Society management

Appeals court upholds dismissal of Freedom Funds charges lawsuit

A federal appeals court has upheld the dismissal of an excessive fees lawsuit, rejecting the idea that offering actively managed funds, even those with underperforming ones, does not in itself justify claims of fiduciary breach.

Interestingly, this is the first decision by the Court of Appeals since the Supreme Court ruled in the case of Hughes v. Northwestern University, which ruled that motions to dismiss in fees and expenses cases under ERISA must use a “context-specific inquiry” that “due consideration is given to the range of reasonable judgments that a fiduciary may render according to his experience and expertise”. Two cases dismissed on appeal that were pending in the Ninth Circuit have been resuscitated following the Hughes decision.

This case

The plaintiff member in this case participated in a defined contribution plan sponsored by a predecessor of CommonSpirit Health. As has been repeatedly alleged in these cases, she claimed that the plan trustees failed in their duty of care by offering actively managed investment options rather than cheaper and better performing index options. In fact, it has been alleged[1] that at least 76% of plan assets were invested in the active management option. She also alleged that the plan’s trustees allowed the plan to pay excessive bookkeeping and management fees. These claims had been dismissed as insufficient to state a claim by the district court.

Specifically, Judge David L. Bunning of the U.S. District Court for the Eastern District of Kentucky rejected comparing performance between active and passively managed benchmarks, citing a recent case that found that “actively managed and passively managed index funds are not ideal comparators: they have different objectives, different risks, and different potential rewards that appeal to different investors. In fact, he went on to note that “offering funds with different management approaches and different levels of risk is one way to diversify the portfolio of investments available,” explaining that “…a plan fiduciary n necessarily act unreasonably simply by including an actively managed fund that performs or costs less than any passively managed fund. Any other conclusion would effectively prohibit plan managers from offering investment that a plaintiff considers to be inferior, which courts have repeatedly held to be not the law under ERISA.

The call

A panel of three Sixth Circuit judges (Yosaun Smith v. CommonSpirit Health, et al., case number 21-5964, before the United States Court of Appeals for the Sixth Circuit) unanimously upheld that decision, writing that the plausibility of a claim for ERISA costs and expenses “depends on a myriad considerations, including common sense and the strength of competing explanations of the defendant’s conduct”. Actively managed funds “represent a common feature of pension plans, and there is nothing wrong with allowing employees to choose them in hopes of earning above-average returns over the long life of a retirement account,” the court noted.

Instead, they noted that, to be considered sufficient, such recklessness claims “require proof that an investment was reckless from the time the administrator selected it, that the investment became reckless over time, or that the investment was otherwise clearly unsuited to the fund’s objectives based on ongoing performance.

It’s not just the higher fees[2] should not be a consideration, but the court was unwilling to accept as an article of faith that there were no other ameliorative factors. “Over time, management fees, like taxes, are not trivial features of investment performance,” the court noted.

The appeal panel also noted that the plan serves over 105,000 people and manages over $3 billion in assets, offers 28 different funds, including several index funds with management fees as low as 0.02% and several actively managed funds with management fees as high as 0.82%. Among these are the actively managed Fidelity Freedom funds, which were the default investment option and a target of the lawsuit.

Active ‘Management’

“Smith, at first, did not plausibly argue that this ERISA plan acted recklessly simply by offering actively managed funds in its mix of investment options,” the court said. “She alleges that ‘investors should be very skeptical of an actively managed fund’s ability to consistently outperform its index’ and that Freedom Funds ‘hunting'[] returns by taking on levels of risk that make [them] not suitable for the average retirement investor,” the ruling acknowledges. “But such investments are a common feature of retirement plans, and there is nothing wrong with allowing employees to choose them in the hope of earning above-average returns over the long lifespan. of a retirement account, sometimes through high growth investment strategies, sometimes through very defensive investment strategies, as it is possible that denying employees the option of actively managed funds, in particular for those willing to take on more or less risk, be inherently unwise.Keep in mind that Smith could always choose an index fund investment for his 401(k), as CommonSpirit offered many such options.

In fact, “we are not aware of any case that says a plan fiduciary violated its duty of care by offering actively managed funds to its employees instead of only offering passively managed funds,” they write. “Several cases actually suggest the opposite.” That said, the court cautioned that ERISA “does not allow trustees to simply offer a wide range of options and stop there.”

However, the court said that the plaintiff “…primarily compares the performance of the Fidelity Freedom Funds to the performance of the Fidelity Freedom Index Funds over a five-year period, noting that the Freedom Funds trailed the Index Funds by up to 0.63 points.” percentage per year.

“We accept that pointing to another course of action, say another fund in which the plan might have invested, will often be necessary to show that a fund acted recklessly (and to prove damages),” wrote the court. “But this factual allegation is not sufficient on its own. Additionally, these claims require proof that an investment was imprudent.

Significant reference

“That a fund’s underperformance, relative to a ‘meaningful benchmark,’ could form a basis for a claim of recklessness is one thing,” the court said. “But it’s another to say it’s enough on its own, especially if the different rates of return between funds can be explained by a ‘different investment strategy’.” when offering segregated funds to meet different objectives for different investors.

The court acknowledged that the plaintiff here feared that “…the imperatives of pleading a lack of process would put her in a deep chasm given the difficulty of obtaining information about how her plan chose each investment.” But while acknowledging that point, the court went on to point out that “…it is Congress, not the courts, that has established a cause of action based on a duty of care, and in any event the difficulties are not not insurmountable. ERISA’s expanded disclosure requirements ease the burden. By law, a pension plan must disclose a range of cost and performance information, including the administrative expenses it charges participants and investment information explaining the features of the plan’s investment options. . Moreover, publicly available information about the performance of an investment may show sufficiently dismal performance that this reality, when combined with “methods claims”, makes it possible to successfully claim that a fiduciary prudent would have acted differently.

With respect to the record-keeping fees, the court found that Smith did not provide the kind of context that could move this claim “from possibility to plausibility” because she had not “argued that the services covered by CommonSpirit’s fees are equivalent to those provided by the plans comprising the average in the industry publication it cites. Although the lower fees paid by smaller plans are often cited as evidence that a larger plan should be able to command an even better price, judges here said that these smaller plans may well “offer less of services and tools to plan members”. Indeed, they noted that “Smith did not allege that the fees were excessive in relation to the services rendered”, and she “…also alleges[s] no facts about other factors relevant to determining whether a fee is excessive in the circumstances”.

The decision ends with, in the words of the court, “…a few loose ends.” These were allegations that CommonSpirit “acted unfairly in addition to being reckless in investing in Fidelity Freedom Funds”, but the court said this was raised too late – and that while it was not was not the case, “she had not pleaded facts suggesting ‘the fiduciary’s operational motive was to serve its own interests’, as required to demonstrate a breach of the fiduciary duty of loyalty. Finally, although Plaintiff Smith requested the ability to amend the lawsuit, she apparently did so “in a form that we do not allow under Civil Rule 15, in the form of a short footnote page in its brief in opposition to CommonSpirit’s motion to dismiss”. And so, they did not and upheld the district court judgment dismissing the lawsuit.

What does that mean

As this is the first decision by an appellate court following the Hughes decision, there is a natural tendency to try to glean what this means for the future. It is probably too early to tell, but it seems useful to recognize that this case, as well as a few other recent decisions, did not accept at face value the simple assertion that certain aspects are per se unwise. The court recognized that there are rational reasons for choosing active management that may well justify higher fees, that there are factors beyond plan size that are worth considering in the assessment of the reasonableness of fees, and that there are factors other than fees that are part of a prudent assessment process, all of which support the “context-specific” inquiry that the Supreme Court endorsed in Hughes .

Here is the hope.


[1] The plaintiff here was represented by Miller Shah LLP, Goldenberg Schneider LPA and Capozzi Adler PC.

[2] “…just as compounding can significantly increase the value of an investment in a mutual fund over time, the costs of that investment can significantly reduce that investment over time.”