In a win for employee retirement plan sponsors and investment managers alike, the U.S. District Court for the Southern District of California recently ruled in favor of the defendants following a bench trial in a class action brought by former employee 401(k) plan participants under the Employee Retirement Income Security Act (ERISA).

The Bench Trial

In Lauderdale, et al. v. NFP Retirement, Inc., et al., the plaintiffs alleged plan sponsor Wood Group U.S. Holdings, Inc., and other defendants breached their fiduciary duties by selecting and retaining affiliated target-date funds (TDFs) for the plan, resulting in significant investment losses. Specifically, the class asserted that the defendants improperly invested in investment manager flexPATH Strategies, LLC’s proprietary TDFs, which plaintiffs claimed underperformed relative to funds offered by unaffiliated third parties.

After a nine-day bench trial, the court concluded the defendants complied with the duties of loyalty and prudence they owed to the plan participants. It noted that flexPATH had not violated the duty of loyalty by recommending or choosing its own TDFs because it reaped no financial or marketing gain by doing so. Moreover, the defendants demonstrated that flexPATH recommended its own TDFs only after performing an exhaustive analysis of several alternative investments and concluding that the flexPATH TDFs best served the plan participants’ interests, which was in keeping with flexPATH’s fiduciary duties.

Furthermore, the court found that flexPATH’s TDFs were not objectively bad investments — they were priced fairly, they were a type of investment endorsed by the U.S. Department of Labor (DOL), and they protected the participants’ investments against long-term inflation. The court also found that, as flexPATH gained no financial or marketing benefit when Wood Group chose its TDFs, there was no prohibited transaction.

As to Wood Group, the court held that plaintiffs’ claims failed because they were derivative of the claims against flexPATH. Even so, the court went on to note that ERISA’s prudence obligations were satisfied, in large part, because Wood Group engaged in a rigorous selection process to identify an investment manager before selecting flexPATH. Notably, the court rejected plaintiffs’ contentions that Wood Group needed to conduct an RFP process immediately before hiring a service provider, and that it needed to document the justifications for engaging flexPATH in committee meeting minutes. The court also found that Wood Group had monitored flexPATH reasonably and in accordance with its investment policy statement.

Summary Judgment Stage

The court’s rulings at trial reflected Wood Group and flexPATH’s successful development of certain evidentiary issues that previously had led the court to partially deny their summary judgment motions. At that stage, although the court did dismiss several claims, it found that Wood Group did not adequately address the question of whether it truly had considered the other investment options, given that the meeting minutes documenting Wood Group’s consideration of the pros and cons of the flexPATH TDFs contained a single “conclusory sentence,” with little to no analysis. The court also declined to find that Wood Group had shown it reasonably monitored its service providers as a matter of law.

Similarly, as to flexPATH, the court found a material question of fact regarding whether the flexPATH TDFs were imprudent or bad investments. Moreover, although flexPATH asserted that it did not directly benefit from the plan’s investment in flexPATH TDFs, the court declined to credit this explanation at the summary judgment stage.

Key Takeaways

These rulings underscore the importance of not just having prudent processes, but also considering how those processes are documented. For example, plan sponsors should:

• consider documenting the assessment and consideration of alternative investment options;
• consider documenting how the plan determines what decisions are or are not discussed in meeting minutes and in what level of detail;
• consider whether and how the plan’s investment strategy and policy align with the DOL’s investment guidance, especially its guidance concerning TDFs;
• be prepared to demonstrate why and how the plan determined fees and costs associated with a particular investment adviser or other service providers are reasonable and competitive; and
• consider the potential for management fees that are not contingent on which fund or funds are selected, thus reducing or eliminating the financial incentive an investment manager might otherwise have in recommending investment in affiliated funds.

ERISA does not require plan sponsors and investment managers to be perfect, always choosing what was, in hindsight, the best investment. Instead, they should exercise prudence and due diligence throughout the process of selecting plan investment options and managing plan compliance on a regular basis throughout the plan year.