Proprietary Funds

Besides the claims of breach of fiduciary duty made of late  against plan sponsors that offer proprietary funds, there have been claims of prohibited transactions. With respect to the latter, plan sponsors have sought to rely on both statutory and administrative exemptions, but with only limited success.

Employee Retirement Income Security Act (ERISA) Section 408(b)(8) provides that the prohibitions of ERISA Section 406 do not apply to a transaction between a plan and a pooled investment fund maintained by a bank, trust company or insurance company if: 1) the transaction is a sale or purchase of an interest in the fund; 2) the bank, trust company or insurance company receives no more than reasonable compensation; and 3) such transaction is expressly authorized by the plan or a fiduciary other than one of those three institutions or an affiliate thereof.

The problem for defendants is that this exemption applies only to a sale or purchase of an interest in the funds, but the alleged prohibited transactions are generally the payment of fees from plan assets. As a California district court made clear last year in Santomenno v. Transamerica Life Insurance Co., Section 408(b)(8) is “not about fees or how fees are properly collected.”

The administrative exemption that plan sponsors of proprietary funds rely upon is prohibited transaction class exemption (PTE) 77-3, which permits employers to offer their own proprietary funds to employees. PTE 77-3 applies so long as the plan satisfies four conditions: 1) it pays no fees to the investment adviser except via the investment company’s payment of its standard advisory and other fees; 2) it pays no redemption fee to any party other than the investment company itself; 3) it pays no sales commission; and 4) “all other dealings between the plan and the investment company, the investment adviser or principal underwriter are on a basis as favorable to the plan [as are those] with other shareholders of the investment company.”

The meaning of this last condition, 77-3(d), was addressed in Brotherston v. Putnam. Plaintiff’s allegation was that Putnam provided revenue-sharing rebates to third-party providers that, in some instances, passed on those rebates to participants in other plans. Despite the fact that PTE 77-3 had existed for approximately 40 years before Brotherston, only one reported case had interpreted this clause—Krueger v. Ameriprise. This 2012 Minnesota District Court case read into the exemption a reasonable compensation component and did not address the scope of the fourth condition.

Putnam argued that the revenue-sharing payments were not “dealings” within the meaning of PTE 77-3(d), and, alternatively, even if they were dealings, the fourth condition was satisfied because of discretionary contributions to plan participants by Putnam. In effect, Putnam argued that the relevant issue was the net position of its plan participants, not the individual rebate transactions. The District Court rejected Putnam’s argument that, because the firm did not negotiate the amount of the rebate between the recordkeeper and third-party plans, there were no dealings for purposes of PTE 77-3(d).

However, the court accepted Putnam’s other argument, stating, “Allowing plan participants to recover for the lack of revenue-sharing payments when they already profited from Putnam’s discretionary contributions to the plan would allow the participants to be unjustly enriched.”

Aside from this victory, however, PTE 77-3 has been of limited utility to defendants. While there is case law to the effect that a breach of loyalty cannot be presumed merely because a defendant needed to rely upon PTE 77-3 to avoid a prohibited transaction, it is also true that, even if the conditions of PTE 77-3 are satisfied, a fiduciary still must discharge his other duties to the plan solely in the interest of the participants and beneficiaries, and prudently. Therefore, PTE 77-3 is inapplicable to a fiduciary’s duties under Section 404.

More importantly, in many instances, PTE 77-3 will not allow a prohibited transaction claim to be dismissed for failure to state a claim. For example, in Wildman v. American Century Services, plaintiffs alleged that American Century introduced a lower-class share class for several of its funds, and that share class was available to other employer-sponsored plans, but the defendant had failed to convert to this new class in time for its own plan to benefit. The complaint also alleged that defendants directed the plan trustees to delay conversion to the lower-cost share classes, in order to collect additional fees, which caused a loss to plan participants.

The bottom line: Plan sponsors that offer proprietary funds now face the prospect of extensive and expensive discovery, which frequently results in settlements to avoid the hazards of litigation.

Marcia Wagner is an expert in a variety of employee benefits and executive compensation issues, including qualified and non-qualified retirement plans, and welfare benefit arrangements. She is a summa cum laude graduate of Cornell University and Harvard Law School and has practiced law for 30 years. Wagner is a frequent lecturer and has authored numerous books and articles.