Traditional Role as Service Provider Does Not Bar Fiduciary Liability

By C. Frederick Reish and Joseph C. Faucher

In a scene from one of the old “Pink Panther” movies, the hapless Inspector Clouseau asked a man walking a dog, “Does your dog bite?” When the man responded “No,” Clouseau moved to pat the dog on the head, and was met with a vicious snap. Clouseau said “I thought you said your dog did not bite!,” and the man responded, “That’s not my dog.”

Like Clouseau, service providers and vendors of investment products to pension plans (such as insurance agents and mortgage brokers) are often surprised to find out that even though they believed they were not ERISA fiduciaries, the courts sometimes disagree. After the Supreme Court’s decision in Mertens v. Hewitt Associates, 508 U.S. 248, (1993),¹ a cheer went up among service providers such as actuaries, accountants, attorneys, and third party contract administrators. The Court in Mertens held that these nonfiduciary service providers could not be held liable for money damages under ERISA for participation in a fiduciary breach. The Court questioned whether there was even a cause of action for participation in a breach by a nonfiduciary. This was welcome news for those who had traditionally been viewed by the courts and by plaintiffs’ attorneys as nonfiduciaries. Service providers had reason to cheer, since Mertens clarified that their advice would not be the grounds for liability under ERISA. Of course, they could be sued for professional negligence–or malpractice–but that is a risk they all take in their work.

Since Mertens, however, several court decisions have muddied the fiduciary liability waters. The fallout from Mertens has been that plaintiffs’ lawyers and the DOL have sought to expand the list of those who are fiduciaries. This strategy has been successful when used against companies and individuals selling investment products to plans. Under the law, stepping over the line separating fiduciaries from service providers results in fiduciary status and all the accompanying consequences. Unfortunately, that line is invisible, changes from case to case, and where it is drawn depends largely on the judge on the case.

Buster. In Thomas, Head & Griesen v. Buster, 24 F.3d 1114 (CA-9, 1994),² Jack Buster, the defendant, was a real estate mortgage broker in Alaska. His relationship with the plaintiffs was similar to many long-term relationships between investment vendors and plans. Buster sold more than 61 notes secured by deeds of trust (totalling about $700,000) over a period of more than nine years. As compensation, he received either a 10% commission or the spread between his cost and the price he charged the plan. His transactions amounted to over 40% of the plan assets. He also attended “regular” meetings with the trustees, during which they discussed investment strategies, the need for diversification, and criteria used by Buster to determine which investments were suitable for the trust. In addition, Buster provided information to the trustees including yield calculations, mortgage analyses, price information, property descriptions, and payment history.

Buster was sued for his sale of some of the notes and deeds of trust. These particular notes carried a promised interest rate of 20%. The Alaska real estate market cooled, and the plan, which was sponsored by a CPA firm, earned less than the promised return. The trial court found that the information Buster provided to the plan amounted to “recommendations as to the advisability of investing in certain deed of trust notes.”

Referring to the above facts, the trial court reached the following conclusions:

1. Buster provided individualized investment advice.
2. The advice was given pursuant to a mutual understanding that it would be the primary ground for the plan’s investment decisions.
3. The advice was provided regularly.
4. The advice pertained to the value of the property or consisted of recommendations as to the advisability of investment in certain property.
5. The advice was rendered for a fee.

Problems with Buster. Buster is even more interesting (or frightening) if one considers that the dissenting opinion pointed out several facts that may have prompted some courts to find that Buster was not a fiduciary, including the following:

• Thomas, Head & Griesen (the plan sponsor) was a CPA firm. The CPAs managing the trust had been partners in a company that sold notes secured by deeds of trust. It can thus be assumed they were sophisticated in these types of investments.
• Although the plan was awarded over $140,000 in damages, the plan never suffered an actual loss. The trust earned a 6% gain on those investments–just not the 20% promised.
• The dissent stated that there was no evidence in the record to conclude that a mutual agreement existed between the Thomas, Head firm and Buster whereby Buster’s advice would be the primary grounds for the plan’s investments.
• Buster’s source of pay was commissions–therefore, the plan trustees clearly knew that Buster’s income was derived by making sales, rather than by providing particularized investment advice solely in the interest of the plan.

Farm King Supply. In Farm King Supply, Inc. Integrated Profit Sharing Plan v. Edward D. Jones & Co. 884 F.2d 288 (CA-7, 1989),³ which the dissent in Buster cited as authority for the conclusion that Buster was not a fiduciary of the CPA firm’s plan, the court noted that a person can provide investment advice without becoming a fiduciary:

Under the appropriate departmental regulations some sort of an agreement or understanding must have existed between the parties, not necessarily that Jones would serve as a fiduciary, but that Jones would provide to the Plan individualized investment advice which would be the primary basis for the Plan’s investment decisions... There is nothing in the record to indicate that Jones or its employees had agreed to render individualized investment advice to the Plan, nor that the trustees so agreed. The only “agreement” between the parties was that the trustees would listen to Jones’ sales pitch and if the trustees liked the pitch, the Plan would purchase from among the suggested investments, the very cornerstone of a typical broker-client relationship.... The situation here mirrors that in American Federation of Unions. In that case, the Fifth Circuit pointed out that “[s]imply urging the purchase of its products does not make an insurance company an ERISA fiduciary with respect to those products.”

The court’s opinion is sketchy on the facts. Apparently, several of the plans bought the partnership interests. At least one plan invested all of its assets in the partnership interests. Those interests either became worthless or worth very little. The DOL investigated the plans and found that they had suffered large losses on these investments. After talking with the plan trustees, the DOL determined that the trustees had performed no investigation of the partnership investments. Instead, they had “rubber stamped” the recommendations made by McManus and Covelli. The DOL investigator also learned that the investments were sold to the plans by the third-party administrator (since McManus and Covelli had not told the plans that they were no longer owners of that firm and since they continued to be the plans’ sole contact with the administration firm). While the court did not explain the significance of those facts, the obvious implication is that the influence of McManus and Covelli was heightened because they were the ERISA compliance “experts” for the plans. As a result, it was a key factor in pushing them over the line into fiduciary status as investment advisors. Other facts in the opinion support the conclusion that the salesmen encouraged the plan trustees to invest without adequate investigation or understanding and to rubber stamp their recommendations.

Reich v. Lancaster. In Reich v. Lancaster, 55 F.3d 1034 (CA-5, 1995), the Fifth Circuit reinforced the lessons of McManus and Farm King Supply. Lancaster and two corporations (controlled by Lancaster and his sons) were hired by the Plumbers & Pipefitters Local 454 Health & Welfare Fund to provide administration and consulting services. Lancaster also sold insurance policies to the Fund on terms favorable to him. The DOL sued, asserting that Lancaster was a fiduciary because of his “control” over the Fund’s assets. The trial court found that Lancaster was a fiduciary and awarded damages against him. Lancaster lost on appeal. The Fifth Circuit summarized its holding as follows:

The Fund in this case was managed by a group of trustees who had no experience or expertise in insurance matters. Every recommendation made by Lancaster in regards to health and medical insurance, life insurance, and even where to invest the Fund’s money was accepted by the trustees. How much the trustees relied on Lancaster becomes glaringly evident when one considers that Lancaster convinced the trustees to spend, in a little over two years, nearly $1,000,000.00 in premiums on life insurance when the Fund only had $750,000.00 in assets. Of the premiums paid by the Fund, over $550,000.00 went to Lancaster in the form of commissions. All of these fees charged by Lancaster were accepted by the trustees, apparently without question. In the first five years after Lancaster was hired, the Fund paid over $120,000.00 more in compensation to Lancaster than would have been paid to Martin Segal, the Fund’s previous consultant. The record supports the determination that Lancaster usurped the Trustees’ independent discretion and effectively exercised authority and control over management and administration of the plan with respect to the insurance policies in questions. Lancaster presented misleading information to Trustees who were unsophisticated in insurance, were dependent upon Lancaster’s special expertise, and uncritically accepted his recommendations.

Importance of documentation. McManus teaches that when there is an appearance of “high trust” in the relationship, courts are more likely to find fiduciary status, and fiduciaries and vendors of investment products should confirm that all investments are fully investigated and files are maintained with complete documentation and information gathered in the investigation. The authors have often run into a lack of documentation when consulting with employers and fiduciaries about plan investment losses. Self-trusteed small and mid-sized plans often have no records supporting their investment decisions. Moreover, those who simply sell investment products, but do not give “individualized” investment advice to any one client, should inform their clients of this fact in writing. Finally, vendors should confirm in writing that their advice is or is not the primary basis for the plan’s investments.

Sophistication of named fiduciaries. Lancaster sets a difficult precedent, partly because its facts are so bad. The decision in Lancaster suggests that when the named fiduciaries are inattentive, unsophisticated, or even incompetent, the vendor of investment products is in jeopardy of becoming an ERISA fiduciary. So, the more gullible the trustee or investment committee, the greater the obligation of the salesperson to make full disclosure, provide complete documentation, and be careful about the products sold and the commissions or fees paid.

Unfortunately for investment product vendors, it probably is not enough to only pay close attention to inexperienced or unsophisticated investor-clients, while letting the sophisticated client fend for itself. Jack Buster’s clients were investment-savvy CPAs with a track record of investing in the notes that Buster sold. The CPAs’ plan did not even lose money–it just did not make as much as the CPAs were promised. The moral of the story is that vendors of investment products and service providers should never assume that they are immune from liability under ERISA. Once a lawsuit is filed, it will be too late to explain to the client that investment advice was not really being given, but rather, one was simply selling a product. Plaintiffs come in all shapes and sizes, and levels of sophistication. Most defendants, on the other hand, have one thing in common–they fail to take steps to avoid liability before it happens.

CONCLUSION
Just as it was not enough for Clouseau to ask “Does your dog bite,” service providers and investment product vendors should avoid assuming that, because of their traditional roles, they are nonfiduciaries. Instead, they should ask whether they are performing any fiduciary functions. If the answer is yes, they can still take the steps necessary to avoid a finding that they are ERISA fiduciaries, or at the very least, they can decide that they need fiduciary liability insurance.

ENDNOTES

¹See Ford and Breyfogle, “Mertens v. Hewitt Associates Raises Critical Issues for Policymakers,” 1 JTEB 186 (Nov/Dec 1993); Tudor, “Liability of Nonfiduciaries after Mertens is Still Uncertain,” 4 JTEB 115 (Sep/Oct 1996).

²See Eccles, “Ninth Circuit Further Clouds Definition of ERISA Fiduciary,” 2 JTEB 237 (Jan/Feb 1995); Hans and Bradbury, “Improving Participant Investment Choices Through Education and New Fund Models,” 4 JTEB 20 (May/Jun 1996).

³See Hans and Bradbury, supra note 2.

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