Compliance July 28, 2020

8th Circuit Affirms Wells Fargo’s Win in Stock Drop Challenge

The plaintiffs failed twice to meet the so-called ‘Dudenhoeffer pleading standard’ before the U.S. District Court for the District of Minnesota, and now their appeal has been rejected by the 8th Circuit.

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The 8th U.S. Circuit Court of Appeals has affirmed a ruling out of the U.S. District Court for the District of Minnesota. Assuming there will not be a successful Supreme Court appeal, the ruling brings to a close a set of complex stock-drop lawsuits filed against Wells Fargo by its own employees.

The underlying lawsuit was filed by participants in Wells Fargo’s retirement program. It relates to the firm’s difficulties in recent years with problematic sales practices in the personal banking side of its business.

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The allegations in the suit follow the classic pattern of so-called “stock drop” litigation. By way of background, negative media reports and congressional inquiries plagued Wells Fargo’s personal banking wing for several years, starting in late summer 2016. According to contemporaneous news reports and the admissions of now-ousted CEO and Chairman John Stumpf, the company’s aggressive sales requirements for low-level banking professionals directly inspired the opening of millions of unauthorized customer accounts. This resulted in a major backlash against the company that cut roughly 12% to 15% of Wells Fargo stock’s value. The company faced separate civil penalties approaching $200 million.

Ruling on the first version of the complaint, which was consolidated with a second lawsuit filed by another set of Wells Fargo employees in the same venue, U.S. District Judge Patrick J. Schiltz disagreed that Wells Fargo fiduciaries violated their duties of prudence and loyalty under the Employee Retirement Income Security Act (ERISA) by keeping company stock as an investment in the 401(k) plan when, plaintiffs alleged, plan fiduciaries knew the stock price was inflated.

In ruling on both the original complaint and the amended complaint, Schiltz relied on the pleading standards set forth by the U.S. Supreme Court in Fifth Third v. Dudenhoeffer. While the plaintiffs did put forth “alternative actions” plan fiduciaries could have taken to avoid participant losses after the September 2016 disclosure of fraud allegations against Wells Fargo caused its stock price to drop significantly, Schiltz found the plaintiffs did not plead specific facts to make plausible their allegation that, under the circumstances of the case, a prudent fiduciary “could not have concluded” that a later disclosure would result in a smaller loss to the company stock fund than an earlier disclosure.

One notable fact about the district court ruling is that it clearly states Dudenhoeffer does not apply to a claim of breach of the duty of loyalty. Still, the judge determined the plaintiffs’ allegations were nonetheless insufficient to plausibly plead that the plan sponsor breached its duty of loyalty. Further, the lower court found that, because the plaintiffs failed to plausibly allege that defense breached its fiduciary duties under ERISA, their derivative claims also failed. This ruling led to an immediate appeal, which has now proven unsuccessful.

On appeal, the plaintiffs limited their argument to two proposed alternative actions: public disclosure of the unethical sales practices, and freezing purchases in the Wells Fargo stock funds. Because the defense could not have implemented a purchase freeze without also disclosing Wells Fargo’s unethical sales practices, the 8th Circuit focused its analysis on the public-disclosure alternative.

“Most circuit courts to consider an imprudence claim based on inside information post-Dudenhoeffer have rejected the argument that public disclosure of negative information is a plausible alternative, finding that a prudent fiduciary could readily conclude that disclosure would do more harm than good by causing a drop in the stock price and a concomitant drop in the value of the stock already held by the fund,” the ruling states. “[The plaintiffs] argue that the present case is distinguishable, however, because they allege [the defense] knew or should have known that public disclosure of the fraud was inevitable and that, based on general economic principles, the longer the fraud is concealed, the greater the harm to the company’s reputation and stock price.”

At this point, the ruling points to a different case in the 5th U.S. Circuit Court of Appeals.

“In rejecting this argument, the 5th Circuit reasoned that if such a principle were as widely known and generally applicable as the plaintiff suggested, then it would apply in virtually every fraud case,” the ruling states. “But, the court explained, such a principle cannot apply in virtually every fraud case because, in Whitley, the 5th Circuit had already found that a prudent fiduciary could easily conclude that taking an action that might expose fraudulent conduct would do more harm than good. Accordingly, the court found that the plaintiff failed to plausibly allege that a prudent fiduciary in the defendants’ position could not conclude that earlier disclosure of negative information would do more harm than good to the fund.”

The ruling continues: “Turning to the present case, we find that [plaintiffs] have failed to plausibly allege that a prudent fiduciary in [defendants’] position could not have concluded that earlier disclosure would do more harm than good. Like the 5th Circuit in Martone, we find [plaintiffs’] allegation based on general economic principles—that the longer a fraud is concealed, the greater the harm to the company’s reputation and stock price—is too generic to meet the requisite pleading standard.”

The full text of the ruling is available here.

Compliance July 28, 2020

VALIC Financial Advisors Charged With Disclosure Failures

The SEC says VALIC Financial Advisors failed to disclose to Florida teachers practices that generated millions of dollars in fees and other financial benefits for the firm.

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The Securities and Exchange Commission (SEC) has charged Houston-based VALIC Financial Advisors Inc. (VFA) in a pair of actions for failing to disclose to teachers and other investors practices that generated millions of dollars in fees and other financial benefits for VFA.

In the first action, the SEC found that VFA failed to disclose that its parent company paid a for-profit entity owned by Florida K-12 teachers’ unions to promote VFA and its parent company services to teachers.

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In the second action, the SEC found that VFA failed to disclose conflicts of interest regarding its receipt of millions of dollars of financial benefits that directly resulted from advisory client mutual fund investments that were generally more expensive for clients than other mutual fund investment options available to clients.

VFA agreed to pay approximately $40 million to settle the charges in these two actions. In the first action, VFA agreed to cap advisory fees for all Florida K-12 teachers who currently participate—and, in some cases, those who prospectively participate—in its advisory product in Florida’s 403(b) and 457(b) retirement programs. 

Stephanie Avakian, co-director of the SEC’s Division of Enforcement, told reporters in a media call that VFA will cap advisory service fees at the most favorable market rate in Florida. She explained that the range of fees in that market is approximately 45 to 60 basis points (bps) annually, with an average of 58 bps. The cap for VFA will be at the low end of that range. “This will result in significant ongoing savings for teachers,” she said.

For the SEC’s order concerning VFA’s mutual fund fee disclosure practices, without admitting or denying the SEC’s findings, VFA has consented to a cease-and-desist order, a censure, disgorgement and prejudgment interest of more than $15.4 million and a civil penalty of $4.5 million. The more than $19.9 million in monetary relief will be placed into a fund for distribution to investors affected by this conduct.

In February 2018, the Division of Enforcement of the SEC announced the Share Class Selection Disclosure Initiative, under which the SEC’s enforcement agents “will agree not to recommend financial penalties against investment advisers who self-report violations of the federal securities laws relating to certain mutual fund share class selection issues and promptly return money to harmed clients.”

Steven Peikin, co-director of the SEC’s Division of Enforcement, told reporters, “For those who self-reported under the share class initiative, there was no penalty. Firms that didn’t self-report were treated more severely, as in this case.”

The Teachers’ Initiative

During the media call, SEC Chairman Jay Clayton noted that the SEC announced its Teachers’ Initiative about a year ago. “We have at least 800,000 teachers who participate in defined contribution [DC] plans with a total of over $1 trillion in assets,” he said. “Stephanie and Steven have recognized that teachers need and deserve our attention, and they have turned this into action.”

Clayton said his message for teachers is to ask questions about investment options, including whether there are any hidden fees or investment expenses. His message to market professionals is to “examine your practice. If you are engaged in any similar conduct, stop it and fix it and report your efforts to us promptly. We believe in substantial credit for self-reporting and cooperation. We also believe those who continue these practices have no place in the market.”

Avakian said part of the Teachers’ Initiative was a focus on undisclosed fees. She said she would rank the action taken against VFA as “one of our most important actions.” Avakian warned, “While this action was focused on a single provider in a single state, we expect other providers to take a hard look at their arrangements and make sure potential conflicts are fully disclosed. We are continuing to actively investigate these issues.”

Details of the Investigation into VFA

VFA is a division of Variable Annuity Life Insurance Co. known as VALIC, which is a subsidiary of AIG. AIG confirmed last fall that the SEC was investigating sales and disclosure practices at VALIC.

According to the SEC’s order, for 13 years, VALIC made payments to an entity owned by the Florida teachers’ unions in exchange for that entity’s exclusive endorsement of VFA as its preferred financial services partner and the entity’s agreement to not promote or endorse VFA’s competitors. VALIC also provided the entity owned by the teachers’ unions three full-time employees to serve as “member benefit coordinators.” These coordinators—who, the SEC says, deceptively presented themselves as employees of the entity owned by the teachers’ unions—promoted VALIC and VFA to Florida K-12 teachers, including at benefits fairs and financial planning seminars, and referred teachers to VFA for investment recommendations. The order finds that the member benefit coordinators increased VFA’s access to K-12 teachers in Florida, and that VFA did not disclose that the for-profit entity was paid to make VFA its preferred financial services provider.

VFA (together with VALIC) earned more than $30 million on the products it sold to Florida K-12 teachers during the period covered by the SEC’s order.

Peikin told reporters the SEC could not comment on what, if anything, was being done regarding the teachers’ unions.

Concerning VFA’s mutual fund fee disclosure practices, according to the SEC’s order, VFA’s wrap agreements with its clients provided that the advisory fee the client paid to VFA included the costs to execute securities transactions. The SEC found that VFA either directly invested or instructed its primary sub-adviser to select new mutual fund investments for clients that were part of VFA’s clearing broker’s no-transaction fee program (NTF Program), and thus would not incur a transaction fee VFA would be responsible for paying. The NTF Program mutual funds were generally more expensive than other mutual funds available to VFA clients, including instances when a less expensive mutual fund share class for the same fund was available outside the NTF Program.

The SEC found that VFA’s participation in the NTF Program generated three key financial benefits to VFA, and that VFA not only failed to provide disclosures regarding these conflicts, but also provided false and misleading disclosures concerning the conflicts. The order sets forth that VFA received both 12b-1 fees and revenue sharing from the clearing broker for client investment in mutual funds within the NTF Program. In addition, according to the order, for clients with wrap agreements in which VFA was responsible for client execution costs, VFA financially benefited by not having to pay any transaction fees for mutual funds in the NTF Program. “Despite being eligible to do so, VFA did not self-report its receipt of undisclosed 12b-1 fees as part of the Division of Enforcement’s Share Class Selection Disclosure Initiative announced in February 2018,” the SEC said in its announcement of the action.

A spokesperson for AIG told PLANSPONSOR: “We are pleased to have resolved these matters involving VALIC Financial Advisors, which is taking all necessary steps to ensure a robust program of disclosure improvements and governance enhancements.”

Along with the announcement, the SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin with tips to help teachers make informed investment decisions, including about retirement plans.

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