| Denali FM: In-depth analysis and discussion of current fiduciary issues |
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| Board Member Responsibilities for ERISA Retirement Plan Management |
| ERISA, the Employee Retirement Income Security Act of 1974, the federal law that governs retirement plan management, does not articulate specific fiduciary governance processes. Indeed, this absence of a statutory example of retirement plan governance is a primary cause for dysfunction in the private retirement plan system in this country. Over many years, the lack of a fiduciary governance safe harbor allowed service vendors to heavily influence the development of Plan Sponsor fiduciary behavior. As might be expected, the very nature of having non-fiduciary service vendors influence the evolution of the retirement industry has been counter productive to the fiduciary intent of serving as a guardian for long-term Trust assets. As a practical matter, dysfunctional fiduciary behavior was irrelevant during much of the 1980’s and 1990’s. The extended bull market effectively shielded fiduciaries from realizing liability. However, events of the past couple of years have created the perfect storm for retirement plan fiduciaries, which includes members of a Plan Administrative Committee as well as those members of the Board of Directors who appoint them. For making such appointments, those Board members (often part of the Compensation Committee) are called “Appointing Fiduciaries”. Thirty years of case law have made certain duties and responsibilities of an Appointing Fiduciary very clear. To the extent their fail to perform their oversight duties, they may incur personal financial liability for plan losses attributable to a breach of fiduciary duty by the Committee members they appointed. Given their net worth, the prospect of attaching personal liability to those Board members makes them tempting targets for plaintiff’s counsel. To limit liability exposure for those Board members with ERISA oversight responsibilities, we recommend the adoption of a systematic approach to ERISA fiduciary governance. Retirement Plan Adoption: The Creation of the Promise and the Liability A company adopts a retirement plan by virtue of a Board resolution. Also by resolution, the Board (or a Committee of the Board) appoints a Trustee for the Plan. A subsequent resolution appoints individuals to a Plan Administrative Committee (PAC) to manage the day-to-day affairs of the retirement plan. Once a plan is created, the company is typically identified as the Plan Administrator as that term is defined in ERISA. Sometimes the PAC itself may be appointed as the Plan Administrator. Once appointed, the individuals serving on the PAC become fiduciaries and are obligated to abide by ERISA’s principles in their conduct. It is their ability to exercise discretion over the Plan’s administration and the disposition of the Plan’s assets that generates their fiduciary status. Many Board members mistakenly believe that once the PAC is appointed, the fiduciary duties, responsibilities and liabilities of the Board members come to an end. As a matter of law, such an assumption is not accurate. The Appointing Fiduciaries have an on-going duty to monitor the PAC’s activity. In essence, they have to assure themselves that the PAC members know what they are supposed to do, have the resources to do what there are supposed to do and fulfill their fiduciary duties to a Prudent Expert standard of care. It makes sense that the Appointing Fiduciaries would have to know what is implied by the Prudent Expert standard of care so that their monitoring efforts can correctly identify whether the PAC’s activities were appropriate – or not. If the PAC members fail to fulfill their duties to the required standard of care and the Plan suffers losses that are tied back to that failure, the liability for those losses can be personal and can fall upon the shoulders of the Appointing Fiduciaries. The monitoring duties of the Appointing Fiduciaries serve as a check and balance in the retirement plan management system. This is why it is so important. Clearly, if substantive monitoring is implemented and documented, a credible defense strategy is more readily constructed. In fact, the very presence of thorough monitoring documentation by the Board will tend to deter litigation. After all, the plaintiff’s bar would rather pursue companies that are unprepared to defend themselves i.e., the low hanging fruit, rather than those companies who have gone to such lengths as to establish a thorough monitoring system. Background: The Creation of Fiduciary Status. The fiduciary duty of Board members to monitor the individuals they have appointed to the PAC is not a new phenomenon. What is also not new is that this monitoring duty never goes away. The monitoring function is on-going and requires, as a best practice, that there be evidence of the monitoring activity. Case law is clear on this point. Government regulatory authorities are also clear on this point. Indeed, the Department of Labor has filed amicus curiae briefs in some of the most visible lawsuits championing the plaintiff’s point of view that the Board’s failure to monitor the PAC’s actions or lack of actions constitutes a breach of fiduciary duty by the Appointing Fiduciaries. Understanding the Basic Framework ERISA defines a fiduciary in operational terms. For example, ERISA states that a party is a Plan fiduciary to the extent it: (1) exercises discretionary authority or control with respect to management of the plan or the management or disposition of plan assets; (2) has discretionary authority or responsibility in the administration of the plan; or (3) renders investment advice, with respect to plan assets, for a fee or other compensation (or has the authority or responsibility to render such advice). While the above definitions seem somewhat obvious, they include the more subtle circumstance in which an individual (or organization) with the authority to exercise discretion over the plan assets or administration did not do so when the circumstances warranted action. From a strict liability perspective, doing nothing, when one should do something, is the same as doing something inappropriate in the first place. There is a fourth kind of definition, somewhat more subtle, as to how one creates a fiduciary status to a retirement plan. It is applied when someone exercises discretion over the plan’s administration or assets even though they may not have known that they did so, may not do so under “normal” circumstances or may have disclaimed any responsibility for doing so. Clearly, the intent of declaring someone to be a functional fiduciary is to capture exogenous events that may otherwise not fit neatly into one of the three definitions above. Mitigating Risk: What Can An Appointing Fiduciary Do? For Appointing Fiduciaries, mitigating ERISA fiduciary risk is a two-fold exercise. First and foremost, an Appointing Fiduciary should promote a fiduciary culture and governance system that shines a bright light on the business relationship every service vendor has to the retirement Plan. Naturally, all service vendors have self-interest embedded in their products or services. In a fiduciary context, the purpose of shining a bright light is to put that self-interest “on the table”. Only then can plan fiduciaries determine whether that self-interest is reasonable, tolerable or does harm to plan participants. If PAC members do not know what a vendor’s self-interest is, they cannot be in a position to assess the appropriateness of the business relationship the vendor has to the retirement Trust. Without that analysis, neither they nor the Appointing Fiduciaries are in a position to honor the duty of loyalty required of an ERISA fiduciary. Secondly, the Appointing Fiduciaries should encourage a system of documentation that will serve as evidence to anyone looking over the PAC’s shoulders that the Plan Sponsor’s fiduciary duties have been properly executed to a Prudent Man (the language ERISA uses) standard of care. This standard of care is often misunderstood. It is often mistaken for some kind of assessment of character – as though the prudence of the PAC members’ personalities would, by itself, be sufficient to meet the standard. We call this circumstance the “…but we’re good people here…” mistake. The Prudent Man standard of care requires that PAC members are knowledgeable as to the duties required of them and how to carry out those duties They are either supposed to be Prudent Experts in all elements of plan management or they are supposed to hire them. Hiring a Prudent Expert whose self-interest conflicts with the best interests of the plan participants is inconsistent with the required standard of care. Unfortunately, neither ERISA nor the Department of Labor articulates a safe harbor against fiduciary liability. They both address fiduciary conduct by articulating principles rather than processes. Our advice to Appointing Fiduciaries on how to avoid liability, in an environment with no safe harbor, is to focus on being very practical. The higher the standard of conduct exemplified by the Plan Sponsor, the greater the likelihood that the risk of liability exposure has been contained. As might be expected, plaintiff’s counsel likes to pursue low hanging fruit. Therefore, the higher up on the tree your governance system puts you, the better your protection against the threat of litigation. When it comes to ERISA fiduciary liability the success of plaintiff’s counsel is directly related to whether there is documentation that illustrates the fiduciaries’ use of prudent processes in their decision-making. This is a dramatically different focus on liability containment from the more commonplace notion that poor investment performance generates liability. Assuring good investment performance results is not a fiduciary duty. Said differently, poor investment performance, in and of itself, is not a sufficient basis by which plaintiff’s counsel can successfully sue a Plan Sponsor for breach of fiduciary duty. Rather, those companies that fail to establish prudent processes or fail to establish thorough documentation of their use, are the ones rightfully characterized by plaintiff’s counsel as “low hanging fruit”. What Can An Appointing Fiduciary Do? Below are a few simple guidelines for Appointing Fiduciaries to assure themselves that a sound fiduciary governance structure and system are in place. 1. The Appointing Fiduciaries set the tone for the fiduciary culture of the Plan Sponsor. Let it be known that the PAC members are expected to exercise courage and conviction in the face of any influence which does harm to the best interests of the plan participants. If it is expected of them, PAC members are more likely to conduct themselves with an intention consistent with those values. Alternatively, if you communicate that “good enough is sufficient” you will allow room for expediency to be master of plan governance rather than purposeful intent. 2. Historically, most PAC members have not been trained to serve as plan fiduciaries. They do not know what is required to exemplify a Prudent Expert standard of care. As you can imagine, defending the fiduciary conduct of a PAC member is more difficult when the PAC has not received substantive ERISA fiduciary training. Such training will lead to higher quality decision making by the PAC members. Inexpensive training is available through Financial Executives International, the largest association of finance officers in the country (at www.fei.org/erisa). 3. PAC members must become well versed in the distinction between the exercise of “sound business judgment” and the exercise of “sound fiduciary judgment”. This is the heart and soul of the problem often referred to as “the wearing of two hats”. What might pass for the exercise of sound business judgment is often insufficient to rise to the standard of conduct required of a retirement plan fiduciary. The inability to draw this distinction generates litigation risk for all fiduciaries. 4. PAC members must be able to identify and use qualified unconflicted advisors in the fulfillment of their duties. The Committee must be provided with adequate resources to do the job. All too often, PACs operate with a loose governance structure and too few resources. Committee charters are often lacking. Further, individual PAC members are not held accountable for the fulfillment of specific statutory duties. The lack of personal accountability generates a dysfunctional governance structure. Without a clear governance structure, there is too much reliance on plan vendors to guide critical issues in plan management. 5. Establish a process to shine a bright light. Typically, the largest Plan vendors disclaim their fiduciary status in their client service agreements. To disclaim such status the non-fiduciary vendor in effect states that they are legally entitled to represent their self-interest first when doing business with the Plan. Vendor self-interest is the very influence which PAC members are supposed to guard against. To make matters worse, mutual fund companies, the largest plan vendors, are granted a statutory exemption from plan fiduciary status. Their self-interest, often not readily apparent, must be identified and challenged if a fiduciary is to uphold their role of guardian. Tolerating the imposition of vendor self-interest leaves PAC members and those members of the Board of Directors who serve as Appointing Fiduciaries open to personal liability. The only way to avoid such exposure is to shine a very bright light on a vendor’s business relationship with the Plan and Plan Sponsor. Implement and document a thorough process to examine the self-interest of all service vendors. 6. An independent investment advisor could be retained to provide the Committee with the advice it needs to oversee the Plan’s investments. Alternatively, the Appointing Fiduciaries could retain an independent fiduciary to manage the plan in its entirety. The independence of an advisor is not always obvious. For example, even if the consulting advisory firm is not economically tied to the plan’s investments, an investment advisor appointed from the same consulting firm engaged in a health and welfare or compensation consulting project is NOT independent. Their lack of independence comes from a reluctance to say or do anything that would jeopardize the revenue from other consulting engagements. The Public Company Accounting Oversight Board (PCAOB) came into existence after intimate auditor involvement in the corporate scandals of the past few years. One of its goals has been to identify conflicts-of-interest for CPA firms that provide a multitude of services to publicly traded companies or their executives. There is no PCAOB equivalent in the employee benefit consulting industry. Therefore, we recommend that no consulting firm with other Plan Sponsor consulting engagements be used to provide investment advisory services to the retirement plan’s fiduciaries. 7. The Appointing Fiduciaries should assure themselves that the PAC has a governance system in place that documents PAC activities. That governance system should be comprehensive and at a minimum, address all statutory fiduciary functions. The documentation created by the system should be clear enough so that an independent observer, reviewing a record of the PAC’s activity two years from now, could follow the thought process and understand the fiduciary basis for the decisions made. The quality and thoroughness of the governance system’s documentation are fundamental to building an effective deterrent to the threat of ERISA litigation. 8. At least annually, the PAC should issue a summary of its activities to the Appointing Fiduciaries. The appointing Board member(s) should review and approve that report. The review and approval of the report should be documented (in Board minutes). Special Note of Caution: ERISA and SOX The Sarbanes-Oxley (SOX) legislation has altered the business landscape and defined new standards for corporate governance. While SOX contained a couple of provisions which explicitly impacted qualified retirement plans, it was the requirements for internal controls under SOX §404 that has the most dramatic impact for plan management practices. The internal controls for an ERISA retirement plan invoke core fiduciary principles applied to the terms and conditions articulated in the plan’s governing documents. Historically, this area of ERISA compliance is problematic for Plan Sponsors. Though operational compliance with the plan’s governing instruments has always been a statutory duty under ERISA, prior to the passage of SOX, failure to achieve that compliance was a manageable challenge. After SOX, failure to delineate and test the retirement plan’s internal controls can be a catastrophic event. Now, a CFO and CEO who sign off on a company’s financial statements will violate SOX provisions if the internal controls of the retirement plan have not been defined and tested. Plan vendors (the major brand names) are not responsible for the retirement plan’s internal controls. They are responsible for their own internal controls. A Plan Sponsor’s internal controls begin with payroll processing and the assurance that the information gathered on plan participants satisfies the requirements outlined in the plan’s governing documents. The best way to assure the retirement plan’s internal controls is through a comprehensive fiduciary examination. The comprehensive examination is an audit-like activity that seeks to uncover discrepancies in operational compliance or the fiduciary governance of the plan. Once identified, such discrepancies can be amended and best practices can be adopted. Such an audit-like function requires specialized skills and should be implemented through outside counsel. It should not be implemented by an individual or organization that has an existing relationship with the Plan or the Plan Sponsor. The audit report is prepared for outside counsel and therefore should be protected by attorney client privilege. If you wait until an IRS or DOL audit discovers such operational defects, the Plan Sponsor and the plan fiduciaries may be subject to ominous penalties, fines and sanctions, including SOX violations, which can be criminal in nature. |
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