In a decision bringing together the two opposing judges in the closely watched fee challenge under Section 36(b) of the Investment Company Act of 1940, Jones v. Harris Associates, the U.S. Court of Appeals for the Seventh Circuit held on September 7 that fiduciaries of a 401(k) plan – even one with over $1 billion in assets – did not breach ERISA fiduciary obligations by including retail mutual funds as investment options.
In Loomis v. Exelon, Chief Judge Easterbrook, joined by Circuit Judges Posner and Tinder, affirmed dismissal of a challenge under ERISA to the fees paid by Exelon’s 401(k) plan. The plan contained 32 investment options, 24 of which were no-load “retail” mutual funds. The expense ratios of the 32 investment options available under the plan ranged from three to 96 basis points. Following its earlier decision in Hecker v. Deere & Co., 556 F.3d 575 (7th Cir. 2009), the court held that a plan fiduciary does not breach its duties by offering this range of investment options.
Notably, the court expanded upon its rationale in Deere by offering further justification for the inclusion of retail mutual funds in a 401(k) investment line-up. It explained that retail fees are set in a competitive market, giving participants the benefit of such price competition. It cited economic literature demonstrating that advertising promotes competition and further drives down fees. The court rejected the plaintiffs’ analogy to a rental car company that receives a “fleet discount” by purchasing cars en masse – instead, in a 401(k) line-up where participants are allowed to direct their own investments, a plan fiduciary does not have the same bargaining power as it cannot guarantee that retirement funds will be invested en masse into any specific investment. Moreover, the court explained that investment options still have to account for retail-like transactions within a 401(k) plan. The panel also identified differences between mutual funds and commingled pools, including liquidity and mark-to-market benchmarks.
Not only did the Seventh Circuit panel identify advantages to retail mutual funds, but the court additionally rejected the participants’ argument that a per capita fee structure would represent a gain for the participants. The court explained that such a structure might represent higher fees for “younger employees and others with small investment balances.” The panel also held that even if a fee restructuring would be beneficial, it could not be achieved given the regulation of mutual funds under the federal securities laws, including the Investment Company Act of 1940, and could run afoul of the tax rule against preferential dividends, 26 U.S.C. § 562(c).1
In addition to rejecting the participants’ arguments as to the central issue of whether the fees were excessive, the court also rejected participants’ argument that the employer, rather than the participants, should be required to bear those fees. The court held that payment of fees for plan services was a question of plan design, and thus was not susceptible to challenge as a breach of fiduciary duty as employers may act in their own interest in designing a plan.
 The panel did not address the impact of Section 307 of the Regulated Investment Company Modernization Act of 2010 (Pub. L. No. 111-325), which repealed the preferential dividend rule for publicly offered funds effective after December 22, 2010.