How 401(k) advisers can bullet-proof themselves against litigation risk under DOL fiduciary rule

Tons of 401(k) advisers will be prone to litigation come June, and advisers need to know where the pitfalls lie and how best to protect themselves

May 20, 2017 @ 12:01 am

By Greg Iacurci

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Many advisers who service 401(k) plans will, for the first time, be considered fiduciaries with respect to their investment advice when the Labor Department's conflict-of-interest rule comes into force next month.

Along with that heightened standard comes litigation risk for retirement plan advisers, as well as those advising 401(k) participants on rollovers to individual retirement accounts.

"Under the rule, it's pretty hard not to be a fiduciary," said Brian Graff, executive director of the National Association of Plan Advisors. "Relative to today, after June 9 there's definitely more litigation risk. For 401(k) plans it's not academic anymore. It's very real."

To a certain degree, it's impossible for advisers to completely bulletproof themselves against litigation. But knowing how to mitigate risks, keeping stringent documentation and being aware of major problem areas are keys to prevention.


Advisers may be wondering how exactly they'll be exposed to litigation risk come June.

After all, many provisions of the fiduciary rule, which raises investment-advice standards in retirement accounts, aren't scheduled to kick in until the beginning of next year. One of those provisions includes execution of a best-interest contract that would allow retail investors to bring class-action lawsuits if they feel they've been wronged.

Participants in 401(k) plans, though, have a 40-plus-year-old mechanism available to them under the Employee Retirement Income Security Act of 1974, which allows them to sue for fiduciary breach. While this is by no means a new legal standard, the number of advisers that will be exposed to it, beginning next month, will climb exponentially.

"If today there are X number of fiduciaries across the land, on June 9 there will probably be 10X," said Skip Schweiss, managing director of adviser advocacy and industry affairs at TD Ameritrade Institutional.

The 401(k) market has been fertile ground over the past decade for class-action lawsuits brought by plan participants against employers and some service providers, such as record keepers, for breach of fiduciary duty under ERISA.

Such lawsuits have yielded some large monetary settlements, typically from big corporations with massive retirement plans. For example, Lockheed Martin paid a record $62 million in 2015; that same year the Boeing Co. paid $57 million in a separate settlement.

"I would caution any adviser to create the record that the [bic] would have wanted ... if it was fully applicable." Lawrence cagney, partner, debevoise & Plimpton

Plan advisers and advisory firms have largely been kept out of the suits. Proving an adviser is a fiduciary under the current framework is difficult, according to observers.

Going forward, advisers and their firms could find themselves co-defendants alongside plan sponsors facing allegations of fiduciary breach.

To a lesser degree, there's also risk of the Labor Department conducting an investigation into a fiduciary adviser's practices. Depending on the outcome of such an audit, advisers may be subject to excise taxes and restoration of any "ill-gotten gains" to retirement plans, said Charles Humphrey, principal at an eponymous law firm and a former DOL attorney.

However, the DOL tends to focus its energy on plan issues rather than issues with specific advisers, said Mr. Humphrey, who doesn't expect "really much [DOL] enforcement in this area" in the next year.

So how can advisers protect themselves?

While there's not much advisers can do to prevent being named in a lawsuit, they should, as a practical matter, conduct a cost-benefit analysis on fiduciary liability insurance ahead of June, said Marcia Wagner, principal at The Wagner Law Group.​

Depending on the policy, the insurance could cover legal fees and damages, she said.

"[Brokers] get errors and omissions insurance, but that's not covering ERISA fiduciary liability issues. In fact, most E&O carves that stuff out. So these guys could be naked to a certain degree," Ms. Wagner said.


Principally, advisers can get in trouble for recommending investments as well as other fiduciary services, such as other fiduciary advisers, for some sort of fee.

Brokers and advisers receiving a fee for their investment recommendations to 401(k) plans come June must adhere to the impartial conduct standards to avoid running afoul of the fiduciary rule and, therefore, ERISA.

Three factors are involved in the impartial conduct standards: acting in a client's best interest, receiving reasonable compensation for a recommendation and making no materially misleading statements to clients.

Most broker-dealers, for example, have handled this in part by moving to a level-compensation arrangement, whereby advisers receive a flat fee, expressed as a dollar amount or a percentage of plan assets, for investment advice on the fund menu, said Fred Reish, partner at law firm Drinker Biddle & Reath. This eliminates any variability in adviser compensation paid via investments, and any consequential influence such variability would have on fund selection.

And, for those advisers who aren't specialized in retirement-plan business, some broker-dealers are mandating those non-specialists can't provide the advice — rather, they must use an outsourced "platform adviser" such as Mesirow Financial to provide the recommendations.

Interestingly, firms exercising more control, by allowing for less individual decision-making on the part of plan advisers, open themselves up to class-action litigation because there's more uniformity of action, and therefore greater likelihood to certify an affected class of participants, said Lawrence Cagney, partner at Debevoise & Plimpton.

On the flip side, with more adviser control comes greater likelihood for improper documentation or consideration of relevant detail, he said.

"It's a very interesting conundrum, and I'm not sure there's a great way to insulate oneself from liability other than creating a record as best you can," Mr. Cagney said. "In the ERISA arena, if you can't prove why you did something, it will be very hard to prevail on that litigation."


But there are some subtle nuances advisers should heed when advising clients.

Whereas advisers and plan sponsors focus most of their energy on the quality of the investment management (e.g., fund performance), that's not where the greatest litigation risk lies, Mr. Reish said. Instead, advisers should be focusing on fund costs and share class. A mutual fund expense ratio is a quantitative, rather than qualitative, issue and is therefore easier to attack in a lawsuit, he said.

In fact, excessive investment fees are where a large portion of the lawsuits to date have centered.

And, perhaps counterintuitively, advisers should incorporate record-keeper benchmarking into their service offerings as a way to determine if fund fees are reasonable, especially if a plan pays for record-keeping services through revenue-sharing fees like 12b-1 or sub-transfer-agency fees, he said.

If participants are paying too much money via revenue sharing to a record keeper, it means the participants are paying too much for investment management, Mr. Reish said. And to know if a record keeper is receiving excessive compensation for its service, an adviser needs to know how to evaluate record keepers.

"It's OK to pay revenue sharing to the record keeper. It's just paying too much that's the problem," Mr. Reish said.

Further, even the recommendation of a record keeper could get advisers in trouble, according to legal experts.


"There are a lot of plan advisers that aren't appreciating the nuance around the record-keeper recommendation," Mr. Graff said. "It's not a previous mistake, but under the new rule the recommendation of a record keeper will be considered, in most cases, a fiduciary act."

While the recommendation of a non-fiduciary service provider such as a record keeper, especially one whose platform is open-architecture and offers hundreds or thousands of investment choices, is not a fiduciary act, recommending a more limited platform — perhaps one with 20-30 investments — could be considered a fiduciary recommendation, Mr. Reish said.

As mentioned previously, another potential area for trip-ups is adviser referrals. While some less-experienced plan advisers may refer current or potential clients to more experienced advisers in order to avoid fiduciary liability, the referral itself could be a fiduciary act, whether the fee is explicit, such as a finder's fee, or implicit.

Rollovers represent perhaps the most significant problem area, experts said. While advice to IRA clients isn't subject to any meaningful enforcement until the full scope of the rule comes into force next year, advice on rollovers from a 401(k) plan to an IRA are subject to litigation risk beginning in June.

That's because the recommendation is affecting money held in an ERISA plan.

"I would caution any adviser to create the record that the best-interest contract would have wanted them to create if it was fully applicable," Mr. Cagney said.

That includes comparing a participant's 401(k) plan with an individual retirement account (including investment options and cost structure), weighing the benefits of both vehicles, and documenting the process to prove a selection is ultimately in a client's best interest, he explained.

Separate from the economics of the recommendation, a client's specific desires may influence the decision — in which case, advisers may wish to have clients sign a document outlining those motivations.

Rollover recommendations, unlike those of 401(k) plan investments, seem less prone to class-action litigation, observers said. The same suite of 401(k) investments is available to participants, so participants are more likely able to represent a class of similarly situated individuals. But IRA recommendations are often more individualized.


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