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Nationwide Wins One, Loses One In Fee Litigation: Troubling Definition of “Plan Assets” Survives

After nearly 18 months of inactivity, the court in Haddock v. Nationwide (September 25, 2007), one of the most closely watched lawsuits challenging 401(k) fee practices, has rejected another attempt to derail the plaintiffs’ claims. Even more importantly, this most recent ruling leaves standing a controversial earlier decision that so-called “revenue sharing” payments may constitute ERISA plan assets.

At about the same time, Nationwide prevailed in a purported class action challenge to its fee practices for Code Section 457(b) plans. The United States District Court for the Southern District of Ohio granted Nationwide’s motion to dismiss in Beary v. Nationwide on September 17, 2007, finding the plaintiffs’ state law claims preempted by the federal Securities Litigation Uniform Standards Act of 1998.

Haddock Definition of “Plan Assets” Survives Another Round

In a March 7, 2006, ruling in Haddock v. Nationwide (“Haddock I”), United States District Judge Stefan Underhill of the District of Connecticut attracted a great deal of attention when he denied Nationwide’s motion for summary judgment. [1]In that ruling, Judge Underhill opined that Nationwide could have acted as an ERISA fiduciary to the small 401(k) plan of which Lou Haddock served as trustee, and thus could be liable for breaching its fiduciary duties by allegedly retaining “revenue sharing” payments made by mutual fund companies.

The court first ruled in Haddock I that Nationwide may have acted as an ERISA fiduciary, because Nationwide had the authority to unilaterally remove investment options offered to plan participants and replace them with other mutual funds. Under Section 3(21)(A) of ERISA, a “fiduciary” includes someone who “exercises any authority or control respecting . . . [plan] assets.” Pointing to two Advisory Opinions issued by the Department of Labor in 1997 as support, the judge held that Nationwide’s authority to remove and replace mutual funds was enough to uphold a conclusion that it satisfied this test for ERISA fiduciary status. [2]

Judge Underhill’s conclusion in the 2006 decision that “revenue sharing” payments are ERISA plan assets was more controversial. That interpretation is critical to the plaintiffs’ claims in many of the fee cases filed after Haddock and currently pending in courts around the country. The premise of the Haddock plaintiffs’ complaint is that, in order to be included in Nationwide’s list of approved mutual fund investment options available to plans, Nationwide required the fund companies to carve off a portion of the asset-based fees they charge investors and “share” it with Nationwide (probably in exchange for administrative services provided by Nationwide, though this fact appears to be lost in the litigation). This, the plaintiffs say, amounted to a use of “plan assets” for Nationwide’s benefit, rather than for the exclusive benefit of participants, constituting a prohibited transaction and a violation of ERISA’s “exclusive benefit” rule. If, however, those revenue sharing payments are really Nationwide’s assets, rather than ERISA-protected assets of the plan, these claims must fail.

In Haddock I, the court adopted what it called a “functional approach” to determine whether the revenue sharing payments were ERISA plan assets:

“plan assets” include items a defendant holds or receives:(1) as a result of its status as a fiduciary or its exercise of fiduciary discretion or authority, and (2) at the expense of plan participants and beneficiaries.

The court’s construction was not based on ERISA itself, but instead was borrowed (at least in part) from a 1992 decision of the Ninth Circuit Court of Appeals. It ignores Section 401(b)(1) of ERISA, which provides that when an ERISA plan invests in a security issued by a mutual fund, the assets of the plan include that security, but not all of the underlying assets which the mutual fund itself holds.

The court’s construction also creates a troubling circularity in ERISA’s statutory provisions. As noted above, Section 3(21)(A) of ERISA defines the term “fiduciary” to include someone who exercises any authority or control over “plan assets.” Yet the first element of the definition of “plan assets” articulated in Haddock I requires, as a prerequisite, fiduciary status. At a minimum, the court’s interpretation of what constitutes a plan asset renders the Section 3(21)(A) definition of fiduciary unworkable in certain situations.

Unfortunately, when presented in Haddock II with the opportunity to clarify his ruling in Haddock I, Judge Underhill declined to do so. After the judge denied Nationwide’s motion for summary judgment in 2006, Nationwide moved to dismiss the plaintiffs’ fifth amended complaint in 2007, arguing again that it was not a fiduciary with respect to the plan and that, even if it was, the payments it received from mutual fund companies were not plan assets. The court summarily rejected both arguments, refusing to readdress its earlier analysis. It denied Nationwide’s motion and allowed the litigation to proceed.

Whether payments from fund companies to 401(k) service providers amount to assets of the plans, or merely income streams of the service providers, is critically important to the retirement plan industry. If other courts adopt the Haddock court’s analysis (so far this has not been the case), the industry may be forced to restructure the mechanisms by which providers are paid for their services. That, in turn, will affect an great many plans and plan sponsors.

Putative Class Action on Behalf of All 457(b) Sponsors Dismissed

Nationwide had more success in a class action lawsuit filed by the Sheriff of Orange County, Florida, on behalf of public employers who sponsor Code Section 457(b) plans. In Beary v. Nationwide, Sheriff Beary contended that Nationwide’s revenue sharing practices constitute a pay-to-play “scheme” that violates state law. (Because Section 457(b) plans of state and local entities are not subject to ERISA, the claims in this case were premised on state law.) Beary purported to bring the lawsuit as a nation-wide class action on behalf of all 457(b) plan sponsors that have engaged Nationwide.

Granting Nationwide’s motion to dismiss the claims, Judge Edmund Sargus Jr., of the Southern District of Ohio agreed that a federal securities litigation reform law preempts the plaintiffs’ state law claims. The Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) was designed to redress abusive securities litigation class actions by requiring that those cases be brought under a standardized system of federal laws, and in federal court. Under SLUSA, any class action claims based on state law that allege an untrue statement or omission of material fact in connection with the purchase or sale of a covered security are preempted, which means that they must be filed within the parameters set by that Act.

Without much difficulty, the Beary court found that the plaintiffs’ state law claims against Nationwide were covered by SLUSA, and thus preempted. The court therefore dismissed those claims, but allowed the plaintiffs to refile them under SLUSA or as an individual action (rather than a class action).

Because the claims in Beary v. Nationwide were based on state law, and not ERISA, the court’s dismissal will have no direct effect on the other, ERISA-based, fee cases.

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[1]Haddock v. Nationwide Fin.Servs.419 F. Supp. 2d 156 (D. Conn. 2006).

[2] Those Advisory Opinions are the foundation on which many 401(k) service providers have built their fee arrangements.