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News March 20, 2006 Issue

Court Questions Legality of Fund Revenue Sharing Payments to 401(k) Recordkeepers Under ERISA

A recent federal court case has raised questions about the legality of "revenue sharing" payments in the 401(k) context.

The March 7 decision in the case of Haddock v. Nationwide Financial Services involved ERISA claims raised by trustees of five employer-sponsored 401(k) plans against Nationwide Financial Services. The trustees alleged that Nationwide, which serves as the plansí recordkeeper, received revenue sharing payments from mutual funds, as a quid pro quo for the funds being made available to plan participants. As a result, claimed the trustees, Nationwide breached its fiduciary duties under ERISA, engaged in prohibited self-dealing, and received prohibited compensation.

The trustees initially filed suit in August 2001. After years of discovery, motions, and counterclaims, Nationwide requested summary judgment.

The court, in its March 7 decision, denied that request.

"A rational fact-finder," viewing the evidence in the light most favorable to the plaintiffs, could find that Nationwideís "ability to select, remove, and replace" mutual funds available for the plansí investment made Nationwide an ERISA fiduciary, said the court. It also said that the trustees "raised triable issues" concerning whether the revenue sharing payments from the funds to Nationwide were "plan assets," and whether those payments resulted in prohibited transactions.

The decision is expected to send waves through the mutual fund and 401(k) communities.

"Itís absolutely worth watching," said Groom Law Group partner Roberta Ufford. "The thing that worries me the most about it is that there is a lot of litigation out there involving 401(k) plans," she said. "We are concerned for our clients about copycat suits."

Revenue sharing arrangements in the 401(k) space are relatively common, Ufford explained. Mutual funds (or their advisers) often make payments to 401(k) recordkeepers to cover the recordkeeperís administrative expenses, since the fundís transfer agent or distributor is not doing the level of shareholder recordkeeping that it would do if every plan participant were recorded as a shareholder on the books of the fund. "Itís become a standard practice," said Ufford. She noted that the Department of Labor has in fact recognized that fee sharing goes on in the industry.

The court seemed to take a different view. The court noted that Nationwide implemented a revenue sharing program in the mid-1990s, under which funds selected by Nationwide made payments to Nationwide based on a percentage of the assets that plans and participants invested through Nationwide. Although the arrangements were characterized as "service contracts," the court said that "a fact-finder viewing the evidence in the light most favorable to the trustees could conclude that the contracts were a guise for making payments to Nationwide or that Nationwide provided only nominal services and that the payments were not in consideration for those services."

A closer look at the courtís analysis:

Is Nationwide an ERISA fiduciary with respect to the plans? Could be, said the court. A reasonable jury, it said, could conclude that Nationwide "exercises some control over the selection and offering of particular mutual funds as investment options for the Plans and participants." The court noted that although Nationwide does not invest the pension contributions in particular mutual funds, it "does exercise some control over the selection of mutual funds that are available for the Plansí and participantsí investments."

However, as Ufford noted, because the case was just at the summary judgement stage, "the judge is just reading the papers before him." Until the facts are more fully fleshed out in a trial, she said, it will be difficult to determine whether the applicable contractual language subjected Nationwideís authority to select funds to approval by an independent plan fiduciary through a negative consent process, as contemplated by DOLís 1997 Aetna letter. There, DOL took the view that a person would not be exercising discretionary authority or control over the management of a plan or its assets solely as a result of deleting or substituting a fund from a program of investment options and services offered to plans, provided that the appropriate plan fiduciary makes the decision to accept or reject the change. "In this regard," said DOL, "the fiduciary must be provided advance notice of the change, including any changes in the fees received, and afforded a reasonable period of time within which to decide whether to accept or reject the change and, in the event of a rejection, secure a new service provider."

Ufford additionally noted that even if the contracts did not contain such a requirement, Nationwide could still fit within the Aetna parameters if it was, in practice, subjecting its fund selection process to the plansí negative consent.

Or, of course, it could turn out that Nationwide simply did not fully comply with the Aetna guidance, Ufford added.

Are revenue sharing payments "plan assets?" Again, the court said they might be. While noting that revenue sharing payments arenít covered under ERISAís plan assets definition, and that no relevant plan document suggested that the payments were plan assets, the court used a functional test to determine whether they are plan assets: "I conclude that "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 or beneficiaries." Under that test, said the judge, the revenue sharing payments might just be plan assets.

Nationwide allegedly received the payments from mutual funds in exchange for offering the funds as an investment option to the plans and participants, i.e., as a result of its fiduciary status or function, it noted. The payments allegedly were made at the expense of the plan participants or beneficiaries (the trustees had alleged that the funds had set their fees to cover the payments). However, Nationwide had produced evidence that the mutual fund charges actually decreased after Nationwide entered into the service contracts with the funds.

Did Nationwide engage in a prohibited transaction? Again, the court said a reasonable juror might concluded it had. And, as the court noted, the whole "plan assets" analysis might be moot: "If Nationwide is an ERISA fiduciary, it may not engage in prohibited transactions even if the payments Nationwide receives are not themselves plan assets."

However, even if revenue sharing payments are ultimately deemed to be plan assets, Ufford noted that ERISA provides an exemption permitting plan assets to be used to pay reasonable compensation for services that are necessary to operate the plan.