discuss this decision in granular detail, but I would like to address three major implications of the Deere decision. The first is the broad immunization that 404(c) was deemed by the courts to offer the Deere fiduciaries. Second is the court’s heavy reliance on access to lower-cost funds through a brokerage window, in defeating claims of excessive investment fees within the core options of the investment menu. Finally, the courts took the view that fee disclosure, and particularly disclosure of revenue-sharing payments, is completely irrelevant to the investment decisions of participants.
Jerome Schlichter
First, when it comes to 404(c) I believe that it is fairly clear that the court’s understanding of 404(c) is very different from that of the Department of Labor. In point of fact, the Department of Labor submitted an Amicus Curiae in support of the plaintiffs that made it very clear where the DOL stands on the 404(c) issue:
” (T)he statutory safe harbor in section 404(c) does not immunize the Plans’ fiduciaries to the extent they acted imprudently in offering investment options with excessive fees. The Secretary’s regulation interpreting section 404(c), issued after notice and comment pursuant to an express delegation of authority, reasonably interprets 404(c) as providing no defense to the imprudent selection or retention of an investment option by the fiduciary of an individual account plan that otherwise provides for participant-directed investments. The Secretary’s contemporaneous interpretation to that effect is expressed in the preamble to her regulation, in briefs, and in Department of Labor Opinion Letters, and is therefore entitled to the highest level of deference under controlling Supreme Court precedent. This interpretation has effectively ensured for fourteen years that plan fiduciaries retain responsibility – and accountability – for the prudent selection and monitoring of plan investment options in accordance with ERISA’s stringent fiduciary obligations. The court’s decision to disregard this interpretation sharply limits the liability of fiduciaries that have imprudently selected or maintained investment options in individual account plans, gives insufficient deference to the Secretary’s determination of an issue expressly delegated to her by Congress, and threatens to deprive participants in individual account plans of adequate remedies for fiduciary misconduct. The court thus erred in dismissing the plaintiffs’ claims based on its misconception about the scope of ERISA section 404(c).” Department of Labor, Amicus Curiae.
The DOL’s interpretation of section 404(c) offers a more limited safe harbor to plan fiduciaries than the court’s interpretation. Under the court’s interpretation plan fiduciaries can seemingly offer “imprudently and disloyally selected investment options with excessive fees” and still be offered protection from liability under 404(c). Until the differences between the court’s interpretation and the DOL’s interpretation ultimately get resolved, for the sake of prudence I imagine most plan sponsors will continue to subscribe to the DOL interpretation. I want to make it clear that I am offering no analysis of the prudence or imprudence of Deere’s investment menu, only an analysis of the potential effect of the Deere decision on fiduciary obligations under ERISA.
Second, in this decision the court placed a high value on access to a brokerage window and to retail mutual funds to shield fiduciaries from claims of excessive fees. Both U.S. District Court Judge Shabaz and Justice Woods were impressed by the volume of funds in Deere’s brokerage window. Both Justices felt that because all of Deere’s retail mutual fund investment options were “offered to investors in the general public,” their expense ratios were “set against the backdrop of market competition” and therefore must be reasonably priced. I find this to be a curious defense. By this logic, a mutual fund manager could open a fund with a 5% expense ratio and provided it was available to the “general public” it would be acceptable under this definition – which is hardly compelling logic. While it is most certainly true that ERISA does not require fiduciaries to “scour the market to find and offer the cheapest possible fund,” the law does impose duties of loyalty and prudence. The true question of prudence is not how many funds are offered, nor whether or not these funds are offered to the public, but rather, whether a prudent investor “acting in a like capacity and familiar with such matters” would select the same retail mutual funds in the core funds as well as the brokerage window as those selected by the Deere fiduciaries. To me, “in a like capacity” does not mean that the Deere fiduciaries must think like a prudent individual “in the general public”, but rather they must think like a prudent investor in control of the design of a $4 billion investment menu. Hypothetically an attorney could make the argument that a prudent investor in control of this $4 billion investment menu would be aware of the scale of the Deere plans and seek to use that leverage to obtain investments at a fraction of the current cost. In fact, the Deere fiduciaries may have even been able to use the exact same investment managers in their new lower-cost investment vehicles thus avoiding claims of inferior performance. If the same exact investment managers, and thus the same investment performance, could be obtained for a lower price I think a prudent investor in this situation would pursue this alternative. This exact approach has been used by numerous plan sponsors to successfully lower fees and obtain the full benefit of their scale. Again, I do not know whether or not the Deere fiduciaries were in fact in breach of their fiduciary obligations. The court thinks they are not, but I think the case here is thinner for the Deere fiduciaries than in other places. In general prudent fiduciaries should always seek to eliminate unnecessary fees, as it is generally both good for participants and good for limiting fiduciary risk. On a more practical note, BrightScope has analyzed the percentage of assets in the brokerage window in plans that it has rated and the percentage is ordinarily quite low. The core funds are clearly the funds that participants are “nudged” towards, and plan fiduciaries following the DOL’s guidance would likely seek to construct a prudent core menu regardless of whether a brokerage window is offered.
The third and final implication of this decision relates to fee disclosure and particularly disclosure of revenue-sharing payments. On one point I agree with the courts. There is “nothing in the statute or regulations that required Deere to disclose the fact that Fidelity Research was sharing part of the fees it received with its corporate affiliate, Fidelity Trust.” The Department of Labor and Congress are working on improving disclosure of revenue-sharing payments, but right now these payments are generally undisclosed. However, the court claims that other than the statutory reporting and disclosure requirements no other disclosures are required under ERISA’s general fiduciary provision. In his opinion Justice Shabaz said that any reporting other than the statutory disclosure “would instead require judicial expansion of the detailed disclosure regime crafted by Congress and the Department of Labor pursuant to its statutory authority.” Justice Woods did not disagree. The Department of Labor believes that although not laid out in the letter of the law, if a disclosure is material to participant decisions it still needs to be disclosed:
“(T)he Secretary disagrees with the district court to the extent that it dismissed this claim based on its erroneous conclusion that, if a fiduciary satisfies ERISA’s express statutory reporting and disclosure requirements, it can never have additional disclosure duties under ERISA’s general fiduciary provisions. This Court and others have held that ERISA’s duties of prudence and loyalty not only forbid fiduciaries from misleading plan participants, but may, under some circumstances, also require fiduciaries to disclose information that participants need to protect their interests, even if the disclosure is not specifically requested or otherwise mandated in ERISA’s reporting and disclosure provisions.” Department of Labor, Amicus Curiae.
Fred Reish
So if additional disclosures may be required under ERISA’s general fiduciary provisions, how do we determine the materiality of these disclosures? I would argue these disclosures would include information that materially affects participants’ retirement outcomes. I believe that Fred Reish does a great job of explaining why revenue-sharing payments are material:
“If a recordkeeper is receiving $50,000 in revenue sharing, and if a reasonable charge for its services is $50,000 – the same amount – there is no conflict. However, if the plan grows with time and the revenue sharing grows to $85,000, but a reasonable charge only increases to $60,000, the fees have become excessive. At that point, the responsible fiduciaries have three jobs: to know about the amount of the revenue sharing, to know the reasonable cost of the recordkeeper’s services, and to reclaim the difference for the plan and the participants.”
Fred makes it clear that revenue-sharing is material to fiduciaries, but must it be disclosed to participants? Justice Woods had something very specific to say about the materiality of revenue-sharing to participants. Namely, that “the total fee, not the internal, post-collection distribution of the fee, is the critical figure” participants needed to “keep from acting to their detriment.” The fundamental difference in thinking here is that the court views only the total fee as being material to the participant, whereas many others view materiality as knowing whether each fee being paid is reasonable. They would argue that allowing participants to overpay for something, even if its full price is disclosed, is not acting with loyalty and prudence. The only way to verify that payments are fair is to break out each major category of service and understand how much is being paid for each. BrightScope believes that plan fiduciaries should be doing this analysis right now and in the name of prudence they should probably disclose what they find to participants. Participants deserve to know if the plan is paying significantly more than other plans of similar size, and if so they deserve an explanation. As another benefit, to paraphrase Stephen Rosenberg, this added level of fee transparency which is not currently required by law may actually serve to reduce lawsuits. Read more about this argument here.
Now, on to the practical implications of this decision on the other lawsuits filed by Schlichter. If a plan is 404(c) compliant and it offers a brokerage window, the Deere decision makes it more difficult to pursue an argument of an imprudently constructed, high-fee menu. So let us ask the following two questions of the other companies that face a Schlichter case:
- Is the plan, or any part of it intended to meet the conditions of 29 CFR 2550.404c-1?
- Are participant-directed brokerage accounts provided as an investment option under the plan?
- General Dynamics
- Savings & Stock Investment Plan:Â 1. Yes, 2. No.
- General Dynamics has 9 other 401k plans.
Northrop Grumman
- Savings Plan: 1. Yes, 2. Yes.
- United Technologies
- Employee Savings Plan – 1. Yes, 2. No.
- Represented Employee Savings Plan – 1. Yes, 2. No.
Lockheed Martin
- Salaried Savings Plan: 1. Yes, 2. Yes.
- Lockheed Martin has 4 other 401k plans.
Caterpillar
- 401k Plan: Yes, Yes.
- ABB Inc.
- Personal Retirement . . . Plan for Employees: Â 1. Yes, 2. No.
- Personal Retirement . . . Plan for Certain Represented Employees:Â 1. Yes, 2. No.
Unisys
Boeing
- Voluntary Investment Plan: 1. Yes, 2. No.
- International Paper Company
- Salaried Savings Plan: 1. Yes, 2. Yes.
- Hourly Savings Plan: 1. Yes, 2. Yes.
While this list represents only a handful of the Schlichter cases some trends jump right out at us. First, almost every single plan is established in such a way as to be 404(c) compliant. In addition it looks like roughly two thirds of the plans on this list do not have a brokerage window. Provided each properly complies, the 404(c) hurdle will be tough for Schlichter to overcome. If Schlichter does break through without knowing anything else about the plans I would suppose that those plans without brokerage windows might be marginally more vulnerable than those with brokerage windows. In the coming weeks I will do a more thorough analysis of the remaining cases and post what I find right here on the BrightScope Blog.
In closing, this is a critically important decision not only because it affects the rest of the Schlichter cases in a meaningful way, but also because of the failing health of Supreme Court Justice Ruth Bader Ginsburg. As it stands, Justice Woods is considered by many to be a front-runner on the Obama administration’s list of nominees to replace Justice Ginsburg. While the impact of this decision is large now it could have a much larger impact if Justice Woods became a Supreme Court Justice, a role she appears qualified to hold.
Disclaimer: This post is not intended by legal advice. BrightScope is not a law firm and is not a fiduciary under ERISA. Please contact your legal counsel with legal questions.
Nice analysis.
I’m still a little surprised by the court’s stance on revenue sharing. Isn’t a potential conflict of interest always material by its very nature?
That’s what one would think, but revenue-sharing is a tricky subject and I don’t think the court fully grasps the implications. We will see what happens with the new DOL regulations under the new administration.
The Court made several mistakes.
The first mistake they made was suggesting that making broad selection of funds available was part of 404(c). That is and has always been incorrect. Selecting the underlying funds is a fiduciary act. If those funds have revenue sharing – the fiduciaries are exercising fiduciary discretion to select revenue sharing. That act does not fall under 404(c).
The second mistake is that for a fund to quality as an investment option under 404(c), it must be “diversified within itself.” That means a mutual fund, collective trust, etc. Open brokerage windows permit the investment of single securities that are not diversified within themselves; just the opposite.
Third, the Court failed to realize that revenue sharing is entirely material, as it is excess revenue beyond what the fund manager needs to be profitable. Its meaning to participants (economically and financially speaking) is absolutely relevant and material – as it is money extracted from their account for something Fidelity admits has nothing to do with managing the actual investments. It goes without saying therefore it must be viewed and measured separately.
Judges are smart. There’s no argument there. Just not smart enough to figure out ERISA.
Looks like BrightScope has done it, though. Good job.
The last thing we need is an “anti-401k” judge on the Supreme court. Great…just great. Uugghhh!!!!
I think the court got revenue sharing and its importance to participants exactly right. As Judge Wood said “The total fee, not the internal, post-collection distribution of the fee, is the critical figure for someone interested in the cost of including a certain investment in her portfolio and the net value of that investment.”
Austin says revenue sharing is excess beyond what the fund manager needs to be profitable. Says who? How much profit is too much? As a participant trying to select between funds, one thing I want to know is how much is going to be taken from the fund for whatever reason, and my returns net of expenses. What the fund manager does with the money, while certainly interesting, is not material to my decision. If 1 fund has 1% taken for expenses, and uses half of that for revenue sharing, and another has 1.25% taken, but no revenue sharing, which am I going to pick if gross returns are the same?
Looking at the issue from the point of view of the fiduciaries who pick the funds to be offered, I agree with Fred Reish that they need to be aware of the details of the revenue sharing agreements and their fairness to participants. I think there is a real risk that dumping all these notices, disclosures, prospectuses, etc., on participants will result in analysis paralysis and hurt participation. I hope the DOL will allocate the responsibilities appropriately.
It’s elementary my dear Thomas.
Revenue sharing is paid to a third party. It’s not kept by the fund manager. Do you see the logic? The fund manager keeps enough to be profitable – otherwise they would charge and keep more if needed. Revenue sharing is not kept by the fund manager.
Thus, unless the fund manager is not acting in its own best interest – and we can assume it does act in its own best interest if it is a legitimate enterprise – anything charged over and above what the manager keeps is excess, meaning the fund manager doesn’t need it or they would keep it for itself.
The Judge blew the decision because she totally ignored the DOL’s opinion on the matter. The DOL stated unequivocally that all revenue sharing must be disclosed to participants as relevant. Further, Deere admitted (and Court recognized) that it had been lying to participants about it. ERISA forbids misleading participants at any time. The Court turned a shameful blind eye to that. I presume you liked that about the ruling, too?
Further, Deere’s investments were retail funds. If you have ever read ERISA – it states that fiduciaries must behave according to prevailing standards. Are retail funds in Multi-Billion dollar 401(k) plans the prevailing standard? Nope.
If this ruling were to stick, it would destroy all confidence in a participants ability to seek remedy for fiduciary breaches caused by blatant disregard for generally accepted fiduciary standards.
Finally, one thing that really bugs me about revenue sharing…why exactly have fund managers, once revered and respected, become the bill paying agents of record keeping firms’ bills? Don’t they have any self respect for who they are professionally?
Reish is only correct in concept. There’s no practical way to monitor and evaluate value for each revenue sharing dollar spent. Reish’s example is clear, but I’d like to see him diligenty track increasing revenue sharing against increasing value of services like Fiduciaries are required to do. So revenue sharing is always a bad idea in plans governed by ERISA for those and many other reasons.
Maybe we should just get rid of the fiduciary standard and let it be a free for all.
I’m not too sure we could expect much from judges who “were impressed by the volume of funds in Deere’s brokerage window” and feel that retail funds are reasonable in a multi-billion dollar 401(k) plan. Shouldn’t Deere employees enjoy the same benefits that these judges do in their U.S. government sponsored Thrift Plan? Excessive fund options and retail offerings are part of the problem in 401(k) and certainly not proof that fiduciaries are carrying out their duties with prudence.
1. The court’s decision that rev share is not a plan assets is interesting but hardly dispositive. We’re not done with that one yet.
2. Yes, judges are smart. But one has to giggle at the ever-so-politely phrased commentaries from ERISA attornies when remarking on questionable rulings, since it is an ariticle of faith among attornies that one never bad-mouths a judge. Remember Jenkins v. Yager?
3. Just because the judge is clearly wrong in the sense that conservative fiduciary opinion is squarely against him on granting 404(c) to a firm that didn’t meet the regulatory requirements, doesn’t mean that he’s not right. After all, there is a statute, and some attorneys (e.g., Sheldon Smith, ASPPA President) have said for years that statutory compliance is possible even if you don’t meet the nitpicky requirements of the 404c-1 regulation. This court brings the statutory vs. regulatory compliance debate into the open.
4. The biggest news in this case is one that no one seems to notice, so I wonder if I’m wrong in thinking it’s the big news: this is now the fourth or so case where a court has granted leniency in a big way, suggesting that the nitpicky view of 404c compliance just doesn’t impress most judges. One gets the sense that if one went to court with tales of prospectuses not delivered, notice language errors, proxy notices not delivered, and similar egregious breaches of the 404c-1 regulatory requirements, the judges would brush it aside and say, “They got to make their choices, so they can just take their own medicine.” Very American, and very contrary to how we fiduciary puritans have always viewed 404(c) compliance. DOL has always strenuously maintained that regulatory compliance is the only path to protection, but here comes Deere, Jenkins v. Yager, in re Unisys, and a handful of others where the judges gave a free pass. It almost appears that the courts will view as protected any participant decisions regardless of what the regs say.
5. Austin said, “The second mistake is that for a fund to quality as an investment option under 404(c), it must be “diversified within itself.†” Actually what the regulation says is, “Where such portion of the account of any participant or beneficiary is so limited in size that the opportunity to invest in look-through investment vehicles is the only prudent means to assure an opportunity to achieve appropriate diversification, a plan may satisfy (the broad range rule) only by offering look-through investment vehicles.” Also it says that there must be at least three alternatives “each of which is diversified.” [29CFR2550.404c-1(b)(3)] Offering a brokerage account that allows access to individual securities does not invalidate the broad range requirement so long as the conditions are met (e.g., three other look-through options meet broad range and brokerage is extra). Only three options are required. Brokerage accounts can qualify for 404c-1 relief.
To summarize:
1. courts are being lenient, inclined not to nitpick on fiduciary compliance and lean toward what they see as common sense
2. rev share as plan asset not resolved, but a blow has been struck in favor of those who don’t want it to be a plan asset.
3. will there now be a rush to add brokerage accounts because they are incorrectly perceived to offer more protection when included, just because of this case? What a wierd and counterproductive twist that would be.
This case seems to invalidate many of the standards of care that our industry has been professing for years. Some of the arguments made by the Judge seem ridiculous to me. To conclude that because a fund is publicly available the costs are reasonable defies logic.
Further, because some “prudent” investors select funds from one fund family, this Plan’s selection of funds from a single fund family must also be prudent is an argument I would not be satisfied with as a participant. A plausible argument might be, “in utilizing a singular fund family we were able to decrease participant costs and we felt those cost decreases outweighed any potential increased return from having multiple fund families, along with the higher costs that would be involved, and here is the evidence from our study.” In my experience this kind of dynamic would come into play only on much smaller plans but wanted to provide an example of something that would seem to fit the definition of Plan fiduciaries acting with prudence.
I have come across so many plans where fees appear egregious to me. Some broker is making 75 or 100k in commission where our hard fee might be 25 or 30k, and the Plan Sponsors just couldn’t care less. This case will only embolden those Plan Sponsors to care even less than they already do, which is really unfortunate.
Also the fact that a self directed brokerage window is available seems irrelevant. In fact, I think one reason self directed brokerage is harful is that it unfairly burdens the particpants remaining in the core options with the costs of the Plan.
Will the DOL jump in at some point with an audit or suit?
It’s getting so complicated that I aggree with the comment that funds with revenue sharing ought to be illegal in qualified plans.
One nice trend I am seeing is record keeping and trust/custodial companies that offer hard fee contracts – it seems like a particulalry good time to peg costs to an absolute dollar, so when the market recovers, fees remain low.
Sure, but that money shift happened a long time ago, nothing new there. Republicans could introduce legislation on Social Security, sure. Some kind of legislation may even be needed. But, they don’t call that a third rail for nothing. They found that out when Bush tried to privatize Social Security, just like Paul Ryan wants to do. Not only will something like that not pass, the pitchforks will be sharpened.