Compliance September 5, 2019

Court Moves Forward Most Claims in MIT Excessive Fee Suit

However, a U.S. District Judge affirmed a motion to dismiss a claim alleging a prohibited transaction between MIT and Fidelity Investments.

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The U.S. District Court for the District of Massachusetts has moved forward most claims in an Employee Retirement Income Security Act (ERISA) lawsuit alleging mismanagement and disloyalty on the part of Massachusetts Institute of Technology (MIT) defined contribution retirement plan fiduciaries. 

However, U.S. District Judge Nathaniel M. Gorton affirmed a motion to dismiss a claim alleging a prohibited transaction between MIT and Fidelity Investments.

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The underlying claims in the suit are for a breach of the duty of prudence (failure to monitor, imprudent investment lineup and excessive recordkeeping fees) and prohibited transactions in violation of ERISA.

As background in the case, prior to July 2015, the plan consisted of four tiers of investment options. Most relevant to the claims at issue is Tier 3, the “MIT Investment Window,” which offered a wide range of investment products and was designed to give individuals with experience conducting investment research a large degree of choice. In July 2015, the plan underwent a major reorganization removing hundreds of mutual funds from Tier 3 and eliminating all but one Fidelity fund. In essence, the plan committee eliminated Tier 3 and expanded Tier 2 to include 37 core options.

Citing a U. S. Supreme Court decision in Tibble v. Edison International, Gorton said an ERISA fiduciary has an ongoing “duty to monitor trust investments and remove imprudent ones” and must review investments at “regular intervals.” With respect to MIT’s duty to monitor, which falls under the general duty of prudence, plaintiffs allege two kinds of breaches regarding MIT’s process for monitoring the plan and MIT’s inclusion of specific underperforming or excessively risky funds.

According to the court order, the plaintiffs assert that MIT’s process for evaluating investments was deficient and lacked due diligence in that the defendants ignored relevant advice from consultants and outside counsel, failed to institute a robust policy to monitor investment alternatives, and before July 2015, failed to make necessary changes to the MIT Investment Window. The defendants respond that MIT’s investment committee is composed of a variety of MIT-affiliated economic experts who diligently executed their duties by collecting data on the performance of the investment window, maintaining a “watch-list” of potentially underperforming funds, and soliciting and duly considering independent advice. They also point to the 2015 reorganization of the plan as clear evidence of the committee’s robust deliberative process and ability to implement logical adjustments.

Gorton found that with respect to the issue of whether MIT met its duty of prudence regarding its process for monitoring, the parties have set forth compelling and competing narratives. On one hand, the plaintiffs submit that MIT’s lack of action and failure to implement outside advice demonstrates its failure adequately to discharge its duty to monitor. The defendants rejoin that their monitoring strategy was reasonable under the circumstances, appropriately deliberative and well in line with its duty and industry practice. “Thus, because neither party has demonstrated as a matter of law that MIT did or did not act prudently, defendant’s motion for summary judgment with respect to the monitoring claims of Count I will be denied,” Gorton wrote in his order.

The plaintiffs, relying on expert testimony, also allege that the University retained several kinds of imprudent and underperforming funds in the plan including regional and sector funds, funds without sufficient performance history and target-date funds. They assert that if MIT had acted prudently, those funds would have been removed or replaced. The defendants dispute those assertions with expert testimony of their own and evidence regarding industry practice.

Gorton decided, “The debate over whether certain kinds of funds should have been included in the plan is a material factual dispute that will be preserved for trial. Accordingly, defendants’ motion for summary judgment with respect to the specific funds claim in Count I will be denied.”

Regarding the claim about excessive recordkeeping fees, Gorton explained that in a revenue-sharing system, the recordkeeper retains some of the investment income of the retirement plan to satisfy the plan’s administrative expenses. In Count II, the plaintiffs claim that the plan was subject to excessive recordkeeping fees in violation of ERISA’s duty of prudence because MIT knew that Fidelity’s recordkeeping fees exceeded the industry standard and MIT did nothing to reduce the fees to the market rate. They assert that MIT’s failure to solicit a request for proposal (RFP), which allegedly would have exerted competitive pressure on Fidelity, demonstrates a clear lack of prudence and that the defendants did not leverage the plan’s size as a bargaining strategy to reduce fees.

The defendants proffer contrary expert testimony that MIT’s fees were well within industry standard, especially when compared to similar university and corporate plans. They contend that the plan committee maintained adequate procedures to constrain costs and succeeded in successfully negotiating revenue sharing rebates from Fidelity, their 2014 restructuring of Fidelity’s compensation to a yearly per-participant flat rate of $33 is clear evidence that MIT took concrete steps to control recordkeeping fees, and ERISA does not rigidly require a fiduciary to submit bids for an RFP periodically because an RFP is just one of many ways to discharge its monitoring duty.

Similar to Count I, Gorton found that the opinions of the parties’ experts as to the proper industry protocol and the amount of fees that should be considered reasonable are in stark contrast. Both parties also present competing narratives surrounding the decision not to conduct an RFP.

“Because those disputes are more than superficial, the Court concludes that they are best resolved at trial. Viewing the entire record in the light most favorable to the nonmoving party, there are genuine issues of material fact as to whether defendants breached their duty of prudence with respect to recordkeeping fees. Accordingly, defendants’ motion for summary judgment on Count II will be denied,” Gorton wrote.

The plaintiffs also allege that MIT failed to monitor its appointed fiduciaries. Gorton said that ordinarily, a duty to monitor other fiduciaries is derivative of the plaintiffs’ other claims. “Thus, because the parties dispute the alleged underlying breach of fiduciary duty claims, plaintiffs’ derivative claims that defendants breached their duty to monitor will also be preserved for trial,” he wrote.

Separate from their claims for breach of the duty of prudence, the plaintiffs allege that defendants breached their statutory duty under ERISA Section 1106(a)(1), which prohibits certain transactions between a plan and a “party in interest.” Gorton found that the plaintiffs have failed to proffer any concrete evidence of self-dealing or disloyal conduct. “The Court is not convinced that plaintiffs’ non-mutual fund claims are more than conclusory.”

Moreover, Gorton said the court now finds that defendants’ non-mutual fund options fall under an exception to Section 1106. He explained that Section 1106 is subject to a number of exceptions, including Section 1108(b)(8) which exempts prohibited transactions where “the bank, trust company, or insurance company receives not more than reasonable compensation.”

In support of its position, MIT cites expert testimony stating that the expense ratios of the plan’s non-mutual fund options were comparable to or less expensive than fees of similar investments during the class period. The plaintiffs offer no rebuttal and simply rejoin that the fees on the non-mutual fund options add to the already unreasonable recordkeeping and administrative fees alleged in Count II.

“In short, plaintiffs have proffered no evidence that the fees specific to the non-mutual fund options were unreasonable or not subject to the exception in Section 1108(b)(8). Accordingly, MIT’s motion for summary judgment with respect to plaintiffs’ Section 1106(a) claim will be allowed,” Gorton wrote.

The prohibited transaction claim had previously been dismissed along with other claims recommended to be dismissed by a Magistrate Judge. However, the plaintiffs in the case filed an amended complaint reiterating their claims. Upon the Magistrate Judge’s recommendation, the court denied the request for a jury trial, which led to the recent motion for summary judgment by the MIT defendants.

Gorton ordered that a pre-trial conference will be held September 11, and the bench trial will commence on September 16.
Compliance September 5, 2019

SEC Complaint Dissects Fee-Based Firm’s Revenue Sharing Strategy

The Securities and Exchange Commission takes issue with revenue sharing tied to a preferred broker’s “transaction fee” program, underscoring how fee-based advisers are not immune from allegations of conflicts of interest.

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In August, the U.S. Securities and Exchange Commission (SEC) filed a lawsuit against Commonwealth Financial Network, suggesting the firm has failed to disclose material conflicts of interest related to revenue sharing received for certain client investments.

Filed in the U.S. District Court for the District of Massachusetts, the complaint states that since at least 2007, Commonwealth had a revenue sharing agreement with the broker it required most of its clients use for trades in their accounts.

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Under that agreement, the SEC alleges, Commonwealth received a portion of the money that certain mutual fund companies paid to the broker to be able to sell their funds through the broker, if Commonwealth invested client assets in certain share classes of those funds. 

Between July 2014 and December 2018, Commonwealth received over $100 million in revenue sharing from the broker related to client investments in certain share classes of “no transaction fee” and “transaction fee” mutual funds, the complaint states.

The SEC’s complaint alleges that Commonwealth breached its fiduciary duty to its clients by failing to disclose the conflicts of interest created by its receipt of compensation through the revenue sharing agreement. Specifically, the SEC’s complaint alleges that Commonwealth “failed to tell its clients that (i) there were mutual fund share class investments that were less expensive to clients than some of the mutual fund share class investments that resulted in revenue sharing payments to Commonwealth, (ii) there were mutual fund investments that did not result in any revenue sharing payments to Commonwealth, and (iii) there were revenue sharing payments to Commonwealth under the broker’s ‘transaction fee’ program.”

“As a result of these material omissions, Commonwealth’s advisory clients invested without a full understanding of the firm’s compensation motives and incentives,” the complaint says.

Technically, the complaint alleges that Commonwealth violated the antifraud and compliance provisions of Section 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7 thereunder.

“By failing to adopt and to implement written policies and procedures reasonably designed to ensure that Commonwealth identified and disclosed these conflicts of interest, Commonwealth violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder,” the complaint alleges. “The Commission seeks: (a) a permanent injunction prohibiting Commonwealth from further violations of the Advisers Act; (b) an order that Commonwealth disgorge its unjust enrichment, plus prejudgment interest; and (c) imposition of a civil penalty due to the nature of Commonwealth’s breach of fiduciary obligation.”

Asked for comment on the lawsuit, a Commonwealth spokeswoman shared the following: “While the enforcement action proposed by the Securities and Exchange Commission is a pending legal matter, Commonwealth Financial Network vehemently denies the allegations and believes they are categorically without merit. We are confident we have operated both appropriately and justly and will vigorously defend our actions in this matter.”

As of April 2019, Commonwealth, in its role as an investment adviser, reported approximately $85 billion in assets under management, with approximately $60 billion of those assets owned by persons who are non-high-net-worth retail clients, meaning clients with less than $1 million in assets under management or a net worth of less than $2 million.

According to the SEC, Commonwealth is also an introducing broker, meaning that it accepts client orders, but has an arrangement with another broker, known as a clearing broker, to execute and clear client trades and maintain custody of the investments held in Commonwealth’s clients’ accounts.

The other relevant entity in the case is National Financial Services (NFS), registered with the Commission as a broker/dealer and investment adviser. Commonwealth contracted with NFS to maintain custody of Commonwealth’s clients’ assets and to act as a clearing broker. NFS is an affiliate of Fidelity Investments, which is a sponsor of Fidelity mutual funds offered by NFS.

Details from Commonwealth’s Operations

Case documents show Commonwealth offers its investment advisory services through approximately 2,300 investment adviser representatives located throughout the United States, and through three Preferred Portfolio Services (PPS) programs, called PPS Custom, PPS Select, and PPS Direct. It also provides clients advisory services through unaffiliated third-party asset manager programs.

According to the SEC, clients who receive investment advisory services through Commonwealth’s PPS programs or third-party asset manager programs generally pay management fees calculated as a percentage of their assets under management. These fees are periodically deducted from clients’ advisory accounts. The SEC reports that Commonwealth’s largest PPS program is PPS Custom. As of the end of 2017, Commonwealth advised 262,061 accounts with assets under management of approximately $71.7 billion in the PPS Custom program. In PPS Custom, investment adviser representatives typically act as portfolio managers, with full investment discretion to develop custom investment portfolios for advisory clients.

The next largest PPS program is PPS Select. As of the end of 2017, Commonwealth advised 61,561 accounts with assets under management of approximately $6.8 billion in the PPS Select program. In the PPS Select program, Commonwealth offers advisory clients a variety of model portfolios of particular share classes of pre-selected mutual funds. These model portfolios are created and managed on a discretionary basis by Commonwealth’s internal teams. Once the investment team creates these model portfolios, Commonwealth makes them available to its adviser representatives and its client base through the PPS Select Program.

SEC says the smallest of the three PPS programs is PPS Direct. As of the end of 2017, Commonwealth advised 6,096 accounts with assets under management of approximately $2 billion in the PPS Direct program. Similar to PPS Select, the PPS Direct program offers clients access to a variety of model portfolios. The model portfolios in PPS Direct, however, are not managed by Commonwealth. They are managed by one or more third-party portfolio managers.

According to the SEC, between 2014 and 2018, Commonwealth’s investment team, which was responsible for creating and managing the model portfolios that Commonwealth offered to advisory clients through the PPS Select program, had a practice of selecting the lowest-cost share class of mutual funds placed into the model portfolios.

“This practice was for the economic benefit of clients who invested through the PPS Select program,” the complaint states. “By contrast, during this same period, Commonwealth did not have a uniform practice of selecting the lowest-cost share class available of a mutual fund for clients in the much larger PPS Custom program.”

More on Revenue Sharing

The SEC complaint includes substantial detail on the revenue sharing arrangement in place between Commonwealth and NFS, which is used to argue that the revenue sharing arrangement created financial incentives for Commonwealth to invest clients in mutual funds in a manner that would lead to greater revenue sharing for itself.

“In particular, Commonwealth had an incentive to select and hold more expensive mutual funds for clients, and to select and hold more expensive mutual fund share classes when lower-cost mutual funds were available for the same fund,” the complaint alleges. “When Commonwealth invested in a mutual fund for a client, it had more than one mutual fund to choose from, and could select or continue to hold mutual funds for which it would receive less or no revenue sharing.”

Further, SEC alleges, when Commonwealth chose to purchase or hold a particular mutual fund for a client, it also sometimes had more than one mutual fund share class to choose from. These available share classes included those that charged a transaction fee and those that did not. The no transaction fee share classes often had higher internal expenses and paid more revenue sharing to Commonwealth than the transaction fee share classes.

“In light of the revenue sharing Commonwealth received from NFS based on client investments in mutual funds in NFS’s no transaction fee program, Commonwealth’s disclosures … were insufficient because they failed to disclose the existence of higher internal expenses that were present in some no transaction fee mutual fund shares, the existence of mutual fund share classes of the same funds with lower expenses, and the conflict of interest presented by this set of circumstances,” the complaint concludes. “These disclosure failures were omissions of material fact and were required to be disclosed to Commonwealth’s advisory clients, and Commonwealth knew or should have known that it had a duty to disclose such information.”

The full text of the complaint is here. 

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