Delta employees sue Fidelity for 'illegal kickbacks' from Financial Engines

Irwin’s Note: Brooke is constantly telling me to report what I see and to keep my opinions to myself. But, having been a practicing securities attorney for more than 40 years, and since my opinion here is about other attorneys, he has given me some leeway. This case revolves around what an investment advisor acting as a 401(k) fiduciary does with its fee after it earns it. Because it chooses to split the fee with Fidelity, the lawyers are arguing that they must be charging the plan participants too much. The attorneys would not want the court to judge them under the same standard that they are asking the court to judge Fidelity. If they win this case, these same lawyers will ask the court to approve their fees at a rate that reflects paying young lawyers from Ivy League schools a quarter-of-a-million-dollars a year to do research that trained paralegals could do; occupying pricey high-rise offices when they would produce the same legal briefs if they worked out of a warehouse; and spending a fortune each year going to seminars and conferences at country clubs and resorts when they could get the same information through webinars. In my opinion, if these lawyers were more judicious with their own expenses, the fees they’ll be seeking from the court would certainly be less.

In an ERISA lawsuit that even has attorneys scratching their heads, employees of Delta Air lines Inc. are suing Fidelity Investments for breaching its fiduciary duty in accounts in which it has farmed out the fiduciary portion of the service bundle.

The suit also makes the more garden-variety allegation that Boston-based Fidelity wrongfully receives fees from mutual funds that it makes available to 401(k) plan investors — mostly of the retail variety. See: Fidelity Investments recognizes power of RIAs in 401(k) market and has increased efforts to work with advisors.

The chief allegation is more novel — that Fidelity is screwing 401(k) plan participants by taking a cut of the fee charged for advice by its subcontractor, Financial Engines Inc.

Financial Engines is, in effect, an advisor for hire with its advice provided both by humans and via robotic automation. The Sunnyvale, Calif.-based firm is a long-time Fidelity partner. See: How giant advice provider Financial Engines can sweep the 401(k) field — or not.

The suit is hardly a slam-dunk, according to Joseph A. Garofolo, principal of Lafayette, Calif.-based Garofolo Law Group, who represents both ERISA plans and plan participants.

“Lawsuits challenging revenue sharing often raise highly fact-specific issues, and cases involving such issues have yielded mixed results for plaintiffs,” he writes in an email.

The basis of the complaint

The suit, Fleming v. Fidelity Management Trust Co. et al., filed in the U.S. District Court in Boston, implies Fidelity breached its fiduciary duty by accepting part of Financial Engines’ advice fee despite Financial Engines providing no advice — an allegation that may not fit the circumstances, according to Sheldon M. Geller, an attorney and president and managing member of Stone Hill Fiduciary Management LLC of Great Neck, N.Y., who authored this article in July 2012: See: 9 things advisors to 401(k) plans must do to keep clients out of hot water.

The suit alleges that “Financial Engines is paying Fidelity 22.5 basis points with respect to Delta Plan accounts invested through Financial Engines. This percentage is exactly half of the maximum fee [45 basis points] charged by Financial Engines.” See: Why almost nobody seems fazed by an ominous lawsuit hanging fire against Financial Engines.

The plaintiffs clearly believe that while the fee charged for the advice is fair, that Fidelity does not give the plan any value for the fee that it receives.

Geller notes that “the 401(k) plan lawsuit against Fidelity is based upon the premise that Fidelity is a fiduciary with respect to the plan. If Fidelity is not deemed a fiduciary with respect to the plan, then the allegations will not be successful against Fidelity as a non-fiduciary service provider.”

Garofolo identifies this same challenge for the Delta plaintiffs — though he proffers his view as a generality.

“Among other things, defendants frequently contest whether they are fiduciaries with regard to the challenged acts and also argue that revenue sharing payments do not constitute plan assets.”

As of Jan. 13, 2014, the Delta Family-Care Savings Plan had $7,844,194,093 in assets, according to its federal filing.

'Kickbacks’ in play?

In Geller’s view, Fidelity is only the recordkeeper and broker-dealer for the plan, which doesn’t include fiduciary exposure.

“It is the plan sponsor, not Fidelity, who makes the fiduciary decision as to whether to offer the investment advice service to their employees,” he says. See: What RIAs must know about hidden, and excessive, fees in serving as fiduciaries to a 401(k) plan.

But the lawsuit alleges otherwise and characterizes this fee-splitting as “illegal kickbacks” and claims that Fidelity is running a pay-for-play scheme.

When asked for comment about the case, Fidelity Spokesman Steve Austin responded: “Fidelity intends to vigorously defend the action because the allegations have no merit.”

Point guard

Financial Engines — which is not named as a defendant in the suit — acknowledges that it is a fiduciary answering to ERISA rules with respect to its financial advice program. The suit does not allege that Financial Engine’s advice was substandard or harmed the participants in any way. It even goes so far as to acknowledge the importance of investment advice in helping participants avoid costly investment errors. See: Hitting a robo wall, Financial Engines buys The Mutual Fund Store for $560 million to bust out of 401(k) confines.

According to its most recent Form ADV, Financial Engines charges up to 75 basis points for investment advice. Financial Engines charges participants on the Fidelity platform 45 basis points.

Fidelity has not yet filed an answer to the complaint with the Court. When it does, it is likely to underscore that Financial Engines’ advice has a market value of 75 basis points. The plaintiffs will need to show how these investors, who are being charged 45 basis points for the same advice, are being cheated. See: Obfuscation Nation: 401(k) fee disclosure laws still don’t give the true cost of plans and may well cause more agita for would-be retirees.

The plaintiffs maintain that if Fidelity was not being paid then the fee that Financial Engines would charge would be substantially less. In response to a question about whether it is reasonable to assume that Financial Engines would charge less were Fidelity not involved, Garofolo says he does not know. See: How RIAs can rule the 401(k) realm by becoming advocates for plan sponsors — and start by eliminating eight marketplace conflicts.

Garofolo notes, however, that the Delta employees are seeking disgorgement in addition to injunctive relief.

Lawsuit for a post-rule era

The novel lawsuit comes at a crossroads in the 401(k) business. Not only has the passing of the DOL final rule changed the legal atmosphere but fees have become the primary concern for 401(k) sponsors. See: How the DOL brought the IRS wolf to the RIA door with its 'rule’ — think IRAs.

Though the Delta suit does not rely on changes made under the DOL rule, it may reflect a change associated with it. According to a recent survey of a representative cross section of 1,435 401(k) plan sponsors conducted by Market Strategies International of Livonia, Mich., the desire to cut fees and expenses outranks investment underperformance for the first time as the most common reason plan sponsors would end a relationship with an investment manager. See: 401(k) industry flummoxed over Yale professor’s 6,000 'threatening’ letters to plan sponsors.

According to that survey, more than one-third (34%) of plan sponsors with at least $500 million in plan assets cite the need to reduce fees/expenses as a reason for dropping an investment manager.

Respondents to the survey ranked Fidelity third on the list of plan service providers who offer the “best value for the money.” See: Fidelity Investments puts hard numbers on the disgruntlement of 401(k) plan sponsors — and launches Z shares with ETF-like prices.

Why not institutional?

The lawsuit employs similar logic in alleging that Fidelity is acting illegally by offering retail classes of shares to investors when institutional shares exist, alleging that the aggregation of all the retail accounts equals one big institutional account.

Though all of the fees and expenses involved in the Delta plan are fully disclosed and these fees are earned by the advisors and funds — not Fidelity — the lawsuit posits that the issue is what the advisor or mutual fund does with those fees after they receive them. The plaintiffs argue that the advisors and funds would charge investors less frequently if they were not sharing their fees with Fidelity.

The Delta Family-Care Saving Plan is a qualified retirement plan under ERISA. Fidelity provides the plan with recordkeeping and administrative services. The suit makes no allegation that the recordkeeping or administrative services that Fidelity provides are deficient in any way. Plan participants can choose from a number of investment options. See: How exactly Fidelity Investments extracted itself from a legal and HR quagmire and why it’ll cost far more than the public $12-million amount.

Plaintiffs complain that Fidelity offers only “retail” shares of these funds rather than “institutional” shares, which would have lower expense ratios. They assert that Fidelity offers these more expensive shares because, again, it is sharing in the fees that the funds are charging.

In 2009, the first year covered by the suit, Fidelity offered the Delta Plan participants 174 funds and received between five and 55 basis points from each. The suit asks the Court to take note of the fact that Fidelity received 35 basis points or more from a majority of the funds.

Retail, not wholesale

About one-third of the Delta plan participants opt to invest for themselves in self-directed brokerage accounts through a plan option called Fidelity BrokerageLink. They can select investments from a wide range of options provided by Fidelity. This includes a list of approximately 170 mutual funds from Fidelity and other fund sponsors. See: A compliance attorney fields four tough 401(k) questions amid crossfire provoked by Ric Lager’s column.

The plaintiffs assert that purchases and redemptions of mutual fund shares by thousands of individual participants in the Delta and other plans using BrokerageLink are aggregated by Fidelity and other individual account plan platform providers through an omnibus account. In the opinion of the plaintiffs’ lawyers, the recordkeeper for these plans is the sole investor in the each mutual fund.

Self-directed option

According to research published jointly by BrightScope of La Jolla, Calif. and the Investment Company Institute of Washington, D.C., in 2014, mutual fund expenses in 401(k) plans decreased between 2009 and 2012 across all asset classes.

The report notes that “actively managed mutual funds can offer investors the chance to earn superior returns, access specialized sectors, or take advantage of alternative investment strategies, all of which can make a fund more expensive to manage. Similarly, equity mutual funds may be priced differently depending on the extent to which they invest in small-cap, mid-cap, or emerging market stocks (which tend to be more expensive to manage) instead of large-cap or developed market stocks (which tend to be less expensive to manage).”

The plaintiffs, legal experts add, will have to contend with the broader context than self-directed investors who select the BrokerageLink option under the plans can also invest in stocks, bonds, CDs, ETFs and a variety of other investments that Fidelity offers to all of its retail customers.

Fidelity also offers all customers several Vanguard Group funds, which have lower expense ratios than many similar funds from other sponsors that it also offers. See: What led to Vanguard allowing its 401(k) plan sponsors to shop around for non-Vanguard target-date funds.

The Delta plan participants are likely to hit other legal obstacles, experts say. Even if the Court agrees that Fidelity should offer “institutional shares” to these small investors, the Court cannot order the funds to do so because their managers are not parties to this action. If the fund managers do not want to make institutional shares available to small self-directed investors, this lawsuit will not give investors that choice. Going forward, the mutual funds could still offer only “retail” shares to these accounts.

If the case is successful, the funds would not be able to share the fees with Fidelity.