First Union Corporation, the nation’s sixth-largest bank, is the target of two lawsuits over the use of its proprietary mutual funds as investment options for its 401(k) plan. A May 1999 suit was filed on behalf of former employees of Signet Banking Corporation, which was acquired by First Union in 1997, and a September 1999 suit was filed on behalf of First Union employees generally. The lawsuits allege violations of the fiduciary responsibility rules of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), as well as other laws that may apply.

Because these lawsuits are still in their early stages and the record is not well developed, it is too early to predict the outcome of the litigation or assess the validity of the plaintiffs’ allegations, which First Union is vigorously contesting. However, these suits do raise a number of issues for financial institutions that use proprietary funds as investment options for their in-house plans, as well as for companies transferring plan investments as part of a 401(k) plan merger.

The first suit was filed on May 5, 1999, in the U.S. District Court for the Eastern District of Virginia in Richmond. It was brought on behalf of about 5,000 former Signet employees against First Union and its Savings Plan Administration Committee in connection with the shifting of investments from Signet’s 401(k) plan into First Union mutual funds when the Signet plan was merged with the First Union plan. The plaintiffs allege violations of the ERISA fiduciary duties of loyalty and prudence, as well as prohibited transactions.

The second complaint was filed on September 7, 1999, in the same court by most of the same lead plaintiffs. It broadens the earlier claims to allege ERISA violations in the use of First Union mutual funds and other First Union services by the First Union 401(k) plan. Specifically, it alleges ERISA violations in the receipt of fees by First Union (and its affiliates) from these mutual funds, from a First Union collective investment fund used by the plan, from the plan’s employer securities investment option, and in First Union’s role as recordkeeper and trustee of the plan. In addition, the plaintiffs allege that First Union’s conduct violated the Racketeer Influenced and Corrupt Organizations Act (commonly known as "RICO") and the Bank Holding Company Act.

Damages in each suit are alleged to be at least $100 million, based on lost investment gains and the fees received by First Union from the plan and plan investments.

The general allegation raised in both suits is that First Union imposed its proprietary funds as investment options on its 401(k) plan solely to increase First Union’s income, rather than in the interests of the plan participants. According to the plaintiffs, First Union engaged in the practice over several years of using the assets in its own 401(k) plan to jump-start its 401(k) business. It did this by having those assets "seed" new mutual funds (i.e., to provide sufficient money to get the funds started and attract investments from outside 401(k) plans and retail investors), in part through the conversion and transfer of assets from First Union collective investment funds, and by retaining itself as trustee and recordkeeper for its plan. These steps were allegedly taken without regard to fund performance or the quality of services. The plaintiffs alleged that First Union had no previous experience as a 401(k) plan trustee or recordkeeper, and that the investment performance of the First Union mutual funds was consistently below that of outside mutual funds over a six-year period.

The plaintiffs also claim that First Union did not permit its plan to use outside or low-cost investment options and services, and imposed what the plaintiffs describe as unreasonable and excessive fees for the investment options and services that First Union provided. They add that if an independent fiduciary had been deciding which funds to use as 401(k) plan investment options, that fiduciary would have selected funds that were "better performing" and "less expensive" than the First Union funds.

The suits also raise the issue of the use of the First Union funds as replacement investment options for plans that were merged into the First Union 401(k) plan. While this conduct allegedly involves the same subordination of the plan participants’ interests, it implicates additional fiduciary responsibility issues.

These issues are highlighted in the Signet complaint. According to the plaintiffs, the decision to transfer the Signet plan investments to the First Union funds was made without any inquiry into whether to retain the non-proprietary funds used by the Signet plan, and without regard to whether those funds were being "mapped" into comparable funds. They allege that those non-proprietary investment options significantly outperformed the First Union funds that replaced them following the plan merger. The September 1999 complaint expands these claims beyond the Signet merger by alleging that First Union engaged in a general practice of transferring the funds of plans of acquired banks into First Union funds without proper investigation or due diligence, to serve its own business interests.

In the Signet lawsuit, the plaintiffs also are challenging the entire "mapping" process, including the eight-week "blackout" period during which participant direction was suspended, as violating the Signet plan provisions on participant direction, since the asset transfers were not authorized by the plan participants.

The plaintiffs allege that First Union provided misleading and false communications to plan participants concerning the proprietary funds being used as plan investment options, particularly with regard to fees. They state that some of the fund descriptions indicated that the associated fees and expenses would be picked up by First Union when that was not in fact the case; other fund descriptions failed to disclose that fees were being charged. The Signet lawsuit claims that the Signet plan participants received inadequate notice of the changes being made to their plan and their right to opt out by having their accounts distributed and rolled over into individual retirement accounts.

The lawsuits provide an opportunity for banks that provide services and products to their in-house employee benefit plans to review their records and documentation of the decisions to enter into these relationships in light of the issues being raised.

The principal issue raised by the lawsuits for plan sponsors using proprietary funds in their 401(k) plans is whether they can demonstrate that the proprietary funds were selected prudently and in the interests of the plan participants and beneficiaries, as opposed to being selected for the purpose of promoting business and generating fees for the plan sponsor. While investments in proprietary funds by in-house plans are covered by PTE 77-3, a class exemption from the ERISA prohibited transaction rules, PTE 77-3 does not provide any exemption from the ERISA fiduciary duties of loyalty and prudence, and may not even extend to the type of conduct alleged in the First Union cases. As the Department of Labor cautioned in a recent advisory opinion interpreting PTE 77-3 (Advisory Opinion 98-06A):

To protect against such allegations, financial institutions using proprietary funds as investment options for their in-house plans should make sure that they have procedures in place to evaluate the use of those funds, both initially and on an ongoing basis, and that those procedures are consistently followed. There also should be a process in place to determine what action should be taken in the event of poor performance. Compliance with these processes and procedures on an ongoing basis should be documented, and such documents should be preserved in anticipation of possible lawsuits.

Furthermore, participant communications should not be overlooked. Plan participants should be provided with complete and accurate information regarding the funds and any associated fees and notified of any material changes, particularly if the plan sponsor is attempting to comply with the section 404(c) exception from the fiduciary responsibility rules. The communications should note that the participants have no vested right to any particular investment option, and that these options can be modified without participant consent (an issue in the Signet case).

The plan merger issues raised in the Signet case also are worth noting. The process used, imposing a blackout period while mapping investments into generally comparable funds in the merged plan, is fairly typical for such transactions. Findings adverse to First Union on whether plan participant authorizations were needed to terminate and transfer their investments from the Signet plan funds, or on the use of a blackout period, could have implications for a number of other companies.