By Jeff Mamorsky (November 17, 2023, 5:25 PM EST)

On Nov. 3, the U.S. Department of Labor published a new set of regulatory proposals expanding the circumstances under which a person will be considered an investment advice fiduciary under the Employee Retirement Income Security Act and the Internal Revenue Code, and proposed amendments to prohibited transaction exemption, or PTE, 2020-02 that increase the reasonable compensation disclosure requirements.

In reviewing the proposed amendments, I immediately thought of the Aug. 4 decision from the U.S. Court of Appeals for the Ninth Circuit in Bugielski v. AT&T Services Inc., where participants in AT&T’s 401(k) plan sued the plan administrator, AT&T Services, and the plan’s investment committee.

The suit alleged that the defendants engaged in a prohibited transaction under ERISA Section 406(a), and breached their duty of prudence under ERISA Section 404(a), by failing to investigate and evaluate all the compensation — direct and indirect — earned by Fidelity Investments Institutional Operations Co . Inc., the plan’s record-keeper, and Brokerage Link, Fidelity’s brokerage account.[1]

The Ninth Circuit decision highlights why it is so important for financial institutions and advisers to disclose third-party compensation arrangements. It also highlights why plan sponsor fiduciaries must review such agreements to ascertain the “reasonableness” of the financial institution or financial adviser’s total direct and indirect compensation.

A determination of reasonableness is a critical component of qualifying for the ERISA Section 408(b)(2) prohibited transaction exemption, known as the “furnishing of services” exemption. In the absence of a determination of the reasonableness of total compensation, plan sponsor fiduciaries are in danger of being sued for breach of fiduciary duty for allowing the plan to enter into a prohibited transaction and the financial institution or financial adviser may be unable to engage in any transaction with the plan including the receipt of compensation.

This is now even more important in view of DOL’s recent issuance of regulatory proposals and proposed amendments to PTE 2020-02, which explicitly conditions compliance on the financial institution’s or fiduciary adviser’s total compensation — direct and indirect — being reasonable. Although the regulatory proposals and proposed amendment have not yet been finalized, this is an important issue to deal with now.

In Bugielski, the claims were prompted by amendments to AT&T’s contract with Fidelity, which gave plan participants access to mutual funds not otherwise available through Brokerage Link, Fidelity’s brokerage account platform, for a fee, and to investment advisory services through Financial Engines, a third-party adviser.

Under this arrangement, Fidelity received revenue-sharing fees from the mutual funds available to participants via the brokerage account platform; and, through its own agreement with the investment adviser, Fidelity received a portion of the fees that the investment adviser earned from managing participant accounts.

According to the Ninth Circuit’s ruling, the compensation Fidelity received from Financial Engines was significant; in some years, Fidelity received approximately half of the total fees that Financial Engines charged participants, resulting in millions of dollars in compensation for Fidelity.

The Ninth Circuit held that the “furnishing of services” exemption requires that the plan fiduciaries scrutinize and evaluate the third-party compensation arrangements between Fidelity, Brokerage Link and Financial Engines, under which Financial Engines would remit to Fidelity part of the fee paid by the plan to Financial Engines for reasonableness.

Connection Between Bugielski and PTE 2020-02

The issue highlighted in Bugielski — the obligation of sponsor fiduciaries to review the reasonableness of indirect third-party fees received by service providers — is identical to a requirement in the recently proposed DOL investment advice fiduciary regulation that explicitly conditions the availability of PTE 2020-02 on the fiduciary adviser’s compensation — direct or indirect— being reasonable.

The sponsor fiduciary’s obligation to review and monitor indirect compensation that is at the heart of Bugielski would also apply to fiduciary advisers. In addition to monitoring the reasonableness of the adviser’s indirect compensation, there are a number of other conditions in the proposal related to the impartial conduct standards that may also require review and monitoring.

Bugielski v. AT&T

The participants argued that AT&T’s amendment of its contract with Fidelity to incorporate the services of Brokerage Link and Financial Engines was a prohibited transaction under ERISA Section406(a)(1)(C), which specifically prohibits a transaction that constitutes the direct or indirect “furnishing of goods, services, or facilities” between a plan and a “party in interest.”

In the Bugielski case, service providers such as Fidelity, Brokerage Link and Financial Engines would be considered a party in interest. The participants argued that this transaction was not exempt under Section 408(b)(2), which only exempts from Section 406’s prohibition of service contracts or arrangements between a plan and a party in interest if:

The contract or arrangement is reasonable; The services are necessary for the establishment or operation of the plan; and No more than reasonable compensation is paid for the services.

For the furnishing-of-services contract arrangement to be reasonable, the party in interest must disclose to the plan’s fiduciary all direct and indirect compensation that the party expects to receive in connection with the services provided pursuant to the contract or arrangement.

The plan participants claimed that AT&T’s amendment of the contract with Fidelity to incorporate Financial Engine’s and Brokerage Link’s services did not satisfy the requirements of Section 408(b)(2) because AT&T failed to obtain the requisite disclosures of the compensation Fidelity received from these service providers and to determine that such compensation was reasonable.[2]

The plan participants also alleged that AT&T violated ERISA Section 404 and its duty to act prudently by failing to consider this compensation. Section 404 imposes a duty of prudence upon fiduciaries, requiring them to discharge their duties “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”

The U.S. District Court for the Central District of California granted summary judgment in favor of the defendants on all claims. The court held that the claims failed because the defendants had no duty to consider the compensation that Fidelity earned from the brokerage account platform or the investment adviser when evaluating Fidelity’s compensation.

On appeal, the Ninth Circuit held that the amendment of AT&T’s contract with Fidelity was a prohibited transaction for the furnishing of services between the plan and a party in interest, and therefore, could be permitted only if it satisfied the requirements for the ERISA 408(b)(2) reasonable-contract exemption.

The Ninth Circuit explained that, in its view, Congress intended ERISA’s prohibited transaction rules to be broad enough to capture even arm’s-length transactions with service providers.

In so holding, the Ninth Circuit rejected the reasoning of other circuit court decisions, which more narrowly construed the prohibition against the furnishing of services based on concerns that a broad, per se construction of the statute would hinder fiduciaries’ ability to contract with third parties for essential services.[3]

These circuit court decisions instead required that a plaintiff plead facts supporting an element of intent to benefit a party-in-interest to state a claim under the ERISA 408(b)(2) contract exemption.

The Ninth Circuit therefore concluded that the duty of prudence requires consideration of the indirect compensation Fidelity received from the brokerage account platform and the investment adviser.

The Ninth Circuit thus remanded the case to the district court to consider whether Fidelity received no more than reasonable compensation from all sources for the services it provided to the plan, and to determine whether the defendants sufficiently considered all components of the recordkeeper’s compensation to satisfy their duty of prudence.

Commentary and Analysis

All of ERISA’s prohibited transactions, including the furnishing-of-services prohibited-transaction exemption contained in ERISA Section 406(a)(1)(C), occur when there is a direct or indirect transaction between the plan and party in interest, which includes plan service providers.

The drafters of ERISA included the phrase “direct or indirect” on purpose to avoid employer plan sponsor and service provider abuse, which is the primary objective of ERISA. I was present during the ERISA drafting process and recall that it was the drafters’ intent that a prohibited transaction is an automatic, per se violation that does not require pleading facts to support an element of intent to benefit a party in interest.

The Ninth Circuit agreed, emphasizing that the prohibition against transactions between plans and parties in interest is per se in nature and that a violation does not depend on whether any harm results from the transaction. Specifically, the Ninth Circuit pointed out that it previously recognized the broad scope of Section 406, explaining that Section 406 creates “a broad per se prohibition of transactions ERISA implicitly defines as not arm’s-length.[4]

PTE 2020-02

The recent proposed amendments to PTE 2020-02 requiring that the fiduciary adviser’s compensation— direct or indirect — be reasonable, and adding a plan sponsor fiduciary obligation to review and monitor indirect compensation, is at the heart of Bugielski.

These requirements are contained in the PTE’s impartial conduct standards, which require financial institutions and investment professionals to provide advice that is in the best interest of the retirement investor, receive only reasonable compensation, and avoid making statements about the recommended transaction and other relevant matters that are materially misleading.

The proposed amendments to PTE 2020-02 would largely maintain the exemption’s impartial conduct standards in their current form. However, the DOL is proposing to amend the requirement that fiduciaries avoid making materially misleading statements.

The change would explicitly prohibit financial institutions and investment professionals from omitting information that is needed to prevent such statements from being, under the circumstances, not misleading. The amendments would also clarify that the requirement applies to both written and oral statements.

New Disclosure Requirements

Currently, PTE 2020-02 requires that financial institutions provide certain disclosures to retirement investors prior to engaging in a recommended transaction. The proposed amendments to PTE 2020-02 would increase the disclosure requirements in the following respects.

Acknowledgment of Fiduciary Status

PTE 2020-02 currently requires that the investment professional and its supervisory financial institution provide a written acknowledgment that they are fiduciaries under ERISA with respect to fiduciary investment advice provided to the retirement investor.

The DOL now proposes to also require a statement that the investment professional and financial institution are providing fiduciary investment advice. In the preamble to the proposed amendments, the DOL emphasizes that a conditional acknowledgment that an investment professional or financial institution may be fiduciaries would not be sufficient to meet this requirement.

Statement of Best Interest Standard of Care

The proposed changes to PTE 2020-02 would include a new requirement that financial institutions provide retirement investors with a statement of PTE 2020-02 ‘s best interest standard of care.

Description of Services to Be Provided and Material Conflicts of Interests

PTE 2020-02 currently requires financial institutions to provide a written description that is not misleading of the financial institution’s and investment professional’s services and material conflicts of interest. The DOL’s proposed changes would clarify that this requirement would be violated if the description is misleading in any respect.

Further, the proposed amendments would require the financial institution to disclose whether the retirement investor will pay for services directly or indirectly, including through third-party payments, defined to include gross dealer concessions; revenue sharing payments; 12b-1 fees; distribution, solicitation or referral fees; volume-based fees; fees for seminars and educational programs; and any other compensation, consideration or financial benefit paid by a third party to a financial institution; and the retirement investor will pay through commissions or transaction-based payments.

What to Do

As a result of the Ninth Circuit decision, plan fiduciaries must review for reasonableness payments to service providers under third-party arrangements.

In particular, plan sponsors need to investigate and evaluate all compensation earned by their plan record-keepers and determine whether they are receiving indirect compensation from third parties and, if they are, determine what action needs to be taken.

Also, financial institutions and investment advice fiduciaries should carefully review the recently issued DOL investment advice regulatory proposals and the proposed amendments to PTE 2020-02 to make sure they are in compliance.

If not, they run the risk of committing a prohibited transaction under ERISA 406(a) since they are a party in interest providing services to the plan, and in the absence of compliance with the 408(b)(2) exemption and PTE 2020-02, are unable to engage in any transaction with the plan including the receipt of compensation.

It is therefore of critical importance that financial institutions and investment advice fiduciaries comply with the prohibited transaction exemptions and the PTE 20200-02 proposed amendments.

The proposed changes increase the disclosure requirements, making it so that that they cannot be misleading in any respect, including the required disclosure concerning whether the retirement investor is paying for services directly or indirectly through third-party payments, such as dealer concessions, revenue-sharing payments, 12b-1 and volume-based fees.

This is an important issue to deal with now, even if the regulations and changes to the PTE have not yet been finalized as proposed.

Jeff Mamorsky is a partner at Cohen & Buckmann PC

The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Bugielski v. AT&T (76 F.4th 894)

[2] 29 C.F.R. § 2550.408b-2(a)

[3] Sweda v. University of Pennsylvania, 923 F.3d 320 (3d Cir. 2019) and Albert v. Oshkosh Corp. , 47  F.4th 570 (7th Cir. 2022)

[4] M & R Inv. Co. v. Fitzsimmons, 685 F.2d 283, 287 (9th Cir. 1982)

The original article can be found here.

In an alarming trend, companies offering 401(k) plans (plan sponsors), their appointed trustees, and their plan advisors, are finding themselves blindsided by class action lawsuits. The lawsuits allege that they’ve failed in their fiduciary duties towards the plan participants. 

A significant number of these lawsuits are zeroing in on the investment decisions made, or not made, by the trustees. The financial implications of such lawsuits can be massive.

The term “blindsided” is apt since these plan sponsors and trustees are often uninformed about the rapidly increasing number of such cases (over 200 in the past two years alone). Most appear entirely unaware of the risks they’re exposed to and the measures they could adopt to safeguard themselves and their companies from these legal claims.

So, how can trustees and companies defend themselves against risks of which they are largely unaware? This article aims to address this critical information gap and propose some preventative steps that merit serious consideration. In the face of rising litigation, understanding these risks and taking proactive measures could mean the difference between financial security and potential financial and reputational ruin.

The recent case and settlement, featured in the 401(k) Specialist online magazine, has sent shockwaves through the industry. This professional publication, written for and read by those who serve 401(k) plans, highlights the stark realities that employers and trustees of 401(k) plans face.

As an employer or trustee, you likely do not consider yourself a “401(k) Specialist”, nor do you likely receive or regularly read this publication. 

That’s where we come in. Our mission at Trustee Empowerment & Protection, Inc. is to bridge this information gap and arm you with the knowledge needed to understand and better protect yourself from the risks associated with your fiduciary position.

This case spotlights genuine hazards often not discussed with you by your advisors, or casually dismissed as “unlikely to happen” to you and your plan. Let’s begin with this one.

Did the company or any of its plan trustees ever imagine that they would be sued and face such a massive potential corporate and personal liability?  If you are a trustee, you need to understand that such liability is unlimited . . . it’s to the full extent of your personal net worth. 

That answer would almost certainly be “NO.”  If they were aware – if they believed their risk of being sued was real – they might have taken protective actions to reduce their chances of being sued.

In the past two years alone, there have been over 200 similar class-action lawsuits against plan sponsors and trustees. Many, if not most, of these cases allege breaches of fiduciary duties in the investment-related decisions made by plan trustees. 

Were these facts communicated and explained to them by their advisors? Likely not.

As a C-suite decision maker of a plan sponsor company, or as a trustee, have these facts ever been disclosed and discussed with you?

As a plan trustee, consider these questions:

• Would $125 million exceed the limit of your plan’s fiduciary liability insurance policy?
• Would $125 million exceed the combined net worth of all your plan’s trustees?
• How would you explain to your family that you’ve been personally sued for an amount exceeding your entire life’s savings and the allegations made against you?

A typical response is: “Well, we have fiduciary liability insurance to cover all of that.” Beyond the question of whether the coverage is sufficient (it may not be), is this. Your fiduciary liability policy (assuming you have one), does not cover the reputational damage you and your fellow trustees will suffer from being publicly accused of being a “bad fiduciary”. 

And then there’s the negative impact on your family as they grapple with inquiries about the fact that you’ve been sued. For many, if not most companies and individual trustees, they rightly consider their reputations to be their most valuable assets, more valuable than the money involved in these claims. Fiduciary liability insurance policies offer no protection against or compensation for any of this.

Here are some other crucial points of which you may be unaware:

In addition to the class-action lawsuit, the Department of Labor (“DOL”) also got directly involved. Unlike law firms that weigh cost-benefit ratios, the DOL isn’t resource constrained and can independently proceed against plan sponsors and trustees (i.e., you) on all ERISA (Employee Retirement Income Security Act) claims.

It only takes one disgruntled employee or ex-employee to represent all employee plan participants in an ERISA class-action lawsuit. With large employee bases, finding a disgruntled employee isn’t difficult. 

It’s important to note that the DOL doesn’t need a disgruntled employee to directly proceed against the company or you.

Delegating all investment decision-making to their investment advisor didn’t protect the company and trustees in this case. Trustees often mistakenly believe that such delegation is an effective defense. It’s not. Have your advisors explained that you?

Further, even if investment-related decision making is entirely delegated to your plan’s investment advisor, trustees (you) still have a duty to monitor the activities and performance of your investment advisor in that role. 

In this case, the DOL found that the company and individual defendants failed to monitor the investment manager’s activities properly. When delegating responsibility to their investment advisor, was the need to do so, and how to appropriately do so, ever adequately explained to them?

This case underscores the importance of awareness of the risks involved in your role as a trustee and of the need for proactive, protective measures to help in mitigating such risks. As a trustee, you need to take all of this seriously. None of the trustees that have individually been sued in this rising wave of class-action lawsuits likely ever believed that they would be sued.

While the rising tide of class-action lawsuits really is a growing and disturbing dark cloud, is there any silver lining in any of this? Absolutely. The first step towards self-protection is awareness. Now that you’re cognizant of these challenges, you’re in a significantly better position to take steps to safeguard yourself and your company against such claims. 

But how?  What steps can you take?

While it’s impossible to retroactively alter past investment decisions, armed with this newfound knowledge, you can proactively shape future decisions to better defend and enhance both your position and that of your company.

The first course of action is further educating yourself. We recommend exploring the resources available at Trustee Empowerment & Protection, Inc. (“TEPI”). A deeper dive into this material will reveal that merely relying on the advice of a single investment advisor doesn’t provide a complete defense against claims of fiduciary imprudence. 

As a trustee, you must have some means to ensure that your reliance on the advice of your investment advisor is reasonably justified. You must also (as is illustrated in this case) have a way to effectively “monitor” your investment advisor’s activities and investment results.  How can this be accomplished?

We propose two strategies, both underpinned by our patented decision-assistance technology:
First is the use of the newly available Professional RapidReview Tool℠ (ProRRT℠). This tool, initially designed for professional investment advisors, is now available to plan sponsors, trustees, administrators, and staff via TEPI. 

The ProRRT℠ enables you to objectively score and rank the investment choices within your plan against other available choice options within any covered asset class. Utilizing up to 48 performance parameters, you can identify those choices aligning best with your plan participants’ desired investment outcomes.

This process takes mere moments and the results can be of tremendous help during quarterly meetings with your investment advisor to ensure that underperforming options are identified and not allowed to remain in your plan (increasing your risks) for far too long. 

Given the fact that claims of chronic underperformance are now some of the largest of the claims being brought against plan sponsors and trustees, this is a critical step.

ProRRT℠ is affordable (less than $10,000), and its cost can be covered by the plan itself. It comes with training and professional consulting assistance to maximize its benefits. 

Using this tool to rid your plan of chronic underperformers should not only provide enhanced protection against fiduciary imprudence claims related to your investment decisions, it can often significantly improve investment results for all plan participants

You can also secure an Investment Choice Protective Review℠ (iCPR℠). This independent review is conducted by an investment advisory firm licensed and trained in using ProRRT℠ technology for comparative evaluations of 401(k) plan investment choices. TEPI serves as a conduit, connecting plan sponsors and trustees with these specialized advisors. 

Please understand that this service isn’t intended to replace your current investment advisor; instead, it offers a valuable, independent second opinion of the suitability of the investment choices offered within your plan. In situations in which your investment-related decision-making is questioned, such a second opinion can be extremely valuable.

These solutions are new, so it’s possible that your advisors are not yet aware of them. We urge you to share this information, as these strategies can also help protect them. With these protective measures in place, you can more confidently and safely perform your important role as a plan trustee.