An Overview of Audits, Lawsuits, And Insurance Issues For Internal ESOP Trustees

It is a challenge for plan fiduciaries to understand and minimize their risk from the government regulators and from conflicts that could result in civil litigation. The appropriate starting point is understanding the different categories and types of conflict situations and what issues are typically in dispute.|

There are two primary areas of concern for Employee Stock Ownership Plan (ESOP) fiduciaries:
  • Department of Labor (DOL) investigations and enforcement actions; and
  • Civil litigation
The Employee Retirement Income Security Act of 1974, as amended (ERISA) provides that each plan must have two types of fiduciaries. Each plan must have a trustee for the plan's assets and each plan must have an administrator. The administrator is often referred to as the plan administrator and may be the committee appointed by the company or may be the company itself if the employer hasn't appointed a committee or individual to serve this function. Some of our comments below provide some insight into who should be serving in these capacities and how they should comport themselves to minimize exposure in these areas. Department of Labor (DOL) Investigations And Enforcement Actions Contrary to a common misperception, the DOL does not "audit" retirement plans. The IRS audits plans. The DOL investigates plans. This distinction is important because a DOL investigation is the front line action for the DOL's regional offices of its Employee Benefits Security Administration (EBSA). The DOL's regional offices investigate plans to determine whether there are ERISA violations. In brief, the DOL:
  • Can compel compliance with the statute to cause ESOP fiduciaries to correct fiduciary breaches, prohibited transactions, or to improve their plan operations to prevent potential problems.
  • Does not unilaterally "impose" penalties for noncompliance, such as the IRS may impose taxes, penalties and interest for Internal Revenue Code violations.
  • Derives its ultimate enforcement ability from litigation it may bring to enforce ERISA provisions. In such actions, the DOL is represented by the Department of Justice Office of the Solicitor (Solicitor). After investigations have closed without a satisfactory result in the DOL's view, the Solicitor's regional office in the given DOL region will be called upon to represent the DOL in litigation.
Although litigation may be brought to enforce the provisions of ERISA, the DOL looks for or demands voluntary compliance in the overwhelming majority of situations. In fact, only a limited number of cases are referred to the Solicitor's office each year. However, the DOL may request assistance from the Solicitor's office where certain legal issues are involved in an investigation or where the Regional Director wishes to negotiate forcefully from a posture that suggests litigation may be imminent if the DOL does not achieve the results it seeks. Handling DOL Investigations All trustees and plan administrators should be aware that DOL investigations are not a certainty, but may result from either a complaint filed by a plan participant or as a result of DOL initiatives. If an investigation is opened involving your plan, it is important to understand the DOL's procedures and their "script" for conducting the investigation. The EBSA manual for handling investigations is available on-line via the DOL's website. Reviewing the manual will help fiduciaries understand the objectives and tenor of investigations as well as a sequence of steps that the investigators follow to complete their review and interact with plan representatives. Even though the uncertainty of an investigation can be maddening, it's important for fiduciaries to do what they can to manage the process and provide themselves a feeling of understanding, if not control, over the process. Being proactive and being prepared helps plan fiduciaries assume the posture that their performance is complete. The potential next steps in the investigation are then more understandable, if not predictable. We advise our clients to push as hard as they can to stay on top of the DOL's process and ensure that the investigation doesn't languish. "We're From The Government And We're Here To Help" Communications and correspondence with the DOL should be cordial and cooperative. A confrontational approach to an investigation does not facilitate the process. There are a handful of things that you should keep in mind, however:
  • Document Requests. Generally, what they want, they get. The DOL is entitled to get anything they want from plan fiduciaries or other related parties or service providers regarding the plan's operation. The DOL has the ability to issue a "desk subpoena" to compel the production of documents without seeking a subpoena from a court. It is one of only a few federal agencies with this type of authority. It is very difficult, if not impossible, to prevent documents from being produced. We recommend responding to the DOL's document request in a thorough, complete and organized fashion. Provide everything, if at all possible, all at once. Index, organize and retain duplicates of everything sent to the DOL to ensure that there are no issues of nondisclosure.
  • Fiduciary Communication. Keep in mind that there is generally no attorney/client privilege between an ERISA plan fiduciary and the fiduciary's attorney when a fiduciary is being advised on plan matters. As a result, all of your attorney correspondence can be obtained and must be produced for the DOL if it relates to plan advice. Advice your attorney may give the corporation or a nonfiduciary regarding plan matters may be protected. Also, advice given to a fiduciary by defense counsel may be privileged. Consult with your attorney as to what advice is provided to which party and for what purpose. It may be advisable for you either to have separate counsel or to have your counsel clearly demark their client's files and engagement agreements (including conflict of interest disclosures) to keep fiduciary representation and advice separate from corporate or plan sponsor advice.
  • Past Actions And Transactions. Review these with counsel carefully in preparation for your interview. Since the investigation will likely deal with transactions that have happened years ago, and may have involved other individuals at the corporation or predecessor trustees, your recollection of the facts and the motivations will be hazy and will require re-examination. It is always important to understand what is contained in the documents that you produce for the DOL, since it will likely be the subject of a fiduciary interview later. More on this below.
  • Trustee Minutes And Records. The law does not specifically require trustees to keep minutes of meetings; however, they are very useful and desirable. Trustees will typically adopt resolutions in connection with plan transactions or significant administrative decisions, but perhaps not on a regular year in and year out basis. Don't be surprised if you are asked for such documents in your interview and you are unable to produce them. This will not prevent the DOL, however, from asking what you did or what you intended in making decisions for the plan.
When The DOL Comes To Call — The Interview In almost every investigation, the DOL will interview the plan fiduciaries. Expect the interview, be prepared. Have all of the documents you produced for the DOL present in the interview in an organized and indexed fashion. The DOL will ask open-ended questions seeking a narrative from you. Make the DOL ask specific questions so you are sure what they are asking and what they are asking about. The purpose for this advice is not to hide anything from the investigator. Rather, it ensures that the interview stays on track and that your time and effort in the process are focused and potentially minimized. If necessary, refer to the documents in the interview to see what they provide so that your responses aren't based on vague recollections which might conflict with the documents and the written record of your prior decisions. Bear in mind that the DOL's objective is to protect the best interests of the participants and beneficiaries. This is your role as fiduciary to the plan as well. Therefore, it's best to keep in mind that you are on the same team as the DOL in this objective, even though you may not always agree with the details of their positions. We encourage you to have an attorney present during the interview. The EBSA manual specifically allows for a fiduciary's attorney to be present. However, the investigators are instructed to withdraw from the interview if the attorney attempts to take over or control the interview. DOL Voluntary Compliance Letter At the close of the investigation, the DOL will issue a "voluntary compliance (VC) letter." This VC letter contains the results of the investigation and the Regional Director's position and findings. There should be no surprises as to what the letter contains. The letter usually asserts one of three conclusions. It may assert that the investigation is closed and no further action is being taken. It might assert that the DOL believes:
  • You "may" have violated certain provisions of ERISA, but at this time, the DOL is taking no further action.
  • The VC letter might assert that the DOL is of the opinion that you "have" violated certain provisions of ERISA and that certain corrective actions are required.
You should strive in the investigation to not receive this last form of letter. If items are discovered in the investigation that are not to the DOL's liking, you should work with the DOL to ameliorate the issue. You may not see eye-to-eye 100% of the time with the investigator or the District Director, but all fiduciaries need to work out solutions that are in the best interests of participants. If such a letter is issued even after lengthy discussions, negotiations and attempts to resolve the issues, then you should engage counsel (if you haven't already!) to evaluate whether or not the DOL is likely to refer the matter to litigation. It may be possible to resolve the situation even after receiving this letter, but further steps shouldn't be taken without obtaining the advice of counsel. Often this letter is issued due to the fact that counsel has not been involved in the investigation and the fiduciaries have not understood the process or what the DOL's objectives and intentions were. There should never be any surprises about what is being issued in a letter from the DOL, and, therefore, you should use counsel, as necessary, in the process to avoid any allegations of breach of duty. Civil Litigation There are generally three types of civil litigation that may be brought against you as a plan fiduciary:
  • Benefits claims
  • Fiduciary breach claims
  • Retaliation claims
Benefits Claims These are the most common forms of confrontation with plan participants. Participants may file a claim with a plan administrator asserting an entitlement to benefits or requesting a clarification of their employee benefit status. DOL regulations require detailed benefit claim procedures to be stated in the plan documents and summary plan descriptions. In the event a claim is filed, the plan administrator should follow the plan's claim procedures to the letter. The plan participant will also be required to follow the procedures to the letter if he wishes to file a claim in court if the dispute is not resolved in his favor. It is possible to have a provision in the plan's benefit procedures requiring a plan participant to file a claim form in order to formally initiate and perfect his benefit claim. This helps avoid the issue of when and whether a participant has made a claim for benefits and when the time line for response and appeal begins and runs. Handling The Benefit Claim Plan administrators should provide claim forms and also should promptly respond to all document requests from the plan participant. If documents are not provided in a timely fashion (30 days), then penalties ultimately may be assessed against the plan administrator in the context of litigation. There is a list of participant available documents in the statute. This includes the plan document, summary plan description, annual report and any other instruments under which the plan is administered. You should seek advice from your counsel as to whether the ESOP's appraisal report is available upon request to the participant. This may vary depending upon the federal circuit in which the plan and employer are located. All responses to benefit claims should be in writing. The plan administrator should cite the time frame for its reply. If an extension of the response time is required, the plan administrator should notify the participant of the need for an extension of time. If the benefit is denied and the participant appeals, the plan administrator must engage in a "full and fair investigation" of the appeal. Ultimately, the plan administrator should issue a detailed written appeal decision which includes the relevant law and facts and terms of the plan under which the appeal is decided. Legal v. Administrative Decisions If the benefit claim ultimately proceeds to court, the court will view the plan administrator's decision differently depending upon whether it is a plan interpretation or a legal decision that the court is reviewing. Plan interpretations are viewed by the courts as presumptively correct, unless the plan administrator made an "arbitrary and capricious" decision to deny the benefit. This presumption applies, as long as the plan specifies that the administrator has the absolute discretion to interpret the plan. Benefit decisions that are legal decisions will be reviewed "de novo" by the courts. No presumption is given to the plan administrator's legal decisions. Finally, a modified level of deference is provided for plan administrators who are under a conflict of interest when they make the benefit decision. Note that some benefit claims will involve decisions of law and interpretive decisions. Be clear in your appeal decisions and consult with counsel regarding the basis for determination and the conclusions in the appeal. What Is An Abuse Of Discretion? A number of factors are taken into account by the courts in this regard. It is important for the plan administrator to demonstrate that there was a consistency with:
  • The terms of the plan
  • The past precedent of dealing with benefits for participants that are similarly situated
  • The applicable statutes and regulations
Overall, the thoroughness of the process that the plan administrator applies to the decision and the thoroughness and the detail of the appeal decision will be critical. It is also important that there is no evidence of bias or conflict of interest in the decision. Fiduciary Breach Claims Suits may be filed for fiduciary breaches by either a plan participant or the DOL. In these cases, there is no need for a plan participant to follow an administrative claims procedure prior to initiating litigation. However, as a practical matter, these types of claims are typically coupled with a benefit claim because a benefit denial will often be alleged to be a fiduciary breach. This is because a plan fiduciary is required to adhere to the terms of the plan document as a fundamental aspect of its duty of prudence. Historically these types of suits have required plan participants to sue on behalf of the entire plan, and not just to recover the benefits in their individual accounts. With the recent decision of the U.S. Supreme Court in LaRue, it is now possible for a participant to bring a suit, individually, to recover losses to his individual account. Retaliation Claims These claims are brought for interference with the exercise of the participant's rights under ERISA. These claims typically are coupled with a wrongful termination suit because the participant is alleging that the reason for termination was because he either raised a complaint regarding a fiduciary's behavior or regarding his rights under the plan or benefit entitlement. These claims are very similar to wrongful termination claims from the perspective of who carries the burden of proof and what facts will be looked at to determine whether the discharge was wrongful or was related to aspects of the participant's ERISA rights. Attorney's Fees The ability to recover attorney's fees in ERISA litigation is an important issue to plaintiffs, as well as fiduciaries, in defense. For plaintiffs, this is important as very few attorneys will take an ERISA case on a contingency basis because the damages sought are the participant's benefits in his account. There is no availability of punitive damages or other consequential damages. The federal courts apply a "five factor" test for determining whether to award attorney's fees. There is a presumption in favor of a prevailing plaintiff that he should be awarded his attorney's costs and fees. However, it is not necessary for a plaintiff to prevail on the merits to have his attorney's fees awarded. The federal courts do not want to discourage plan participants from asserting his rights under the statute. In contrast, there is a great hesitation by the courts to award fees for the defense, even if the defense is successful on the merits. Even though there is not a multitude of attorneys who spend a significant amount of time litigating benefit claims or fiduciary breach actions against retirement plans and ESOPs, those attorneys who take these cases typically understand the likelihood of being awarded attorney's fees, or not, in connection with a particular case. It is also possible for fees to be awarded on an interim basis as litigation progresses at critical points in the litigation. Indemnification Indemnification is the payment of a party's costs or damages by another party that assumes the responsibility by the terms of its contract or agreement. Plan fiduciaries are typically provided indemnification by the plan or by the employer under the terms of the plan document. The plan or the corporation may fund the indemnification by purchasing director's and officer's insurance (D&O), or fiduciary insurance. It also is possible to simply fund the indemnification out of corporate assets. Note that there generally is a limit on indemnification in ESOP cases where funding the indemnity would damage the stock price of the corporation sponsoring the ESOP. Also keep in mind that if fiduciary insurance is purchased by the plan out of plan assets, the law requires that the insurance coverage gives the insurance company recourse against the fiduciary to recover damages resulting from the breach. Therefore, it is advantageous to have the corporation purchase the insurance coverage since this is not a required term of an insurance contract under ERISA. Fiduciary insurance coverage and D&O policies should be carefully reviewed. Some D&O policies have gaps or "carve outs" that specifically exclude coverage for matters relating to an ERISA employee benefit plan. For these policies, a specific "rider" or additional policy must be purchased to provide the ERISA fiduciary coverage. This leads to the question of how much insurance coverage you should purchase to protect your plan fiduciaries. Also, when should you consider buying fiduciary coverage for your ESOP fiduciaries? Since coverage is typically most valued for covering the cost of the defense and not always for potential penalties resulting from the litigation, the amount of coverage may be a fraction of the ESOP's overall stock value. However, the more complex the plan or transaction, the greater the policy limit that is desirable. Note that some policies will not pay for the actual plan losses or benefits that are payable to the plan participant. An Ounce Of Prevention Is Worth ... Consider the following suggestions for proactive risk management:
  • Get It In Writing. Get any available answers to your technical questions or advice from your advisors in writing. Seek planning memos and written analyses of issues of fiduciary responsibility and liability for plan decisions and transaction decisions. Try to have your advisors and attorneys make clear: the unique situation, who bears the burden of the decisions, what the legal standards are for making the decisions, and what the process should be for reaching conclusions. Written guidance will help you better document the actions that you are taking.
  • Cross-Communications. Are your advisors, including your third party administrator (TPA), certified public account (CPA), corporate counsel, and ESOP counsel communicating with one another? In ESOP transactions and in ESOP planning situations, it is absolutely critical for all of your advisors to be in the loop on the advice being given. It must be clear which advisors are assuming responsibility for which issues. With specific acknowledgements among the advisors, a fiduciary client can help ensure that he is getting the right advice from the right professional. It is not unusual for a specific advisor to disclaim responsibility for advice as long as another advisor is reaching the conclusion and making the appropriate recommendations. Team communication will avoid gaps in your advice.
  • Documentation On Calculations. It is important, to have the particular advisor that is responsible for or controls the issue to provide the documentation for the rationale and conclusions that are being reached. The same is true for calculations that affect the administration of the plan. The CPA and the TPA should be in close communications so that the tax returns and the plan's administration agree and are completely accurate. Finally, if there are tax positions that are being taken which may affect your income tax return, be sure that your attorney and CPA are identifying who is the "preparer" for purposes of that issue on the return. It is possible for your attorney to be considered a return preparer if the attorney's advice is being relied upon for a reporting position on the return.
What To Do? It is a challenge for plan fiduciaries to understand and minimize their risk from the government regulators and from conflicts that could result in civil litigation. The appropriate starting point is understanding the different categories and types of conflict situations and what issues are typically in dispute. Most importantly, fiduciaries should ensure that their risks are insured and their process for reaching conclusions are well thought out, well advised, and well documented. It is impossible to always be completely prepared. An acceptable level of exposure exists in all these areas. We don't think that you should beware of these exposures. Rather, we advise that you be aware of what can be an important element of exposure in any of these areas in advance and be prepared.

Kevin Long

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Kevin Long

Kevin G. Long is certified as a Taxation Law Specialist by the California State Bar Board Of Legal Specialization — one of only some 300 tax specialists out of over 156,000 active California lawyers. His particular emphasis is on ESOPs and ESOP transaction planning and nonqualified and equity deferred compensation planning.

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