The past 15 years have witnessed a steady stream of lawsuits alleging that employers’ 401(k) or 403(b) plans forced participants into underperforming or overpriced investment options, or that plan participants’ accounts were burdened by excessive recordkeeping fees. On Jan. 24, the United States Supreme Court, in Hughes v. Northwestern University, declined to follow a path laid out by the Seventh Circuit Court of Appeals in 2020 that might have significantly diminished the flow of these lawsuits. For 401(k) and 403(b) plan sponsors, the Supreme Court’s decision dashes the hope of a “magic bullet” to fend off participant lawsuits through investment menu structure and means that significant attention to fiduciary process with regard to the individual investment choices within a plan’s investment lineup will continue to be required.
The Seventh Circuit had held in Divane v. Northwestern University, 953 F. 3d 980 (7th Cir, 2020) that claims of excessive fees made by some Northwestern plan participants could not survive a motion for dismissal because, even if the funds that the plaintiffs had invested in under the Northwestern plan had excessive investment fees, alternative funds with lower fees that met the plaintiffs’ standards were available to them within the plan’s fund lineup. The Seventh Circuit held that this meant that, as a matter of law, the Northwestern plans’ fiduciaries could not be held liable for any excessive fees that the plaintiffs might have suffered. Thus, the plaintiffs’ case could be dismissed without the need for discovery regarding the fiduciary process surrounding the selection and retention of the allegedly overpriced funds.
The Seventh Circuit’s decision drew a bright line that would have led to the dismissal of many 401(k) and 403(b) excessive fee lawsuits before plaintiffs could engage in discovery, as long as the plan’s investment lineup contained funds with acceptable fee levels in addition to the funds with the allegedly excessive fees levels. However, the Supreme Court has now unanimously ruled that no such bright line exists. Instead, the Supreme Court has held that “the appropriate inquiry [that the federal courts must engage in when judging claims of excessive 401(k) or 403(b) fees] will necessarily be context specific.” One may infer that such a context-specific inquiry will typically require discovery by plaintiffs regarding a plan’s fiduciary process before a court may reach a decision regarding the plaintiffs’ underlying claims.
In its opinion, the Supreme Court seems to place importance on whether the Northwestern plans’ fund lineup was too large and confusing for the plan’s participants to fully understand the choices available to them. Accordingly, plan sponsors should pay increased attention to the size and structure of their fund lineup.
Background
Virtually all 401(k) and 403(b) plans offer participants investment choices for their accounts in arrangements designed to comply with Section 404(c) of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). Under ERISA Section 404(c), a plan’s sponsoring employer and the plan’s other fiduciaries, such as an investment committee, generally cannot be held liable for the asset allocation choices made by participants. This is the case as long as the plan provides investment choices that allow participants to diversify their account among diverse asset classes and that provide issuer diversification within each asset class (e.g., by including among the plan’s investment options mutual funds investing in large cap stocks, small cap stocks, international stocks, and corporate and/or government bonds). However, ERISA Section 404(c) does not shield the plan sponsor and the plan’s other fiduciaries from responsibility for the prudent selection of plan investment alternatives, including that they demonstrate reasonable performance and do not charge excessive fees.
The federal courts have recognized that retirement plan investment decisions involve difficult probabilistic judgments in the face of uncertainty, and so the courts have generally held that the standards to which 401(k) and 403(b) plan fiduciaries should be held under ERISA are ones of diligence and prudent process, not perfection of outcomes. Thus, 401(k) and 403(b) plan sponsors and fiduciaries facing claims by participants of poor investment performance or excessive fees are provided an opportunity to demonstrate that their fiduciary process was diligent and prudent, even if it resulted, with the benefit of hindsight, in less than optimal results.
However, proving that a plan’s fiduciary process was diligent and prudent can be burdensome for plan sponsors and fiduciaries. Moreover, the factual record may contain ambiguities that potentially weaken a plan sponsor’s defenses. Thus, many ERISA lawsuits brought against 401(k) and 403(b) plan sponsors for poor investment performance or excessive fees are settled by defendants for a significant amount if the plaintiff can obtain discovery regarding the defendants’ fiduciary process.
In order to avoid discovery regarding their fiduciary process and defend themselves in the most effective manner possible, plan sponsors and fiduciaries will typically try to have the plaintiffs’ case dismissed as a matter of law before the plaintiffs are entitled to discovery. The Seventh Circuit’s analysis in Divane v. Northwestern would have led to a larger percentage of 401(k) and 403(b) fee cases being dismissed before discovery if the defendants’ plan included funds with acceptable fee levels as well as those with potentially excessive fee levels. The Seventh Circuit effectively told plaintiffs that it doesn’t matter what the plan’s fiduciary process was with respect to the funds you claim had excessive fees, because it is your own fault for investing in those funds rather than investing in other funds available to you under the plan that did not, by your own standards, have excessive fees.
The Supreme Court has concluded that the Seventh Circuit’s rule was too simplistic, essentially ignoring potential reasons other than the plaintiffs’ own fault that may have led to their investing in funds with excessive fees, reasons that could perhaps be proven by plaintiffs in discovery. In this regard, it is worth noting that in explaining its decision in Hughes v. Northwestern, the Supreme Court noted that the plaintiffs had alleged that Northwestern’s plan had too many investment options and that this had led to confusion and poor investment decisions on the part of some participants. One may infer that the Supreme Court saw this as a potential counter by the plan’s participants against any conclusion that the plaintiffs were themselves responsible for paying the high fund fees that they objected to.
In any event, in reversing the decision of the Seventh Circuit, the Supreme Court’s Jan. 24 decision in Hughes v. Northwestern likely ensures a continuing flow of 401(k) and 403(b) fee cases.
