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Fiduciary irresponsibility?

A lawsuit challenges the common practice of revenue-sharing in the 401(k) industry

Not long after he retired as an IBM Corp. executive, Louis Haddock bought Flyte Tool & Die Co., a Bridgeport, Connecticut, outfit that makes plastics for industrial applications. As the sole owner of the 20-person firm, Haddock serves as Flyte’s president and also as the trustee of its 401(k) plan.

For years he found being trustee a straightforward affair. Then, in August 2001, Haddock became one of five trustees of small defined contribution plans suing Nationwide Financial Services. The Columbus, Ohio–based insurer had sold Flyte and the four other plans a group annuity contract under which Nationwide acted as the intermediary between the company and mutual fund firms. The plans’ charge: Nationwide violated its fiduciary duties and had a conflict of interest in receiving payments from fund firms for its services.

The suit has alarmed the defined contribution industry. So-called revenue-sharing is a common practice, and it now appears to be under legal assault. In early March, Stefan Underhill, justice of the U.S. District Court for Connecticut, ruled against Nationwide’s motion for a summary judgment dismissing the case, saying there was reason to air the facts.

The judge asked the plaintiffs to rewrite their complaint to address issues he had raised in rejecting the summary judgment. He is expected to rule on the defendants’ motion to dismiss that revised complaint this month or next.

If Underhill rules against Nationwide, he will next consider the plaintiffs’ request to be certified for a class-action suit. Flyte and the other plans demand recompense for what they consider illegal revenue-sharing by Nationwide, plus attorneys’ fees.

“Should the judge decide for the plaintiffs, this case could have enormous implications,” contends Brian Graff, executive director of the American Society of Pension Professionals & Actuaries, a trade group for retirement plan administrators. He’s worried a ruling could apply to investment vehicles other than group annuity contracts. Adds Joseph Ready, the senior vice president who heads Wachovia’s retirement services, “Were the judge to rule for the plaintiffs, the decision would have huge reverberations throughout the retirement business.”

Until the Nationwide lawsuit no one had ever challenged revenue-sharing intended to cover the costs of investment management services and administration of 401(k) plans. The charge that such arrangements create a conflict is unprecedented.

Usually a defined-contribution-plan sponsor contracts with an intermediary — either a broker or, as in Flyte’s case, an insurer — to deal with asset managers and also hires a recordkeeper, frequently a third-party administrator. This was the setup for Flyte and the other plans. The other common arrangement involves a single retirement-services provider that administers plans and manages assets, such as Fidelity.

If Underhill finds that an investment-products packager like Nationwide had fiduciary responsibilities in its role as an intermediary between the plans and the funds, the decision could change how the defined contribution industry conceives of a fiduciary.

What is more, if the judge ratifies the plaintiffs’ core allegation that this sort of revenue-sharing arrangement necessarily entails a conflict of interest, it would set the 401(k) industry on its ear.

Linda Shore, a benefits-law attorney in the Washington office of Mayer, Brown, Rowe & Maw, calls Underhill’s opinion permitting the suit to go forward “reasoned but also ambiguous and vulnerable.” Underhill’s dismissal of the summary judgment reinterprets common practice. A sentence in his ruling reads, “Congress intended the term ‘fiduciary’ to be ‘broadly construed.’”

Since the federal Employee Retirement Income Security Act provides relatively few causes of action for potential litigants other than breach of fiduciary duty, Underhill would have to deem Nationwide a fiduciary for the plaintiffs’ lawyers to collect contingency fees.

The plan sponsors are represented by Dallas-based Stanley, Mandel & Iola, which specializes in personal injury, class action and business tort litigation. Partner Roger Mandel is the lead attorney on the case, and his co-counsel is Richard Bieder, a partner at Koskoff Koskoff & Bieder, which is based in Bridgeport, Connecticut.

The Flyte case (Haddock v. Nationwide) tests the conventional definition of “fiduciary.” The plaintiffs and the defendant agree that Nationwide, acting as a go-between, proposed to the five plans a roster of mutual funds that were included in the insurer’s variable annuities. Nationwide had the latitude to change the lineup of funds in its group annuity contracts without obtaining the approval of its plan sponsor clients.

In quashing the summary judgment, Underhill cited an internal memorandum from Nationwide, dated April 1995, that appears to indicate that the insurer was weighing its relationships with fund firms, at least in part, on the basis of which ones had agreed to make revenue-sharing payments and which had not.

The plaintiffs allege in their complaint that the investment managers were, in effect, paying Nationwide for access to 401(k) plan participants. That, in turn, created a conflict of interest in the insurer’s loyalties. The plaintiffs further charge that Nationwide executives may have not kept plan participants’ interests uppermost in their minds when choosing among funds.

The insurer counters that its payments were an entirely appropriate form of compensation and, indeed, helped Flyte and other small businesses offer cost-effective retirement plans. Nationwide argues, moreover, that it acted as a salesperson, offering a financial product that the plaintiffs could buy or decline.

“Nationwide does not believe that it became a fiduciary of retirement plans simply by offering variable annuities for sale to these retirement plans,” says Nationwide spokesperson Erica Lewis. “ERISA fiduciary obligations have never been imposed by any court on a company like Nationwide that simply sells a financial product that the plaintiffs were free to purchase or not.”

As benefits-law attorney Shore sees it, “The big question is this: Is the court really saying that restricting the fund lineup makes you a fiduciary? Most providers have limited menus. Is it rather a question of the latitude the provider has in removing existing investment options?”

The Department of Labor, which administers ERISA, has issued two advisory opinions about revenue sharing. The DoL’s 1997 Frost letter gives intermediaries, such as Nationwide, a green light to receive revenue-sharing payments when those intermediaries have some discretion over the funds offered.

The Securities and Exchange Commission’s Aetna letter, which also appeared in 1997, says that intermediaries do not become fiduciaries solely on the basis of making changes to a mutual fund roster, provided they give enough advance notice (four months or more) to plan sponsors to allow them to switch to another intermediary if they choose.

In his March ruling, Underhill identified two questions at the heart of the suit. First, did Nationwide have a fiduciary responsibility to the plan participants because the insurer could determine which mutual funds would be available as investments? Second, did Nationwide have a conflict of interest in making those fund selections, considering that some funds, but not others, offered Nationwide revenue-sharing payments, and certain funds offered larger payments than others?

Legal wrangling over 401(k) revenue-sharing dates to the late 1990s, when plaintiffs’ lawyers at Stanley, Mandel & Iola suspected that revenue-sharing agreements might be ripe targets for litigation. Typically, the agreements were not disclosed to plan sponsors, and that lack of transparency fostered suspicions of overcharging.

“Disclosure is the right answer, although it must be simple and consistent,” contends Wachovia’s Ready. “Then the buyer can make an informed decision.”

Of the current case, attorney Mandel asserts, “Given the judge’s denial of the motion for summary judgment, we believe our clients have a fair shot at winning the case.” And shaking up the 401(k) industry in the process.