erisa 3(38) fiduciary status managing liability

INVESTMENT ADVISOR SERIES

ERISA 3(38) Fiduciary Status Managing Liability for Investment Managers through Errors & Omissions Insurance and required Bonding

By Gary Sutherland, CIC

Presented by

North American Professional Liability Insurance Agency, LLC (NAPLIA)

WWW. NAPLI A . COM 161 Worcester Road, Suite 504, Framingham, MA 01701 Tel 866.262.7542 Fax 508.656.1399

Copyright 2012 by North American Professional Liability Insurance Agency, LLC. All rights reserved.

This paper provides an overview of Errors & Omissions insurance and related coverage specific to ERISA 3(38)

What do you need to know and what concerns you

may have regarding proper coverage for your services as an ERISA 3(38) Investment Manager

Overview of the requirements under ERISA

section 412 bonding

The information provided in this paper is intended solely for general educational purposes. It is not intended for the

purpose of providing specific legal, insurance, or other professional advice to any particular recipient or with respect to any

particular jurisdiction. The author, publisher, and distributor of this document (1) make no representations, warranties, or

guarantees as to its technical accuracy or compliance with any law ( federal, state, or local) or professional standard; and,

(2) assume no responsibility to any recipient of this document to correct or update its contents for any reason, including

changes in any law or professional standard. You should formally retain the counsel of an attorney knowledgeable as to

your industry, your practice, and the laws of any jurisdiction(s) within which you conduct your practice to ensure the

document’s maximum usefulness and compliance with applicable laws and professional standards.


Introduction

A plan sponsor can delegate both significant responsibility and liability to an ERISA section 3(38)

investment manager for the selecting and monitoring of investment options, including full

discretion.

Under ERISA section 402(C) (3) a named fiduciary may appoint a 3(38) investment manager(s)

to manage plan assets. In other words, the plan sponsor may hire an ERISA 3(38) investment

manager to accept the fiduciary responsibility (and legal liability) for the investment options

offered to plan participants.

However, the plan sponsor can never delegate away its fiduciary responsibility (and legal

liability) for the “selection” of the 3(38) investment manager.

Through the acceptance of a written contract, the advisor becomes an independent fiduciary to

the plan via ERISA s 405(d)(1). In this capacity, the advisor is solely responsible, and liable, for

investment decisions concerning the selection, monitoring, and replacement of plan investment

options.

As an ERISA 3(38) fiduciary, the advisor has legal “discretion” in making these decisions. In Fact,

the plan sponsor has transferred their liability for such decisions to the advisor.

3(38) advisors are required by ERISA to state in writing that they are fiduciaries.

This action creates potential coverage issues within your Errors & Omissions

policy.

What steps then does an Investment Manager who has elected ERISA 3(38) status need to take

to manage this liability?


Overview of Errors & Omissions Insurance

An Errors & Omissions (E&O) policy protects advisors and consultants against losses due to an

actual or alleged negligent act, error or omission committed in the scope of their duties as

investment counselors/advisors. Historically, E&O policies excluded an advisor’s acts as a

fiduciary. Times have changed and today there are four ways that an E&O policy may address

third party fiduciary coverage:

1. The policy contains an absolute exclusion. The intent is clear to exclude any claims as a

result of the policyholder’s capacity as a fiduciary.

2. The policy is silent in reference to fiduciary coverage. As the policy does not affirmatively

provide, nor exclude, fiduciary coverage it is difficult to determine the intent of the policy.

3. The policy provides limited or modified coverage. In this scenario, the policy may provide

coverage as a limited 3(21) fiduciary but exclude discretionary authority over client funds.

4. The policy provides affirmative coverage for fiduciary activity. This is the most preferable

scenario, and recognizes the policyholder’s fiduciary duties to clients and provides a clear

statement of the policy’s coverage intent.

When an advisor takes on the role of an ERISA 3(38) investment manger it is important to make

sure that the advisors current E&O insurance policy is not included in the first three types of

coverage mentioned above. It is most common for affirmative fiduciary coverage to be

included specifically in the body of the policy, or added by endorsement. In either instance, it is

policy language that specifically states coverage’s for ERISA fiduciary services for others for a

fee that is crucial.


A standard, and acceptable, exclusion is when an advisor is a fiduciary for their own plan or

where an advisor is a plan participant.

An advisor should also make sure there are no limitations upon discretionary authority and that

the policy covers “the advisor” for all discretion over ERISA plans, other than the advisor’s own

plan(s).

In addition to the above, a significant concern with an advisor’s E&O insurance policy is the

contractual liability exclusion and how it may relate to contracted services as an ERISA 3(38)

investment manager. A standard exclusion might read like the following:

(This policy does not apply to) The liability of others assumed by any

of you (the advisor) under any contract or agreements unless the

liability would have attached to you “the advisor” even in the absence

of such contract or agreement.

Specifically, the agreement or contract of a 3(38) advisor is a written fiduciary

acknowledgement given to the plan sponsors. The intent of the foregoing exclusion is to avoid

claims were the advisor is contractually obligated (and thereby, the insurance company) to

assume risks beyond the scope of their areas of practice and or outside the scope of their

applications and supporting documentation.


Because the 3(38) advisor accepts the risk of the plan

sponsor for the selection and monitoring of investment

options, including the full responsibility to control and

dispose of plan assets, the contract exclusion may apply.

This then becomes a grey area of coverage intent that could

lead to a coverage dispute, or worse, a denial of coverage.

Acceptable modification of this exclusion might read as:

The liability of others assumed by any of you

(the advisor) under contract or agreement

except for any written fiduciary agreements

or contracts given to clients other than you

:the advisor” for a fee unless such liability

would have attached to you ‘the advisor”

even in the absence of such agreement or

contract

This clarifies the intent of coverage and lessens the potential

for misinterpretation. When possible it is prudent to make

sure that the definition of professional services is broadly

worded to specifically address services as a 3(38) as defined

by ERISA s402(c)(3).

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It is important for the advisor to understand that all polices designed for investment

professionals are not standardized, so the full policy including all endorsement needs to be

analyzed and matched to the advisor’s firm’s activities and business model.

Case Study:

We recently reviewed a policy form (without endorsements) that appeared to provide

broad coverage intent for the investment advisor. However, upon full review of the

policy’s endorsements, it was obvious that the endorsements negatively modified

coverage. In fact, one endorsement contained a “discretionary authority exclusion” that

effectively removed coverage for more than 50% of the advisor’s areas of practice. The

advisor had this policy in place for several years and clearly the insurance agent was not

familiar with the advisor’s business.

ERISA Investment Bonds / Fidelity Bonds

The fidelity bonding requirements of ERISA, is often misunderstood and produces significant

questions and concerns among advisors.

ERISA bonds protect plans from losses due to theft and fraud of plan funds. ERISA Section 412

requires every fiduciary of an employee benefit plan and every person who handles funds or

other property of such plan, to be bonded.

The responsibility for ensuring bonding requirements falls to the plan officials.

Under ERISA section 412(b) it states that is unlawful for any plan sponsor to

permit any others to receive, handle, disburse, or otherwise exercises custody or

any control over plan funds or other property without being bonded in

accordance with ERISA section 412.


An ERISA section 3(38) advisor is required to be bonded

for each plan that they service up to $500,000 per plan,

or up to $1,000,000 if the plan has company stock. The

Department of Labor (DOL) has confirmed this coverage

requirement and plan sponsors are obligated under

ERISA to confirm bonding from each advisor that has any

discretionary authority over plan assets. This means if

the advisor is paid directly from plan assets they are

required under ERISA section 412 to be bonded.

Exceptions: A person that provides investment

advice, but does not exercise, or have the right

to exercise, discretionary authority with respect

to purchasing or selling securities or other

property for the plan and does not collect fees

directly from the plan, is not required to be

bonded solely by reason of providing such

investment advice for others for a fee.

In some instances we have seen an advisor added to a plan’s required ERISA bond; However,

this is not recommended as it may be a breach of fiduciary duties of the plan sponsors in the

event that ultimately a loss is not covered due to an erosion of limits of coverage. Remember,

the Bond caps losses at $500,000; whereas a plan may purchase increased aggregate limits of

coverage if the advisor were provided with individual bonds. In addition, some plans require

more than the minimum bonding requirements under ERISA section 412.

Definition of “Handling” and relation to bonding The term “handling” carries a broader meaning than actual physical contact with “funds or other property” of the plan. A person is deemed to be “handling” funds or other property of a plan so as to require bonding whenever his duties or activities with respect to given funds or other property are such that there is a risk that such funds or other property could be lost in the event of fraud or dishonesty on the part of such person, whether acting alone or in collusion with others. According to ERISA Attorney, Marcia S. Wagner, “the primary standard to determine whether a person should be bonded is whether plan funds could be lost as a result of that person’s dishonesty”>


Bonds can be written several ways. The most common formats are “blanket” and “individual”.

Blanket bonds are designed to cover all the plans an advisor has at the inception of the policy.

Each plan is rated based on the current assets of the plan up to the required 10% and the

premium is based on the cumulative totals. Any new plans added during the policy period are

automatically covered and at renewal a new schedule of plans and plan assets are reported to

the insurance carrier for the premium calculations. Certificates of insurance can be issued to

plan holders meeting the notification requirements for plan sponsors

Individual bonds are unique to a particular plan and often will have to provide protection in

excess of the minimum ERISA bonding requirements. Such plans are usually the mid-to-larger

size plans. Most insurance carriers will offer up to $25 million in bonding capacity, and

additional coverage is available by requested excess coverage.

Conclusion

It is an axiom that not all fiduciaries are alike; the same can be said for insurance policies. It is

essential for an advisor to understand their exposure, identify potential gaps in coverage, and

take the necessary steps to ensure proper coverage including:

1. Identify the fiduciary coverage in your existing policy

2. Identify the contractual exclusion in your existing policy

3. Identify your need for an ERISA Investment Advisor Fidelity Bond

The importance of these items cannot be understated, but they do not represent all of the

potential coverage concerns for any one particular practice or policy. Whenever possible work

with an insurance specialist who is familiar with investment professional’s insurance policy

language and has the experience of negotiating coverage enhancements.


Contact

Gary Sutherland is the Chief Executive Officer of North American Professional Liability Insurance Agency,

LLC (NAPLIA). He can be reached at [email protected] or 508-656-1350.

About NAPLIA

Established in 1998, North American Professional Liability Insurance Agency, LLC (NAPLIA) specializes in

providing professional liability insurance, errors and omissions insurance and related products to the

financial industry. Our focused approach makes us leaders in the industry. NAPLIA has been named to

the INC 5000 list of the fastest growing private companies in America every year since 2008.

Additional Resources

Using your Insurance as a Marketing Tool (for Investment Advisors)

http://www.investmentadvisorinsurance.com/white_papers/index.htm

How to inform your clients about Fiduciary Insurance

http://www.investmentadvisorinsurance.com/fiduciary-insurance/why_fiduciary_insurance.htm

The information provided in this paper is intended solely for general educational purposes. It is not intended for the

purpose of providing specific legal, insurance, or other professional advice to any particular recipient or with respect to any

particular jurisdiction. The author, publisher, and distributor of this document (1) make no representations, warranties, or

guarantees as to its technical accuracy or compliance with any law ( federal, state, or local) or professional standard; and,

(2) assume no responsibility to any recipient of this document to correct or update its contents for any reason, including

changes in any law or professional standard. You should formally retain the counsel of an attorney knowledgeable as to

your industry, your practice, and the laws of any jurisdiction(s) within which you conduct your practice to ensure the

document’s maximum usefulness and compliance with applicable laws and professional standards.

http://www.investmentadvisorinsurance.com/white_papers/index.htm

http://www.investmentadvisorinsurance.com/fiduciary-insurance/why_fiduciary_insurance.htm

erisa 3(38) fiduciary status managing liability

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