Investing August 21, 2019

Litigators Share What They Investigate for Filing TDF Lawsuits

A litigation firm has listed what it is investigating for potential lawsuits over target-date funds (TDFs) in retirement plans, and an ERISA attorney makes suggestions for how plan fiduciaries may avoid such suits.

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There’s been a recent wave of lawsuits over the target-date funds (TDFs) being offered in 401(k) plans recently.

A settlement in a lawsuit accusing Franklin Templeton of self-dealing in its 401(k) plan requires it to add a nonproprietary TDF option to the investment lineup in addition to the plan’s qualified default investment alternative (QDIA)—the LifeSmart Target Date Funds. More recently, a lawsuit was filed alleging fiduciaries of the Walgreen Profit-Sharing Retirement Plan selected and kept TDFs in the plan that underperformed their benchmarks. And, last week, retirement plan fiduciaries at Intel were accused of failing to properly monitor and evaluate “unconventional, high-risk allocation models” adopted within the company’s custom target-date funds.

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On its website, litigation firm Cohen Milstein says it is investigating a number of issues concerning the selection and offering of TDFs. The firm shares what it is looking for:

Improper Investment Strategy: The firm says, “The actual investment strategy (e.g. the allocation between equities and bonds) may not be same as the fund advertised.  The fund may be pursuing a far riskier investment strategy than participants and plan sponsors are led to believe, even as plan participants near retirement.”

Excessive Fees: “The fees charged by a target-date fund may not be justified by the performance of the investment.  The fees for target-date funds can vary significantly, particularly depending on whether the fund’s fees are “layered” or the underlying investments of the fund are actively or passively managed,” Cohen Milstein says.

Self-Dealing or Imprudent Selection: The firm says, “Many providers offer a wide variety of target-date funds.  The fiduciary of the plan may have chosen the particular provider for improper reasons.  For example, where the fiduciary of the plan or the employer sponsoring the plan markets a target-date fund, it improperly chose its own target-date funds without considering whether those funds are most appropriate for its own 401(k) plan participants.”

Improper Default Selection: Where a TDF suite is the plan’s QDIA, “the fiduciary of the plan has an obligation to ensure that the target-date fund was prudently, properly, and appropriately selected.”

This should inform retirement plan sponsors that offer TDFs in their plan investment menu.

In a blog post, Carol Buckmann, an Employee Retirement Income Security Act (ERISA) attorney with Cohen & Buckmann, P.C. in New York City, offers suggestions for plan fiduciaries which she says “will probably require consulting an investment adviser and ERISA counsel for assistance.”

She recommends fiduciaries:

  • Understand the basics of how TDFs work and the fees payable, including those for underlying investments;
  • Study the underlying investments.  Some TDFs can include alternative investments such as real estate and some will continue to alter the mix of investments after the assumed retirement age;
  • Understand the risk profile of the investments. Make sure that it is appropriate for plan participants; and
  • Benchmark TDFs for performance and fees.

She also says more plan sponsors should consider doing an actual request for proposals (RFP) for their TDFs.

“It is equally important to document the steps taken to evaluate the selected target-date funds so that there is a record to point to if a lawsuit is filed,” Buckmann concludes.
Compliance August 21, 2019

Court Says Participant Misunderstood Valuation for ESOP Purchase

A federal district court judge found that since shares for the ESOP were purchased with borrowed funds, the subsequent lower valuation of the stock was an immediate equitable benefit to participants.

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In a very concise decision, a federal district court judge found a participant in an employee stock ownership plan (ESOP) did not have standing to sue regarding the valuation of stock price for the setup of the ESOP because she did not prove she suffered any harm.

In late 2016, Choate Construction Company created its ESOP. The Choate ESOP purchased 8 million shares of Choate stock for $198 million. These 8 million shares represented 80% of Choate. According to the court’s opinion, Choate’s employees did not pay the company $198 million for the shares. Instead, Choate borrowed $57 million from a bank and then turned around and loaned that $57 million to the Choate ESOP for part of the purchase. To finance the remainder of the purchase, the Choate ESOP issued notes to the selling shareholders for the remaining $141 million at a 4% annual rate. Argent Trust, named in the lawsuit along with Choate defendants, as trustee of the Choate ESOP, oversaw and approved the transactions.

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The plaintiff, a former Choate employee who worked for the company from April 2007 to April 2017, was “fully vested in the ESOP when her employment ended. She alleges, on behalf of herself and similarly situated current and former Choate employees, that the “creation of the Choate ESOP … was not conducted in the best interests of the employees.” In particular, she relies on a $64.8 million valuation of the Choate ESOP’s stock on December 31, 2016—less than one month after the creation of the ESOP—as evidence in support of her contention that the $198 million that the ESOP paid for Choate stock was excessive.

“Plaintiff, however, fundamentally misunderstands the nature of the December 2016 transaction that created the Choate ESOP and Choate’s subsequent valuation,” Chief U.S. District Judge Terrence W. Boyle of the U.S. District Court for the Eastern District of North Carolina wrote in his opinion.

He compared the ESOP purchase to the purchase of a mortgage-financed house. Boyle explains that a buyer of a house for $198,000 that gets a mortgage for the entire value has taken on a $198,000 debt (the mortgage) and, in return, obtained a $198,000 asset (the home), resulting in her asset and her corresponding obligation creating $0 in new equity. When the value of the home increases to $262,800, if the buyer sells her house at that value, after paying off her mortgage, she would be left with a profit of $64,800.

Likewise, Boyle says, the Choate ESOP obtained its 8 million shares of Choate at a price of $198 million, and the Choate ESOP took on $198 million in debt to obtain the stock. The $64.8 million valuation at the end of December 2016 reflects the fact that the Choate ESOP, like the hypothetical home buyer, realized an immediate equitable benefit. He notes that the benefit has only grown since, as the Choate ESOP’s value was pegged at $107.2 million by the end of 2017.

“As the Choate ESOP actually purchased the 8 million shares in 2016 at a discount, and an immediate equitable benefit inured to the Choate ESOP and its members, plaintiff has not plausibly alleged that she suffered any concrete and particularized injury,” Boyle wrote in his opinion.

Boyle dismissed the lawsuit.

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