A federal appellate court has affirmed the dismissal of a lawsuit alleging that Fidelity Trust Company offered and mismanaged a stable value fund for its own benefit rather than the benefit of 401(k) plan participants.

The suit, Ellis vs. Fidelity Management Trust Co., accused Fidelity of engaging in imprudent investment strategies for the Fidelity Group Employee Benefit Plan Managed Income Portfolio Commingled Pool (MIP), a stable value fund offered as an investment option in some 401(k) plans for which Fidelity was trustee.

According to the lawsuit, during a specified class period, the MIP had “such low investment returns and high fees that it was an imprudent retirement plan investment.” The weak performance and high fees of the MIP were the result of the intentional actions and omissions of Fidelity as trustee of the plans, the suit alleged. Fidelity delegated day-to-day management of the MIP to its affiliate, Fidelity Management and Research Company, and the lawsuit accused Fidelity of failing to continuously monitor and supervise its affiliate. Among other issues, plaintiffs claimed this lack of prudence and monitoring resulted in the stable value fund purchasing excessive wrap insurance that unnecessarily dampened return prospects and resulted in conflicts of interest.

According to the 1st U.S. Circuit Court of Appeals opinion, in the wake of the 2007–2008 financial crisis and the ensuing economic decline, Fidelity fund managers expressed concern about the availability of wrap insurance for Fidelity’s various funds, including the MIP, going forward. For example, a 2009 PowerPoint noted a “[d]earth of new wrap capacity.” During this time period, several major wrap providers for the MIP, including AIG, Rabobank, and at a later point, JP Morgan, forecasted an intention to leave the wrap market. 

Further illustrating Fidelity’s concern is a 2011 e-mail from an attorney for Fidelity, noting that JP Morgan had been “shed[ding]” wrap capacity, that there were a “dwindl[ing]” number of new entrants into the wrap market, and that Fidelity ran the risk of being “left out in the cold” if the number of insurers of stable value funds was limited, as he expected it to be, the court said. Ultimately, Fidelity secured sufficient wrap coverage from a new source.

The appellate court notes that the primary investment objective of the MIP is to “seek the preservation of capital as well as to provide a competitive level of income over time consistent with the preservation of capital.” As a benchmark, the MIP used the Barclay’s Government/Credit 1-5 A- or better index throughout the relevant time period.

The 1st Circuit points out that during the years covered by the lawsuit, the MIP fully achieved its objective of preserving the investors’ capital. The rate of return earned by investors, however, lagged behind that of many other stable value funds offered by competitors. “The immediate cause of these lower returns is undisputed: Fidelity allocated MIP investments away from higher-return, but higher-risk sectors (e.g., corporate bonds, mortgage pass-throughs, and asset-backed securities) and toward treasuries and other cash-like or shorter duration instruments,” the appellate court wrote in its opinion. “While these allocations made the MIP a safer bet and thus more attractive to wrap providers, they also positioned the MIP less favorably in the event that markets improved.”

The court notes that markets did improve, the added safety turned out not to be required, and competitors whose investments were more aggressive achieved both asset protection and higher returns. But, it pointed out that such is what occurs in most markets, and certainly most investment markets. Fund managers make different predictions about future market performance, and the differences ultimately generate a distribution curve of returns as some funds do better than others.

According to the opinion, specifically, plaintiffs claim that Fidelity agreed to overly conservative investment guidelines in a failed effort to lock up all wrap coverage so that its competitors would not be able to obtain such coverage, allowing Fidelity to corner the stable value market and generate business for its many other stable value funds even if the MIP suffered. Additionally, plaintiffs argue that Fidelity was imprudent in structuring and operating the MIP by being overly and unnecessarily conservative.  Specifically, they say, a prudent Fidelity would have (say plaintiffs) negotiated less restrictive wrap guidelines, picked a more aggressive benchmark, and invested in higher-risk, higher-return instruments.

The appellate court pointed out that it, like the district court, has examined plaintiffs’ Statement of Disputed Facts and finds no evidence that the MIP itself did not face a threat of insufficient wrap coverage between 2009 and 2012. The court said the plaintiffs’ theory of how Fidelity behaved disloyally “suffers from the added disability of making little sense.” 

“To believe that Fidelity’s competitors could be driven out of the market due to Fidelity’s capture of available wrap insurance, one must also believe that wrap insurance at the relevant times was a scarce and limited resource. Were that the case, though, it would make no sense to posit that Fidelity had no reason to try hard to secure new wrap coverage for the MIP if its existing suppliers hinted at possible exit announcements. Conversely, if Fidelity knew that the supply of wrap insurance was not finite, attempts to purchase excessive quantities of it so as to deny competitors access would be equally illogical; one cannot consume all of a good where its quantity is effectively unlimited. Viewed thusly, plaintiffs’ theory of a loyalty breach based on aggressive pursuit of wrap coverage requires that we infer that Fidelity embarked on a course that was not only against both its interests and the interests of its investors, but was also plainly illogical. Such an inference, without more to support it, is too speculative to carry a claim forward,” the court wrote in its opinion.

The court also notes that at oral argument, the plaintiffs contended that wrap coverage was indeed a finite good, but that Fidelity did not need to pursue it aggressively because other insurance products, suitable for the MIP but not suitable for Fidelity’s competitors, were available. The plaintiffs pointed to guaranteed investment contracts (GICs) as an example. The 1st Circuit found problems with this argument, the first being that plaintiffs did not raise it in their briefing before the district court. Citing its decision in McCoy v. Mass. Inst. of Tech., the court said “It is hornbook law that theories not raised squarely in the district court cannot be surfaced for the first time on appeal

In addition, the court said even if it were to consider the argument, it would be persuaded. To succeed with this argument, the plaintiffs would need to convince a reasonable factfinder that GICs or other insurance products were an available and appropriate option for the MIP and the same insurance products were not equally available to or appropriate for Fidelity’s competitors. The only portion of the record that plaintiffs’ counsel cited at oral argument in support of this new theory was an e-mail from a Fidelity lawyer, which discusses a single competitor, Galliard, and notes that Galliard is more willing to use alternative insurance products than Fidelity is. But this e-mail says nothing about whether GICs or other insurance products would have been an appropriate substitute for wrap coverage for the MIP. According to the 1st Circuit, it also undermines the second premise necessary for the plaintiffs’ theory to succeed—that competitors would be unable to replace wrap coverage with GICs or other insurance products—because the e-mail specifically states that the one competitor it mentions does employ those products. “Thus, even if we were inclined to consider plaintiffs’ new theory on appeal, it would fail due to the lack of any competent evidence supporting it,” the court concluded.