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Who is a Fiduciary?

A common law principle, the concept of fiduciary duty applies to parties who deal with other parties’ money.  To make it real simple, a fiduciary is someone who has an ethical responsibility to deal prudently with Somebody Else’s Money.

If you want to get technical about the legal definition, ERISA set the standard in the following definition: A fiduciary subject to ERISA’s fiduciary responsibility provisions is defined as a person who–

Exercises any discretionary authority or discretionary control respecting management of an employee benefit plan subject to ERISA or exercises any authority or control respecting management or disposition of its assets;

Renders investment advice for a fee or other compensation, direct or indirect with respect to monies or property of a plan or has authority or responsibility to do so; or

Has any discretionary authority or responsibility in the administration of a plan. [Section 3(21)(A)]

Somewhere along the line, either the DOL will input their Fiduciary Rule which makes “Best interest of the client” the standard for Retirement accounts, including IRAs, or the SEC will adopt their fiduciary rule for all retail investments.  OR Both.  We have to wait, watch and see.

Similar standards have been applied by the individual States to non-ERISA accounts via the UniformTrust Act, UPIA, UMIFA and similar State law since 1974, and common law applied the Trust principle since the Doomsday Book in 1066.  However, as we have already pointed out throughout this book, when courts apply the definition of “fiduciary” the majority tend to apply the sophisticated “Duck” theory of function over form.

Authority or responsibility in administration or authority or control over disposition of plan assets are keys to the interpretation of the black-letter laws.  Generally, to be a fiduciary there must be an element of authority either direct or implied.  This becomes a question of fact for the court to determine.  For example, it is unlikely that a person who is only a custodian of plan assets absent any control would be a fiduciary.

Trustees are vested with the responsibility for management of plan assets; they clearly are fiduciaries.  A company’s officers and directors, members of the investment committee, fiduciaries “named” in plan documents.  Persons delegated fiduciary duties by “named” fiduciaries, persons who select fiduciaries–all of them fit the test.  Someone who is authorized to perform these duties will be a fiduciary regardless of title.  To the extent that financial advisers, including accountants and attorneys, influence or exercise discretionary authority or control over plan management or investment of plan assets, they are fiduciaries.

Purely clerical or ministerial duties like record keeping, reporting, processing, or disseminating information generally will not be enough to render fiduciary liability on a person absent the authority, discretion or control.  Sponsors, corporate directors, officers, shareholders, and employees, however, are more likely to have the requisite control necessary to qualify as performing a fiduciary function.  So, for a company maintaining some plan that has employee money in it, it likely has discretionary authority and any officer or employee who exercises some authority on behalf of that company relative to the assets, is a fiduciary.

Members of a company’s board of directors are fiduciaries to the extent that they perform fiduciary functions such as the selection and retention of other plan fiduciaries.  The company and its board of directors will be fiduciaries in virtually all employee benefit plans including, as we have seen, 401k plans, stock purchase plans, welfare plans, ESOPs, and incentive plans; and if a company has shareholders, these fiduciaries have a duty to those shareholders to deal fairly with their money.  While the fiduciary responsibilities of the board members may appear to be limited to certain discreet matters, their status as fiduciaries may have broader implications with respect to co-fiduciary liability for prohibited transactions and breaches of the general duties involving plan assets, company money and shareholder money.

While attorneys, accountants, and actuaries generally are not fiduciaries when performing their normal professional functions, if they advise on matters of policy or the advisability of certain investments, they may be considered a fiduciary.  The law is becoming increasingly broadly construed.

Investment advisors are fiduciaries if they provide advice as to the value of securities or property or the advisability of purchasing or selling such property–AND–the advisor may generally have discretionary authority or control to purchase or sell.  If the advisor renders advice to the plan on a regular basis with the understanding that the advice will be an integral factor in the investment decision-making process relative to the particular needs of the plan, then the advisor will be a fiduciary.

Note that Mutual Fund investment managers are NOT fiduciaries, as Mutual Funds are securities, bought and sold on exchanges, not controlled plans.  However, the independent directors of Mutual Funds (and all Mutual Funds are required to have them) have a fiduciary duty to the shareholders of the fund.  The shareholders ARE the owners, after all.

If the investment advisor is correctly appointed to manage assets, trustees or named fiduciaries will not have co-fiduciary responsibility for acts or omissions of the advisor unless he knowingly participates in or tries to conceal those acts or omissions.

It is not only pension plans that are subject to fiduciary responsibilities, but welfare funds that provide medical, dental, accident, disability, death, unemployment or certain other specified benefits are all subject to the laws.  Included are defined contribution, defined benefit plans, single employer, multi-employer, multiple employee, union collective bargaining plans and non-collective bargaining plans and, in the non-ERISA area, State and municipal retirement plans, other trusts, foundations, and endowments.  Investment advisors who manage portfolios have the same fiduciary duty to individuals for whom they manage accounts of any type.

“The Unknowing Fiduciary”

In his excellent article, “The Fiduciary Trap”, noted ERISA authority the late Matthew McArthur, Esq. (may he rest in peace, Friend), recounted the case of a company bookkeeper merely doing his job who was found to be a fiduciary of the company retirement fund because he was responsible for disbursing its assets.  Under some financial duress, the company principals instructed the bookkeeper to advance fund assets to the company in the form of a loan.  The loan significantly drew down plan assets so that the bookkeeper was unable to collect his own plan benefit when he left the company.  When he sued for his benefit, the courts not only denied his claim, but held him liable for the improper loan.  He was required to pay in the amount of the difference between the value of his benefit and the loan.

In defining the fiduciary duties of trustees, a self-trusteed fund defined their role as follows:  “Without any question the firm is a fiduciary and each member of the board of directors (who hold management authority over the firm and the plan) is also a fiduciary.  Any other firm employee is a fiduciary if he exercises or possesses any discretionary authority or responsibility in the administration or management or disposition of plan assets.”  It certainly applies to all money held or managed for someone else, PERIOD!

To summarize, fiduciaries include, among others:

  • Trustees
  • Investment advisors Stockbrokers
  • CPAs
  • Officers of the company
  • Owners of the company
  • Directors of the company
  • Plan administrators
  • Financial Advisors

A fundamental factor in determining whether someone is a fiduciary or not is the client’s reliance on what the party holds itself out to be.

Fiduciaries have to provide individualized investment advice pursuant to a mutual understanding (i.e. “Written contract with client”) on a regular basis pertaining to valuations or recommendations as to investing, for a fee.

While ERISA has a provision that fiduciaries are required to acknowledge their fiduciary status in writing, failure to do so does not mean you are not a fiduciary.  Non-ERISA venues do not have this provision.  Courts have been eager to apply our aforementioned “Duck” theory (although not actually by that name).  A fiduciary status will be defined by the actions of the party in question.  Often, if the client relies on a party as fiduciary, it will be found to be one.  In Blatt v. Marshall and Lasserman in finding an accounting firm to be a fiduciary because it controlled whether or not contributions were returned to plan participants, the court said that, “Fiduciary status is determined by focusing on the function performed by the individual rather than on the individual’s title”.

What the Courts Say

A key case that established the prudence standards later incorporated into Federal and State was the 1971 decision in Blankenship v. Boyle which we talked about elsewhere several times where trustees of the United Mine Workers (Yes, THAT Tony Boyle) were found to have breached their fiduciary responsibilities by letting substantial cash accumulate interest-free in a Union owned bank and also directed retirement trust funds to be invested in electric utility companies in order to give the Union proxy control, forcing the utilities to buy Union mined coal.  Even though the beneficiaries’ interests were clearly served because retirement contributions were directly related to Union mined coal, the trustees’ investment activities were found to clearly advance the Union’s interests first.  The aid to the fund was only incidental to the Union enhancement.  The court found the trustees’ activities were clearly imprudent in accumulating excess cash and in directing investments not solely in the interest of participants. (But the unions pushed a lot of coal.)

Fiduciary Liability

Liability is personal and impersonal.  Impersonal in that courts don’t care WHO is responsible–they’ll get anybody (even Martha Stewart).  Personal, in that fines and penalties are assessed, and have to be paid directly by the perpetrators.  For instance, a Seattle Union’s trustees were fined $74,000 for having all $9 million of the plan in a local bank, paying slightly below market CD rates.  The court said it was “too much risk”.

In GIW Industries v. Trevor Stewart, Burton and Jacobson, a money manager was liable for not inspecting the investment objectives of a fund.  Trevor Stewart invested 75% of GIW’s portfolio in long-term government bonds.  GIW knew of TSBJ’s investment philosophy but hired them with no restrictions.  No one at TSBJ read plan documents, knew the plan history, their cash needs or the demographics of the participants.  When Trevor was terminated, they had lost over $700,000 and collected fees of $17,031.54.

The court said TSBJ subjected GIW to too much market risk and liquidity risk and failed to diversity for investments.  They were fined $537,000 and had to rebate their fees.  The court, then, turned around and found the trustees jointly responsible for “allowing” TSBJ to violate the investment objectives.  Guess who paid.  (No, TSBJ paid–deeper pockets.)

Since then, courts and regulators have been becoming consistently more liberal in their application of the question, “Who is a fiduciary?”  Some things they have said about fiduciary status include the following:

  • An employee benefit fund trustee is a fiduciary because they have “exclusive authority and discretion to manage and control assets of plan” and their loyalty is to the beneficiaries of the plan, not to the party who appointed them.
  • Pension plan trustees are fiduciaries, but a bank acting only as depository for funds is not a discretionary advisor.
  • Attorneys who knowingly participate in breaches of duty committed by fiduciaries are also considered fiduciaries.
  • Non-fiduciaries who aid fiduciaries in breach of duty are liable as if they were fiduciaries.
  • An individual who was not a trustee, but who represented that he has such authority and control will be construed as a fiduciary.
  • An insurance company may be a fiduciary, because of its power to amend a life insurance contract, altering its value.
  • An arrangement to pay pension benefits to ONE former employee creates an employee pension benefit subject to ERISA.  James Williams worked 34 years for the Wright Pest Control Co. of South Carolina, Inc.  Williams received a letter from WPCC’s president which described in detail a “plan, which will provide for an uninterrupted continuation of cash as you gradually alter your work schedule to a retirement status”.  The letter promised Williams, among other benefits, a monthly check in the amount of $500 and noted that “these benefits will continue until your death or when you have no use for them”.  The difficult question for the court was whether the payment of a $500 monthly retirement check to Williams created a “pension plan” within the meaning of Section 3(2) of ERISA.  The court held that an ERISA plan existed, due to the four factors necessary: (1) “intended benefits”, (2) “beneficiaries”, (3) the “source of financing” for the benefits, and (4) “procedures for receiving benefits”.
  • ERISA permits the named plan fiduciary the option of delegating the responsibility of investing plan assets to a professional investment advisor who then might assume the ERISA fiduciary obligations to the plan, including the duties of care and loyalty.
  • Fiduciary status is determined by focusing on the function performed by the individual rather than on the individual’s title; an accounting firm was a fiduciary to the extent that it controlled whether or not contributions were returned to plan participants.
  • ERISA Section 3(2)(A) limits the scope of both fiduciary status and responsibility; a person is a fiduciary with respect to only those aspects of the plan over which he or she exercises control or authority, and his or her fiduciary duty extends solely to those functions.  Jury instructions should delineate the requisite control necessary to consider a person a fiduciary and warn jurors against drawing inferences of control or authority merely from a person’s status, including status as a former employer, an officer, a principal shareholder or a director.
  • A stockbroker becomes a fiduciary when, without authorization, he invests the assets of a client in unsuitable, highly speculative securities and disregards the client’s instructions to liquidate.

    What the Regulators Have Said

    The following have been defined as plans subject to fiduciary responsibility:

  • An HR 10 Plan if it covers both self-employed and their employees
  • A collectively bargained vacation fund
  • Prepaid legal service
  • Group health, life and disability insurance plans
  • Apprenticeship and training plans
  • A collectively bargained vacation benefit account
  • A severance pay plan
  • A contributory hospitalization plan
  • Insured benefit program providing accident, medical and life coverage for fewer than 10 employees
  • Severance pay funds, under which certain employees would receive one week’s pay for every year of service
  • A non-contributory hospital benefit program for 4 employees
  • Employee bonus program where cash is deposited into employee’s IRA
  • An employer’s life insurance program under which the employer and participating employees split the premium costs
  • Group term life insurance and time loss benefits for disabilities
  • Financial assistance to an artist guild sick and relief fund
  • A relief fund that provides financial aid and other benefits to alleviate the financial hardship of a labor union’s members in the event of sickness or death
  • A hospital’s prepaid legal services plan which provides for both employer and employee contributions
  • A union death benefit fund
  • Guaranteed annual income fund
  • Death, disability and medical benefits for employees traveling on company business
  • Group insurance trust
  • Bond purchase plan
  • Dental benefits
  • Disability benefits
  • Collectively bargained severance program
  • Monthly benefits to employees retired on pensions with certain are and service requirements met
  • Union “remembrance fund” which provides burial expenses of $1,500 to union members
  • Association’s contributory savings and security plan
  • Trusts which make monetary grants to industry apprenticeship and training programs established by employers and employee organizations
  • A bonus plan to key employees
  • An in-house confidential session with a psychological counselor who provides professional assistance
  • Welfare benefit plan for life and health insurance
  • Supplemental benefits to workers who meet certain requirements
  • Plan providing lump sum death and retirement benefits to current and retired fire department members
  • A production participation plan assigning royalty points to employees and making annual payments from property
  • An association formed to provide medical and medicinal services to it members
  • Medical, surgical, hospital care, sickness, accident, disability and death benefits for association members and union local
  • Foundations
  • Endowments
  • Charities
  • corporate accounts
  • 401(k)s
  • IRAs
  • Custodial accounts (for minors or others)
  • Individual accounts belonging to basically Mom and PopThe regulators, and the courts can answer the facts of whom and what is subject to fiduciary responsibilities.  If there are an employer and employees or employee organization and there is jurisdiction under the commerce clause under normal business activities, and benefits are provided to participants and/or their beneficiaries, or there are parties that have a financial interest (like shareholders) the fiduciary responsibilities apply from Dr. Smith’s four person KEOGH to IBM’s pension fund.  If you can think of a pool of assets that represent Somebody Else’s Money, then “fiduciary” applies to someone.  What can you think of?

    What it Means for Investors

    Authority or responsibility in the administration or authority and control over the disposition of plan assets are keys to the interpretation of the law.  Generally, to be a fiduciary, there must be an element of authority either direct or implied. although the regulators have significantly softened their stance on this issue, this becomes a question of fact for the court to determine.

Trustees of funds have been found liable for violating their fiduciary duties in case after case.  Seattle pension trustees liable for $74,000 because their fund lost opportunity costs for being invested in regular savings accounts (unreported DOL letter.)  Trustees have hired investment professionals, yet have been liable for investment loss because specific prudent procedures weren’t followed.  Schetter v. Prudential Bache Securities (10EBC 1190).

Trustees are suing investment managers by bringing charges to the SEC only to have the DOL sue them for not following prudent procedures in selecting and monitoring their managers.

Trustees are suing money managers for investment loss only to have the courts find that the trustees themselves violated their fiduciary responsibilities by adopting or continuing the use of imprudent investment policies.

The single greatest problem facing investors is education or lack of it.  If the small to intermediate businessman doesn’t find competent professional help, he bears the risk of financial loss alone.

Fiduciaries have to provide individualized investment advice given pursuant to a mutual understanding (read: contract) on a regular basis pertaining to valuation or recommendations as to investing for a fee.  In the investment management arena, this defines the money manager, and often the financial advisor, broker, or consultant.  The duties of a fiduciary require unconflicted loyalty to the client first and the penalties for fiduciary breach are stiff, as discussed above.  There are five general standards which govern a fiduciary’s conduct:

1. They must be solely in the interest of the participants and beneficiaries.  Benefits must inure to the individual plan participants who have a right to monitor the activities of the fiduciary and the investments of the plan.  But the clients aren’t listening.

2. They must be for the exclusive purpose of providing secure benefits to participants and their beneficiaries.  But the clients aren’t listening.

3. They must be discharged in accordance with written instruments and documents which should include written investment objectives.  Fiduciaries have the right to rely on professionals to assist them through this process.  But the clients aren’t listening.

4. Investment duties must be discharged with the care, skill, prudence and diligence of an expert familiar with such matters.  A fiduciary must consider all the facts and circumstances HE SHOULD KNOW are relevant to the plan’s investment objectives.  But the clients aren’t listening.

5. Investments must be diversified so as to minimize the risk of large losses unless under the circumstances it is clearly prudent not to do so.  It is difficult to conceive of a situation where it would be clearly prudent not to minimize the risk of large losses.  But the clients aren’t listening.

Any plan fiduciary who breaches fiduciary responsibility rules is personally liable for losses caused by the breach.  This liability extends to the owner, corporate officer, director, trustee, administrator, investment manager, and service provider.  Furthermore, if a fiduciary knows or should have known of a breach buy another fiduciary, he may be personally liable.  Finally, a non-fiduciary who participates in, conceals or knows of a breach may be personally liable.  Ignorance, lack of experience, failure to be informed or faulty communications will not be defenses.  As a stark example, a trustee who is responsible for investing plan assets will have to pay out of his pocket losses to the plan as a result of imprudent investments.  In a case of a failure to diversity, the fiduciary is personally liable for losses or missed opportunities resulting from the non-diversified excess.

Losses may be determined by comparing the earnings from the improper investment with what would have been earned in other investments.  The most profitable investment is taken as the standard.  Courts will consider market advantages to holding the asset, conditions affecting price of the improper purchase and other plan assets as well as the beneficiaries’ interests.  Liability may include interest and attorneys’ fees.

All plans and their advisors must have bonding on officials which at least provides protection to the plan for losses that might arise due to the dishonest activities of someone who exercises any control over plan assets.  See below for two cases dealing with investment approaches being appropriate for prudent fiduciaries . In Lanka v. J.D. Higgins, a contrarian money manager was deemed to not be imprudent, and in Landegraff v. Columbia, investing a stock benefit plan in company stock was not imprudent.

The “Responsibility” in “Fiduciary Responsibility”

Anyone who is a fiduciary has significant responsibilities to those whose money they hold authority over, and they may or may not know it.  The job of the financial advisor in this area, is to help the fiduciary understand their responsibilities, and to pro-actively assist them in fulfilling these responsibilities.

Discussion of fiduciary responsibility begs the question, “Who is a fiduciary?”  For the time being a basic understanding of the concept of the fiduciary is essential.  Someone has fiduciary responsibility when they are charged with managing, administering, advising to, or consulting to, a pool of assets, which is owned by someone else.  Thus, from an investment perspective, prudent fiduciary responsibility is the ethical treatment of Somebody Else’s Money.  Fiduciaries include trustees, investment advisors, CPAs, administrators, financial advisors and investment management consultants and a host of others that we’ll talk about.

Pools of assets subject to fiduciary duties and responsibilities include all employee benefit plans such as pensions profit sharing, welfare plans, 401ks, IRAs, KEOGHs, all trusts, endowments, foundations, and many charities, individual pools of assets, IRAs– basically just about any category of assets you can imagine.

Courts use the comparative total return analysis to examine investment losses.  The prudence of individual investment decisions is judged on the condition of the fund as a whole.  The same factors that go into setting prudent investment objectives are those which are used to judge the actual asset investments.  These include risk, return, liquidity, cash flow requirements, income, funding objectives and portfolio composition.  The prudence of an investment is based on the time it is made, not on subsequent performance.  This is why the initial selection of the investment is the most critical factor in the investment process.

Penalties may be imposed six years after the breach of duty or other fiduciary violation or three years after the party bringing suit had actual knowledge of the breach.

A willful violation will carry personal criminal penalties and up to a 20% fine and one year in prison for reporting or disclosure violations.

Civil actions can be brought by participants, beneficiaries, fiduciaries, and the Secretary of Labor.  Losses to the plan must be restored as well as profits made from the use of plan assets.  Failure to disclose information to participants will incur a substantial penalty.  Injunctions, removal from duties, and placement of control over assets may be taken by the Department of Labor.

While a fiduciary can purchase fiduciary insurance, it is an extremely expensive proposition.  Indemnification agreements can be made, errors and omissions coverage obtained, or liability coverage purchased.  These will in no way relieve the fiduciary from liability.  The only way to avoid the liability is by proving that the fiduciary acted with prudence at all times.

How to Interpret Fiduciary Liability

Fiduciaries of funds have been found liable for violating their fiduciary duties in case after case.  Trustees have hired investment professionals, yet have been liable for investment loss because specific prudent procedures weren’t followed.  Fiduciaries are suing investment managers by bringing charges to the SEC only to have the DOL sue them for not following prudent procedures in selecting and monitoring their managers.  Trustees are suing money managers for investment loss only to have the courts find that the trustees themselves violated their fiduciary responsibilities by adopting or continuing the use of imprudent investment policies.

So what is the problem?  Fiduciaries aren’t listening.  The single greatest problem facing fiduciaries is education or lack of it.  If the small to intermediate businessman doesn’t find competent professional help, he bears the risk of financial loss from personal liability alone.

The Message to Fiduciaries is Clear

If you are a fiduciary, the message cannot be any clearer.  Regulations are relatively black and white and their interpretation by the courts has been largely uniform.  Fiduciaries bear the risk of loss if they have not established prudent procedures.  Prudence begins with a defined investment policy specific to the fund.  It continues with a precise investment strategy tailored to fit the investment policy and it contains precise investment objectives and guidelines to the professionals chosen to assist.  It continues through a precise evaluation and monitoring procedure to measure progress along the way and it provides a thorough review process at least quarterly.  For trustees or other fiduciaries who haven’t gotten the message, it is your duty to hire competent professionals to assist you in managing this enormous burden.  Professional competence abounds in plan administrators, actuaries, lawyers, investment consultants and money managers and other vendors.  The watchword is DUE DILIGENCE.  You have the right to pay these professionals reasonable and fair compensation.  But, a caveat is issued–your selection of these competent professionals must be made with the same standards of prudence that the regulations require of investments.

What the Financial Advisor Should Do

First, if the financial advisor is giving clients investment advice (and what else would you expect a financial advisor to do), then the advisor should admit and acknowledge that he or she is a fiduciary to clients.  Period.  If they don’t, they should exit the business quickly and find another job in another industry (preferably a menial one that has little responsibility and no client contact).  Many classes of prospective clients who can employ the services of a financial advisor to assist in at least some facet of the investment process of employee benefit fund, trust, or institutional assets are in need of help, but they don’t need some charlatan who will give them poor advice, or worse–rip them off.  Advisors need to recognize that the regulations do not apply only to pension and profit-sharing funds, but also to state or municipal funds, trusts, foundations and endowments and even individuals.  Anyone identified as a fiduciary is faced with potential liability problems concerning the investment of plan assets.  All of these fiduciaries need to be educated as to their responsibilities and duties.  It is not a matter of willful avoidance, but rather a matter of not knowing.

The advisor’s primary job, as far as the firm is concerned is to identify potential pools of assets.  That part is easy–you need only to look at employers.  Potentially, any employer has a pool of assets in the class of employee benefits, corporate funds, and a bunch of managers or officers who may meet the definition of “high net worth”.  A well- developed questionnaire or interview can identify this quickly.  Once a pool of assets is discovered, there will be one or more fiduciaries in the form of trustees, owners, directors, shareholders, and officers, and, of course, the advisor, once the client signs on.  The hard part comes when the advisor has a legal and ethical obligation to put the client first, deal fairly, provide full disclosure and not charge excessive fees.

Think of ethical financial advisors as Owens-Corning for investors.  Ethical advisors are the first line of defense in insulating investors from fraud.