THE FIDUCIARY CORNER: Selecting the 401(k) Fund Lineup Creates Risk and Opportunity
Gregory L. Ash, Wednesday, February 16, 2011 | Filed under: 401(k) Plans, ERISA Litigation, Fiduciary Duties, Plan Investments
In late January the United States Court of Appeals for the Seventh Circuit (whose jurisdiction includes Illinois, Indiana, and Wisconsin) weighed in yet again on the extent to which ERISA’s fiduciary duty rules apply to the selection of 401(k) plan investments. As you may recall, the Seventh Circuit issued one of the most important rulings on this topic in recent years in Hecker v. Deere & Co. (2009), a case challenging as imprudent the fees attached to such investment options. Now, just two years later, the court appears to have reconsidered its analysis in Hecker, adding even more murkiness to these muddy waters.
The Department of Labor has taken the position for many years that the selection of the core investment funds from which 401(k) plan participants may choose is a fiduciary act under ERISA. The DOL argues that setting the fund lineup is not an act that is shielded from liability by Section 404(c) of ERISA, which otherwise makes participants solely responsible for investment losses attributable to their own investment decisions. Thus, according to the DOL, a fiduciary who includes an imprudent fund in the menu of options may be liable to participants who suffer losses as a result of investing in such a fund.
The courts, however, have not always agreed with the DOL’s position. The Seventh Circuit, in particular, hinted in Hecker that as long as a plan offered a sufficient number of investment options, the presence of a few imprudent options would not subject the plan’s fiduciaries to liability.
In companion rulings handed down on January 21, 2011, however, the Seventh Circuit appears to have abandoned its earlier reasoning in favor of the DOL’s interpretation of Section 404(c). (Howell v. Motorola, Inc. and Spano v. Boeing Co.). According to the court, the Section 404(c) safe harbor protects fiduciaries from losses incurred in participant-directed accounts “only with respect to decisions that the participant can make.” Because participants do not set the menu of investment options, Section 404(c) does not apply to those decisions. Instead, the plan’s fiduciaries remain liable for the selection and monitoring of that lineup. Somewhat remarkably, the Howell decision was drafted by the same judge who wrote the court’s earlier decision in Hecker.
While reaching what is undoubtedly a participant-friendly result in Howell, however, the Seventh Circuit gave plan sponsors and fiduciaries reason for hope in Spano v. Boeing Co. In Spano, the court created significant procedural obstacles for participants (and their lawyers) who wish to bring ERISA class actions. Class actions allow large numbers of participants to bring suit collectively, thus leveraging what might otherwise be small individual claims. Without the leverage of a class action, many ERISA claims would be prohibitively costly to pursue.
Like Hecker, the plaintiffs in Spano alleged that plan fiduciaries selected an investment lineup that included excessively expensive options. The district court concluded that the Spano plaintiffs could pursue their claims as a class. Reviewing the lower court’s order on that subject, the Seventh Circuit Court of Appeals ruled that, while such cases might be amenable to class status in some circumstances, this case was not one of them. The appellate court therefore overruled the class certification order and sent the case back to the district court.
In doing so, the Seventh Circuit strongly hinted that the individual investment decisions that permeate participant-directed 401(k) plans might make class actions involving such plans difficult to pursue. When, as was the case here, the plan’s administrative fees vary from investment fund to investment fund, and when individual participants can choose on a daily basis whether to invest in one or more of those funds, defining a class of participants who were assessed the same fee, and thus whose interests are sufficiently similar — or “typical,” in the parlance of the Federal Rules of Civil Procedure that govern class actions — may be extremely difficult.
The Spano ruling suggests a number of considerations that employers should take into account when designing participant-directed plans. Some of these decisions could strengthen the employer’s position in the event that plan-wide litigation is filed. For instance, the Seventh Circuit’s ruling hints that plans with a large number of investment options — particularly those with brokerage windows — may make it difficult for potential plaintiffs to demonstrate a sufficient commonality of interest to justify a class action.
It remains to be seen whether other courts will adopt the Seventh Circuit’s rationale, either with respect to the Section 404(c) defense or class certification issues. Until that becomes more clear, plan sponsors and fiduciaries would be wise to follow a prudent process when selecting and monitoring their 401(k) plan fund lineup. In light of the class action analysis in Spano, sponsors also should discuss with their counsel the advisability of creating a fund and fee structure that makes it more difficult for plaintiffs’ lawyers to create a “typical” class.