Texas Chapter Presents: Fiduciary Liability Trends

1. Texas Chapter Presents: Fiduciary Liability Trends May 10, 2007~ Houston, Texas

2. Seminar Goals • Identify exposures faced by employers who offer employee benefit plans • Understand the management liability products available to address these exposures • Discuss how the market is reacting to new exposures • Explore how employers make decisions with respect to fiduciary liability coverage • Identify current trends in ERISA litigation

3. History of Fiduciary Liability Coverage • ERISA: Employee Retirement Income Security Act • Enacted in 1974 in response to: • Funding shortages • Vesting abuses • Studebaker case

4. Goals of ERISA • Protect plan participants and beneficiaries from abuses • Establish strict minimum standards of conduct for those who run pension plans • Eliminate exculpatory provisions • Provide exclusive access to Federal Courts • Ensure financial soundness of plans

5. ERISA Applies to Employee Benefit Plans • Pension benefit plans • Sole sponsored and multi-employer • Defined benefit and defined contribution • ESOPs • Welfare benefit plans

6. ERISA Applies to Plan Fiduciaries • Any person who exercises discretionary authority or control in management, or • Anyone named in the Plan

7. ERISA Mandated Standards of Conduct for Fiduciaries • Exclusive Benefit Rule – investments must be selected and managed “solely for the benefit of plan participants” • Prudence Rule – fiduciaries must act in the same manner as a prudent expert would under like circumstances

8. ERISA Mandated Standards of Conduct for Fiduciaries • Diversification Rule – assets must be diversified to avoid risk of large losses • Plan Target Rule – fiduciaries must follow the plan terms to the extent they are consistent with ERISA

9. Plan Fiduciaries are Subject to Personal Liability • Fiduciaries shall be personally liable to restore to the Plan any losses resulting from a breach of fiduciary duty and to restore to such Plan any profits made by the fiduciary through the use of Plan assets.

10. ERISA Enforcement • Participants or beneficiaries • Department of Labor • Fiduciaries • The Plan

11. Sources of Claims Against Plan Fiduciaries • How do fiduciaries get into trouble? • Making false or misleading statements • Imprudent investments • Lack of diversification • Non-compliance with Plan documents • Errors in Plan administration

12. The Cost of a Claim • Tillinghast Survey • $1.9 million average indemnity payment of a fiduciary claim • $121,000 average defense cost • Public companies and companies involved in M&A activity have higher incidences of claims

13. Available Insurance • EBL • ERISA Bond • D&O • Fiduciary Liability Coverage

14. Fiduciary Liability Insurance What is covered? / Who is covered? • Common coverage provisions • Common coverage exclusions • Potential coverage enhancements

15. Fiduciary Liability Insurance What is covered? Common policy provisions • Breach of duties imposed by ERISA or COBRA • Negligence, error or omission in the administration of employee benefits • Definition of Claim usually includes written demands for monetary or non-monetary relief, civil proceedings, criminal proceedings, formal administrative or regulatory proceedings, and alternative dispute resolution proceedings

16. Fiduciary Liability Insurance What is covered? Administration means…. • Giving counsel, advice or notice • Interpreting plan benefits • Handling records • Effecting enrollment, termination or cancellation of plan participants in benefit plans

17. Fiduciary Liability Insurance What is covered? Loss/Damages • Compensatory damages and defense expenses • Punitive damages – “most favorable venue” • ERISA 502(i) and 502(l) penalties

18. Fiduciary Liability Insurance Who is covered? • Benefit plan (scheduled to policy or omnibus) • Merged/terminated/sold plans • Plan sponsor and subsidiaries • Fiduciaries/trustees of the plans and plan sponsor and subsidiaries (D&Os and employees) • Spousal extension

19. Fiduciary Liability Insurance Common Coverage Exclusions • Benefits due • Deliberate fraud/willful violation of statute • Personal profit • BI/PD • Prior and pending litigation; notice given to prior carrier • Discriminatory hiring or firing, retaliation, and wrongful termination, other than claims under ERISA Section 510

20. Fiduciary Liability Insurance Potential Enhancements • Additional defense coverage • Coverage for HIPAA violations • IRS and DOL voluntary compliance settlement fees • Coverage for benefit plans not subject to ERISA Title I • Amended settlement provision (“hammer clause”)

21. Pension Protection Act • What is it? • Why was it enacted? • What does it do? • Possible effects on fiduciary liability?

22. Pension Protection Act What is it? • Signed into law August 16, 2006 • Modified dozens of ERISA and Internal Revenue Code provisions • Major changes to defined benefit plan funding rules • New reporting and disclosure requirements • New safe harbors for certain plan features and plan types

23. Pension Protection Act Why was it enacted? • Improve funding of defined benefit plans • 2000 – 2003 “Perfect Storm” • Record PBGC deficit in 2004 • Funding relief requested by plan sponsors • Improve accuracy of valuing plan liabilities • Limited ability to overfund plans during good years • Response to collapse of Enron

24. Pension Protection Act What does it do? • Modifies defined benefit plan funding rules • Improves disclosure and reporting of defined benefit and defined contribution plans • Creates a safe harbor for cash balance plans • Creates new diversification rights for certain 401(k) participants • Creates safe harbors for 401(k) plan automatic enrollment, default investments, and investment advice • Increases bonding requirements • Miscellaneous changes to ERISA and Internal Revenue Code

25. Pension Protection Act What does it do? • Modifies defined benefit plan funding rules • Increases minimum funding target • Requires more rapid payment of funding deficits • Imposes benefit restrictions on poorly funded plans • Improves disclosure of defined benefit plan funding and benefits • Triennial benefit statements • Annual funding notices

26. Pension Protection Act What does it do? • Creates a safe harbor for cash balance plans against age discrimination claims • Prospective relief only (post-June 28, 2005) • Accelerated vesting • Prohibits “wearaway” after a traditional DB plan conversion • Annual interest credits must be the same for similarly situated employees • Eliminates the “whipsaw” issue

27. Pension Protection Act What does it do? • Creates new diversification rights in plans with employer securities • Creates safe harbors for 401(k) plan automatic enrollment, default investments, and investment advice • Express preemption of state payroll laws • Qualified Default Investment Alternative (QDIA) • Eligible Investment Advice Arrangement • Improves disclosure of defined contribution plan rights and benefits • Annual benefit notices (quarterly for participant-directed account plans)

28. Pension Protection Act What does it do? • Increases bonding requirements • Maximum bond limit increased from $500,000 to $1,000,000 for plans that hold employer securities • Miscellaneous changes to ERISA and IRC

29. Pension Protection Act Implications for plan fiduciaries? • Numerous changes to existing administrative practices • New safe harbors contain a laundry list of new rules • Defined benefit plan funding requirements are more onerous • Possible increase in the number of defined benefit plan amendments, conversions, freezes and terminations • Greater plan transparency may prompt more comments, inquiries and complaints from plan participants • Plan fiduciaries may be on their own until additional technical guidance is issued by the DOL and IRS • Possible need for a corrections bill from Congress

30. How Are Claims Handled? • Duty to defend • Insurer pays first dollar defense • Defense covered for all counts • Reimbursement • Flexibility to choose defense counsel • Coverage must be determined prior to reimbursement • Reporting of Claims • Reported during policy period (or within ERP) • “as soon as practicable” language

31. Claim TrendsCost of a Claim $858,000 Legal action brought by employees alleged the wrongful elimination of a profitable investment option and improper selection of another and FAILURE TO MONITOR the actions of the outside investment manager. Defense costs were $358,000 and the jury awarded the plaintiffs $500,000 in damages. $400,000 Plan participants alleged that the fiduciaries of a 401(K) PLAN had failed to divest the plan of an investment option that was not keeping pace with the performance of the comparable index and RESULTED IN POOR RETURNS. The case settled for $250,000 after $150,000 in legal fees had been spent. $530,000 Participants of a health plan sued the plan’s trustee alleging that the TRUSTEE DID NOT MONITOR the performance of its third party administrator (TPA) and paid excessive fees. Damages and defense expenses totaled $530,000.

32. Texas Trends • Claim Trends • Failure to send Cobra Notices • Failure in HR to properly enroll employees in life and health plans • Texas Specific- Non Subscriber Worker’s Compensation Claims • Fee Sharing and Pension Protection Act (to be discussed later)

33. Claims Breakdown • Denial of benefits – 32% • Misleading representations – 10% • Administrative error in benefit plan – 9% • Communication of plan benefits – 9% • Imprudent investment – 2% • Civil rights/human rights, including discrimination – 2% • Inadequacy of plan assets – 2% • 2003 Survey

34. Stock Drop Litigation

35. Stock Drop Litigation: Overview • Focus is on defined contribution plans: participant directed eligible individual account plans (“EIAP”) • EIAP is a profit sharing or stock ownership plan that allows for the acquisition and holding of stock issued by the plan sponsor. • At least 19% of all 401(k) assets are invested in employer stock • 2,000 companies feature company stock in their plans • When the stock declines, participants allege ERISA based complaints that plan fiduciaries breached their duties

36. Stock Drop Litigation:Plaintiffs’ Claims • The company stock declined as a result of wrongdoing by the company or insiders. • The corporate insiders are ERISA fiduciaries. • Even if the employer is not designated as the fiduciary, ERISA imposes fiduciary status if a party undertakes certain discretionary actions with respect to a plan or its assets • A plan sponsor usually delegates its fiduciary responsibilities to the Board of Directors and an Administrative Committee • Directors: limited fiduciary status with responsibility only over those activities for which they are responsible • Administrative Committee: general ERISA fiduciaries who are charged with the highest care

37. Stock Drop Litigation:Plaintiffs’ Claims The insiders breached ERISA fiduciary duties: prudence, failure to monitor, and disclosure. Specifically, corporate insiders: • Failed to provide adequate information, such as accurate financials • Acted imprudently by failing to close company stock as an investment option or failing to divest the plan of company stock • Acted imprudently in offering company stock as an investment option • Labored under a conflict of interest and violated duties by failing to retain an independent fiduciary • Improperly encouraged participants to invest in company stock while knowing it was a bad investment • Breached duties by failing to disclose to participants material inside information regarding the company • Failed to disclose illegal business practices at the company • Breached duties by insider trading • Breached fiduciary duties by freezing company stock as an investment alternative

38. Stock Drop Litigation: Prevention • Draft plan documents to reflect that the sponsor has appointed the board as the responsible fiduciary • Set forth a simple fiduciary structure in the plan documents • Invoke section 404(c) and appropriate risk language in the plan documents • Communication with participants should be confined to written materials • Companies should warn about the risks of investing in company stock in every communication and should warn that forward looking statements may not be accurate • Communicate adverse news aggressively to participants • More communication is better

39. Stock Drop Litigation:Lessons • Do not appoint senior corporate officers to the fiduciary committee • The committee must be prepared to establish procedural prudence

40. 401(k) Expense Litigation

41. 401(k) Expense Litigation:Overview • Plan fees have received attention and are subject to debate and scrutiny • Labor Department provided a fact sheet for plan sponsors to use in selecting pension consultants and for monitoring plan fees • Labor Department proposed changes to the Form 5500 to require plan administrators to disclose indirect plan fees • GAO recommended that legislation be considered that would require tax code 401(k) plan sponsors to disclose the total fees charged to plan participants • Recently filed lawsuits: Actions filed on behalf of employees of Boeing Co., Caterpillar Inc., Exelon Corp., General Dynamics Corp., International Paper Co., Kraft Foods Inc., Lockheed Martin Corp., Northrop Grumman Corp., and United Technologies Corp. and others

42. 401(k) Expense Litigation:Why? • “There has been increased literature regarding excessive plan fees and potential breaches of fiduciary duties by plan fiduciaries, which reflects an increasing amount of dissatisfaction among plan participants that their ability to have a secure retirement is being harmed by plan fiduciaries who are ailing to make sure fees are reasonable.” Jerome J. Schlicter of Schleinter, Bogard & Denton (filed class actions involving plan fees)

43. 401(k) Expense Litigation: Plaintiffs’ Claims • Plan fiduciaries breached their duties of loyalty and care by permitting providers to charge excessive and improper fees • Specifically, Plaintiffs claim that they are charged “hidden fees” from revenue sharing payments that are not accounted for or disclosed by plan fiduciaries

44. 401(k) Expense Litigation:Plaintiffs’ Relief under ERISA • 502(a)(2): participant or a fiduciary in an ERISA covered plan can bring a civil action for relief • Defendants are liable to restore to the 401(k) plan the losses that arose from the alleged fiduciary breach • 502(a)(3): participant or a fiduciary in an ERISA covered plan can obtain equitable relief • Plan participants are entitled to an equitable accounting of excess fees and expenses • Expenses constitute prohibited transactions under ERISA sections 406 and 408

45. 401(K) Expense Litigation:Safeguards by Plan Sponsors • Document the plan fiduciary’s review and negotiation of all plan service arrangements • Review and revisit fee arrangements and investment alternatives on a regular basis • Review the plan’s fiduciary governance structure to make sure that plan fiduciaries are clearly identified • Implement and review the plan’s investment policy statement • Ensure that the plan does not obligate the sponsor • Regularly review and document decisions regarding the liquidity targets

46. Disclaimer • The views expressed in these materials are those of the authors and do not necessarily reflect the views of The Travelers Companies, Inc., Beazley, Westfield or any of their subsidiary companies. These materials are for general informational purposes only.  None of it constitutes legal advice, nor is it intended to create any attorney-client relationship between you and the author.  You should not act or rely on this information concerning the meaning, interpretation, or effect of particular contractual language or the resolution of any particular demand, claim, or suit without seeking the advice of your own attorney.