WASHINGTON, D.C. - Two class action suits involving the use of proprietary funds with in-house pension plans have opened the door for class action lawyers who are likely to go after other mutual fund companies, according to industry lawyers.

A class action suit filed against First Union of Richmond, Va. in Sept. 1999, was settled last month for a total of $26 million. Judge Richard Williams of the U.S. District Court for the Eastern District of Virginia gave preliminary approval to the settlement on March 22. The final hearing on the fairness of the settlement is scheduled for June. Another class action suit, brought against New York Life Insurance Company, was filed last June. (MFMN 6/26/00) That case is still in the early stages of discovery and no trial date has been set.

The two complaints allege similar misconduct. First Union used its Evergreen Funds and New York Life used its MainStay Funds in their own employees' pension plans, a relatively common practice, according to Gary Tell, special counsel specializing in employee benefits at O'Melveny & Myers of Washington, D.C. Tell, who was formerly with the U.S. Department of Labor where he handled ERISA litigation, recently spoke here at a conference on retirement plans sponsored by the Investment Company Institute of Washington, D.C.

ERISA, the Employee Retirement Income Securities Act of 1974, allows companies to use their own mutual funds with their in-house retirement plans, according to Sherwin Kaplan, of counsel at Piper Marbury Rudnick & Wolfe of Washington, D.C., who also spoke at the ICI conference. However, certain conditions of fairness must be met, he said. Kaplan was also formerly with the Department of Labor. The plaintiffs in the First Union and New York Life suits allege that the companies used the in-house plans as seed money to increase the size of their mutual funds to attract new investors, according to the complaints. New York Life's in-house plans make up 56 percent of the $4.5 billion in its funds, according to Tell.

The companies also placed the retirement savings in funds with especially high fees without seeking alternative investment options, according to the complaint. Furthermore, neither company conducted a prudent investigation with regard to their misconduct, the complaints say.

"The worst aspect of the First Union settlement is that it will probably be the declaration of open season by class action lawyers on many, many more proprietary funds," said Kaplan. Class action lawyers, upon hearing of these cases and their outcomes, will scrutinize mutual fund companies and their use of their own funds with retirement plans, and attack them with class action suits if there is any sign of fraud, according to Tell and Kaplan. These cases are even more dangerous than other types of class action suits because they involve a company's own employees, according to Michael Sjogren, first vice president and assistant general counsel at Merrill Lynch of New York.

"From some experiences, you need to remember that the decision you make in the context of considering a current transaction might not look so good when a class action lawyer is out there stirring up adverse publicity among your employees," said Sjogren at the conference. "This type of transaction can be very detrimental to your health because you're dealing with your own employees. It's not that you've got some client who feels [injured] and wants to come after you for some money. This is a class action lawyer going around your employees and stirring up things that were perfectly sound business decisions. You really need to think carefully how they're going to look in the aftermath ... I have a personal fear that this is a great road for class action suits."

The recent increase in consolidations among financial institutions is another reason class action cases of this nature can generate many more, according to Thomas Kim, assistant counsel at the ICI.

"One of the reasons for that is one of the things plaintiffs' lawyers need is either disgruntled employees or ex-employees," said Kaplan. "They need members of the class and [one of the] things that do tend to cause a lot of unrest and dissatisfaction are mergers." A lot of anxiety is created among the employees of the company that sees itself as the weaker entity in the merger, he said. A rapidly declining market also makes employees more open to suing.

In the First Union case, plaintiffs demanded total damages of $450 million, Tell said. Of the $26 million settlement, $8 million is going to the plaintiffs' lawyers, Kaplan and Tell said.

"I guarantee that every plaintiffs' class action lawyer in the country has now got money signs in their eyes because of that settlement," said Kaplan.

Those lawyers may be a greater threat to mutual fund companies than the Department of Labor, at least in this area of litigation, according to Tell.

"We think the real fear is not from the Department of Labor from the enforcement standpoint, but it is class action lawyers," he said. "There is a growing, more aggressive class action litigation bar, focusing on ERISA and looking at big targets like financial institutions, mutual funds, and the like. It's my sense from Department of Labor folks that this occurrence of class action litigation focusing on this topic is not a bad development, and its going to force mutual funds to clean up treatment of their own employees."

The issues involved with these cases satisfy the needs of class action lawyers more than that of the Department, said Kaplan. In the area of pension legislation, the Department tends to pursue much smaller matters, such as a small employer not forwarding 401(k) contributions, he said.

"The truth of the matter is, with these kinds of issues, the Department of Labor has been a non-player and will probably continue to be a non-player," said Kaplan. "The litigation that will be affecting people running mutual funds will be class action litigation, not D.O.L. litigation."

To avoid this type of litigation, companies should be careful when using their own funds, according to Kaplan. Companies need to follow a procedure so that it can be determined if the funds are diversified adequately and the fees are reasonable, he said. In doing so, it is critical that companies continuously document the decisions it makes in selecting funds for the plans. Companies should adopt procedures so that if there is any reason for not using its own funds, it becomes immediately apparent internally, he said.

It is not enough, however, to simply have a sound process in place, according to Sjogren. Companies must strictly comply with their internal guidelines because any internal discrepancies between what a company says it will do and what it actually does is exactly the kind of thing class action lawyers look for, he said.

"These are land mine areas to be careful about," said Kaplan. "The real point to take away from this is not where the fine line is drawn because it's a constantly changing line. The point to bear in mind is that [these] are cutting edge issues, and you don't want to be the test case."

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