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The Fiduciary Duty to Avoid Conflicts of Interest in Selecting

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					 The Fiduciary Duty to Avoid
Conflicts of Interest in Selecting
    Plan Service Providers




                 A WHITE PAPER
                           by


  C. FREDERICK REISH AND JOSEPH C. FAUCHER



                    February 2009




               Reish Luftman Reicher & Cohen
             11755 Wilshire Boulevard, 10th Floor
                Los Angeles, CA 90025-1539
            (310) 478-5656 / (310) 478-5831 [fax]
       FredReish@Reish.com / JoeFaucher@Reish.com
                       www.reish.com
                                        TABLE OF CONTENTS



I.   EXECUTIVE SUMMARY                                      3. A financial institution offers a plan
                                                               fiduciary favorable mortgage terms
II. ANALYSIS AND DISCUSSION                                    on his personal residence if the
                                                               company transfers custody of its
     A. Introduction                                           401(k) plan assets to the financial
                                                               institution
     B. The Law Governing Conflicts of Interest
                                                            4. The plan’s investment fiduciary
         1. Who Are The Fiduciaries?                           (e.g., the chair of the plan
                                                               committee) buys and sells securities
         2. What Are The Fiduciaries’                          through a particular broker-dealer.
            Fundamental Duties?                                The broker-dealer – using a portion
                                                               of the commissions received from
         3. ERISA’s Prohibited Transaction                     the purchase and sale transactions –
            Rules                                              pays for the fiduciary to attend
                                                               conferences at expensive resorts
             a. ERISA §406(a) – Transactions
                between a plan and a party in               5. A retirement plan administration
                interest                                       firm refers the plan to a money
                                                               manager for investment advisory
             b. ERISA §406(b) – Fiduciary                      services. The money manager
                self-dealing                                   makes       payments     to      the
                                                               administration firm for each plan
     C. Situations Giving Rise to Conflicts of                 that uses the money manager’s
        Interest                                               services. Neither the money
                                                               manager nor the administration firm
         1. The president of a manufacturing                   disclose the payment to the
            company secures more favorable                     fiduciary
            banking terms for the company if it
            transfers its plan to the bank              D. What Should A Fiduciary Do?

         2. A law firm provides legal services          E. Conclusion
            for a trust company. During the
            course of the relationship, the trust
            company notifies the law firm that it
            prefers to send its legal work to law
            firms that maintain their 401(k)
            assets with the trust company. The
            law firm transfers its plan assets to
            the trust company




                                                    i
                                              I. EXECUTIVE SUMMARY

In the course of our legal practice and            broker-dealer – using a portion of      whom they provide multiple services.
in our conversations with others in the            the commissions received from the       The rules, however, change when
retirement plan industry, we have seen             purchase and sale transactions –        retirement plans are involved.
and heard about increasing numbers of              pays for the trustee to attend
conflicts of interest for fiduciaries in           investment strategy conferences in      In an effort to increase the transparency
their dealings with investments and                exotic locations                        – and simplify the evaluation – of
service providers. The purpose of this                                                     conflicts of interest, the United States
White Paper is to analyze the law             3.   A financial institution offers a
                                                   fiduciary favorable mortgage            Department of Labor (“DOL”) issued a
relating to conflicts of interest that                                                     proposed regulation in 2007 requiring
retirement plan fiduciaries may                    terms on his personal residence if
                                                   the company transfers its 401(k)        service providers to disclose certain
encounter in selecting the investments                                                     conflicts of interest that may affect
and service providers for 401(k) plans.            services     to   the    financial
                                                   institution.                            plans.       Although that proposed
                                                                                           regulation has not been finalized, it
As part of our analysis, we review            4.   A law firm provides legal services      reflects the thinking of the DOL about
several scenarios that raise issues about          for a trust company. During the         what is required in order for fiduciaries
conflicts of interest and we analyze               course of the relationship, the trust   to be able to fulfill their duties to plan
how those conflicts may violate the                company notifies the law firm that      and is likely to increase the expectation
Employee Retirement Income Security                it prefers to send its legal work to    that fiduciaries will prudently review
Act of 1974 (“ERISA”). Specifically,               law firms that maintain their           and respond to the disclosed
we discuss conflicts in the context of             401(k) assets with the trust            information. It is reasonable to assume
ERISA’s fiduciary duty and prohibited              company. The law firm transfers         that, in the future, the DOL and
transaction rules. In that context, it is          its plan assets to the trust            plaintiffs’ attorneys will focus more on
clear that plan sponsors, and the                  company.                                conflicts of interest and the conduct of
officers and managers who serve as                                                         fiduciaries in evaluating those conflicts.
fiduciaries, are required to identify and     Conflicts of interest adversely affect
evaluate conflicts of interest and to         the integrity of the private retirement      When a conflict exists for fiduciaries of
protect the plan and the participants         system. At the least, the appearance of      a retirement plan that is governed by
from their consequences. The failure to       impropriety      calls   into    question    ERISA, two distinct sets of ERISA
do so is a breach of fiduciary duty for       fiduciaries’ loyalty to participants. At     requirements are implicated: (1) the
which those officers and managers are         worst, a conflict of interest can have a     rules governing breaches of fiduciary
personally liable. It is equally clear that   direct adverse impact on the plan and        duty found in ERISA §404(a) and (2)
where plan sponsors and their                 its participants. For instance, a conflict   the prohibited transaction rules in
fiduciaries engage in prohibited              of interest, gone unchecked, can result      ERISA §§406(a) and (b).
transactions (that is, certain specified      in the plan paying more than reasonable
conflicts), they will be liable for           compensation to service providers or         The fundamental fiduciary duties are
disgorging any benefits and for making        result in fiduciaries offering mediocre      set forth in the so-called “prudent man”
the plan whole.                               and overly expensive investment              rule, the duty of loyalty and the
                                              options when superior products are           “exclusive benefit” rule. These duties
In our practice, we find that fiduciaries     available at equal or less expense.          require fiduciaries to carry out their
often do not recognize that they are          Conflicts of interest, therefore, can        duties as would “a prudent man
engaging in conflicts of interest. Our        adversely affect the benefits available      engaged in a like capacity and familiar
goal in writing this White Paper is to        to participants at retirement – the          with such matters,” to act “solely in the
educate fiduciaries and their advisors        exclusive purpose for which retirement       interest” of plan participants and to act
about how these conflicts arise and the       plans exist.                                 for the exclusive purpose of providing
legal dangers they present.                                                                retirement benefits to participants.
                                              When fiduciaries seek to benefit the
Examples of potentially conflicted            employer or themselves, they are –           Fiduciaries are obligated under
situations are:                               sometimes unwittingly – engaged in           ERISA’s fiduciary responsibility rules
                                              violations of ERISA. That is,                to (1) identify conflicts (or potential
1.   A bank offers a manufacturing            fiduciaries may not recognize or take        conflicts) that may impact the
     company       favorable   business       the time to consider that their actions      management of a plan; (2) evaluate
     banking terms if the company             are in conflict with the best interests of   those conflicts and the impact they may
     transfers its retirement or 401(k)       the plan and with the fiduciaries’ duty      have on the plan and its participants;
     plan to the bank.                        of loyalty to the participants. Conflicts    (3) determine whether the conflicts will
                                              may seem innocuous to many                   adversely impact the plan; (4) consider
2.   The retirement plan’s trustee buys       fiduciaries. After all, it is not            protections that would protect the plan
     and sells securities through a           uncommon for companies to give more          and participants from any potential
     particular broker-dealer. The            favorable terms to those businesses to       adverse affect of the conflict (for



                                                                  1
instance, appointing an independent         participants and for the exclusive             Absent an exemption, fiduciaries are
fiduciary to evaluate the investment or     purpose of providing benefits. If              absolutely precluded from entering into
proposed service provider) and; (5) if      material adverse impact on the                 a contemplated transaction if it meets
the conflict adversely impacts the plan     participants cannot be avoided or              the criteria of the prohibited transaction
and its participants, change service        properly mitigated, entering into the          provisions of ERISA §406 – even if
providers, investments or other             transaction would not be prudent and           doing so could otherwise be considered
circumstances related to the conflict.      would trigger a fiduciary breach.              “prudent” and therefore satisfy ERISA
                                                                                           §404.
Although a conflict of interest may         Furthermore, if a conflict of interest is
exist in connection with a proposed         precluded under ERISA's prohibited             Fiduciaries should be aware of both of
transaction,   entering    into    the      transaction rules, the fiduciaries cannot,     sets of rules and conduct themselves
transaction may or may not be a breach      as a matter of law, allow the plan to          accordingly.
of fiduciary duty – the determining         become a party to the transaction –
factors are whether the fiduciary           even if the action were otherwise
prudently evaluates the conflict, and       reasonable or profitable to the plan.
acts solely in the interest of the



                                            ANALYSIS AND DISCUSSION

A.   Introduction                           and recordkeeper for limiting the plan’s       Avoiding conflicts of interest – and at a
                                            investment options to funds for which          minimum, taking appropriate steps to
In the course of our practice and in        the    trustee’s   affiliate   provides        mitigate any effect they have on a plan
speaking with others in the retirement      investment management services.1               – is a must, both to manage the risk of
plan community, we have encountered                                                        litigation and to properly protect
numerous conflicts of interest that         The second reason is the increased             participants’ retirement benefits.
affect plan sponsors and fiduciaries.       focus by the United States Department
For ease of reference, we will refer to     of Labor (“DOL”) on the conflicts of           The first step in avoiding conflicts of
both plan sponsors and their fiduciaries    interest that may adversely affect the         interest is to recognize them. That isn’t
(e.g., plan committee members) as           services they provide to plans. In late        always easy. Fiduciaries may believe
“fiduciaries.”                              2007, the DOL issued a proposed                that, in order for a conflict of interest to
                                            regulation focusing largely on the             exist, the fiduciary must somehow act
The law governing how fiduciaries are       conflicts of interest affecting the plan’s     in a manner that is adverse to the plan.
to address conflicts of interest has not    service providers (rather than the             However, the better approach is for
changed significantly since Congress        benefits that the fiduciaries may enjoy        fiduciaries to ask themselves whether
passed the Employee Retirement              by virtue of directing the plan to do          someone other than the participants
Income Security Act of 1974                 business with a particular service             benefits as a result of the selection of a
(“ERISA”). However, our experience is       provider).2 Although that proposed             service provider or an investment
that fiduciaries often fail to understand   regulation has not been finalized (and         decision. The second step is, of course,
when they are operating under a             deals with service provider conflicts          to prudently evaluate any conflicts.
conflict of interest, fail to understand    rather than the conflicts affecting plan
the rules that govern their conduct and     sponsors), it is likely to increase            Later in this White Paper, we discuss
do not know how to comply with their        expectations by the DOL, participants          cases we and others have encountered
obligations in that setting. Our goal is    and plaintiffs’ attorneys that fiduciaries     that create conflicts for plan fiduciaries.
to educate those fiduciaries and thereby    must be aware of the conflicts that            In some of the circumstances, the
help them avoid potential liability by      infect their own relationships with the        decision made by the fiduciaries may
fulfilling their duties to act prudently    plan’s other fiduciaries and service           not have been “bad” from the
and for the exclusive purpose of            providers. Fiduciaries, therefore, should      standpoint     of     the     participants.
providing benefits to participants.         inform themselves about the law that           However, in each example the fiduciary
                                            governs those conflicts, the ways in           arguably entered into the transaction or
At least two recent changes warrant         which conflicts can arise and what             selected the service provider for the
renewed focus on conflicts of interest.     should be done when they do arise.             wrong reasons – to benefit themselves
The first is the current wave of high-                                                     or their employer – and unwittingly
profile litigation that is premised, in                                                    subjected themselves to liability. To
                                            1
part, on claims that fiduciaries have         See, e.g., Complaint in Hecker v. Deere &    understand why, fiduciaries need to
acted under conflicts of interest,          Co., United States District Court for the      know the rules that govern their
thereby breaching their fiduciary duties    Western District of Wisconsin, Case No. 06-    relationship to their plan.
and engaging in transactions prohibited     C-0719-S.
                                            2
                                              The text of the proposed Regulation, which
by ERISA. For example, in one case
                                            has not been finalized, can be found at 72
the plaintiffs criticize the plan trustee   FR 70988, 71004-71005.



                                                                 2
B.   The Law Governing Conflicts of               the administration of such              example members of a company’s
     Interest                                     plan.4                                  board of directors may themselves be
                                                                                          fiduciaries to the extent they are
Among a fiduciary’s fundamental              For purpose of this White Paper, we          responsible for appointing the plan’s
responsibilities is the “avoidance of        will focus on the first and third            fiduciaries,    since      they     have
conflicts of interest.”3 While conflicts     definitions: the asset manager fiduciary     discretionary authority or discretionary
of interest can arise in any number of       (who selects the plan’s investments)         control with respect to the management
ways, they are not always easy to            and the administrator fiduciary (who         of the plan:
identify. What at first appears to be a      selects the plan’s provider).
“win-win” transaction may in fact be a                                                         Members of the board of
conflict of interest. After all, in the      Employers, as plan sponsors, are, by              directors of an employer
business world, companies and their          definition, fiduciaries.5 Indeed, unless          which maintains an employee
owners commonly receive more                 the plan specifies otherwise, the plan            benefit     plan    will     be
favorable terms from their vendors and       sponsor is the “administrator”6 and               fiduciaries only to the extent
service providers when they do               therefore a fiduciary.                            that they have responsibility
business on several fronts. For instance,                                                      for the functions described in
a business owner may have access to          As the DOL has noted, certain plan                section 3(21)(A) of the Act
better home mortgage interest rates          officers such as trustees, administrators         [ERISA]. For example, the
from the lender with whom the                and members of a plan’s committee are             board of directors may be
business banks. The business itself          fiduciaries simply by virtue of their             responsible for the selection
might receive more favorable line of         appointment to a plan-related office:             and retention of plan
credit facilities in exchange for having                                                       fiduciaries. In such a case,
the same bank handle its payroll                  Some offices or positions of                 members of the board of
services. However, the rules change               an employee benefit plan by                  directors             exercise
when a transaction involves an ERISA-             their very nature require                    "discretionary authority or
governed retirement plan. Those                   persons who hold them to                     discretionary          control
transactions       implicate    ERISA’s           perform one or more of the                   respecting management of
fiduciary duties and prohibited                   functions described in section               such plan" and are, therefore,
transaction rules.                                3(21)(A) of the Act. For                     fiduciaries with respect to the
                                                  example, a plan administrator                plan.9
1.   Who Are The Fiduciaries?                     or a trustee of a plan must, be
                                                  the very nature of his                  As a result, the plan sponsor, officers
The first step in discussing a fiduciary’s        position, have “discretionary           appointed to plan committees or
obligations is to determine whether               authority or discretionary              otherwise designated to make plan
someone is a fiduciary. ERISA defines             responsibility       in     the         decisions, and directors who appoint
“fiduciary” as follows:                           administration” of the plan             plan fiduciaries, are all fiduciaries
                                                  within the meaning of section           under ERISA. Therefore, they are
     a person is a fiduciary with                 3(21)(A)(iii) of the Act.               subject to the law’s fiduciary and
     respect to a plan to the extent              Persons who hold such                   prohibited transaction rules in their
     (i)    he     exercises    any               positions will therefore be             administrative decisions (such as
     discretionary authority or                   fiduciaries.7                           selecting service providers) and
     discretionary           control                                                      investment decisions (such as selecting
     respecting management of                Selecting and monitoring the plan’s          the investments for the plan).
     such plan or exercises any              service providers is one of the fiduciary
     authority       or      control         functions of the plan administrator.8        The next step in our analysis is to
     respecting management or                Thus, those who select the plan’s            review those rules.
     disposition of its assets, (ii)         service providers must comply with
     he renders investment advice            their fiduciary duties when doing so.        2.   What Are The Fiduciaries’
     for    a    fee     or    other                                                           Fundamental Duties?
     compensation,      direct    or         Other persons become fiduciaries by
     indirect, with respect to any           virtue of the functions they perform,        ERISA imposes high standards upon
     moneys or other property of             regardless of title or whether they think    fiduciaries. The courts refer to those
     such plan, or has any                   of themselves as fiduciaries. For            duties as “the highest known to law.”10
     authority or responsibility to                                                       The three fundamental obligations of
     do so, or (iii) he has any
     discretionary authority or              4
                                               ERISA §3(21)(A).
                                             5                                            9
     discretionary responsibility in           See, generally, In re Enron Corp.           29 C.F.R. §2509.75-8 at D-4.
                                                                                          10
                                             Securities, Derivative & ERISA Litigation,     Sommers Drug Stores Co. Employee
                                             284 F.Supp.2d 511, 551 (S.D. Tex. 2003).     Profit Sharing Trust v. Corrigan, 793 F.2d
                                             6
                                               ERISA §3(16)(A)(ii).                       1456, 1468 (5th Cir. 1986); Donovan v.
3                                            7
  Mertens v. Hewitt Assoc., 508 U.S. 248,      29 C.F.R. §2509.75-8 at D-3.               Bierwirth, 680 F.2d 263, 272 n. 8 (2d Cir.),
                                             8
251-52, 113 S.Ct. 2063, 124 L.Ed.2d 161        Liss v. Smith, 991 F.Supp. 278, 300        cert. denied , 459 U.S. 1069, 103 S.Ct. 488,
(1993).                                      (S.D.N.Y. 1998).                             34 L.Ed.2d 631 (1982).



                                                                  3
ERISA fiduciaries are set forth in            enterprise of a like character and with             provider and any conflicts of
ERISA §404(a). The first two are the          like aims.”13                                       interest that may adversely
duty of loyalty and the exclusive                                                                 affect the service provider’s
purpose rule:                                 Consequently, when selecting service                performance       under     the
                                              providers, fiduciaries must engage in an            contract or arrangement. 17
     [A] fiduciary shall discharge his        appropriate process: “… [T]he failure               (Emphasis added.)
     duties with respect to a plan            to exercise due care in selecting and
     solely in the interest of the            monitoring a fund's service providers          In selecting the plan’s investments,
     participants and beneficiaries           constitutes a breach of . . . fiduciary        fiduciaries are obligated to focus first
     [the duty of loyalty] and –              duty.”14 “At the very least, trustees          on the plan’s interests. That is, they
                                              have an obligation to (i) determine the        cannot consider factors other than the
     (A) for the exclusive purpose            needs of a fund's participants, (ii)           plan’s benefit unless and until they
     [the exclusive purpose rule] of:         review the services provided and fees          determine that investments they might
                                              charged by a number of different               otherwise select are equally beneficial
        (i) providing benefits to             providers and (iii) select the provider        to the plan. As the DOL explained in
        participants    and  their            whose service level, quality and fees          describing the fiduciaries’ duty in
        beneficiaries; and                    best matches the fund's needs and              evaluating “economically targeted
        (ii) defraying reasonable             financial situation.”15                        investments”:
        expenses of administering
        the plan . . .                        As part of that process, fiduciaries must           ERISA's fiduciary standards
        (Emphasis added.)                     take conflicts of interest into account.            expressed in sections 403 and
                                              As the DOL recently stated:                         404 do not permit fiduciaries
Plan fiduciaries, therefore, have a duty                                                          to select investments based
of loyalty that runs directly to the               With regard to the prudent                     on factors outside the
participating employees. This means                selection of service providers                 economic interests of the plan
that the fiduciaries must “exclude all             generally, the Department has                  until they have concluded,
selfish interest and all consideration of          indicated that a fiduciary                     based on economic factors,
the interests of third persons.”11                 should engage in an objective                  that alternative investments
                                                   process that is designed to                    are equal. A less rigid rule
They must also act for the exclusive               elicit information necessary                   would allow fiduciaries to act
purpose of providing retirement                    to assess the provider’s                       on the basis of factors outside
benefits to the participants. When                 qualifications, quality of                     the economic interest of the
corporate directors and officers are               services      offered     and                  plan in situations where
acting in their capacity as plan                   reasonableness      of    fees                 reliance on those factors
fiduciaries, their exclusive purpose               charged for the service. The                   might      compromise        or
must therefore be to provide benefits –            process also must avoid self                   subordinate the interests of
they are obligated “to avoid placing               dealing, conflicts of interest                 plan participants and their
themselves in a position where their               or       other       improper                  beneficiaries.18
acts as directors or officers of the               influence.16
corporation     will   prevent    their            (Emphasis added.)                         Fiduciaries who violate their duties can
functioning with the complete loyalty                                                        be held personally liable to restore to
to participants demanded of them as           Although it has not been finalized, the        the plan any losses resulting from the
trustees.”12                                  DOL’s proposed Regulation under                breach.19 Consider, for example, a
                                              ERISA §408(b)(2) reflects the DOL’s            fiduciary that hires a bank to provide
The third duty is to act prudently –          thinking regarding the need to avoid           recordkeeping services for the plan
fiduciaries must act “with the care,          conflicts of interest, and to ferret out all   based on the bank’s offer to make a
skill, prudence and diligence under the       of the compensation the service                favorable mortgage loan to the
circumstances then prevailing that a          providers are to receive:                      fiduciary. If the cost of the trustee
prudent [person] acting in a like                                                            services are greater than what other
capacity and familiar with such matters            The Department believes that              qualified recordkeepers charge for
would use in the conduct of an                     in order to satisfy their                 similar services, the fiduciary is liable
                                                   ERISA obligations, plan                   to the plan for the difference.
                                                   fiduciaries need information              Alternatively, consider a fiduciary who
                                                   regarding all compensation to             hires an investment manager for a
                                                   be received by the service                retirement plan because of collateral
11
   McMahon v. McDowell, 794 F.2d 100,
110 (3rd Cir. 1986), cert. denied, 479 U.S.
                                              13                                             17
971 (1986), citing 7 G. Bogert, The Law of       ERISA §404(a)(1)(B).                           72 FR 70988, 70989.
                                              14                                             18
Trusts and Trustees § 543 at 197-98 (2d          Mahoney v. J.J. Weiser & Co., Inc., 564        29 C.F.R. §2509.08-1, Supplemental
rev.ed 1978)                                  F.Supp.2d 248, 255 (S.D.N.Y. 2008).            guidance relating to fiduciary responsibility
12                                            15
   Donovan v. Bierwirth, 680 F.2d 263, 271       Liss v. Smith, supra, 991 F.Supp. at 300.   in considering economically targeted
(2nd Cir. 1982) cert. denied 459 U.S. 1069,   16
                                                 DOL Field Assistance Bulletin No. 2007-     investments.
                                                                                             19
103 S.Ct. 488, 74 L.Ed.2d 631 (1982).         01, Feb, 2, 2007                                  ERISA §409(a).



                                                                   4
benefits to the fiduciary personally (for     Section 408 [which provides a statutory       Fiduciaries must therefore “… act with
example, favorable personal or                exemption for certain otherwise               prudence in investigating whether a
corporate financing, or discounted            prohibited transactions] does not             party in interest relationship exists.”28
personal     investment     management        sanction any derogation from the strict       The ERISA Conference report indicates
services), rather than engaging in a          requirements of Section 404.”24               that whether a fiduciary has prudently
prudent process focused on the needs of                                                     carried out its obligation must be
the plan. If the plan investments             Since transactions that violate §406 –        determined on a case-by-case basis. At
selected by the investment manager            particularly the transactions described       a bare minimum, however, the
underperform the return from a                in §406(b) – are illegal per se, some         fiduciary has a duty to inquire about the
prudently selected portfolio of similarly     courts have found that it is not              service provider’s relationships:
priced investments, the fiduciary may         necessary for a plaintiff to show that
be liable for the difference. That is, a      the plan was harmed in order to show a               The type of investigation that
court would decide what the plan              violation: “… whether one of the                     will be needed to satisfy the
would be worth “… if the funds had            provisions has been violated does not                test of prudence will depend
been invested prudently.”20                   depend on whether any harm results                   upon the particular facts and
                                              from the transaction.”25                             circumstances of the case. In
3.   ERISA’s Prohibited                                                                            the case of a significant
     Transaction Rules                        We now take a closer look at the two                 transaction, generally for a
                                              broad     categories of   prohibited                 fiduciary to be prudent he
In addition to the general fiduciary          transactions.                                        must make a thorough
duties under §404, ERISA regulates the                                                             investigation of the other
relationships between (1) fiduciaries         a.   ERISA §406(a) – Transactions                    party's relationship to the
and plans (§406(b)) and (2) plans and              between a plan and a party in                   plan to determine if he is a
their service providers (406(a)). This is          interest:                                       party-in-interest. In the case
accomplished through a second and                                                                  of a normal and insubstantial
distinct set of rules – ERISA’s                                                                    day-to-day transaction, it may
                                              ERISA §406(a) prohibits fiduciaries
prohibited transaction rules.                                                                      be sufficient to check the
                                              from enabling the plan to enter into
                                                                                                   identity of the other party
                                              certain transactions with “parties in
Violations of ERISA’s prohibited                                                                   against a roster of parties-in-
                                              interest.” Service providers are one
transaction rules are often described as                                                           interest that is periodically
                                              type of person or company that ERISA
“per se” violations. In adopting the                                                               updated.29
                                              refers to as “parties in interest.”26 Other
prohibited transaction rules, “Congress       parties in interest include other
intended to create an easily applied per      fiduciaries, plan accountants and             b.     ERISA §406(b)– Fiduciary self-
se prohibition of the type of transaction     attorneys, plan advisors or brokers, and             dealing
in question.”21 This means that, in           the plan sponsor.27 Generally, §406(a)
order for a violation of the prohibited       prohibits fiduciaries from allowing the       ERISA §406(b) focuses on benefits the
transaction provisions to occur, there        plan to engage in certain transactions        fiduciaries themselves receive. It
need be no “fiduciary misconduct.”22          with the plan, including selling or           prohibits fiduciaries from three basic
Indeed, a violation of the prohibited         leasing property, lending money or            types of conduct:
transaction rules can occur even in           extending credit and transferring plan
cases where there is “… no taint of           assets to a party in interest.                     (1)    Dealing with the assets of the
scandal, no hint of self-dealing, no                                                             plan for his own interest or for his
trace of bad faith … the result of a                                                             own account.
                                              Avoiding       §406(a)        prohibited
misunderstanding.”23       On the other
                                              transactions requires fiduciaries to               (2)     Acting adverse to the plan in
hand, the mere fact that a fiduciary
                                              understand who the parties in interest             a transaction involving the plan
avoids a prohibited transaction does not
                                              are and to investigate the benefits they
immunize the fiduciary from liability                                                            (3)     Receiving consideration from
                                              might be receiving as the result of a
under §404’s general duties of                                                                   a party dealing with the plan in a
                                              plan transaction. For example, a plan
prudence and loyalty. Therefore, while                                                           transaction involving plan assets.
                                              can loan money (as long as the loan is a
a transaction may be subject to a
                                              prudent investment) – but it can’t loan
statutory exemption – and, therefore,
                                              money to a party in interest.                 §406(b) presents “a blanket prohibition
not violate the prohibited transaction
                                                                                            of certain transactions, no matter how
rules – the fiduciary is still obligated to
                                                                                            fair.”30
comply with the general fiduciary
obligations set forth in §404: “…
                                              24
                                                 McMahon v. McDowell, supra, 794 F.2d
                                              at 110.
20                                            25                                            28
   Meyer v. Berkshire Life Ins. Co., 250         Raff v. Belstock, 933 F.Supp. 909, 916        Marshall v. Kelly, 465 F.Supp. 341, 351
F.Supp.2d 544, 572, fn. 36 (D.Md. 2003).      (N.D. Cal. 1996), citing McDougall v.         (W.D. Okla. 1978).
21                                                                                          29
   Cutaiar v. Marshall, 590 F.2d 523, 529     Donovan, 552 F.Supp. 1206 (N.D. Ill.             H.R.Rep. 93-1280, Cong., 2d Sess. at p.
(3rd Cir. 1979).                              1982).                                        307; 1974 U.S.Code Cong. and
22                                            26
   Id.                                           ERISA §3(14)(B).                           Admin.News at p. 5087.
23                                            27                                            30
   Id. at 528.                                   ERISA §3(14).                                 Id. at 530.



                                                                  5
When a fiduciary engages in a                    not always easy to spot. As mentioned        purpose”    of   providing   retirement
transaction prohibited under §406(b),            above, however, the fact that a              benefits.
the fiduciary is liable to the plan              fiduciary has no malicious intent and
regardless of whether the plan suffers           may be perceived to act “fairly” to the      2.   A law firm provides legal
any damage from the transaction. The             plan is not likely to shield him from             services for a trust company.
focus in prohibited transaction cases            liability, particularly if the transaction        During the course of the
“… is not the loss of plan assets but            violates the prohibited transaction               relationship, the trust company
instead the risking of the trust's assets        rules. Here are some of the situations            notifies the law firm that it
at least in part to aid the defendants.” 31      that we have encountered – and a                  prefers to send its legal work to
(Emphasis in original.) The amount of            discussion of how the law applies to              law firms that maintain their
the fiduciary’s liability is measured by         those situations.                                 401(k) assets with the trust
the benefit that the fiduciary received in                                                         company. The law firm
connection with the transaction:                 1.   The president of a                           transfers its plan assets to the
                                                      manufacturing company secures                trust company.
     ERISA clearly contemplates                       more favorable banking terms
     actions against fiduciaries                      for the company if it transfers         As a condition of obtaining legal work
     who profit by using trust                        its plan to the bank.                   from the trust company, the trust
     assets, even where the plan                                                              company requires the law firm to
     beneficiaries do not suffer                 At first glance, transferring the plan’s     transfer its plan to the trust company.
     direct      financial     loss.             assets to the bank may appear to be an       The law firm – a plan fiduciary – is
     [Footnote       omitted]      A             innocuous transaction, especially if         effectively using the plan’s assets to
     fiduciary who breaches his                  there is no discernible “harm” that the      benefit itself and violating ERISA
     duties “shall be personally                 plan would suffer, and if the president      §406(b) in the process. And, as in the
     liable ... to restore to such               obtains no direct benefit from the           prior example, the firm may be
     plan any profits of such                    transaction. In reality, however, the        committing an independent breach of
     fiduciary which have been                   president (who is making the decision        fiduciary duty if it makes the switch
     made through use of assets of               regarding who will provide services to       without adequately investigating the
     the plan by the fiduciary.”32               the plan and is, therefore, acting as a      investments and services offered by the
                                                 fiduciary) and the plan sponsor may be       trust company and comparing them to
Therefore, any benefit that the fiduciary        breaching their fiduciary duties and         other service providers offering similar
realizes as a result of the prohibited           violating      ERISA’s        prohibited     services and investment products.
transaction must be disgorged to the             transaction rules.
plan. The DOL’s Voluntary Fiduciary                                                           In this circumstance, under the
Correction program discusses the                 Beginning      with     the     prohibited   prohibited transaction rules, the law
amount that needs to be restored to the          transaction rules, the decision to           firm could be required to disgorge to
plan:                                            transfer plan assets in exchange for         the plan all of the benefit it received
                                                 better banking terms for the company         (the proceeds from the legal work that
     the       principal     amount              violates the provisions of ERISA             it may have otherwise foregone) as a
     involved, plus the greater of               §406(b). That is, the transaction            result of transferring the plan to the
     lost earnings, starting on the              violates 406(b)(1) and (3) because the       bank.
     date of the loss and extending              responsible fiduciary (the plan sponsor)
     to the recovery date, or                    has dealt with the assets of the plan for    3.   A financial institution offers a
     profits resulting from the use              its own benefit (i.e., better banking             plan fiduciary favorable
     of the principal amount,                    terms) and has received consideration             mortgage terms on his personal
     starting on the date of the loss            (e.g., lower interest rates) from a third         residence if the company
     and extending to the date the               party in a transaction involving plan             transfers custody of its 401(k)
     profit is realized.33                       assets.                                           plan assets to the financial
                                                                                                   institution.
C.   Situations Giving Rise to                   The president and the company may
     Conflicts of Interest                       also have independently breached their       In this case, the plan sponsor receives
                                                 fiduciary duties. For instance, assume       no direct benefit from the decision
Conflicts of interest – which can trigger        the sponsor failed to adequately             about service providers, but the
violations of ERISA’s fiduciary duty             investigate the investments and services     fiduciary who makes the decision (for
and prohibited transaction rules – are           offered by the bank before making the        example, the CFO) receives a favorable
                                                 switch. If better performing or lower-       mortgage on his personal residence in
31
                                                 priced equivalent investments were           exchange for using his influence to
   Leigh v. Engle, 727 F.2d 113, 122 (7th Cir.   reasonably available, and there is no
1984), citing ERISA §409(a).
                                                                                              transfer the plan to the financial
32                                               other reason justifying the transfer, the    institution.
   Id.
33
   Voluntary Fiduciary Correction Fact           fiduciary breached its duties to act
Sheet, May 2006, available at                    prudently and for the “exclusive
http://www.dol.gov/ebsa/newsroom/fs2006v
fcp.html.



                                                                     6
The circumstance is similar to a court       This example is a so-called “soft                  money manager’s services.
case (Whitfield v. Tomasso34), in which      dollar” or directed commission                     Neither the money manager nor
the    trustee    invested    significant    arrangement. It’s possible for a plan to           the administration firm disclose
percentages of a union trust fund’s          benefit by these arrangements –                    the payment to the fiduciary.
available assets in certificates of          provided the plan recaptures the portion
deposit (“CDs”) issued by an insurance       of the commission that otherwise              In this case (unlike in most of the
company. In return, the insurance            would be received by the broker-dealer.       examples above), no one associated
company’s founder arranged for               However if, as in this example, the           with the plan sponsor receives any
another of his companies to make             fiduciary is the beneficiary of the           benefit as a result of the plan’s decision
mortgage loans to the trustee and his        arrangement, he violates the prohibited       to use the money manager’s services.
associates, gave the trustee money for       transaction rules and breaches his            However, the fiduciary has enabled one
causing the fund to loan money to the        fiduciary duties:                             of the plan’s service providers (the
insurance company and forgave                                                              administration firm) to receive a benefit
payments due on the loans to the                  A fiduciary with respect to              beyond that which the administration
trustee from the affiliated company.              an ERISA plan is generally               firm contracted to receive from the
The trust fund’s fiduciaries failed to            prohibited,      by     section          plan.
adequately investigate the quality and            406(b)(1), from causing the
creditworthiness of the insurance                 plan to engage in a                      Fiduciaries are legally responsible for
company that issued the CDs, or even              transaction if the fiduciary             determining       the      amount      of
consider that CDs are usually issued by           has an interest in the                   compensation received by service
banks and not insurance companies.                matter which may affect the              providers (and any potential conflicts
They also enabled the union that                  fiduciary’s best judgment                related to that compensation) and
sponsored the trust fund to retain                as a fiduciary. For example,             assessing whether that compensation is
employer contributions that were owed             an employer which is the                 reasonable in relationship to the
to the fund. The court concluded that,            named fiduciary for its plan             services provided. When they fail to do
in making the investments in the                  and which does not exercise              so, they engage in a breach of fiduciary
insurance company at the same time the            investment discretion would              duty (since they have failed to carry out
insurance company’s affiliate loaned              normally be prohibited from              their responsibilities prudently).
money to the trustees, the trustees               directing the plan’s brokerage
breached their fiduciary duty of                  transactions           through           Claims such as these are not, by the
loyalty,35 dealt with the fund assets in          designated broker-dealer who             way, merely hypothetical. Alleged
their own interest and for their own              agrees to utilize a portion of           failures to identify and determine the
account,36 received consideration for             the brokerage commissions                reasonableness of revenue sharing
their own account from a party dealing            received from the plan to                payments received by service providers
with the fund in a transaction involving          procure goods or services for            are at the root of a number of high
fund assets37 and caused the fund to              the benefit of the employer              profile recent lawsuits against plan
lend money to a party in interest,38 all          … Each use of the broker-                fiduciaries.39
of which were violations of ERISA’s               dealer that results in the
prohibited transaction rules.                     receipt of goods and services
                                                                                           D.   What Should A Fiduciary Do?
                                                  by the employer following
Among other things, the court held the            that designation would create
                                                                                           To avoid liability for fiduciary breaches
trustees personally liable for the several        an additional violation of
                                                                                           related to conflicts of interest and
hundreds of thousands of dollars                  sections 406(a)(1)(D) and
                                                                                           prohibited transactions, plan sponsors
invested in the CDs by the fund.                  406(b)(1)      of      ERISA.
                                                                                           and their officers need to know whether
                                                  (Emphasis added.)
                                                                                           there is a possibility of liability.
4.   The plan’s investment fiduciary
     (e.g., the chair of the plan            As a result, in our example the
     committee) buys and sells                                                             The first step in that analysis is to know
                                             fiduciary would be liable to restore the
     securities through a particular                                                       whether you are a fiduciary. As a
                                             cost of the resort trips, together with the
     broker-dealer. The broker-                                                            practical matter, committee members
                                             missed earnings on these amounts, to
     dealer – using a portion of the                                                       and the officers and managers who
                                             the plan. In addition, if the plan
     commissions received from the           overpaid for the services of the broker-
     purchase and sale transactions –        dealer, the fiduciary could be liable to      39
                                                                                              See, e.g., Complaint in Taylor v. United
     pays for the fiduciary to attend        the plan for those amounts.                   Technologies Corp., United States District
     conferences at expensive resorts.                                                     Court, District of Connecticut, Case No.
                                             5.   A retirement plan                        3:06-cv-01494 (WWE), filed September 22,
                                                  administration firm refers the           2006; Complaint in Renfro v. Unisys Corp.,
                                                  plan to a money manager for              currently pending in the United States
34
   682 F.Supp. 1287 (E.D.N.Y. 1988).                                                       District Court, Eastern District of
35                                                investment advisory services.
   Id. at 1301.                                                                            Pennsylvania (and originally filed in the
36
   Id. at 1302.                                   The money manager makes                  United States District Court, Central District
37
   Id.                                            payments to the administration           of California), Case No. 2:07-cv-2098
38
   Id.                                            firm for each plan that uses the         (BWK).



                                                                 7
have discretion over the selection of       • avoid any transactions that use          • ensure that conflicts of interest
a plan’s service providers or                 the plan or its assets to benefit          do not adversely affect the plan
investments are fiduciaries.                  the employer or the fiduciaries;           and the participants.
                                            • avoid any arrangements where
The second step is for the identified                                             E.     Conclusion
                                              the employer gets payments or
fiduciaries to engage in a
                                              other value (e.g., favorable
thoughtful, prudent analysis of the                                               Fiduciaries      must     scrupulously
                                              loans) from a provider;
transactions the plan enters into and                                             identify, examine and, where
the persons hired to provide services       • avoid any “quid pro quo”            possible, avoid conflicts of interest.
and investments to the plan. What             transactions, where the plan        Some conflicts may, if properly
does this mean? At the outset, it             sponsor or the fiduciaries          managed, be acceptable under the
means that fiduciaries must                   receive anything in exchange        fiduciary      responsibility     rules.
determine whether anyone other                for plan transactions, assets or    However, even then, transactions
than     the    participants      (and        services.                           involving conflicts will cause the
particularly whether the plan                                                     decisions made by plan fiduciaries
sponsor or a fiduciary) are               In addition to the prohibited           to be more closely scrutinized.
benefiting from a decision. Does the      transaction issues, those decisions     However, certain conflicts – those
employer benefit (for example,            may be fiduciary breaches. To avoid     classified as prohibited transactions
when it obtains favorable banking         that outcome, fiduciaries should:       by ERISA – are never permissible
terms in exchange for allowing the                                                (unless there is a specific legal or
bank to handle the 401(k))? Does                                                  regulatory      exemption).     Where
the fiduciary himself benefit? If the       • compare the service provider to
                                                                                  fiduciaries allow their plans to
answer is “yes,” it is possible, if not       competing providers;
                                                                                  engage in prohibited transactions,
likely, that the transaction – the          • analyze the scope and quality       they are subject to both sanctions
hiring of the service provider or             of services provided;               (i.e., excise taxes) and personal
selection of the investments –                                                    liability for any losses to the plan or
violates the prohibited transaction         • reach an informed and               personal       gains      from       the
rules. Specifically, the fiduciaries          reasoned conclusion that the        transactions.
should:                                       compensation being paid is
                                              reasonable; and




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