Pension & Benefits News Fidelity breached duty of prudence by failing to monitor proprietary investments and expenses in own plan
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Friday, July 24, 2020

Fidelity breached duty of prudence by failing to monitor proprietary investments and expenses in own plan

By Pension and Benefits Editorial Staff

Fiduciaries and the sponsor of a 401(k) plan maintained by a financial services company for its employees breached ERISA’s duty of prudence by failing to monitor mutual fund investments (other than designated investment alternatives) and recordkeeping expenses, according to a federal trial court in Massachusetts. The proprietary mutual funds provided under the plan were not the equivalent of a self-directed brokerage account and, thus, were not exempt from the fiduciaries’ continuing duty to monitor. However, the fiduciaries did not breach their duty of loyalty, were not required to offer or investigate stable value funds or other mutual fund alternatives, and did not engage in a non-exempt prohibited transaction.

Proprietary plan amended pursuant to settlement of class action. Fidelity maintains a 401(k) plan for its employees, covering more than 58,000 participants and holding assets under management (as of the end of 2016) of nearly $17 billion. In October 2014, Fidelity entered into a settlement of a class action alleging fiduciary breach. Pursuant to the settlement, Fidelity amended the plan, selecting two designated investment alternatives (DIAs), that would be subject to full fiduciary monitoring. Plan participants, however, were also offered the opportunity to invest in an array of other Fidelity and non-Fidelity funds.

In order to address the issue of excessive recordkeeping costs, the settlement further required Fidelity to update its existing revenue credit system to create mandatory revenue sharing (revenue credits) with plan participants. The revenue credits would match or exceed the management fees and revenue generated by Fidelity pursuant to its role administering the various funds, including the cost of recordkeeping. The credits would be paid to the plan at the end of the year. The administrative costs were not monitored, according to Fidelity, because all administrative expenses paid to Fidelity would be credited back to the plan through the revenue credits.

In October 2018, former employees, who remained plan participants, again brought suit against the named fiduciaries of the plan and the plan sponsor (collectively “Fidelity”), alleging that Fidelity breached it duties of prudence and loyalty by failing to: (1) monitor the mutual funds in the plan other than the DIAs; (2) investigate alternatives to the mutual funds, such as stable value funds, collective trusts, and separate accounts; and (3) monitor and control administrative expenses. In addition, the participants charged that the payments made by the plan to Fidelity fiduciaries for administrative expenses constituted a prohibited transaction. Finally, as a remedy, the participants asked for the disgorgement of profits that Fidelity accrued as a result of its ERISA violation.

Fidelity maintained that: the plan’s mutual funds were the equivalent of a self-directed brokerage account that was exempt from monitoring; the revenue credit system relieved it of the need to monitor recordkeeping costs; and the payment of administrative expenses was exempt under PTE 77-3.

The parties filed for summary judgment. However, as an alternate to summary judgment, the parties agreed to submit the case to the court for review, on the undisputed facts, as a “case-stated” hearing.

Funds subject to duty to monitor as not self-directed brokerage accounts. The court determined that Fidelity was subject to fiduciary liability for its failure to monitor investments subsequent to the settlement. However, first the court addressed whether the fiduciaries had a duty to monitor self-directed brokerage accounts.

The fiduciaries were required to monitor the DIAs. However, under ERISA Reg. 2550.404a-5(a)(4), DIAs that must be monitored do not include brokerage windows, self-directed brokerage accounts, or similar plan arrangements that enable participants and beneficiaries to select investments beyond those designated by the plan. The participants charged that the fiduciaries had a duty to monitor investments other than the DIAs as an aspect of their duty of prudence. Fidelity, however, maintained that its proprietary funds were the equivalent of self-directed brokerage accounts and, thus, it was under no obligation to monitor the non-DIA funds.

The court, citing inconsistent judicial precedent and a lack of explicit regulatory guidance, was “hesitant to state unequivocally” that there either is, or is not a fiduciary responsibility to monitor self-directed brokerage accounts. However, the court avoided resolving the issue by concluding that Fidelity was not offering its proprietary funds through a brokerage window or its equivalent.

The court noted that the manner in which Fidelity offered proprietary mutual funds to plan participants was not similar to the manner in which it offered funds through a brokerage window. While self-directed brokerage accounts are designed to allow investors access to a large investment universe, all of Fidelity’s proprietary funds (in which the majority of plan assets were invested) were offered on an internal platform while a different platform was used to access the non-proprietary. Thus, Fidelity’s offering of its proprietary funds was not similar to a self-directed brokerage window, and it was subject to fiduciary liability for its failure to monitor the funds subsequent to the settlement agreement.

Fiduciaries under no duty to investigate mutual fund alternatives. The court’s ruling that the fiduciaries breached their duty of prudence by failing to monitor the mutual fund investments did not mean that the fiduciaries had a duty to investigate alternatives to the mutual funds (e.g., collective trusts and separate accounts). Non-mutual funds, which are subject to SEC reporting, governance, and transparency requirements, are so different from mutual funds, the court explained, as to make even “apples-to-oranges” comparisons difficult. Accordingly, Fidelity breached no duty by declining to offer or investigate stable value funds, collective accounts, or collective trusts.

Duty to monitor recordkeeping expenses. The court next concluded that Fidelity breached its fiduciary duty to monitor the plan’s recordkeeping expenses. Fidelity acknowledged that it did not monitor recordkeeping expenses (or conduct third-party benchmarking of its fees) but argued that it did not violate its fiduciary duties because all expenses were returned to the plan through the mandatory revenue credit and, thus, netted to zero. The participants countered that the plan actually did incur a loss because the revenue credits were “illusory” and former employees did not benefit from the credits.

The court, noting that the members of the participant class paid higher recordkeeping fees as a result of the Fidelity’s failure to monitor expenses, ruled that the failure was a breach of the duty of prudence. While the higher expenses did not constitute a breach of the duty of loyalty (as the plan was not designed to extract value from beneficiaries and transfer it to Fidelity) the failure to monitor the expenses was clearly negligent and imprudent. But for the lack of monitoring, the class members would have paid less in recordkeeping costs, the court stressed. The fiduciaries’ belief that the plan incurred no recordkeeping expenses was not a valid defense, the court further explained, because the fiduciaries failed to investigate the available documentation to confirm that belief.

Surcharge appropriate remedy. Having concluded that the plan fiduciaries were negligent in failing to monitor recordkeeping expense, and finding no special circumstances excusing the breach of duty, the court determined that surcharge was the appropriate remedy. However, because 100 percent of the money collected for recordkeeping expenses was returned to the plan, restitution and the disgorgement of profits were not appropriate remedies.

Fiduciaries did not engage in prohibited transaction. Consistent with its finding that the fiduciaries did not breach the duty of loyalty, the court determined that Fidelity did not engage in a prohibited transaction because its dealings with the proprietary products were no less favorable to the plan as a whole than to other shareholders of Fidelity funds. Absent the revenue credit, Fidelity’s dealings with the plan would have been on terms less favorable than Fidelity’s dealing with other shareholders of Fidelity-advised mutual funds (in violation of the conditions of PTE 77-3). However, the court agreed with Fidelity that, because of the revenue credit system, there was no net transfer of consideration from the plan to Fidelity for administrative expenses.

Source: Moitoso v. FMR LLC (DC MA).

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