Fidelity Faces ERISA Prohibited Transaction Charges in New Lawsuit

The lawsuit accuses Fidelity of requiring "secret" payments from funds to make up for declining amounts of revenue sharing payments received by the firm as a result of the increasing use of passive mutual funds, institutional and R6 share classes of mutual funds and collective trusts

A participant in the T-Mobile USA, Inc. 401(k) Retirement Savings Plan and Trust has sued FMR (Fidelity) and several of its affiliates claiming the firm engaged in prohibited transactions by charging a “secret” fee for mutual funds and engaging in self-dealing.

In a statement to PLANADVISER, Fidelity says, “Fidelity emphatically denies the allegations in this complaint. Fidelity fully complies with all disclosure requirements in connection with the fees that it charges.”

The proposed class action explains that Fidelity acts as a recordkeeper, service provider, a party-in-interest and a fiduciary for thousands of defined contribution (DC) retirement plans in the U.S. It offers plans the opportunity to invest in third-party mutual funds and similar investment vehicles through its “Funds Network”, which Fidelity launched in 1989 and, according to the complaint, describes as “one of the industry’s leading fund supermarkets.” 

According to the complaint, beginning in or about 2017, Fidelity began requiring various mutual funds, affiliates of mutual funds, mutual fund advisers, sub-advisers, investment funds, including collective trusts, and other investment advisers, instruments or vehicles that are offered to the plans through Fidelity’s Funds Network, to make what the lawsuit calls “secret” payments or “kickbacks” “to Fidelity for its own benefit in the guise of “infrastructure” payments or so-called relationship-level fees in violation of the prohibited transaction rules of the Employee Retirement Income Security Act (ERISA).

The plaintiff alleges that the kickback payments are part of a pay-to-play scheme in which Fidelity receives these payments from mutual funds in the event that otherwise disclosed revenue-sharing payments fall below a certain level and Fidelity requires payment of these kickbacks in return for providing the mutual funds with access to its retirement plan customers.

“Although Fidelity attempts to categorize these secret kickback payments as flat-dollar payments, the payments are, in fact, calculated based upon the assets the mutual funds maintain under management [multiplied by designated basis point (bp) amounts], including the plans’ assets invested in the mutual funds, and are offset by the amount, if any, of revenue sharing payments generated by the assets for which Fidelity provides recordkeeping and related services,” the lawsuit says. It alleges that these payments clearly constitute indirect compensation that Fidelity is required to disclose to the plans under ERISA Section 408(b)(2), but Fidelity does not disclose them. According to the complaint, the payments amount to at least tens of millions of dollars per annum, and likely in the hundreds of millions of dollars per annum, to the plans. It also accuses Fidelity of forbidding the mutual funds from disclosing the amount of these payments, despite their legal obligation to do so.

The lawsuit says the payments have the effect of increasing the expense ratios and/or other expenses of the mutual funds, which are deducted directly from the assets of the plans and their participants. It adds that Fidelity is a fiduciary under ERISA by virtue of its discretion and exercise of discretion in negotiating/establishing its own compensation by and through its setting of the amount and receipt of the payments. 

“While the kickbacks are internally described by Fidelity as ‘infrastructure payments’ and reimbursement for expenses incurred in providing services for, to, or on behalf of the mutual funds, and deceptively characterized as such to retirement plans and their participants … the amounts of these kickbacks bear absolutely no relationship to the cost or value of any such services and, instead, plainly are a replacement for declining amounts of revenue sharing payments received by Fidelity as a result of the increasing use of passive mutual funds, institutional and R6 share classes of mutual funds and collective trusts, which pay little or nothing in the way of [revenue sharing],” the complaint says. The court document explains that Fidelity also reserves the right to increase the amount of the kickbacks and to impose them upon mutual funds at its discretion. “Fidelity occupies a conflicted position whereby it effectively operates a system in which it is motivated to increase the amount of such payments, while improperly incentivizing the mutual funds to provide [revenue sharing payments] to Fidelity and/or to conceal the true nature of fees associated with these funds, and requiring the plans and/or participants who invest in mutual funds and similar investments to unwittingly incur and pay undisclosed fees for the services provided to them.”

The plaintiff argues that the services provided by Fidelity that may incidentally benefit mutual funds are actually services that Fidelity has historically provided to its retirement plan customers as a necessary part of its business in return for fees directly collected by it from such customers, and these fees generally do not change as a result of Fidelity’s receipt of the kickbacks from the mutual funds and are not reduced in a manner that corresponds with the amount of the kickback payments received.

“Fidelity’s receipt of the kickback payments at issue violates ERISA’s prohibited transaction and fiduciary duty rules and should not be countenanced since the receipt of such payments places Fidelity in a conflicted position in which the interests of its retirement plan customers can be and are sacrificed in the interest of Fidelity earning greater profits through the receipt of such payments,” the lawsuit contends.

It also charges Fidelity with engaging in acts of self-dealing with respect to the retirement assets of the plans, in violation of ERISA’s prohibited transaction and fiduciary duty provisions.