January 2005 Bulletin 05-01 Labor Department Issues Guidance on Fiduciary Responsibilities of Directed Trustees If you have questions or would like additional information on the material covered in this Bulletin, please contact one of the authors: Donald J. Myers (Washington, D.C.) 202.414.9231 dmyers@reedsmith.com Michael B. Richman (Washington, D.C.) 202.414.9289 mrichman@reedsmith.com or the Reed Smith attorney with whom you regularly work. This bulletin is presented for informational purposes and is not intended to constitute legal advice. Reed Smith LLP 2005. All Rights Reserved. Reed Smith refers to Reed Smith LLP, a limited liability partnership formed in the state of Delaware. The U.S. Department of Labor ( DOL ) has issued a Field Assistance Bulletin ( FAB ) on the fiduciary responsibilities of a directed trustee under ERISA, with specific attention to issues raised for plans holding publicly traded employer securities. Reacting to questions raised by recent litigation on these issues, the FAB provides, for the first time outside of the enforcement area, detailed guidance on the responsibilities of a trustee whose legal obligation is to follow the directions of the named fiduciaries of the plan. Background ERISA generally requires that the assets of a benefit plan be held in trust, and that the trustee of that trust be responsible for managing those assets. One of the exceptions to the general rule of trustee management is where the trustee is directed as to investment matters by a named fiduciary of the plan, that is, a fiduciary designated as such in the plan document typically either an individual or a committee. Specifically, section 403(a)(1) of ERISA states that a plan may expressly provide that the trustee or trustees are subject to the direction of a named fiduciary who is not a trustee, in which case the trustees shall be subject to proper directions of such fiduciary which are made in accordance with the terms of the plan and which are not contrary to ERISA. A trustee subject to named fiduciary direction in this manner is commonly referred to as a directed trustee. DOL has taken the position that a trustee, even if directed, is a fiduciary under ERISA, subject to the ERISA fiduciary rules in carrying out its trustee responsibilities. What the specific responsibilities of a trustee are when it receives such directions has not been clear. The threshold question is what it means for a direction to be proper within the meaning of section 403(a)(1). The related question is what degree of scrutiny a directed trustee must apply in order to be satisfied that a direction is in accordance with the terms of the plan and not contrary to ERISA. According to the ERISA conference report, a directed trustee is obligated to follow the directions of a named fiduciary unless it is clear on their face that the actions to be taken under those directions would be prohibited by the fiduciary responsibility rules or would be contrary to the terms of the plan or trust. This standard suggests that only a cursory review of the directions is required, with a very limited (if any) duty of further inquiry. While many institutions have relied on this language in the absence of other guidance, DOL and some courts have rejected this standard. During the past three years, the issue of the appropriate standard for directed trustees has been raised in a series of high-profile cases regarding investments by 401(k) plans in the stock of the plan sponsor (so-called employer securities ). In filing an amicus brief in litigation involving Enron Corporation in September 2002, DOL interpreted section 403(a)(1) to provide that a directed trustee may LONDON NEW YORK LOS ANGELES SAN FRANCISCO WASHINGTON, D.C. PHILADELPHIA PITTSBURGH OAKLAND PRINCETON NORTHERN VA WILMINGTON NEWARK MIDLANDS, U.K. CENTURY CITY RICHMOND r e e d s m i t h. c o m
not follow directions that it knew or should have known violated ERISA s fiduciary rules or the plan document. DOL s filing of this brief led industry groups to complain that DOL was attempting to make new law through litigation, which was unfair to those institutions that, in the absence of DOL guidance, had been following different but reasonable interpretations of section 403(a)(1) on a consistent basis since ERISA was enacted. To address the uncertainty in this area, several banks asked that DOL provide formal guidance to help directed trustees understand how to comply with their legal obligations. In December 2004, DOL responded to these requests by providing guidance on the responsibilities of directed trustees under ERISA in the form of FAB 2004-03. This is a format DOL uses when it decides to set forth its position on an issue in a formal statement that, while internal within DOL, is made available to the public. Although an FAB is not binding on a court of law, a judge would be expected to give it weight as representing the considered view of DOL as the agency charged by Congress with administering and enforcing ERISA. FAB 2004-03 Directed Trustee as a Fiduciary DOL begins by reiterating its position that a plan trustee, by definition, is always an ERISA fiduciary to a plan as a result of its authority or control over plan assets. However, not all trustees have the same level of authority or discretion to manage plan assets. In particular, ERISA section 403(a)(1) significantly limits a directed trustee s responsibilities as a plan fiduciary. Where the plan documents so provide, the duties of a directed trustee are therefore significantly narrower than the duties generally ascribed to a discretionary trustee under common law trust principles. Proper Directions DOL says that a direction is proper if it is made in accordance with the terms of the plan and not contrary to [ERISA]. This reading, which treats the second part of section 403(a)(1) as an elaboration as to what is proper rather than separate and additional requirements, is consistent with the legislative history and prior case law. Therefore, according to DOL, when a directed trustee knows or should know that a direction from a named fiduciary is not made in accordance with the terms of the plan or is contrary to ERISA, the directed trustee may not, consistent with its fiduciary responsibilities, follow the direction. This statement repeats the know or should know standard from DOL s Enron brief. For a directed trustee to determine that a direction is in accordance with the terms of the plan, the trustee must request and review all the documents and instruments governing the plan that are relevant to its duties as directed trustee. If the trustee fails to request the documents or fails to review them, and as a result follows a direction that is contrary to the terms of the plan (such as purchasing a stock not permitted under the plan s investment policy), the directed trustee may be liable for following such direction because the directed trustee should have known that the direction was not in accordance with the terms of the plan. It is not necessary that the plan specifically authorize a particular investment or investment course of action. A direction can be consistent with the terms of the plan if the plan documents do not prohibit it. If the plan documents are ambiguous, DOL says that the directed trustee should obtain a clarification of the plan terms from the plan fiduciary responsible for interpreting those terms, and may rely on that fiduciary s interpretation. For a directed trustee to conclude that a direction is not contrary to ERISA, DOL says, by way of example, that a directed trustee cannot follow a direction that it knows or should know would result in a transaction prohibited by ERISA section 406, or would violate the prudence requirement of section 404(a)(1). DOL elaborates on what is required of the trustee for each of these categories: Prohibited Transactions: A directed trustee must follow processes that are designed to avoid prohibited transactions. It could satisfy its obligation by obtaining appropriate written representations from the - 2 -
directing fiduciary that the plan maintains and follows procedures for identifying prohibited transactions and, if prohibited, identifying the individual or class exemption applicable to the transaction. A directed trustee may rely on the representations of the directing fiduciary unless the directed trustee knows that the representations are false. Prudence: The directing named fiduciary has primary responsibility for determining whether a particular transaction is prudent, meaning that the scope of a directed trustee s responsibility is significantly limited. A directed trustee does not have an independent obligation to determine the prudence of every transaction, or an obligation to duplicate or second-guess the work of the plan fiduciaries that have discretionary authority over the management of plan assets. Consequently, the directed trustee does not have a direct obligation to determine the prudence of a transaction. In support of its position, DOL cites the recent district court decision in the WorldCom ERISA litigation, as well as one of the principal directed trustee cases prior to the current round of employer securities litigation, the 1997 Eleventh Circuit decision in Herman v. NationsBank Trust Co. (which dealt with a trustee being directed on how to respond to a tender offer for employer securities). Public and Non-Public Information Regarding Employer Securities Recent employer securities cases raise the issue of whether a directed trustee has a duty to act on public or nonpublic information it may have, or to which it may have access, about the plan sponsor. Acknowledging that a directed trustee s obligation to question market transactions in publicly traded stock on prudence grounds is quite limited, DOL says, nevertheless, that such an obligation could arise where the directed trustee possesses material non-public information about the issuer. If so, then the directed trustee has a duty to inquire about the named fiduciary s knowledge and consideration of such information prior to following a direction that would be affected by such information. For example, if the directed trustee has non-public information indicating that a company s earnings are significantly inflated in publicly filed financial statements, the trustee could not simply follow a direction to purchase that company s stock at an artificially inflated price. However, where an organization maintains procedures designed to prevent the illegal disclosure of such information under securities or banking law, the possession of non-public information by one part of the organization generally will not be imputed to the organization as a whole, unless those individuals responsible for the directed trustee services have actual knowledge of the information. DOL adds that if the directed trustee concludes that the company s financial statements are materially inaccurate based on its own internal analysis, the trustee then, too, would have an obligation to disclose this analysis to the named fiduciary before following a direction. A related question is to what extent the directed trustee must act on public information. DOL says that a directed trustee will rarely have an obligation under ERISA to question the prudence of a direction to purchase publicly traded securities at the market price solely on the basis of publicly available information. This position is based on assuming the general efficiency of the markets in reflecting public information in stock prices, securities laws obligations requiring accuracy in company financial records, and the fiduciary obligations imposed on the instructing fiduciary. Because stock prices fluctuate, even a steep drop in a stock s price would not, in and of itself, indicate that a named fiduciary s direction to purchase or hold such stock is imprudent and, therefore, not a proper direction. Nevertheless, there may be extraordinary circumstances, such as a bankruptcy filing or formal charges of financial irregularities, raising issues as to a company s viability. Such circumstances may obligate a directed trustee to make further inquiry before following the named fiduciary s directions. DOL intends this as a relatively high threshold, noting that media and public reports that merely speculate about a company s continued viability would not rise to the level of knowledge of clear and compelling evidence concerning the company sufficient to give rise to a directed trustee s duty to act. Even in such circumstances, says DOL, there may be situations in which additional stock investment may reasonably make sense, in light of proposed changes - 3 -
to the company and other factors. If an independent fiduciary is appointed to manage a plan s investment in company stock (a step recently taken by several financially troubled airlines), an independent assessment of the transaction by the directed trustee would not be necessary. Effect of Questioning a Direction If a directed trustee questions a direction, what is the effect on the directed trustee s limited fiduciary status? DOL says that the nature and scope of a directed trustee s fiduciary responsibility does not change merely because the trustee questions the propriety of a direction, or declines to follow a direction it does not believe is proper. Information provided to a named fiduciary concerning the prudence of a direction is not investment advice for ERISA purposes. If the named fiduciary changes a direction in response to the directed trustee s queries, the directed trustee s fiduciary responsibility remains governed by section 403(a)(1) the directed trustee does not become primarily responsible for the prudence of the direction. Co-Fiduciary Liability DOL also points out that the directed trustee is subject to the co-fiduciary duty rules of ERISA section 405(a)(1), which make a fiduciary liable for the breach of another fiduciary if the first fiduciary participates knowingly in the second fiduciary s breach. Thus, if a directed trustee knows that the named fiduciary is failing to discharge its obligations in accordance with ERISA, the directed trustee cannot simply follow the directions but must take reasonable steps to remedy the breach, such as reporting the breach to other plan fiduciaries or to DOL. Observations The FAB provides important guidance on the roles and responsibilities of a directed trustee. While starting with a relatively broad standard, it places several constraints on that standard designed to acknowledge the limited role that ERISA intended for trustees subject to named fiduciary direction, as well as the nature of the environment in which a directed trustee operates. The broad standard is the formulation, also adopted by some of the recent court decisions, that a directed trustee may not follow a direction if it knows or should know that the direction is not made in accordance with the terms of the plan or is contrary to ERISA. While a knowledge standard can be derived from the co-fiduciary responsibility rules of ERISA section 405, since the directed trustee is a co-fiduciary of the directing named fiduciary, there is no clear basis in the statute for imposing a should know standard on a directed trustee. The should know language does appear in section 406(a), the prohibition on certain types of transactions with parties in interest to a plan, but that is a single provision that operates independently of the directed trustee provision in section 403(a)(1). In the recent litigation, arguments in favor of a should know standard generally cite to the common law of trusts rather than ERISA. Having used expansive language to describe the directed trustee s obligation, DOL then limits the nature of the inquiry a directed trustee must make to meet its obligation. In the case of prohibited transactions, DOL permits the directed trustee to rely on representations from the directing fiduciary. This is crucial, as the directed trustee would not have access to the information necessary to make legal determinations about whether a transaction is prohibited or, if prohibited, whether it may be covered by an exemption. DOL even uses a narrower standard in this discussion it says that the trustee has no duty of further inquiry unless it knows that the representations are false, not adding the should know language found in other parts of the FAB. The discussion of prudence is significant in that it acknowledges that the directed trustee should not have to second-guess the named fiduciary s prudence analysis. While earlier cases, in particular the Herman v. NationsBank decision, had taken that position, the more recent cases have been less clear on where a directed trustee s inquiry obligation ends. A different result would undermine the purpose of a directed trustee exception - 4 -
to the general rule of trustee management of plan assets, by making the directed trustee equally responsible for prudence decisions with the instructing fiduciary. The discussion of the directed trustee s responsibility in dealing with public and non-public company information addresses issues raised in the recent employer securities cases that have been of great concern to trust institutions. The decisions to date have permitted allegations based on a trustee s knowledge (or constructive knowledge) of public and/or non-public information to go forward on the basis that some set of possible facts could constitute a violation, but they have not as yet applied the statutory standard for directed trustees to the actual facts of the particular cases. This has created uncertainty. The FAB is the first formal guidance that describes boundaries as to how far a directed trustee s responsibilities may go in these circumstances. Consistent with informal statements by DOL staff over the past two years, the FAB makes clear that ordinary market fluctuations should not trigger additional inquiry it reserves the higher level of inquiry for extraordinary situations. This creates a higher pleading standard for plaintiffs they must allege something more than a drop in stock price to avoid dismissal. (Some courts have made the same point, but typically have found that the allegations went beyond a mere drop in price, so that the cases were not dismissed.) In addition, while a directed trustee must take appropriate action if it is in possession of material non-public information, DOL acknowledges that this obligation does not arise if the information is segregated in a separate part of the organization pursuant to applicable law. This acknowledgement is crucial for financial institutions that provide a broad array of financial services, as they depend on such information barriers to be able to provide all of those services consistent with banking and securities laws, and would find it difficult to operate if those barriers were not recognized for ERISA purposes as well. While an FAB is not binding on a court, DOL s guidance is likely to receive consideration in the pending employer securities cases. It describes legal standards that are far more detailed than any of the case law to date as to the level of inquiry required. While the defendant trustees may take issue with the know or should know standard, they would seek to use the other standards described in the FAB to demonstrate that they had no actual or constructive knowledge that would have permitted them to reject directions. Plaintiffs, on the other hand, may argue for a more stringent duty of inquiry. The next step is to see how the FAB affects the developing case law on the fiduciary responsibilities of directed trustees. * * * * * * * Reed Smith, a leading global law firm with nearly 1,000 lawyers located in 14 U.S. and two U.K. cities, represents Fortune 100 as well as mid-market and emerging companies. Clients include technology companies and entrepreneurs, financial services firms, life sciences companies and health care providers and insurers, communications companies, manufacturers, universities, non-profit organizations, real estate developers, and municipalities throughout the United States, the United Kingdom, and in 40 other countries. For more information, please visit reedsmith.com. - 5 -