Plaintiffs Rebuffed by Appeals Court in Active Management Lawsuit

The defendant in the case, CommonSpirit Health, was accused of committing fiduciary breaches in the provision of an active target-date fund suit—allegations rejected both in district court and on appeal.

The 6th U.S. Circuit Court of Appeals has ruled in favor of the defendants in an Employee Retirement Income Security Act lawsuit targeting CommonSpirit Health, a large not-for-profit corporation that provides hospital services across the United States.

The plaintiffs had appealed the matter out of the U.S. District Court for the Eastern District of Kentucky, after that court ruled in favor of the CommonSpirit defendants. The basic claims in the case are that the defendants provided an inadequate selection of investment options in the CommonSpirit employer-sponsored 401(k) plan and allowed for unreasonable expenses to be charged for investment management services and the administration of the plan.

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In particular, the complaint named the Fidelity Freedom Funds, a suite of 13 funds that are actively managed by Fidelity fund managers, as having higher operating costs than Fidelity’s passively managed index funds. As alleged in the complaint, while the expense ratio for the passive index suite was as low as 0.08%, the expense ratio for funds in the active suite allegedly ranged from 0.42% to 0.65% for the K Share class, which the plan used until 2018. The plan has since updated to the K6 share class, with expense ratios ranging from 0.37% to 0.49%.

In its dismissal, the District Court said the plaintiff had failed to “allege facts showing that the recordkeeping fees exceeded those of comparable plans or were excessive in relation to the service provided.” The court also stated that the plaintiff had “failed to identify another recordkeeper that would have been willing to conduct the same service as Fidelity” at a reasonable rate. On the claim that CommonSpirit Health had breached its duty of loyalty, the court found that the complaint did not differentiate between the defendant’s alleged violations of the duties of prudence and loyalty, as required when alleging disloyalty under ERISA. As a result, this claim was also dismissed by the court.

The text of the appellate ruling runs to just 13 pages, and it sides firmly with the conclusions of the District Court.

“Yosaun Smith claims that her retirement plan should have offered a different mix of fund options, in particular that it should have replaced actively managed mutual funds with passively managed mutual funds,” the appellate ruling states. “But the Employee Retirement Income Security Act, ERISA for short, does not give the federal courts a broad license to second guess the investment decisions of retirement plans. It instead supplies a cause of action only when retirement plan administrators breach a fiduciary duty by, say, offering imprudent investment options. Because Smith has not alleged facts from which a jury could plausibly infer that CommonSpirit breached any such duty and because Smith’s other claims do not get off the ground, we affirm the district court’s dismissal of her complaint.”

The ruling states that, just as the kinds of retirement plans available to employees have changed over the last few decades, so have the investment options available to them. In the past, the ruling states, most investment options, whether for defined benefit or defined contribution plans, turned on active management, in which the portfolio manager actively makes investment decisions and initiates buying and selling of securities in an effort to maximize return.

“Investors today have the option of using index funds, which create a fixed portfolio structured to match the overall market or a preselected part of it, which require little to no judgment, and which have grown in popularity as an alternative to active management,” the ruling states. “Little surprise, actively managed funds, which require considerable judgment and expertise, charge more than passively managed funds, which require little judgment and expertise.”

The ruling goes on to note that, in gauging the sufficiency of a complaint, the 6th Circuit has taken “a well-worn trail.”

“Civil Rule 8 requires that a plaintiff’s complaint contain a short and plain statement of the claim showing that the pleader is entitled to relief,” the order reads. “And Civil Rule 12 permits a district court to dismiss a complaint that fails to state a claim upon which relief can be granted. Taken together, the two rules require the plaintiff to provide sufficient facts to state a claim to relief that is plausible on its face.”

As the appellate ruling stipulates, plausibility requires the plaintiff to plead sufficient facts and law to allow the court to draw the reasonable inference that the defendant is liable for the misconduct alleged. The plausibility of an inference depends, in turn, on a host of considerations, including “common sense and the strength of competing explanations for the defendant’s conduct.”

“[Plaintiff] as an initial matter has not plausibly pleaded that this ERISA plan acted imprudently merely by offering actively managed funds in its mix of investment options,” the ruling states. “She alleges that investors should be very skeptical of an actively managed fund’s ability to consistently outperform its index and that the Freedom Funds chase returns by taking levels of risk that render [them] unsuitable for the average retirement investor. But such investments represent a common fixture of retirement plans, and there is nothing wrong with permitting employees to choose them in hopes of realizing above-average returns over the course of the long lifespan of a retirement account—sometimes through high-growth investment strategies, sometimes through highly defensive investment strategies.”

The ruling concludes that, to the contrary, it is in fact possible that denying employees the option of actively managed funds, especially for those eager to undertake more or less risk, would itself be imprudent from a fiduciary perspective.

Reached for comment on the importance of the new 6th Circuit ruling, Daniel Aronowitz, managing principal at the fiduciary insurance firm Euclid Fiduciary, calls it “the best decision ever written in an excessive fee case,” as it effectively rebuts the arguments of fiduciary imprudence asserted in most excessive fee lawsuits in which plaintiffs are asking the court to infer fiduciary malpractice based on circumstantial evidence of what participants consider an undesirable outcome.

“The 6th Circuit instead says that participants need more than a disfavored outcome to plead imprudence—they need proof of a negligent process,” Aronowitz says. “It is the best case demonstrating that the pleading standard for excessive fee cases that are based on circumstantial evidence must plead a higher standard in order to proceed to discovery. We consider this case a vindication of [the idea] that fiduciary law is based on process—and does not allow hindsight claims based on disappointing outcomes.”

Aronowitz says the decision makes the following key points that are relevant to all excessive fee cases:

  • There is nothing imprudent about merely offering active funds in a defined contribution plan. In fact, as the court states, it may be imprudent not to offer some active funds.
  • It is possible after the Supreme Court’s Northwestern decision to allege that plan fiduciaries imprudently offered specific actively managed funds, but participants must do more than simply point to a fund with better performance. They must allege a deficient process. This case suggests that participants would need “significantly more serious signs of distress to allow an imprudence claim to proceed.”
  • The 6th Circuit takes on the argument frequently advanced by plaintiffs that they should not be required to prove a deficient process because they lack access to the fiduciary decisionmaking. The court is sympathetic to the fact that “the imperatives of pleading a process-based defect put [plaintiff] in a deep hole given the difficultly of gaining information about how her plan chose each investment.” But the court ultimately responds that it is the role of Congress to set the standard, and Congress has established fiduciary law based on process, which does not allow hindsight challenges based on circumstantial evidence of allegedly imprudent outcomes.
  • As Euclid argued in its amicus brief before the Supreme Court, plaintiffs have significant access to DOL-required fee and investment disclosures to make a better case about poor process. They do have a good regulatory disclosure regime to build a process-based case.
  • Finally, the 6th Circuit rejects the typical recordkeeping fee allegations that lack the proper context concerning the type of services and how they compare to other similar plans, as opposed to a few plans that are taken out of context.

“We would like to think that the CommonSpirit [decision] will be influential in other circuits, including in the 7th Circuit, as it decides the remanded Northwestern case [from the Supreme Court] and the Oshkosh case that was just argued,” Aronowitz says. “As we discussed in our June article, Judge Easterbrook took a radically different position in the Oshkosh argument as to what the Supreme Court ruled in Hughes v. Northwestern.”

SEC’s Proposed Climate Regulation Draws Support and Criticism

Investment consultants' sustainability group and others are supportive, while financial services firms and asset managers raise objections.

The extended public comment period for the Securities and Exchange Commission’s proposed climate impact disclosure regulations has ended, and the regulator is hard at work digesting the more than 5,000 comments filed by individuals, institutional investors, asset managers and many other stakeholders in the financial services ecosystem.

Given the volume of commentary, it will take time for the full scope of the public feedback to be appreciated by SEC observers and the regulator’s own staff. However, even a cursory review of the published letters shows the comments come from a wide variety of perspectives and positions, with commenters ranging from anonymous individuals to midsize advisory shops to some of the biggest and most influential asset managers in the world. 

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Some of the letters voice outright opposition to the notion of the federal government mandating the disclosure of climate-change-related information of any kind. On the other hand, many more of the letters appear to acknowledge the increasing importance of climate-related data and insights when it comes to individual and institutional investors’ decisions. That said, while many of the letters argue the SEC is the appropriate regulator to be addressing this issue, others see the ambitious regulatory package proposed earlier this year as a step beyond the SEC’s traditional purview.

The Investment Consultants Sustainability Working Group – United States, a collaboration among 17 investment consulting firms including Aon, Cambridge Associates, Callan, Meketa Investment Group, Mercer, NEPC, Russell Investments, WTW and Verus, submitted comments supporting the proposed rule.

The ICSWG-US said it believes the SEC’s proposed rule “can help ensure that investors have access to consistent, comparable, reliable, and decision-useful information on financially material risks and opportunities related to climate change.”

The comments continue: “In the absence of standardized disclosures, investors seeking climate-related information collect this data from numerous sources, including companies’ voluntary disclosures that are unverified and often difficult to compare, and rely on third party estimates in the absence of reported data,” which is a burden on debt and equity issuers and results in market inefficiencies, the organization wrote.

They also said it is important that the proposed rule is based on the Task Force on Climate Related Financial Disclosures and the Greenhouse Gas Protocol, of the Financial Stability Board, because it will align with global standards on such disclosures. “The TCFD climate disclosure framework is widely used across the largest capital markets and regulators have begun mandating TCFD-aligned reporting in jurisdictions including the UK, Brazil, the EU, Hong Kong, Japan, New Zealand, Singapore, and Switzerland,” the group wrote.

Alternatively, the American Securities Association, which represents wealth management and capital markets interests of regional financial services firms, said that it opposes the proposed rule because it “represents a dramatic and unwarranted turn away from this regime. The Commission is proposing to adopt a prescriptive approach to disclosures—one that mandates numerous disclosures the Commission alleges will protect the environment, not investors.”

The ASA’s comment letter outlines how they believe the proposed rule “exceeds the Commission’s statutory authority, (2) is arbitrary and capricious, and (3) raises serious First Amendment concerns. As a result, the ASA urges the Commission to drop this rule and refrain from fundamentally transforming the securities laws in this way without express Congressional authorization.”

The Investment Company Institute and several asset management firms, including BlackRock, Fidelity and Dimensional Fund Advisors, were critical of the proposed regulation for using a different definition of “materiality” than the SEC has used in other rules.

The ICI wrote: “We urge the Commission to adopt a final rule that requires a company to file certain climate-risk related information which the company determines is material in annual reports and registration statements (SEC filings) and, to the extent that the company determines this information is not material, to furnish such information and any additional SEC-mandated information in a new climate report.”

Two other groups that publicly filed supportive comment letters about the SEC’s ambitious regulations are the Consumer Federation of America, which advocates for the rights and fair treatment of U.S. consumers, and the Investment Adviser Association, which advocates on behalf of the fiduciary investment adviser industry. The two organizations operate under a very different set of goals and principles, but their comments regarding the SEC’s climate regulations share some key similarities—including offering broad support for the direction in which the SEC is heading.

In its letter, the IAA says it agrees with the SEC that the provision of “more consistent, comparable and reliable ESG disclosures” of material information by registrants will allow investment advisers to better serve their clients by improving transparency for investors and facilitating apples-to-apples analysis and comparison of registrants.

“We also believe that this will in turn lead to better and more accurate pricing of risks, and thus largely support the proposal,” the letter states. “We agree with the Commission that these rules should require presentation of climate-specific financial information on a separate basis and not specify particular time periods for time horizons but instead issue guidance. In addition, we recommend that any rules that the Commission adopts balance flexibility for registrants and standardization of disclosures; eliminate certain proposed prescriptive board oversight requirements; and provide additional examples of physical and transition risks.”

The IAA’s letter states that the organization agrees with the proposed requirement that registrants disclose Scopes 1 and 2 greenhouse gas emissions data, which involves the emission of greenhouse gases more or less directly by the company in question. The IAA also voices is support for the requirement that larger reporting company registrants obtain attestation for Scopes 1 and 2 greenhouse gas emissions. However, the IAA voices opposition to the requirement that registrants disclose Scope 3 emissions data. As commonly defined, Scope 3 emissions are those produced as a result of activities from assets not owned or controlled by the reporting organization, but that the organization impacts in its value chain and business operations.

“We recommend that the Commission not require registrants to disclose their Scope 3 GHG emissions at this time due to data gaps and the absence of agreed-upon measurement methodologies,” the letter states. “Should the Commission nevertheless require disclosure of Scope 3 GHG emissions, we recommend that it only require disclosure of Scope 3 GHG emissions when they are material, and not require disclosure if the registrant has set an emissions target or goal that includes those emissions.”

With respect to all required climate-related disclosures, the IAA recommends that the SEC clarify the standard for materiality to be used. The letter also recommends that the SEC require GHG emissions attestation providers to have familiarity with the specific industry of the registrant for which the attestation report is being provided.

The Consumer Federation of America’s comment letter speaks directly to the question of the SEC’s authority to pursue these regulations.

“Taking these steps is not only well within the Commission’s authority, but also essential if the Commission is to fulfill its public interest mission to protect investors, promote fair, orderly and efficient markets, and facilitate capital formation,” the letter states. “We encourage the adoption of the proposed amendments without undue delay.”

According to the CFA, factors driving demand for better climate-related disclosures can vary, but of principal significance is the growing consensus that climate change may present a systemic risk to financial markets.

“This concern is detailed in the recent report of the Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee of the Commodity Futures Trading Commission,” the CFA letter points out. “The report was unanimously approved by the subcommittee’s 34 members, who represent banks, asset managers, agribusiness, the oil and gas sector, academia and environmental organizations. This concern is widely acknowledged across virtually all segments of the economy in general and the financial system in particular.”

The CFA’s letter further notes that both retail and institutional investors are demanding better climate-related disclosures that can inform better investment decisionmaking.

“First, institutional investors are explicitly demanding enhanced climate-related disclosures because they know that climate-related risks and opportunities can affect returns,” the letter continues. “Second, they are demanding enhanced climate-related disclosures so that they can offer investment products and services that meet their clients’ needs and goals.”

The CFA letter suggests that while investor focus is appropriately centered on the downside financial risks of climate change, it is equally important to highlight the benefits that investors seek via better climate-related information.

“Where markets and economies are decarbonizing, both retail and institutional investors need reliable information to determine the effects of this process on registrants,” the CFA letter concludes. “Investors have demonstrated that they need climate-related information when making decisions about how best to allocate their capital—whether to buy, hold or sell a company’s shares, and how to vote their proxies. To do so, they need information about companies’ plans related to climate change and the potential cost of those plans.”

 

 

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