Under Cover

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.