401(k) 'kickback' suit against Fidelity booted from court

Fidelity Investments has won a legal challenge to its practice of collecting shelf-space payments from third-party mutual funds used in its retirement plan record-keeping business.

The company negotiated such payments with fund providers on its FundsNetwork system in 2017, applying the fees if the revenue-sharing it receives from funds are below a certain threshold.

Participants in several retirement plans sued the company a year ago, calling the charges “secret payments” or “kickbacks,” and alleging that the practice violated the Employee Retirement Income Security Act.

The company has defended the arrangement to charge “infrastructure fees” as legal, stating that it is all but necessary, given the thin margins in the defined-contribution record-keeping business. Per-participant record-keeping fees have fallen over the past decade, and many plans have shifted to revenue-sharing-free share classes of funds, largely due to fiduciary and liability concerns.

Between Jan. 1, 2017 and Jan. 1, 2019, Fidelity “tripled the amount of infrastructure fees charged to mutual funds,” court records state.

“The mutual fund companies pass on the additional costs of the infrastructure fees to the plans through their investment fees, with the result that the plans and their participants ultimately pay more (via higher expense ratios) than they agreed to pay in the contracts,” the plaintiffs stated. They also alleged that Fidelity does not properly disclose the arrangement to participants.

Last Friday, a federal judge dismissed the case, finding that the plaintiffs failed to show that Fidelity had acted in a fiduciary capacity in setting the fees it charges fund providers. Additionally, Fidelity was not liable as a party-in-interest in a nonfiduciary capacity, Judge Leo Sorokin wrote in his order granting the record keeper’s motion to dismiss.

The decision is likely to be appealed. But it is meaningful for record keepers that have started charging fund companies for shelf space. Other large defined-contribution plan providers, such as Empower Retirement, now do so.

It is not clear whether the plaintiffs will appeal. A law firm representing the plaintiffs did not immediately respond to a request for comment.

“Since this suit was first filed, Fidelity has been firm in its conviction that the court would see the factual and legal flaw in the allegations and dismiss them,” a company spokesman said in a statement, adding that the firm makes all disclosures required by ERISA. “We take our responsibilities as a record keeper seriously and any claims that are contrary and question our integrity in providing the best services possible for our 401(k) retirement plan sponsors and participants are simply wrong.”

Participants in T-Mobile’s 401(k) plan filed class-action claims against Fidelity in U.S. District Court in Massachusetts, and several cases were combined last year.

The court’s order to dismiss the case “does not have the weight of a Court of Appeals decision that addresses the issue of whether an entity is acting as a functional fiduciary,” Marcia Wagner, founder of The Wagner Law Group, said in an email. “The decision does not break any new ground: It acknowledges that Fidelity would be a fiduciary if it had discretion unilaterally to modify its compensation, but the court concluded that under the terms of the relevant agreements, Fidelity did not have such discretion.”

However, Ms. Wagner said, “It might appear that Fidelity is complying with the letter of the law, rather than the spirit of the law, and it is possible that another district court addressing this Fidelity structure would reach a different conclusion.”

In determining that Fidelity was not shown to be a fiduciary to the plans in question, the judge noted that the company does not have full control over the fees because it negotiates with fund providers. Further, he wrote, the plaintiffs could not prove that fund managers passed higher fees along to plan participants. And Fidelity was not a fiduciary in its decision to add or remove funds from its FundsNetwork because plan sponsors are ultimately responsible for choosing which products end up on plan menus, according to the order.

“Selecting the funds available on the FundsNetwork Platform does not, without more, transform Fidelity into a fiduciary,” Mr. Sorokin wrote.