Employee Relations. Are You in Good Hands? Why Employers Should Carefully Read Their Fiduciary Liability Insurance Policies

Transcription

1 VOL. 33, NO. 3 WINTER 2007 Employee Relations L A W J O U R N A L ERISA Litigation Are You in Good Hands? Why Employers Should Carefully Read Their Fiduciary Liability Insurance Policies Craig C. Martin and William L. Scogland The downside of the fabulous rewards gained from service as fiduciary of an employee benefit plan is certainly the potential liability fiduciaries face with each plan decision they make. Even the best-intentioned fiduciaries are subject to personal liability if a court determines they failed to act prudently. Even in ERISA cases that are not ultimately tried, the settlements particularly for employer stock drop class actions can run into the tens of millions of dollars. Settlements or verdicts are on top of the attorneys fees that must be paid to defend against even meritless claims. Considering this potential liability, the doughnuts at benefit committee meetings appear much less worth it. How can fiduciaries protect themselves? ERISA expressly voids agreements purporting to relieve fiduciaries of responsibilities or liabilities that ERISA imposes. 1 However, under ERISA, plans, fiduciaries, or employers may purchase insurance to cover plan fiduciaries potential liabilities. 2 Director and officer (D&O) policies typically do not cover ERISA fiduciaries in that capacity. 3 Rather, ERISA fiduciaries must rely on fiduciary liability insurance policies. 4 Like all insurance, fiduciary liability insurance may not be fully appreciated until it is needed. When served with an ERISA complaint, it is comforting to know that insurance will cover a potential loss, as well as Craig C. Martin, a partner in Jenner & Block LLP s Chicago office, is chair of the firm s ERISA Litigation Practice. William L. Scogland, who also is a partner in the firm s Chicago office, is chair of the firm s Employee Benefits and Executive Compensation Practice and co-chair of the ERISA Litigation Practice. The authors, who wish to thank Douglas Sondgeroth, an associate at the firm, for his assistance on this column, can be reached at cmartin@ jenner.com and wscogland@jenner.com, respectively.

2 the legal defense costs. While these policies can soothe jangled nerves, fiduciaries should ask important questions about the policy, preferably before a potential claim arises. Collectively, the questions demonstrate that fiduciaries are well served by carefully reading their policies and effectively communicating with their insurers. Regardless of the ultimate outcome of the case, it is best if from the very beginning the insured and insurer are on the same page as to how the policy operates. Because trial and settlement strategies may differ depending on what insurance is available to cover defense costs or to indemnify any losses, fiduciaries should know early if they are in good hands when an ERISA action arises. What Law Governs? In evaluating a fiduciary policy, it is important to determine what law governs the policy. ERISA claims usually present exclusively federal issues, but it is state contract and insurance law that heavily dominates insurance coverage claims. Interpreting the policy is usually critical in coverage claims, and state law provides the interpretive principles for insurance policies. While many of the interpretation principles are common and somewhat similar in most states, their precise application varies depending on the state. Because claims for coverage arise under state law, federal court jurisdiction of such claims is usually based on diversity jurisdiction. 5 If the parties citizenship is not completely diverse, a federal court may dismiss the claim for lack of jurisdiction. 6 A particular wrinkle can arise if the benefit plan, which is a trust, is a party because, as the Seventh Circuit has explained, a trust s citizenship is based on its trustee s citizenship, not its principal place of business. 7 If having the coverage claim in federal court is important, care should be taken to determine if the trust is a necessary party to the action and if including it defeats diversity jurisdiction. 8 How Do the Duty to Defend and the Duty to Indemnify Differ? Who pays for the defense? and Who pays for a loss? are essential questions for insurance coverage in any lawsuit, especially an ERISA suit. The duty to defend addresses the first question, and the duty to indemnify addresses the second. As the Fourth Circuit has explained, the duty to defend is broader than the duty to indemnify. 9 Under the duty to defend, the insurer must defend the insured when a suit is filed, and the duty is triggered at the outset of the litigation if the policy potentially cover[s] the asserted claims. 10 The duty to indemnify arises only for losses incurred for a covered claim. 11 Insureds cannot obtain indemnification by arguing the Vol. 33, No. 3, Winter Employee Relations Law Journal

3 losses were caused by claims that were potentially related to a breach of fiduciary duty because the potentiality rule only applies to the duty to defend. Similarly, claims that are reasonably related to a breach of fiduciary duty may trigger the duty to defend, but the duty to indemnify arises for losses that the policy in fact covers. For example, in Perdue Farms Inc., v. Travelers Casualty & Surety Co., an insured had been sued for both violations of the Fair Labor Standards Act and ERISA. 12 Because at the outset of the litigation, the claims asserted were reasonably related to ERISA and potentially covered by the ERISA fiduciary policy, the court held that the insurer had a duty to defend the insured and could not recover defense costs it had already paid to the insured. However, because the ultimate settlement was clearly based predominantly on the FLSA claims and not ERISA fiduciary breaches, the insurer had no duty to indemnify the insured for portions of the settlement related to the non-covered FLSA claims. It is important to assess early whether the policy s indemnification provisions will likely cover the underlying ERISA claims. Because the duty to defend is broader than the duty to indemnify, the duty to defend is more likely to apply even if the indemnification provisions ultimately do not cover the underlying claims. But while the defense costs are important, knowing what portion of the possible loss may or may not be covered is crucial to the decision-making process. This underscores the importance of strong communication between insurers and insureds. It is best for the insured and insurer to be on the same page early as to what the policy does and does not cover. By working together and communicating early, insurers and insureds are better able to avoid misunderstandings that may later cause friction when the insured seeks indemnification under the policy. What Losses Does the Policy Cover? The crucial question, then, is what losses does the policy cover? Interpreting the policy is central to this question. In interpreting the policy, courts give words their ordinary meaning and attempt to determine the parties reasonable expectations by reading the policy as a whole. Insureds frequently remind courts that insurance policies must be interpreted against the insurer, but courts are quick to note that that principle applies only if the policy is ambiguous. 13 The principle also may not apply if the insured is a sophisticated business entity. 14 Considering the numerous fiduciary liability policies that exist, relatively few coverage claims have been litigated in either federal or state court. 15 In available cases where insureds do seek indemnification under a fiduciary policy, however, courts have often determined that no indemnification was available because the underlying ERISA claim was not a covered fiduciary breach claim. 16 Employee Relations Law Journal 3 Vol. 33, No. 3, Winter 2007

4 For example, courts have held that losses incurred because fiduciaries violated a contractual obligation to pay benefits under a benefit plan or ERISA itself are not covered losses because they were not incurred because of a breach of fiduciary duty. 17 In Pacific Insurance Co. v. Eaton Vance Management, the First Circuit denied coverage where the underlying ERISA action alleged that the trustees failed to pay participants amounts pursuant to obligations the plan s terms imposed. 18 While the trustees failure to fund the accounts at the time they should have been funded was perhaps a breach of fiduciary duty, the underlying obligation to fund the accounts in the first place and the loss the trustees sought to recover was incurred by reason of the plan and not by reason of a fiduciary breach, as the policy required. 19 In rejecting a claim for coverage in a similar case, the Seventh Circuit held that because a fiduciary liability policy excluded claims for benefits due under the plan terms, the policy did not cover losses caused by defendants failure to pay benefits in accordance with ERISA s terms. 20 Judge Posner rejected the heads I win, tails you lose position the insured advanced: It would be passing strange for an insurance company to insure a pension plan (and its sponsor) against an underpayment of benefits, not only because of the enormous and unpredictable liability to which a claim for benefits... could give rise, but also because of the acute moral hazard problem that such coverage would create. ( Moral hazard is the term used to denote the incentive that insurance can give an insured to increase the risky behavior covered by the insurance.) Such insurance would give the plan and its sponsor an incentive to adopt aggressive (just short of willful) interpretations of ERISA designed to minimize the benefits due, safe in the belief that... the insurance company would pick up the tab. 21 Of course, whether a loss is covered is ultimately determined by an interpretation of the policy. It is possible that the relevant policy actually covers contractual obligations under the plan or ERISA as well as fiduciary claims. The point is that care should be taken to determine if the policy covers only fiduciary breach claims, and if so, whether the potential loss in the underlying ERISA claim would arise from a breach of fiduciary duty or really from a contractual obligation to pay benefits. Consider the area of employer-stock drop litigation. A survey of settlements in this area reveals that tens of millions of dollars have been paid to settle these claims, often by insurers. 22 Recently some federal courts have decided that plaintiffs in stock-drop cases who are former employees have standing to sue because what they seek in these cases typically the value of what they claim their accounts would have been worth if the fiduciaries had not imprudently continued to allow investments in the employer s stock are benefits. 23 In future coverage disputes, insurers may attempt to argue that cases like Eaton Vance reflect that Vol. 33, No. 3, Winter Employee Relations Law Journal

5 a fiduciary liability policy does not cover losses in stock drop cases where the ERISA claims seek a plan benefit pursuant to a contractual obligation that the participants will receive what they are owed under the plan s terms. Due to the significant exposure fiduciaries face in employer stock-drop cases, it is essential for fiduciaries to confirm that their insurers will continue to cover losses or settlements in stock drop cases or seek policies that will. Communication and careful review of the policy s terms with the insurer is crucial in avoiding unwanted and expensive surprises and disputes later. Insurers also have avoided coverage under fiduciary policies by employing an argument that fiduciaries have used to avoid liability under ERISA. Relying on cases that hold fiduciaries do not act in a fiduciary capacity when they amend or terminate plans, insurers have successfully defeated claims for coverage by arguing that the alleged ERISA violation was not related to a fiduciary act. 24 For example, the Ninth Circuit denied coverage under an ERISA fiduciary policy where the insured was sued for its management of surplus funds from a terminated ERISA plan. 25 Because the plan had been terminated and all accrued benefits had been paid, the insured was acting as a corporate employer and not a plan administrator. However, if the insured can demonstrate that the underlying loss resulted from a discretionary act carried out in accordance with an existing plan provision rather than a modification or amendment, the claim will be more likely to relate to a covered wrongful fiduciary act. 26 A litigation strategy or the possible settlement amount is likely to be affected, if not determined by, the availability of insurance coverage for the loss. After the litigation is over or after a settlement is signed is not the time to learn that all along the claim would not be considered a covered breach of fiduciary duty. Early communication with the insurer on the scope of the policy is essential. Insureds may also wish to seek written assurances from insurers as to which losses the policy will cover. What Are the Exclusions? Even if the insured can establish that the policy covers the underlying ERISA claim, an exclusion may allow the insurer to avoid coverage. The insurer typically must establish an applicable exclusion. 27 Also, courts narrowly interpret exclusions. 28 Nevertheless, insureds should carefully review the policy s exclusions. Many exclusions prevent coverage for wrongful acts arising from the fiduciaries intentional misconduct or failures that the fiduciaries arguably could have prevented themselves. For example, coverage could be denied for losses arising because the insured gained personal profit or advantage to which it was not legally entitled. 29 Coverage also may be denied if the fiduciaries had prior knowledge that the conduct that caused the loss was wrongful. 30 These and other common exclusions reflect concerns that Judge Posner expressed above the policy should Employee Relations Law Journal 5 Vol. 33, No. 3, Winter 2007

6 not promote risky behavior that cause losses that insurance policies might otherwise cover. The insured v. insured exclusion is a common exclusion in D&O policies that often does not apply to ERISA fiduciary policies. 31 This exclusion denies coverage if a person the policy insures brings a claim against another insured by the policy, and it developed to prevent socalled friendly lawsuits in which corporations sued their officers and directors to obtain insurance coverage to recoup business losses. 32 In Bodewes v. ULICO Casualty Co., the insurer argued that the insured v. insured exclusion applied because one of the plaintiffs in the underlying ERISA suit was an insured fiduciary. Reflecting how D&O policies and fiduciary policies can differ, the court found that the rationale for the exclusion in D&O policies did not exist in the ERISA fiduciary context. There was no evidence the suit was due to collusion and to deny coverage simply because one of the plaintiffs was also a fiduciary would bar claims by plan fiduciaries at the expense of also barring claims by plan participants that were never intended to be subject to the exclusion. Applying the exclusion broadly as the insurer argued would have been contrary to the principle that exclusions must be construed narrowly. Additionally, some costs a fiduciary paid as a result of fiduciary breaches may be excluded under the terms of the policy. For example, the Iowa Supreme Court considered a policy that covered losses related to breaches of fiduciary duty but not fines or penalties imposed the law. 33 The fiduciary breached his fiduciary duties under ERISA by acts which the IRS also found were prohibited transactions. The IRS assessed excise taxes on the fiduciary pursuant to an Internal Revenue Code s provisions on prohibited transactions. While the taxes were related to the fiduciary breaches, the court denied coverage because the taxes were penalties rather than losses. Again, however, in any particular case, the policy s terms will control, and a policy may cover penalties. For example, many policies expressly cover penalties that the Secretary of Labor may assess against fiduciaries under ERISA. 34 What Are the Notice Provisions? Policies generally set forth a requirement to provide notice of a claim to the insurer. Failure to provide notice in accordance with the policy is a prime basis to deny coverage. 35 In some cases, the policy may require notice to be given within a certain time of discovery of facts that may give rise to a claim for breach of fiduciary duty, rather than when a lawsuit actually commences. 36 If a policy does not have an express reporting requirement, an insured may be able to argue that the insurer cannot establish that it was prejudiced by the timing of the notice. 37 However, there is no substitute for reviewing the notice provisions and carefully following them so that timely notice is provided to the insurer. 38 At any rate, as we have Vol. 33, No. 3, Winter Employee Relations Law Journal

7 discussed, timely communication with the insurer is always essential, not just because of the policy s notice requirement. Does the Policy Itself Create a Breach of Fiduciary Duty? Much of the available authority related to fiduciary liability insurance relates to claims by insureds to obtain coverage for ERISA claims. Under particular circumstances, however, fiduciaries could possibly breach their fiduciary duties through the purchase of the insurance itself. In Reich v. Continental Casualty Co., the Department of Labor sued fiduciaries who bought a $1 million extension of liability coverage for $970,000 and the fund paid the premium. 39 The department alleged that the trustees breached their fiduciary duties by using fund assets to buy insurance for their own benefit at a price that was disproportionate to any possible benefit to the fund. The trustees settled with the department, and the court did not discuss the merits of the claim. However, the case reflects that the same level of prudence and reasonableness that guide other aspects of a fiduciary s decisionmaking should also guide the fiduciaries decisions with respect to purchases of insurance coverage for those fiduciary decisions. What Are Some Best Practices to Consider When Obtaining a Policy? Ultimately, any coverage under a fiduciary liability policy will depend on the specific facts of the case and the terms of the policy. There are some best practices to consider when obtaining a new policy or renewing an existing one. For example, it is wise to make sure that fiduciary policy is stated broadly enough to cover fiduciaries at the company other than those on the investment committee (e.g., more than just the obvious ones) because, under ERISA, a fiduciary is functional and not just by title or position. Similarly, the policy should cover any employee who the company asks to be an employer-representative trustee of a union multiemployer plan. You may also want to consider following the fairly common practice of including the plan as a named insured on the policy. Also, underscoring the need for effective communication with the insurer, when answering the application questionnaire or providing information to the insurer, be broad and forthcoming with information. In addition to the company benefits and risk management departments, ERISA and insurance counsel should also review the application questionnaire and policy annually because there can be important changes each year to not only the policies and the questionnaires, but also benefits and insurance law and the company s benefit programs. ERISA fiduciaries have enough to worry about already without also adding concerns over the very insurance products that they buy to Employee Relations Law Journal 7 Vol. 33, No. 3, Winter 2007

8 manage their liability risks. However, by asking the right questions, effectively communicating with the insurer, and carefully reading the policies they pay for, fiduciaries are more likely to find themselves in good hands. Notes U.S.C. 1110(a) U.S.C. 1110(b). Under ERISA, if a plan buys insurance for its fiduciaries, the insurer must have recourse against the fiduciaries for breaches of their fiduciary obligations. 29 U.S.C. 1132(b)(1). 3. John H. Mathias, Jr., et al., Directors and Officers Liability, 8.11 (Law Journal Press 2003). 4. Fiduciary liability insurance differs from fidelity bonds, another type of insurance product, in three important ways. First, while fiduciary liability policies provide coverage for negligent conduct of fiduciaries and may have an exclusion for dishonest or fraudulent conduct, fidelity bonds provide coverage for loss arising from the want of honesty, integrity, or fidelity of an employee or other person holding a position of trust. E.g., Oriental Fin. Group v. Federal Ins. Co., 309 F. Supp. 2d 216, 219 (D. Puerto Rico 2004) (quotations omitted). Second, while fidelity bonds protect losses to the plan s assets, fiduciary liability policies protect the fiduciaries against personal losses from claims by third parties. Third, ERISA does not require fiduciary liability insurance, but it does require that every fiduciary and person who handles plan funds be bonded. 29 U.S.C Of course, a clause in the policy may require that any policy disputes be arbitrated rather than litigated. 6. See May Dep t Stores Co. v. Federal Ins. Co., 305 F.3d 597, 599 (7th Cir. 2002). 7. Id. 8. In May Dep t Stores Co., the parties argued the trust was not an indispensable party and asked that it be dropped if including it would defeat diversity jurisdiction. While reluctant to drop the trust because it feared doing so would create two actions where only one existed, the court decided to drop the trust after it agreed to be contractually bound to whatever decision the court rendered. 9. Perdue Farms, Inc. v. Travelers Cas. & Surety Co., 448 F.3d 252, 257 (4th Cir. 2006). 10. Id. 11. Id. at Id. at E.g., Pac. Ins. Co. v. Eaton Vance Mgmt., 369 F.3d 584, 589 (1st Cir. 2004) (applying Massachusetts law); Cement & Concrete Workers Dist. Council Pension Fund v. ULICO Cas. Co., 387 F. Supp. 2d 175, 183 (E.D.N.Y. 2005) (applying New York law); BOC Group, Inc. v. Federal Ins. Co., 2007 WL , at *8 (N.J. Super. Ct. App. Div. July 30, 2007) (applying New Jersey law). Vol. 33, No. 3, Winter Employee Relations Law Journal

9 14. See May Dep t Stores Co., 305 F.3d at 600 (considering Missouri law but noting contrary Missouri authority). 15. However, as noted above, many coverage disputes may not be reported because they go to arbitration rather than litigation. 16. E.g., Eaton Vance Mgmt., 369 F.3d at 590; May Dep t Stores Co., 305 F.3d at 601; Cement & Concrete Workers, 387 F. Supp. 2d at ; BOC Group, Inc., 2007 WL , at *11; see also Perdue Farms, Inc., 448 F.3d at 262; Benequity Props. v. Nat l Union Fire Ins. Co., 956 F.2d 274, 1992 WL 39032, at *1 (9th Cir. Feb. 28, 1992); American Inst. of Baking v. Int l Ins. Co., 1989 WL 7885, at *2 (D. Kan. Jan. 27, 1989). 17. EatonVance Mgmt., 369 F.3d at 590; see also May Dep t Stores Co., 305 F.3d at 601 (finding benefits claim exclusion applied); BOC Group, Inc., 2007 WL , at *11 (same). 18. Eaton Vance Mgmt., 369 F.3d at Id. at May Dep t Stores Co., 305 F.3d at Id. This is consistent with Judge Posner s view that a fiduciary does not breach fiduciary duties by following the law. See Harzewski v. Guidant Corp., 489 F.3d 799, 808 (7th Cir. 2007) (citing Wright v. Oregon Metallurgical Corp., 360 F.3d 1090 (9th Cir. 2004) and Craig C. Martin, Matt J. Renaud and Omar R. Akbar, What s Up on Stock-Drops? Moench Revisited, 39 John Marshall L. Rev. 605, 629 (2006). 22. See, e.g., Fiduciary Counselors. Inc., ERISA Class Actions, Settlements and Attorneys Fees, (June ), available at pdf. 23. E.g., Graden v. Conexant Sys. Inc., F.3d, 2007 WL , at *4 (3d Cir. July 31, 2007); Harzewski, 489 F.3d at 807 (but noting benefits were allegedly diminished because of breaches of duty). 24. Benequity Props., 956 F.2d 274, 1992 WL 39032, at *1; Cement & Concrete Workers, 387 F. Supp. 2d at Benequity Props., 956 F.2d 274, 1992 WL 39032, at * See, e.g., Tourangeau v. Uniroyal Inc., 189 F.R.D. 42, 46, 47 (D. Conn. 1999). 27. See, e.g., BOC Group, 2007 WL , at *8 (applying New Jersey law). 28. Id.; see also Bodewes v. ULICO Cas. Co., 336 F. Supp. 2d 263, 272 (W.D.N.Y. 2004) (applying New York law). 29. Perdue Farms, Inc, 448 F.3d at 256 n Cement & Concrete Workers, 387 F. Supp. 2d at 189; see also Perdue Farms, Inc, 448 F.3d at 256 n.3 (loss for failure to collect contributions excluded). 31. See Bodewes, 336 F. Supp. 2d at Id. at Hofco Inc. v. Nat l Union Fire Ins. Co., 482 N.W.2d 397, 400 (Iowa 1992) U.S.C. 1132(i), 1132(l). Employee Relations Law Journal 9 Vol. 33, No. 3, Winter 2007

10 35. E.g., Pitta v. Chubb Group of Ins. Cos., 191 A.D.2d 347, (N.Y. App. Ct. 1993). 36. Id. 37. Pension Trust Fund for Operating Eng rs v. Federal Ins. Co., 307 F.3d 944, 956 (9th Cir. 2002) (holding under California law that claim could be allowed if insurer was not prejudiced). 38. E.g., Bodewes, 336 F. Supp. 2d at (finding it was beyond dispute that timely notice was provided). 39. Reich v. Continental Cas. Co., 33 F.3d 754, 755 (7th Cir. 1994). Reprinted from Employee Relations Law Journal Winter 2007, Volume 33, Number 3, pages , with permission from Aspen Publishers, Inc., Wolters Kluwer Law & Business, New York, NY, ,