A federal judge in Philadelphia has rebuffed a petition by Vanguard Group to dismiss a lawsuit by retail investors who say the company's changing of its target-date policy caused them to incur unwanted capital gains taxes.
"We hold that the investors have standing and state a plausible claim for breach of the fiduciary duty of care," U.S. District Court Judge John F. Murphy wrote on Nov. 20.
The plaintiffs sued in March 2022, saying Vanguard's changing its fee-schedule for institutional priced shares for a target-date fund to $5 million from $100 million could harm retail investors in taxable accounts.
The lawsuit accuses Vanguard and corporate officers of, among other things, gross negligence, breach of fiduciary duty, unjust enrichment and breach of good faith and fair dealing.
Vanguard announced cutting the fees in December 2020.
The fee-schedule change affected a target-date series marketed to individuals as well as to retirement plans with less than $100 million in assets. Retirement plans with at least $5 million in assets were eligible.
This meant the smaller retirement plans that had invested in the retail-priced funds "could sell their shares and move over to cheaper, but otherwise identical, institutional funds," said the original complaint now known as In Re: Vanguard Chester Funds Litigation. "If there is a massive sell-off of assets in their target date fund, this results in massive tax bills," the compliant noted.
Vanguard's target-date funds are organized as Vanguard Chester Funds, a Delaware statutory trust, the lawsuit said.
Vanguard's policy change led to at least 8,500 small 401(k) plans with 3.2 million participants to move from offering retail-priced shares to offering institutional shares, the district court judge wrote.
Plans redeemed 490 million shares leading to an "unprecedented sales of assets (that) generated capital gains," the judge wrote. "The mass share redemption caused a sharp spike in capital gains distributions."
The policy didn't affect participants who kept their money in a 401(k) plan.
"The Retail Fund shareholders that did not elect for a tax-advantaged account faced unexpected, sizable capital gains tax liabilities," the judge wrote.
"Some Retail Fund shareholders had to sell off other assets to cover the surprise tax bills," he added. "Other shareholders faced IRS and state law penalties for failing to pay the amount owed in capital gains taxes."
Vanguard subsequently merged its retail and institutional shares offering a tax-free exchange of retail shares to institutional shares. However, "some investors felt that the damage had already been done," the judge wrote.
The judge dismissed some of the plaintiffs' arguments, but he allowed the claim of fiduciary breach relating to duty of care against Vanguard's officers and the company's independent trustees to go to trial. He also allowed the claim of breach of covenant and good faith and fair dealing against the independent trustees to proceed to trial.
He also ruled that plaintiffs had presented sufficient information to show Vanguard's action may have violated state consumer protection laws in Colorado, Illinois and Massachusetts. He dismissed a similar claim involving California's consumer protection law.
