Pension & Benefits News Retention of underperforming, high fee proprietary investment funds did not state fiduciary breach claims against Morgan Stanley
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Wednesday, March 4, 2020

Retention of underperforming, high fee proprietary investment funds did not state fiduciary breach claims against Morgan Stanley

By Pension and Benefits Editorial Staff

Conclusory allegations that fiduciaries of a plan sponsored by an investment company breached duties of prudence and loyalty by offering underperforming, high cost proprietary investment options and retaining underperforming target date funds offered by a preferred customer were not sufficient to state claims under ERISA, according to a federal trial court in New York. In a scathing dismissal, the court concluded that, by zeroing in on the underperformance of certain investment options, the plan participants and their “opportunistic Monday-morning quarterbacking” lawyers “came nowhere close” to sufficiently alleging an ERISA action.

Plan investment menu included underperforming proprietary funds. Morgan Stanley sponsors an individual account 401(k) plan that holds $60 billion in assets and covers 60,000 current and former employees. Among the plan’s investment options were six propriety Morgan Stanley (MS) mutual funds. Plan participants alleged that the six funds charged excessively high fees. In addition, the participants maintained that three of the MS funds (Small Cap, Mid Cap, and Global Real Estate Funds) performed so poorly that a reasonable fiduciary would have removed them from the plan’s menu of investment options.

The participants further charged that the plan included seven underperforming retirement funds offered by BlackRock. The participants maintained that the BlackRock target date options were either poorly performing or untested when they were added to the plan’s investment menu. Moreover, the participants alleged that the target date options were retained only because MS was interested in developing a business relationship with BlackRock.

Participants lack standing with respect to non-selected funds. The participants’ case was brought as a putative class action. However, MS argued that the plaintiffs collectively invested in just six of the thirteen challenged funds and, thus, lacked standing to bring claims related to the other seven funds (i.e., non-selected funds). According to MS, the participants lacked standing to challenge the non-selected funds because the alleged poor performance of those funds did not have any effect on the value of the assets in the participants’ accounts.

The participants countered that, because they had styled their action as a derivative suit under ERISA Sec. 502(a)(2), to recover for injuries to the plan as a whole, they were not required to allege an individualized injury. In rejecting the argument, the court explained that the mere fact that the participants purported to bring the action in a derivative capacity did not absolve them of the need to establish an Article III Constitutional injury-in-fact based on the poor performance of the non-selected funds. The court, thus, firmly declined to exempt derivative suits from the requirement under Article III that a plaintiff suffer individualized harm.

Offering of proprietary funds did not breach fiduciary duty. The participants charged that the fiduciaries breached their duty of loyalty by offering MS proprietary funds to plan participants and charging higher advisory and administrative fees to them than it charged to outside “separate account” clients with similar assets and investment strategies for substantially the same services. As framed by the court, the participants essentially argued that the MS fiduciaries did not: (1) offer plan participants the opportunity to invest in separate accounts that replicated the strategies of the MS funds, but with reduced fees, or (2) unilaterally discount the fees associated with the MS funds to equal those charged to the separate account clients.

In dismissing the argument that the fiduciaries should have provided the participants with the opportunity to participate in the separate accounts, the court, noting that plan fiduciaries may not deal with plan assets in their own interest, stressed that there was no exemption that permitted fiduciaries to invest plan assets in single client separate accounts in which the fiduciary has an interest or receives fees. Moreover, even if an exemption did apply, the court explained, ERISA does not require a plan to offer separate accounts in lieu of reasonably priced mutual funds.

Similarly, the court noted that the fiduciaries were not required by ERISA to unilaterally offer plan participants a discounted fee for investing in the MS funds. Nor were the fiduciaries required to reduce the market-based fees of the MS funds to equal the fees charged to separate account clients merely because the funds were included in the ERISA plans.

Retention of underperforming funds did not violate ERISA. The participants’ challenge to the Mid-Cap Fund was based on its underperformance relative to its benchmark, the Russell Mid Cap Growth Index Fund and to two alleged comparators maintained by T. Rowe Price and Vanguard. In addition, the participants charged that the Fund had lower Morningstar ratings than comparable investment options and sustained mass redemptions during the class period.

In concluding that the retention of the Fund did not plausibly establish imprudence on the part of the fiduciaries, the court noted that the allegations of underperformance were based on a prospectus and data that was not available to the fiduciaries throughout much of the class period. In fact, the court noted, the fiduciaries removed the Fund after the prospectus became public.

In addition, the court found that the Fund’s alleged underperformance in average annual returns did not raise a plausible inference that a prudent fiduciary would have found the Fund to be so “plainly risky” as to render the investment imprudent. While acknowledging that consistent underperformance over a long period may support a breach of the duty of prudence claim, the court stressed that difference of less than one percentage point between performance of the Fund (7.42%) and its Russell benchmark (8.16%) could not support the inference that the fiduciaries imprudently retained the Fund.

The participants’ charges related to the alleged imprudent retention of the Global Real Estate Fund that underperformed its benchmark were similarly dismissed as “impermissibly hindsight based.” The difference in performance was, again, viewed as too small to support a claim for breach of the duty of prudence, while claims of underperformance relative to other comparators were not sufficiently detailed to support a claim.

Fee differential not sufficient to establish disloyalty. The court initially acknowledged that a duty of loyalty claim may lie when plan fiduciaries offer proprietary funds that charge fees that are excessive when compared with similar investment products and where the fiduciaries are positioned to gain from the fees. However, the fee difference between the actively managed Mid Cap Fund (0.61%) and the passively managed Vanguard Fund (0.08%) was not insignificant. Moreover, the court stressed, fee differential alone is not sufficient to demonstrate disloyalty without evidence that the fiduciaries acted for the purpose of providing themselves or others a benefit. Absent evidence suggesting an improper purpose or motivation, the participants could not plausibly state a claim for breach of the duty of loyalty.

Failure to remove BlackRock Trust not imprudent. The participants, relying on a strategy the court repeatedly rejected, charged that the retention of the 2025 BlackRock Trust was imprudent because it: underperformed its benchmark and allegedly comparable investment options; charged higher fees than a Vanguard Trust; carried a lower Morningstar rating than the Vanguard Trust; and was a relatively new product at the time it was included in the plan.

The court, as with the claims regarding the proprietary funds, found the conclusory allegations of cumulative underperformance to be insufficient to state a claim, reasoning that “backward-looking contentions regarding overall performance are improperly grounded in hindsight.” Specifically, the court, after first noting that the trusts may not have been comparable, found that the data indicated only intermittent underperformance by the 2025 Trust. Moreover, the court concluded that the marginal fee disparity between the 2025 Trust (0.12%) and the Vanguard product (0.075%) was not sufficient to support a fiduciary breach claim.

The participants alternatively maintained that the fiduciaries’ retention of the 2025 Trust breached the duty of loyalty because it was motivated by a desire to foster a business relationship with BlackRock. Initially, the court noted that the mere fact the MS might “incidentally” benefit from the relationship with BlackRock did not raise an inference of disloyalty. Moreover, the court stressed that the participants failed to allege any facts suggesting that the business relationship between the two financial institutions was contingent on MS offering BlackRock Trusts in the plan.

Investment in proprietary funds was exempt prohibited transaction. Finally, the participants alleged that the fiduciaries committed a prohibited transaction by investing plan assets in the MS funds and permitting the funds to deduct annual fees from the plan assets invested in the funds. The fiduciaries countered that fiduciaries, under PTE 77-3, are authorized to invest in affiliated mutual funds.

The court found the fiduciaries to be in compliance with the conditions of PTE 77-3. The plan did not pay investment fees to the MS funds (although the funds did compensate their own managers); the MS funds were not subject to redemption offers or sales commissions; and the plan investments in the MS funds were treated with parity with the contributions of outside investors to the MS funds.

Source: Patterson v. Morgan Stanley (DC NY).

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