More On Legal & Compliancefrom The Advisor's Professional Library
- RIAs and Customer Identification Just as RIAs owe a duty to diligently protect their clients privacy and guard against theft, firms also play a vital role in customer identification. Although RIAs are not subject to an anti-money laundering rule, securities regulators expect advisors to address these issues in their policies and procedures.
- Dealings With Qualified Clients and Accredited Investors Depending upon an RIAs business model and investment strategies, it may be important to identify “qualified clients” and “accredited investors.” The Dodd-Frank Act authorized the SEC to change which clients are defined by those terms.
If you have any function with an employee benefit, retirement, profit sharing, 401(k), savings, health, or other type of plan, or if you serve such a plan as an RIA, you probably are a fiduciary. That means you could be held personally liable for any wrongful act, knowing or unknowing, direct or indirect, that happens to the plan under which you could be proven to be a fiduciary.
You cannot take this liability lightly. Court records show many cases where fiduciaries became personally liable, perhaps for acts of which they were unaware or in areas they did not know were within their responsibility. Thirty years after the Employee Retirement Income Security Act (ERISA) became law, there still exists a widespread lack of understanding about fiduciary liability. But not knowing your responsibilities is no defense: The fact that trustees may have acted with good intentions or in good faith is no defense if their conduct did not meet the objective standard. Moreover, the cost of your defense will probably be yours personally and will not be paid by either the plan or your company.
The good news is that this liability can be avoided by acting in a procedurally prudent manner. As a result, it's in your best interest to understand the laws that govern your behavior.
ERISA's prudence standard is largely procedural in nature. Most courts have considered such factors as who was acting in the plan's interests, what procedures were employed to investigate the proper course of action for the plan at the time the fiduciary decision was made, and whether and to what extent the fiduciary's actions were properly documented in determining whether a fiduciary breach occurred. Prudence is not limited to plan investment matters. It is also relevant in judging a number of other fiduciary actions, including plan administration, which includes the selection and monitoring of service providers.
Given ERISA's prudent expert rule, many plan trustees regularly consult with expert advisors. Courts have frequently held that such consultation with expert advisors is evidence of prudent behavior.
With regard to investments, ERISA does not create a legal list of permissible plan investments. But the prudence of a particular plan investment should be viewed in relation to how that investment fits within the plan's overall portfolio. In general, just because a plan investment results in losses does not mean that a fiduciary has breached her fiduciary duty if she can demonstrate that she followed a prudent course of conduct at the time the investment decision was made. However, a fiduciary can be held liable for a breach of fiduciary duty even though the plan has not suffered a loss. This could include poor investment performance due to an overly conservative investment policy, especially in the case of defined contribution plans.
While ERISA's basic fiduciary standards apply uniformly to both defined benefit and defined contribution plans, there are practical differences between the nature and the potential for ERISA-related litigation. In the case of defined benefit plans, participants are promised a stated benefit and the plan sponsor has the obligation to make the contributions necessary to meet the promised benefits. In addition, benefits under most private sector defined benefit plans are guaranteed by the Pension Benefit Guaranty Corporation (PBGC) up to stated limits. As a result, in defined benefit plans, the risk of related investment performance is borne by plan sponsors and, in certain cases, the PBGC.
However, defined contribution plan participants and beneficiaries will only receive the balance in their individual accounts. Individuals' accounts are calculated as the sum of applicable employer contributions, forfeitures, and investment experience, less any related administrative expenses assumed by the plan. Benefits under defined contribution plans are not insured by the PBGC. As a result, in defined contribution plans, plan participants and beneficiaries bear the risk of related investment performance. Some defined contribution plans allow participants to decide how all or a portion of their account balance will be invested; these are known as "participant-directed individual account plans." Indeed, in reaction to the fear of liability, most companies have adopted participant-directed 401(k) plans over the past 20 years. The goal of the plan sponsors in adopting these plans is that the investment decision and liability are shifted to plan participants. However, many plan sponsors are discovering that they still haven't avoided their responsibility to prudently manage the process under ERISA. In this area, ERISA does provide two methods for further reducing liability for fiduciaries of participant-directed defined contribution plans.
Given the above scenarios, the relative risks of fiduciary litigation are greater in the case of defined contribution plans as opposed to defined benefit plans, especially with regard to participant-initiated lawsuits. For example, several large class action fiduciary suits by employees of Enron, AOL, and other corporations have been initiated by plan participants recently in connection with investment losses and overly conservative asset allocations (see Table I: Litigious Times, below).
Preponderance of Evidence
Unlike in criminal litigation where the government always has the burden of proof, in civil litigation the burden of proof may lie with the defendant. This means that to win, the defendant fiduciary must prove that the plaintiff's claims are not true.
Under the new ERISA 404(c) regulations, the plan sponsor has the burden of proof in any given case to show by a preponderance of evidence that it met the requirements necessary to achieve the protection provided by the regulation. In other words, a plan participant merely needs to allege that the plan failed to meet the criteria of the regulation and the sponsor will be presumed not to have done so. The plan sponsor must then prove to a court that in fact the regulation was satisfied.
When Congress created the authorizing legislation for 401(k) plans in 1978, neither the Internal Revenue Service nor the Department of Labor predicted that these vehicles would become the dominant retirement plan vehicle of the 1990s. Both agencies have regulatory authority over qualified plans. Then in 1991, the IRS issued its final regulations governing 401(k) plans. At the same time, the Labor Department issued its final regulations applicable to participant-directed plans under section 404(c) of ERISA. These regulations, which govern the investment and communication component of 401(k) plans, have changed forever the landscape of the 401(k) plan business.
The regulations provide a framework for plan fiduciaries to insulate themselves from the results of their participants' investment decisions in participant-directed plans. Only through compliance with the regulations can a plan fiduciary hope to be protected from responsibility for participants' investment decisions (see Table 2: ERISA Milestones, at bottom).
ERISA's Definition of Fiduciary
You must make sure that you understand the basics of the law, follow a procedure, and document your investment process. The scope of fiduciary responsibility is much wider than generally recognized because the ERISA definition of fiduciary is so broad. To be considered a fiduciary, one must only have an element of authority or control over the plan, including plan management, administration, or disposition of assets. The definition also includes any person who renders investment advice to a plan for a fee.
To the extent that plan sponsors influence or maintain discretionary authority over plan management or its investments, they are also considered to be fiduciaries. Corporate officers, directors, and some shareholders often exert enough control also to be deemed fiduciaries. Investment consultants and advisors are fiduciaries if they provide advice on the value and advisability of owning investments or if they have the discretionary authority to purchase or sell investments with plan assets. However, if trustees or named fiduciaries properly select and appoint a qualified money manager, they will not have a co-fiduciary responsibility for acts and omissions of the investment advisor unless they knowingly participate in or try to conceal any such acts or omissions.
The key to understanding this legislation is to realize the government's interest is in protecting the participant, not the fiduciary or plan sponsor. Virtually every time a conflict arises between the interests of the participant and those of the sponsor, legislation favors the participant.
Proper Conduct for Fiduciaries
ERISA holds fiduciaries to as high a standard as that of a professional money manager or investment expert in making investment decisions. A good argument can be made that professional money managers, investment advisors, banks, and trust companies (which serve as qualified plan fiduciaries) hold themselves out to be experts, and are, therefore, subject to ERISA's prudent expert rule. This is apparent from the case law.
ERISA does recognize degrees of professionalism, depending on the size of the plan's assets. For example, an unpaid fiduciary of a plan with a small amount of assets is, arguably, judged differently from a plan with a large amount of assets. Therefore, if the size and nature of the plan would indicate the need for an experienced manager, the fiduciary should not be heard to plead his lack of expertise after his investments go sour. The fiduciary is required to at least be familiar with pension investment management or seek help from a qualified professional.
Any fiduciary that breaches ERISA's fiduciary obligations can be held personally liable for losses caused by the breach of duty. As discussed earlier, the definition of a fiduciary is broad and the responsibilities are not mitigated by simply delegating fiduciary duties.
Moreover, fiduciaries may be personally liable if they know, or should have known, of a breach by another fiduciary. Pleading ignorance, bad communications, or inexperience will not be an adequate legal defense. Delegation to prudent experts and the proper oversight of them are the only defenses upon which a fiduciary can rely.
ERISA makes no provision for punitive damages. But it does provide for the assessment of a penalty against a fiduciary of 20% of lost profits or any amount recovered as a result of an ERISA violation. According to ERISA Sec. 409(a), "Any person who is a fiduciary with respect to a plan who breaches any of the responsibilities, obligations, or duties imposed upon fiduciaries by this title shall be personally liable to make good to such plan any profits of such fiduciary which have been made through use of assets of the plan by the fiduciary, and shall be subject to such other equitable or remedial relief as the court may deem appropriate, including removal of such fiduciary."
Penalties may be imposed for up to six years after the fiduciary violation, or three years after the party bringing suit had knowledge of the breach. A willful violation carries personal criminal penalties of up to $5,000 ($100,000 for corporations) and up to one year in prison.
In addition, losses to the plan, as well as profits made from the improper use of plan assets, must be restored to the plan. Failure to disclose information to plan participants can result in daily monetary penalties. The Department of Labor can also remove the fiduciary and take control over plan assets.
Civil actions can be initiated by plan participants, beneficiaries, other fiduciaries, or the Labor Department. As participants become more knowledgeable about their rights--and sophisticated about investment alternatives--lawsuits will undoubtedly increase.
Prudent Investment Procedures
The General Standard of Prudent Investment Procedures was originally formulated as a general statement that would allow fiduciaries the flexibility appropriate to particular circumstances. This standard requires that reasonable care, skill, and caution be applied to investments, not in isolation, but in the context of the total portfolio and as a part of an overall investment strategy that should incorporate risk and return objectives reasonably suitable to the trust. In essence, the fiduciary must conform to fundamental fiduciary duties of loyalty and impartiality; act with prudence in deciding whether and how to delegate authority and in the selection and supervision of agents; and incur only costs that are reasonable in amount and appropriate to the investment responsibilities of the trusteeship.
These are the steps that must be taken by a fiduciary that invests plan assets:
1. The qualified plan must establish a written investment policy and the policy must be followed (ERISA Sections 402(b)(1) and 404(A)(1)(D)).
2. The qualified plan assets must be diversified, unless under the circumstances it is clearly not prudent to do so (ERISA Section 404(a)(1)(C)).
3. Qualified plan investments must be made according to ERISA "Prudent Man" requirements (ERISA Section 404(a)(1)(B)).
4. The performance of qualified plan investments must be monitored and reviewed. ERISA Section 405(a) provides that a fiduciary may be held personally liable to the plan for all losses. Arguably, the review should be more frequent than once every three- to five-year market cycle.
5. Qualified plan investment expenses must be reasonable (ERISA Section 404(a)).
6. A qualified plan investment must not result in a direct or indirect prohibited transaction (ERISA Section 406).
Each fiduciary must assume that his investment decisions will be examined in detail in the future. Documentation is critical and spans a wide array of both internal and external reporting requirements. Internal record-keeping functions require building an audit file that can be produced and reviewed quickly to verify compliance. External reports are required to satisfy plan participants and regulatory authorities.
Planners should familiarize themselves with the five main duties of fiduciary responsibility:
Loyalty. ERISA requires fiduciaries of retirement plans to make decisions based solely on the best interests of plan participants. As long as the fiduciary can demonstrate through documentation that the employees' best interests were considered, a decision resulting in a loss to the participant doesn't necessarily mean that the fiduciary is in violation of ERISA. The main issue at the basis of the Act is whether the fiduciary acted in a procedurally prudent manner.
Diversification. According to ERISA Section 404(a)(1)(C), a qualified plan must offer a diversified investment menu that allows participants to minimize the risk of long-term losses. Fiduciaries must display a knowledge of the investment marketplace; this means they will be held to an expert standard. In areas where they may be deficient, fiduciaries are expected to consult with or even hire financial experts to help them conduct a thorough analysis of their plan investment offerings. These experts can then alert the fiduciaries to add certain asset classes or demonstrate that it is prudent not to have those asset classes. For example, one of the issues in recent fiduciary actions involving Enron and WorldCom is whether there was adequate diversification away from the company stock that was so prevalent in the plans, and whether there was excessive encouragement by fiduciaries to invest in these shares. In light of these current events, advisors and fiduciaries should exercise caution and greater diligence when there is a high concentration of company stock inside company-sponsored 401(k)s.
Management of Expenses. It is incumbent upon the fiduciary to know and understand all expenses of the plan and to make sure that the expenses are reasonable when compared with the market. An annual review of outside, objective benchmarking studies can provide a comparison with similar plans and relevant demographics. There are many comparative studies by various groups, including the Employee Benefit Research Institute and the Department of Labor, for guidance on the expense issue.
Determining whether expenses are reasonable does not mean that the expenses have to be the lowest, nor are fiduciaries automatically safe if their expenses are the lowest. However, if the costs are higher than the benchmark, the fiduciary should document why. It could be because of the geographic diversity of the group; it could be because the managers are particularly expensive because of their superior performance; or it could be some additional benefit. These are all adequate reasons.
Monitoring and Oversight. While fiduciaries can delegate or shift responsibility for managing the retirement plan's money to someone who is better qualified, they cannot delegate their duty to monitor the managers in a well-defined, consistent manner to ensure compliance with agreed-upon tasks, consistency of style, performance against benchmarks, and any significant changes.
To be diligent, fiduciaries should ask specific questions of their money managers every year, including:
Did you file the annual disclosure with the SEC?
How many employee-participants and managers did you lose?
Did you commit any fraud?
Even if the managers lie about their answers or commit grievous errors, the fiduciaries are protected because they reviewed the materials, monitored the activities the best that they could, and documented the results.
Avoidance of Prohibited Transactions. Prudent management and oversight of the plan includes safeguarding against activities that constitute a conflict of interest. Such activities might include the direct or indirect sale, exchange, or leasing of property; lending money or other extension of credit; and furnishing of goods, services, or facilities.
Advisors and trustees should familiarize themselves with modern investment theory practices, which are likely to become increasingly important because of their contribution to investment performance. In addition, these investments measure their ability to present objective numerical guidelines for trustees' examination and as responses for any subsequent litigation.
The extensive references to modern investment theory concepts in the Restatement of Law Third (which modernizes traditional fiduciary common law principles to incorporate the investment concepts of Modern Portfolio Theory), and the growing use of these practices, suggest that their use by the investment decision-maker would be extremely desirable. Consequently, there will be greater use of professional advisors who employ modern investment theory concepts and increased use of no-load mutual funds. Trustees who are now held to a higher standard will establish more rigorous selection and review procedures that can improve investment performance and decrease vulnerability to litigation.
As Congress seeks to help retirement plan participants, it is likely that financial advisors will play a bigger role in providing guidance and advice to these participants. With this expanded marketplace come new opportunities to work with more participants and plan sponsors. Advisors will thus find themselves assuming the role of fiduciary more often. It is therefore even more critical that advisors understand their liabilities and responsibilities under ERISA.
Ken Ziesenheim, JD, LLM, CFP, is president of Thornburg Securities and managing director of Thornburg Investment Management in Santa Fe. He can be reached at firstname.lastname@example.org. This is an excerpt from Ziesenheim's Understanding ERISA: A Compact Guide to the Landmark Act (Marketplace Books, 2004).