Financial services provider was not a fiduciary subject to liability for allegedly excess fees

A financial services provider that selected investment options included in group annuity contracts sold to 401(k) plans for which it allegedly charged excess fees was not subject to ERISA liability as a fiduciary, according to the U.S. Court of Appeals in Philadelphia (CA-3). The service provider did not act as an ERISA fiduciary with respect to the alleged breach of fiduciary duty because plan trustees actually exercised final authority over the investment options made available under the plan. Thus, the provider did not control its own compensation.

Menu of investment options constructed by service provider

A financial services provider (John Hancock) sold group annuity contracts to 401(k) plans. As part of the product, Hancock assembled a variety of investments into which plan participants could direct contributions. The collection of investment options (“Big Menu”) was comprised primarily (but not exclusively) of John Hancock mutual funds. Although the Big Menu was created by Hancock, the plan trustees selected the actual investment options that would be offered to plan participants (“Small Menu”).

Plan trustees could select for the Small Menu any option off the Big Menu, as well as investments offered by companies other than John Hancock. However, Hancock offered a Fiduciary Standards Warranty (FSW) to plan trustees that selected for the Small Menu at least 19 funds offered by John Hancock. Pursuant to the FSW, Hancock “warrants and covenants” that the investment options selected by the trustees will satisfy the prudence requirements of ERISA. In addition, Hancock agreed to reimburse the plan for any losses arising out of litigation challenging the prudence of the plan’s investment selection, including litigation costs.

Hancock monitored the performance of all investment options on the Big Menu and retained the authority to add, delete or substitute investment options. Hancock also reserved the authority to change the share class for each fund into which participant contributions have been invested.

Note: The share class is significant, because the expense ratio, in part depends on the share class in which a fund is invested.

Plan participants filed a class action suit, alleging that Hancock violated its ERISA fiduciary duties by charging excessive fees for its services. Specifically, the participants charged that: specified fees were in excess of and duplicative of the underlying funds’ 12b-1 fees; Hancock selected Big Menu investment options that charged 12b-1 fees instead of negotiating for access to share classes that did not impose the fees; and the Big Menu included funds that paid excessive advisory fees. A federal trial court dismissed the action, ruling the John Hancock was not a fiduciary with respect to any of the alleged misconduct.

Fiduciary with respect to alleged breach

In affirming the trial court, the Third Circuit focused on the threshold issue of whether John Hancock was a fiduciary with respect to the activity forming the gravamen of the participants’ complaint (the charging of excess fees). Thus, the issue was not whether John Hancock acted as fiduciary to the plans at some point, and then charged an excess fee for the service, but whether it acted as fiduciary with respect to the allegedly excessive fees that it set. Essentially, the court looked to whether John Hancock, as a fiduciary, actually set its own compensation.

Initially, the Third Circuit advised that service providers owe no fiduciary duty to a plan with respect to the terms of the service agreement if the plan trustee exercises final authority in deciding whether to accept or reject those terms. The court then stressed that John Hancock, in constructing the menu of investment options and in monitoring the performance of the options, did not assume fiduciary status because the plan trustees exercised final authority over the funds made available to plan participants. While the FSW may have incented the trustees to select John Hancock Funds (with the allegedly high fees) the decision to select those funds, the court continued, was made by the trustees, who were not precluded from rejecting the fund options or selecting an alternative services provider. Thus, John Hancock did not effectively set its own fees.

In further rejecting the participants’ assertion that John Hancock became a fiduciary by retaining the authority to change the investment options offered on the Big Menu and to alter the fees it charged, the court explained that this authority lacked a “nexus” with the conduct comprising the alleged breach. A complaint alleging breach of ERISA fiduciary duty, the court stressed, must “plead that the defendant was acting as a fiduciary when taking the action subject to complaint.” Absent this nexus, the court concluded, Hancock’s ability to alter the funds and its fees could not give rise to a fiduciary duty.

In addition, even assuming a nexus between the alleged breach and John Hancock’s ability to substitute funds, the participants did not establish that Hancock exercised discretion over plan management. The ultimate authority to accept or reject any changes to the investment menus, the court again stressed, resided with the trustees, who could reject any change without penalty and terminate the arrangement.

The participants alternatively argued that John Hancock was subject to ERISA as fiduciary under ERISA §3(21)(A)(ii) because it rendered investment advice to the plan for a fee. However, the court, after first noting that the charge that John Hancock provided investment advice bore no nexus to the allegation that it assessed excess fees, held that John Hancock was not an investment advice fiduciary under ERISA. John Hancock, the court explained, did not render investment advice as defined by the 5-factor test set forth in ERISA Reg. §2510.3-21(c)(1), primarily because Hancock disclaimed any fiduciary responsibility in the service agreement, thereby precluding its advice from being rendered pursuant to a mutual agreement that the advice would be the primary basis for investment decisions with respect to plan assets.

Source: Santomenno v. John Hancock Life Insurance Co. (CA-3)

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