401(k) FIDUCIARY TOOLKIT Sponsored by ishares Prepared by The Wagner Law Group Fiduciary Liability Liability Case Studies & Strategies for 401(k) Plan Fiduciaries
IMPORTANT INFORMATION The Wagner Law Group has prepared this guide. BlackRock does not represent that this information is accurate and complete, and it should not be relied upon as such. This guide is intended for financial advisors who provide advisory services to 401(k) plans in a fiduciary capacity under the Employee Retirement Income Security Act of 1974, as amended (ERISA). This guide is intended for general informational purposes only, and it does not constitute legal, tax or investment advice on the part of The Wagner Law Group or BlackRock. BlackRock is not affiliated with The Wagner Law Group. The case studies presented in this guide involve fact patterns that contemplate civil litigation under ERISA, a complex area of law which has been simplified for educational purposes. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor. FOR FINANCIAL PROFESSIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION 3031-04MW-9/10
ishares 3 Help protect yourself and your 401(k) clients from liability by understanding the indemnification and insurance provisions of ERISA and how plan fiduciaries may be impacted by them. This guide, prepared by The Wagner Law Group, includes three case studies highlighting the real life importance of understanding ERISA provisions. Whether you re taking over a new 401(k) client or are focused on servicing existing plan clients, the information included in this guide can offer another way for you to provide value to your clients. For more information, visit our Fiduciary Resource Center at www.ishares401k.com/fiduciary. To learn how to use ishares ETFs in 401(k) plans, call the Retirement Plan Sales Team at 1-888-450-4015.
4 Fiduciary Liability Executive Summary To highlight the real life importance of the indemnification and insurance provisions of ERISA, this guide presents the following case studies to illustrate how plan fiduciaries may be impacted by them: Case Study 1 A financially strapped employer takes the compensation deferrals of its employees, but instead of contributing them to its 401(k) plan, the employer uses these funds to pay down its debt. In addition to criminal penalties for the theft, the sponsor is personally liable for the participants losses. Unless the plan s financial advisor knew, or should have known, about the employer s theft of 401(k) plan contributions, it generally would not be subject to co-fiduciary liability for failing to stop the plan sponsor s breach. The plan (or its representative) could file a claim under the plan s ERISA fidelity bond. KEY CONCEPT Under ERISA Section 409(a), a fiduciary that breaches its duties is personally liable for the resulting plan losses. Under ERISA Section 405(a), a co-fiduciary can be held liable for another fiduciary s breach in certain circumstances. STRATEGY TIP Co-fiduciaries should have a clear understanding of their respective roles and responsibilities.
ishares 5 Case Study 2 After a plan sponsor transfers its 401(k) plan to a full service provider offering a fiduciary warranty on plan investments, a participant files a lawsuit for losses sustained under the plan. Under the terms of this type of contractual warranty, the plan sponsor can seek indemnification if the lawsuit claims that the investment funds in the plan menu were selected imprudently or did not include a broad range of alternatives. However, the warranty would not protect against other types of fiduciary claims. If the plan s financial advisor were held liable under the participant s lawsuit, the advisor may be covered under the fiduciary liability insurance policy of the advisor s firm. STRATEGY TIP When taking advantage of a provider s investment warranty, a plan sponsor should read its terms and conditions carefully to understand the scope of its coverage and any procedural requirements. STRATEGY TIP With regard to a financial advisor s fiduciary liability insurance coverage, it is important to determine the extent to which ERISA liability is covered, including any applicable exclusions and deductibles. Case Study 3 A perpetrator of identity theft drains the accounts of several plan participants, using personal information stolen by a co-conspirator who works at a call center for 401(k) plans. If the plan sponsor s selection of the service provider was made imprudently, the sponsor could be held responsible for the participants losses. In this situation, the sponsor may be able to seek a recovery from its service provider based on the terms of its service agreement. KEY CONCEPT A plan fiduciary has a duty to select service providers prudently, taking into account the qualifications of the provider, the quality of services offered and the reasonableness of the fees charged in light of the services offered. STRATEGY TIP Plan sponsors should consider any limitation-of-liability provisions and related indemnification terms carefully when selecting and negotiating with providers.
6 Fiduciary Liability Introduction The courts have classified the Employee Retirement Income Security Act of 1974, as amended (ERISA), as a remedial statute protecting the interests of plan participants. This view is based on the fact that ERISA was designed to provide remedies for participants in the form of federal causes of action, which can be brought by the U.S. Department of Labor (DOL), plan fiduciaries as well as by individual participants. 1 The remedial provisions of ERISA are an enforcement mechanism for the fiduciary standards under ERISA, which the courts have cited as the highest known to the law. 2 These provisions can impose severe liabilities on plan sponsors and other plan fiduciaries who fail to satisfy the stringent standards of ERISA. Despite the harsh implications of these rules, a surprising number of plan fiduciaries are unaware of their potential exposure. Fiduciaries can be subject to personal liability and civil penalties for breaching their duties under ERISA, and they can also be held responsible for the misconduct of co-fiduciaries and service providers. However, many plan fiduciaries have not investigated the sufficiency of their insurance and contractual protections. Waiting until the last minute can be a costly mistake, since it is often too late to develop a strategy to minimize a plan fiduciary s potential exposure, once a significant failure relating to a fiduciary breach occurs. 1. See, e.g., Shaw v. Delta Airlines, 463 U.S. 85 (1983). 2. Donovan v. Bierwirth, 680 F.3d 263 (2d Cir.), cert. denied, 459 U.S. 1069 (1982).
ishares 7 In order to highlight the real life importance of the indemnification and insurance provisions of ERISA, this guide will utilize case studies to illustrate how plan fiduciaries may be impacted by these rules. This guide will examine the following three scenarios, which are based on actual incidents and cases that have recently occurred: Case Study 1 A financially strapped employer redirects compensation deferrals under its 401(k) plan, using these funds to pay down its outstanding debt. Case Study 2 After a plan sponsor transfers its 401(k) plan to a full service provider offering a fiduciary investment warranty, a participant files a lawsuit for investment losses sustained under the plan. Case Study 3 A perpetrator of identity theft drains the accounts of several plan participants, using personal information provided by a co-conspirator working at a call center for 401(k) plans. Plan fiduciaries reading this guide should consider the following questions as they work through these case studies: What is my potential liability? Am I responsible for the actions of another fiduciary or service provider? Do I have a duty to intervene if I suspect any type of wrongdoing? Do I have any insurance or contractual protection against these potential liabilities?
8 Fiduciary Liability Case Study 1: A Financially Strapped Employer Diverts 401(k) Plan Salary Deferrals An employer sponsoring a mid-sized 401(k) plan is under enormous financial pressure to pay off its debts during a downturn in the local economy. The plan sponsor tells its financial advisor that it may need to use the 401(k) plan deferrals of its employees, to pay down some of this debt. In response, the advisor sternly warns the plan sponsor that taking compensation deferrals from its employees, but failing to contribute them to the plan on a timely basis, would result in a violation of ERISA. 3 After hearing this warning, the sponsor assures the advisor that it would never breach its fiduciary duties. Several months later, the DOL launches an investigation based on a tip from a disgruntled participant, which confirms that the plan sponsor had stopped depositing payroll deductions into the 401(k) plan, and that it had indeed been using these funds to pay down its overdue loans. 4 Implications for Plan Sponsor In addition to being subject to criminal penalties for the theft, the sponsor is also personally liable for the losses suffered by the plan participants as a result of the breach of its fiduciary duties. Furthermore, ERISA Section 502(l) empowers the DOL to assess a civil penalty against a fiduciary in breach of its duties or any other person that knowingly participates in such breach. The civil penalty is equal to 20% of the settlement amount recovered by the DOL. The IRS can also impose excise taxes on self dealing prohibited transactions. KEY CONCEPT Under ERISA Section 409(a), a fiduciary that breaches its responsibilities under ERISA is personally liable for any losses to the plan resulting from such breach, and must disgorge any related profits. Other penalties can also apply. Implications for Financial Advisor If the advisor did not have knowledge of the sponsor s theft of 401(k) plan contributions, the financial advisor generally would not be subject to co-fiduciary liability under ERISA. On the other hand, if the advisor did have actual knowledge of, or should have known about, this illicit activity, the advisor would have to make reasonable efforts to remedy the breach in order to avoid potential co-fiduciary liability. 3. Under 29 CFR 2510.103-2 of the DOL regulations, an employee s payroll deductions must be deposited with the plan on the earliest date on which such contributions can reasonably be segregated from the employer s general assets. In no event will a deposit be considered timely if made later than the 15th business day of the month following the month of salary deferral. For plans with fewer than 100 participants, deposits are automatically considered to be timely if made within 7 business days. 4. This case study is based, in part, on the Criminal Enforcement News Release from the DOL Employee Benefit Security Administration website at http://www.dol.gov/ebsa/newsroom/criminal/main.html, Owners of Now Defunct Ballard Electrical Firm Guilty of Embezzlement from Employee 401(k) Plan (October 16, 2009).
ishares 9 KEY CONCEPT Under ERISA Section 405(a), a co-fiduciary is liable for another fiduciary s breach if (1) the co-fiduciary knowingly participates in such breach, (2) the co-fiduciary fails to carry out its own duties prudently, enabling such breach, or (3) the co-fiduciary has knowledge of such breach and fails to make reasonable efforts to remedy the breach. STRATEGY TIP Co-fiduciaries, including the plan sponsor and the plan s financial advisor, should have a clear understanding of their respective roles and responsibilities. It may be helpful to memorialize this understanding formally or informally with a letter or document. Advisors should consider documenting their investment responsibilities in specific detail and indicating whether they have any oversight responsibilities with respect to any aspect of plan operation or service providers. Plan s Protection from ERISA Bond If the plan participants are unable to recover their stolen money from their employer, the plan (i.e., through its trustee or other representative) could file a claim under the plan s ERISA fidelity bond. An ERISA bond must be maintained by the plan sponsor, and this fidelity bond specifically protects the plan against losses due to fraud or dishonesty on the part of a fiduciary or any other person who handles plan funds. 5 Unless the plan sponsor chooses to add third party coverage to its ERISA bond, any third party who handles plan assets must be covered by its own ERISA fidelity bond. 6 However, a financial advisor who provides non-discretionary investment advice only is not deemed to handle plan assets, and such advisor does not need to be bonded. 7 Furthermore, no bond is required of a registered broker-dealer (or its employees) that is subject to the fidelity bond requirements of FINRA, and similar exemptions apply for banks and insurance companies. Under a typical ERISA bond, the plan is the named insured and can make a claim on the bond if a covered plan official causes a loss due to fraud or dishonesty. The bond must provide coverage for at least 10% of plan assets, up to a maximum of $500,000 ($1,000,000 in the case of a plan holding employer securities). 8 STRATEGY TIP Determine whether the plan sponsor s ERISA bond covers third parties. If not, ensure that the plan s third party service providers are covered under a separate fidelity bond or that they are exempt from this requirement under ERISA. 5. ERISA Section 412. 6. ERISA Section 412. 7. Field Assistance Bulletin No. 2008-04. 8. ERISA Section 412, as amended by Section 622 of the Pension Protection Act of 2006, effective for plan years after 2007.
10 Fiduciary Liability Case Study 2: A Full Service Provider Offers a Fiduciary Investment Warranty Based on a financial advisor s recommendation, a plan sponsor transfers its 401(k) plan to a full service provider offering a fiduciary investment warranty. Under the terms of the warranty, the provider guarantees that the plan s investment menu selection will be consistent with the prudence standard under Section 404(a)(1)(B) of ERISA, and that the menu will include a broad range of investment alternatives within the meaning of the DOL regulations under ERISA Section 404(c). To be eligible for the protection under the warranty, the plan sponsor must select an available fund from each of 10 different investment style categories. The plan sponsor must also agree to certain procedural duties, which include working with the plan s financial advisor on an ongoing basis and reviewing certain written materials concerning the provider s pre-screening process for determining its available funds. If these conditions are met, the provider agrees to indemnify the plan sponsor for any participant claims relating to the fiduciary standards guaranteed under the warranty. Shortly after the 401(k) plan s transfer to the full service provider, a participant files a lawsuit for losses sustained as a result of investing in poorly performing funds under the plan. The lawsuit is filed against both the plan sponsor and the financial advisor. 9 9. This case study is loosely based on the investment warranties offered by certain full service providers to 401(k) plan sponsors. Although the terms and conditions of these warranties may vary, they typically provide similar assurances to plan sponsors with regard to the selection of investment alternatives for the plan s investment menu. However, the procedural conditions which must be satisfied under the terms of the warranty vary considerably.
ishares 11 If Participant Claims Investment Funds in Menu Were Selected Imprudently As provided under the warranty, if the participant s lawsuit claims that the investment choices in the menu were not selected in a prudent manner, the plan sponsor could seek indemnification for the costs of the lawsuit. However, this protection would only be available if the plan sponsor complied with the specific conditions of the warranty. Because the warranty is a contractual promise, and not a mandated responsibility under ERISA, the actual provisions of the warranty would govern the provider s obligations with respect to the lawsuit filed against the plan sponsor. Under the terms of the warranty, the plan sponsor is required to meet with the plan s financial advisor on an ongoing basis and to review the provider s pre-screening process with respect to the available funds. If these procedural conditions were met, a strong argument could be made that the sponsor satisfied its duty of prudence under ERISA with respect to the selection of investment options for the plan s menu. The duty of prudence under ERISA Section 404(a)(1)(B) is largely procedural in nature, and can generally be satisfied by gathering the relevant information and making an informed investment decision. 10 Thus, the sponsor should be able to prevail against the participant s claim, minimizing the provider s indirect exposure to such claim under its contractual warranty to the sponsor. KEY CONCEPT The duty of prudence under ERISA Section 404(a)(1)(B) requires a fiduciary to act with the care, skill, prudence, and diligence that a prudent man acting in a like capacity and familiar with such matters would use. STRATEGY TIP When taking advantage of a provider s investment warranty, plan sponsors should read its terms and conditions to understand the scope of its protection as well as any potential gaps in coverage, and to ensure that all procedural requirements are satisfied by the sponsor on an ongoing basis. If Participant Claims Menu Did Not Have Broad Range of Alternatives In accordance with the terms of the warranty, if the participant s lawsuit claims that the plan menu did not have a broad range of investment alternatives, the plan sponsor could seek indemnification for its related costs. As required under the warranty, the plan sponsor must select at least 10 investment funds from designated investment style categories. Assuming that these categories represent a diverse grouping of asset classes, such diversity would give the sponsor a strong argument that it satisfied its duty of diversification under ERISA Section 404(a)(1)(C). Under this duty, the plan sponsor must ensure the plan menu has sufficient investment diversity, enabling participants to allocate the investments 10. See also, e.g., In re Unisys Savings Plan Litigation, 74 F.3d. 420 (3d Cir.) cert. denied, 519 U.S. 810 (1996).
12 Fiduciary Liability in their accounts so as to minimize the risk of large losses. Given the sponsor s strong likelihood of prevailing against the participant s claim, the provider s indirect exposure to such claim under its warranty should be rather limited. If Participant Makes Other Investment-Related Claims Even though the provider s warranty would protect the sponsor against claims relating to the breach of its duties of prudence and diversification, the sponsor would not be able to seek protection under the warranty for other types of fiduciary breaches. For example, a fiduciary has a duty of loyalty to plan participants under ERISA Section 404(a)(1)(A)(i) and the related prohibited transaction rules. ERISA Section 404(a)(1)(A)(ii) imposes a fiduciary duty to ensure that any fees paid by the plan are reasonable. Under ERISA Section 404(a)(1)(D), a plan fiduciary has a duty of obedience, which requires compliance with the provisions of the plan document and any other governing instruments. In addition, if the plan fails to satisfy all the requirements of ERISA Section 404(c), the plan sponsor could be held responsible for any imprudent investment allocation decisions made by participants. A plan must satisfy the requirements of ERISA Section 404(c) in order to shift the responsibility for investment allocation decisions to participants. KEY CONCEPT To be eligible for 404(c) protection, a plan must include a broad range of investment alternatives, and it must also provide participants with an opportunity to exercise control over their accounts, which also requires sufficient information to be provided so that participants are able to make informed investment allocation decisions. 11 Although the provider s warranty includes a guarantee with respect to the plan menu having a broad range of investment alternatives, which is a 404(c) requirement, the warranty does not guarantee compliance with the other 404(c) conditions, such as providing the necessary investment disclosures to participants. Thus, in spite of the provider s assurance that the plan menu includes a broad range of alternatives, the protection of ERISA Section 404(c) may not necessarily be available to the plan sponsor. If the necessary 404(c) disclosures have not been provided to participants, the plan sponsor could potentially be held responsible for the investment allocation of participant accounts. STRATEGY TIP Given the value of ERISA Section 404(c) protection, the plan sponsor should confirm with its administrative service provider that the necessary investment disclosures are being provided to participants. 11. A broad range of investment alternatives within the meaning of ERISA Section 404(c) includes a sufficient range of options that provide participants with a reasonable opportunity to: (1) materially affect the potential investment return of their accounts, (2) choose from at least three alternatives with materially different risk and return characteristics, and (3) diversify the investments in their accounts so as to minimize the risk of large losses. The related 404(c) disclosures generally can be provided in the form of investment brochures, fund fact cards, and fund prospectuses.
ishares 13 Implications for Financial Advisor Because the financial advisor is also named in the participant s lawsuit, the advisor could be subject to liability in the event the court rules against the advisor for making investment recommendations that were inconsistent with its fiduciary duties under ERISA. Advisor s Protection from Fiduciary Liability Insurance The provider s contractual warranty protects the sponsor, and not the advisor. However, if the financial advisor were to be held liable under the participant s lawsuit, the advisor may be covered under his or her s own firm s fiduciary liability insurance policy. Professional service firms customarily maintain an errors and omissions or a similar professional liability policy for the firm and its registered representatives. Such policies typically provide coverage for various types of fiduciary liability, including ERISA-related liability. Fiduciary liability insurance for plan fiduciaries is vastly different from ERISA fidelity bonds, which protect plans against theft by covered plan officials. KEY CONCEPT Fiduciary liability insurance generally protects fiduciaries and their personal assets from lawsuits alleging breaches of fiduciary responsibility, and this type of insurance protection is not mandatory under ERISA. STRATEGY TIP In the case of a financial advisor s coverage under a fiduciary liability insurance policy, it is important to determine the extent to which any potential ERISA liability is covered, including any applicable exclusions and deductibles.
14 Fiduciary Liability Case Study 3: A Perpetrator of Identity Theft Drains the Accounts of Plan Participants An imposter gains access to several different 401(k) plan accounts using confidential customer identity information, which was stolen by a co-conspirator working as a customer service representative at a call center for 401(k) plans. After taking over these participant accounts, the duo clean them out by having rollover checks issued and deposited into bank accounts under their various aliases. More than $700,000 is stolen under this scheme, but none of this money is ever recovered and the two perpetrators remain at large. Alleging that the administrative service provider s security system was inadequate, the defrauded participants file a lawsuit against the plan s administrative service provider and the plan sponsor. 12 Implications for Plan Sponsor In theory, the plan sponsor could be held accountable for the participants losses to the extent the sponsor is deemed to have selected the plan s administrative service provider imprudently. However, if the selection was made prudently, the sponsor would not be held responsible under ERISA for the provider s errors. KEY CONCEPT In selecting a service provider to the plan, a plan fiduciary must make the selection prudently, taking into account the qualifications of the provider, the quality of services offered and the reasonableness of the fees charged in light of the services offered. 13 12. This case study is based, in part, on the Criminal Enforcement News Release from the DOL Employee Benefit Security Administration website at http://www.dol.gov/ebsa/newsroom/criminal/main.html, Newark Man Pleads Guilty to Stealing Retirement Funds from 401(k) Accounts and Laundering the Proceeds (February 20, 2009). 13. See DOL Field Assistance Bulletin 2002-3.
ishares 15 Sponsor s Recovery from Service Provider If the plan sponsor were held liable by the court, the sponsor may be able to recover its losses from the service provider to the extent the provider had breached the standard of care under its service agreement. Typically, service providers will seek to limit their liability strictly to losses caused by an applicable level of misconduct and negligence (e.g., willful misconduct, gross negligence). In addition, service providers may include indemnity provisions in their contracts which require the sponsor to indemnify them for litigation costs relating to participant claims that do not involve their misconduct or negligence. Thus, even if a service provider concedes that it made an error, it could potentially assert that the error was consistent with its promised standard of care under the agreement, and it may even seek indemnification from the sponsor for its litigation costs. If a plan sponsor is willing to accept such terms, a service provider has a significant amount of flexibility with regard to negotiating its liability and indemnity provisions. However, as provided in DOL Advisory Opinion 2002-08A, a sponsor should never agree to limit the liability of a provider when it is due to the provider s fraud or willful misconduct. KEY CONCEPT Under ERISA, it would be imprudent for a plan sponsor or any other fiduciary to surrender its right to seek remedies against a provider for fraud or willful misconduct. STRATEGY TIP Plan sponsors should review the limitation-of-liability provisions and the related indemnification terms in their contracts with service providers, so that they understand their contractual rights in the unlikely event of an error resulting in a significant loss to the plan. Plan sponsors should consider these provisions carefully when selecting and negotiating with.
16 Fiduciary Liability Conclusion Given the gravity of the ERISA indemnification and insurance rules, plan fiduciaries should take steps to investigate their potential liability exposure under ERISA as well as the sufficiency of their available insurance and contractual protections. Plan fiduciaries should recognize that ERISA fidelity bonds are designed to protect the plan (and not fiduciaries). Plan sponsors are principally protected through the contractual provisions in their service arrangements. Financial advisors should confirm their professional liability insurance provides an appropriate level of ERISA liability coverage. Of course, the best form of protection and defense against ERISA liability is developing an awareness of the fiduciary rules and ensuring the plan s operation is consistent with these requirements.
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