Good Risk Governance Pays - Investment Best Practices | Risk Management | Valuation

Courtesy of Strafford Publications, Dr. Susan Mangiero spoke on the topic of ERISA investment fiduciary pain points and the role of service providers. She was joined by esteemed colleagues Andrew L. Oringer (Partner, Ropes & Gray) and Christine A. Dart (Vice President, Chubb & Son) in a lively and informative debate about current ERISA litigation trends, "must do" action items regarding ERISA fiduciary liability insurance procurement and the vetting of investment decisions relating to fees, third parties, use of derivatives, hard-to-value investing, leverage and risk management.

Click to read the transcript of comments by Dr. Susan Mangiero on the topic of ERISA investment fiduciary considerations.

Click to order a recording of the full 90-minute program entitled "ERISA Fiduciaries Under Attack: Key Litigation and Regulatory Developments."

According to its April 19, 2011 press release, Advisen Ltd's new survey about lawsuit filings suggests lots more activity in the courtroom. Their examination of documents related to 362 securities litigations is an increase from 342 filed in the first quarter of 2010. What caught my eye in particular was the breakdown of cases. Notably, securities class action suits "had accounted for more than one third of securities suits filed" in the past but was declining as "breach of fiduciary duties suits continue to account for most of the largest settlements."Their statistics suggest an average securities class action settlement of nearly $55 million.

Attorney Kevin LaCroix has a nice wrap-up of the full survey. Click to read "Advisen Releases First Quarter 2011 Corporate and Securities Litigation Report," posted on April 19, 2011. Not surprisingly, in the aftermath of the sub-prime and credit crisis, many of the lawsuits included in the Advisen study report involve financial industry defendants. Author of the D&O Diary, uber blogger LaCroix describes the breach of fiduciary duty suits as mainly filed in state court and filed "shortly after the announcement of a proposed merger or acquisition." He adds that "These breach of fiduciary suits represent about a third of all corporate and securities lawsuit filings in the first quarter of 2011, up from only eight percent of all corporate and securities filings as recently as 2004."

My discussions with ERISA attorneys suggest that fiduciary breach allegations are on the rise and will continue to make their way to federal courts. Whether this parallel phenomenon portends a worldwide trend - more frequently holding fiduciaries accountable by triers of fact - remains to be seen. This would make sense since the definition of fiduciary is being expanded by the U.S. Department of Labor ("DOL") for federally regulated employee benefit plans at the same time that the U.S. Securities and Exchange Commission is focused on augmenting fiduciary standards.

Fiduciary is fast becoming the veritable "buzz" word of modern financial times.

The U.S. Department of Labor's ("DOL") proposal to expand the definition of fiduciary is stirring the pot for multiple sectors of the investment world. Investment News journalist Darla Mercado writes that the U.S. Securities and Exchange Commission ("SEC") and the DOL should work together on any initiative that expands the scope of the fiduciary in order to ensure compatiability across regulators. See "B-Ds plead for DOL, SEC to team up on fiduciary rule: Efforts to rewrite regulations produce overlap, angst" (March 3, 2011). In reviewing the comment letters submitted to the U.S. Department of Labor on this matter, I came across a particularly interesting response on behalf of broker-dealers and asked the primary author to elaborate. In the Q&A that follows, Attorney John R. Fahy (with Whitaker Chalk Swindle & Sawyer) predicts big changes ahead.

Q: You represent broker-dealers as a securities attorney and authored the 33-page letter to the Employee Benefit Security Administration ("EBSA") dated January 11, 2011. In that letter, you suggest that certain transactions may no longer be available to ERISA plans should rules change. As things stand today, SEC-licensed securities brokers and dealers who act only as "executor of instructions relating to securities transactions during the ordinary course of its business as a  broker or dealer" are exempted from the definition of ERISA fiduciary. Would you elaborate?

A: It's helpful to consider what broker-dealers are likely to stop doing on behalf of ERISA plans should they be forced to wear the hat of fiduciary. For one thing, if a plan sponsor wants to get a second opinion about something like asset allocation trends or the state of the economy from a broker-dealer with which it has a long-standing relationship, that broker-dealer is almost surely going to say "no" for fear of being seen as giving advice and, by extension, having fiduciary liability. Plan sponsors won't get the benefit of a "give and take." This may not be a huge problem for larger plans that have the budget to hire consultants. It could be a problem for smaller plans and individual investors such as IRA account owners. Blocked communications could impede investment literacy at a time when financial planning education is critical.

Q: ERISA currently defines certain transactions as "prohibited." Should the ERISA fiduciary definition be expanded, how will the universe of services now provided by broker-dealers to ERISA plans change?

A: ERISA has a list of specific prohibited transactions that cover many of the services that broker-dealers provide to plans and plan participants. For example, ERISA prohibits ERISA fiduciaries from loaning money or otherwise providing credit facilities to plan and plan participants. In the broker-dealer context, this would mean no more margin accounts from broker-dealers deemed to be fiduciaries. Margin accounts are required for options. So plan and plan participants would not be able to engage in legitimate option-based hedges of their holdings through such accounts. The broker-dealer industry does have a split between the clearing brokers - those who provide the margin loans - and the introducing broker-dealers that provides the personalized services. An argument could be made that the firm providing the credit facility is not the one that recommends transactions. However, clearing agreements typically allow the clearing firm to pursue the introducing broker-dealer for unpaid customer margin losses. In this sense, the introducing broker(s) would be on the hook for the credit facility. I am not sure what impact that would have as an ERISA prohibited transaction. Additionally, none of the foregoing applies to self-clearing firms that may be in the position of both recommending a transaction and providing the credit facility. These organizations may be deemed to be a fiduciary and forced to shed the margin loan(s) in place. Generally speaking, plans and their participants will have a narrower universe of investment and financing choices. Investment services will cost more and there will be fewer counterparties available. ERISA also prohibits self-dealing transactions. As a result, principal trades would be construed as a prohibited transaction, even if the principal trade settlement could have fulfilled the trade order at a better prices than an agency trade. Firmly underwritten offerings such as IPOs would be off limits as they would be deemed principal trades. To reiterate, ERISA plans and plan participants would see their investment selection pool shrink.

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In "The Post-Madoff Emergence of a Fiduciary Duty of Due Diligence - Recent Regulatory Enforcement Actions and Their Impact on Best Practices for Investment Managers" (Practical Compliance & Risk Management For The Securities Industry, September-October 2009), Attorneys Scott A. Meyers and James G. Martignon describe a renewed scrutiny of the relationship between hedge funds, investment advisers, broker-dealers and their investors. As a follow-up, Chicago-based Attorney Martignon (with Ulmer & Berne LLP) answered additional questions about the investment world in the aftermath of highly publicized financial fallout.

Q: Jim, I came across your interesting article in research for my new book on investment risk governance. You and Attorney Meyers did a terrific job of elaborating on fiduciary duties and the relationship between asset managers and their clients. Thanks for joining me today to talk further about this important topic. Let's start with understanding your motivation to write the article.

A: It's pretty straightforward. Our clients are mostly asset managers and broker-dealers. With so much news about regulatory mandates and the increased number of lawsuits being filed in the last few years, our clients asked for more information about their responsibilities to investors and what they should be doing differently, if anything, to mitigate their risks.

Q: Whom do you think bears the responsibility for compliance at a fund and is good governance seen as a differentiator?

A: Good fund managers care about doing the right thing for their investors. It's always a balancing act between the general counsel and chief compliance officer and the sales team. However, unless a fund is around for the long haul, everyone loses. Business development professionals have a lot to gain by supporting their colleagues in legal and compliance. Importantly, it's not just adhering to the letter of the law. Fiduciary duty means applying common sense as well. I recall hearing the former head of the SEC's Office of Compliance and Investigations and Examinations tell a story that stayed with me. A hedge fund chose not to do something that was legal but didn't quite pass the smell test. The examiners were impressed that the fund was sensitive to going the extra mile. 

Q: Is there a difference between vulnerability to litigation for a fund that trades more frequently?

A: Probably. For example, the trigger factors for a hedge fund that actively trades are likely to be different than let's say a private equity fund that can perhaps dedicate more resources to monitor fewer positions. With more active trading (and I'm not even addressing high frequency trading issues here), issues that attract scrutiny include compensation, performance reports, trading across multiple entities and delegation of some work to others (such as a custodial bank or prime broker).

Q: You write extensively about fiduciary duties that include (a) good faith, full and fair disclosure (b) prudence in selecting agents and in making and monitoring investments (c) fulfilling representations made to clients and(d) furnishing information to clients, obtain material information and disclose limitations on inquiry or investigation. Are you saying that these duties are more important now than in the past?

A: No. Discharging one's fiduciary duties have always been important. It's just that so many investors were surprised by situations involving investment fraud as well as those that reflected poor oversight of operational and financial risks. Things go in waves and financial reform is no different. The Madoff scandal revealed chinks in the armor. You had a name fund manager that consistently reported great returns and continued to attract investors. Given the scale of losses, it's no surprise that people took a further look at what went wrong. We've lived through investment fraud before but never had multiple catalysts occurring at the same time. After news broke about Lehman Brothers, Bear Stearns and others, investors clamored for answers about systemic vulnerability. For example, if an investor allocates money to a hedge fund, they have to understand that they are exposed to a wide array of risks, not just the price movement of what's inside the hedge fund's portfolio.

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In its 2011 edition of Workplace Class Action Litigation Report, law firm Seyfarth Shaw predicts  a "make-or-break year" with a flurry of labor-related class action lawsuits being filed and regulators flexing their enforcement muscles. Not out of the recessionary woods yet, lots of retirement plan participants have lost plenty of money and are not prepared to sit back and rest easy. This 664-page tome, authored by Seyfarth Shaw partner Gerald L. Maatman, Jr. and in its seventh annual publication, provides some scary numbers.

• "The top ten settlements of wage & hour, ERISA, and governmental enforcement class actions increased to $1.16 billion, the highest amount ever."
• Employment-related class action settlements rose four-fold in 2010 versus dollar outlays paid in 2009.
• The U.S. Supreme Court has three cases under review (Dukes v. Wal-Mart, AT&T Mobility v. Concepcion and Smith v. Bayer) that are destined to change class and collective action litigation, regardless of the outcome.

While interested parties can register for a February 8, 2011 webinar that details the results of this new study, Seyfarth Shaw attorney and co-chair of the ERISA litigation practice was kind enough to provide insights for readers of www.goodriskgovernancepays.com about ERISA litigation trends.

Q: Please comment on the general theme of the just published 2011 - Annual Workplace Class Action Litigation Report, an evaluation of nearly 900 employment law class action decisions, including dozens of ERISA cases. 

A: We don't see the end of the tunnel with respect to mammoth work place class action lawsuits. Despite defense-friendly precedents, the plaintiff's bar is filing more and more cases. Many of them relate to alleged discrimination or benefit claims. Others are examining procedural prudence on the investment side. More than a few large 401(k) sponsors have found themselves on the receiving end of stock drop litigation. Some cases focus on risk-taking as relates to securities lending programs by pension funds. Transparency may also  prove to be a hot button if the SEC's risk disclosure case against CalPERS changes things for state and municipal bond issuers.

Q: How did the credit crisis of 2008 and 2009 impact the current state of the ERISA litigation landscape?

A: The last few years have been tough. The global economy continues to endure an extreme stress test. The credit crisis has exposed potential weaknesses in previously unchallenged investments and poor investment returns have triggered a host of other pension woes. Then there is the spate of cases relating to the sub-prime meltdown and others that focus on benefits cutbacks, illiquid assets, service provider due diligence and much more.

Q: The new study documents much larger settlements in 2010 than 2009. Is that true for all types of ERISA cases?

A: No. Settlements in 2010 for stock drop cases  were down substantially. In 2009, we saw settlements in the $30 million  and higher range, but in 2010, most settlements were less than half that amount. Defense friendly rulings have made  fiduciaries and plan sponsors more willing to take the stock drop cases further than before and not to settle early.

Q: What other factors influence settlements?

A: The likelihood of a settlement, let alone the amount, depends on other factors as well. Some judges are reluctant to deny motions to dismiss. The plaintiff's bar is becoming increasingly sophisticated and well financed. Keep in mind too that the political climate encourages regulatory enforcement, the outcome of which could impact civil litigation outcomes. Another interesting phenomenon are the counterclaims being filed in securities lending cases. Some banks that were sued by plan fiduciaries for supposedly taking on too much investment risk have countersued, likely to drive settlements. 

Q: Are large organizations more vulnerable to litigation than small to mid-size organizations?

A: Yes and no. On one hand, large plan sponsors and their asset managers, custodian banks and consultants are perceived as having deep pockets. In addition, in some cases, plan assets can drive exposure. Even a few basis points tied to multi-billion dollar portfolios add up to real money. On the other hand, large plan sponsors tend to devote more resources to oversight and plan management, which can reduce the risk of liability. 

Q: Given the expanded definition of fidiuciary, as proposed by the U.S. Department of Labor ("DOL") and being reviewed by the U.S. Securities and Exchange Commission ("SEC"), do you agree with those who predict more lawsuits that involve advisors and consultants to plan sponsors?

A: I'm not convinced that heightened regulatory enforcement will necessarily lead to more and/or bigger ERISA lawsuits.

Q: What is the relationship between 10b5 lawsuits and ERISA claims?

A: Sometimes securities litigation cases occur first. In other situations, an ERISA lawsuit may be filed first, as a precursor to a 10b5 allegation.  In 10b5 cases, the governing statutes impose a very high standard for pleadings and pleading standards in ERISA cases were previously seen as more lenient.  However, the U.S. Supreme Court decision in Ashcroft v. Iqbal ("Iqbal") in 2009 raised the bar for  pleading all claims, including ERISA claims and this may be a deterrent to some of the "piggy-back" ERISA filings we have seen.

Q: What are your thoughts on the role of directors as retirement plan fiduciaries?

A: Post Enron, many companies tried to move directors and officers out of retirement plan fiduciary roles as a way to avoid perceived conflicts of interest and worries about material, non-public information being used to influence the menu of 401(k) plan choices for participants. At least at the motion to dismiss stage, however, many courts still allow claims against directors and officers to stand, even if they had little or nothing to do with plan administration. 

Q: What are some areas on which fiduciaries should focus on in 2011?

A: Investment fiduciaries need to pay attention to whether they have adequate ERISA and Directors and Officers ("D&O") liability insurance coverage. Additionally, they need to recognize the importance of process, if they don't already. So much litigation centers on incomplete and/or missing process. Also, not keeping participants properly apprised of investment risks and benefit plan changes is another trouble spot.  

Attorney Morrison's comments certainly provide food for thought. Interested readers can click "Seyfarth Shaw Publishes 2011 Workplace Class Action Litigation Report, 01/05/11. For those interested in the Iqbal case, click to read the 435 page memo from Andrea Kuperman to the Civil Rules Committee, Standing Rules Committee entitled "Review of Case Law Applying Bell Atlantic Corp. v. Twombly and Ashcroft v. Iqbal" and dated December 15, 2010.