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)161 Worcester Road, Suite 504, Framingham, MA 01701 Tel 866.262.7542 Fax 508.656.1399 WWW.NAPLIA.COM
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 bondingThe information provided in this paper is intended solely for general educational purposes. It is not intended for thepurpose of providing specific legal, insurance, or other professional advice to any particular recipient or with respect to anyparticular jurisdiction. The author, publisher, and distributor of this document (1) make no representations, warranties, orguarantees 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, includingchanges in any law or professional standard. You should formally retain the counsel of an attorney knowledgeable as toyour industry, your practice, and the laws of any jurisdiction(s) within which you conduct your practice to ensure thedocument’s maximum usefulness and compliance with applicable laws and professional standards. Copyright 2012 by North American Professional Liability Insurance Agency, LLC. All rights reserved.
IntroductionA 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 fulldiscretion.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) investmentmanager to accept the fiduciary responsibility (and legal liability) for the investment optionsoffered to plan participants.However, the plan sponsor can never delegate away its fiduciary responsibility (and legalliability) for the “selection” of the 3(38) investment manager.Through the acceptance of a written contract, the advisor becomes an independent fiduciary tothe plan via ERISA s 405(d)(1). In this capacity, the advisor is solely responsible, and liable, forinvestment decisions concerning the selection, monitoring, and replacement of plan investmentoptions.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 & Omissionspolicy.What steps then does an Investment Manager who has elected ERISA 3(38) status need to taketo manage this liability? Copyright 2012 by North American Professional Liability Insurance Agency, LLC. All rights reserved.
Overview of Errors & Omissions InsuranceAn Errors & Omissions (E&O) policy protects advisors and consultants against losses due to anactual or alleged negligent act, error or omission committed in the scope of their duties asinvestment counselors/advisors. Historically, E&O policies excluded an advisor’s acts as afiduciary. Times have changed and today there are four ways that an E&O policy may addressthird 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 makesure that the advisors current E&O insurance policy is not included in the first three types ofcoverage mentioned above. It is most common for affirmative fiduciary coverage to beincluded specifically in the body of the policy, or added by endorsement. In either instance, it ispolicy language that specifically states coverage’s for ERISA fiduciary services for others for afee that is crucial. Copyright 2012 by North American Professional Liability Insurance Agency, LLC. All rights reserved.
A standard, and acceptable, exclusion is when an advisor is a fiduciary for their own plan orwhere an advisor is a plan participant.An advisor should also make sure there are no limitations upon discretionary authority and thatthe policy covers “the advisor” for all discretion over ERISA plans, other than the advisor’s ownplan(s).In addition to the above, a significant concern with an advisor’s E&O insurance policy is thecontractual 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 fiduciaryacknowledgement given to the plan sponsors. The intent of the foregoing exclusion is to avoidclaims were the advisor is contractually obligated (and thereby, the insurance company) toassume risks beyond the scope of their areas of practice and or outside the scope of theirapplications and supporting documentation. Copyright 2012 by North American Professional Liability Insurance Agency, LLC. All rights reserved.
Because the 3(38) advisor accepts the risk of the plan Using Insurance as asponsor for the selection and monitoring of investment Marketing Tooloptions, including the full responsibility to control and In a recent poll, clients citeddispose of plan assets, the contract exclusion may apply. trust, or lack thereof, as the major factor (60%) for leavingThis then becomes a grey area of coverage intent that could their Investmentlead to a coverage dispute, or worse, a denial of coverage. Advisor. In fact, trust ranked higher than the actualAcceptable modification of this exclusion might read as: performance of their investment assets. The liability of others assumed by any of you So, how can you as an advisor gain the trust of your clients and (the advisor) under contract or agreement prospects, so that you can continue to grow your business? except for any written fiduciary agreements Proactively using your insurance or contracts given to clients other than you coverage as a marketing and education tool will help you: :the advisor” for a fee unless such liability Demonstrate your Knowledge would have attached to you ‘the advisor” and Added Value even in the absence of such agreement or Create "Peace of Mind" contract Confirm "Fiduciary" Coverage Raise the Bar for yourThis clarifies the intent of coverage and lessens the potential Competitionfor misinterpretation. When possible it is prudent to make Read NAPLIA’s White Paper;sure that the definition of professional services is broadly Using your Insurance as a Marketing Tool for moreworded to specifically address services as a 3(38) as defined information.by ERISA s402(c)(3). Copyright 2012 by North American Professional Liability Insurance Agency, LLC. All rights reserved.
It is important for the advisor to understand that all polices designed for investmentprofessionals are not standardized, so the full policy including all endorsement needs to beanalyzed 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 BondsThe fidelity bonding requirements of ERISA, is often misunderstood and produces significantquestions and concerns among advisors.ERISA bonds protect plans from losses due to theft and fraud of plan funds. ERISA Section 412requires every fiduciary of an employee benefit plan and every person who handles funds orother 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 topermit any others to receive, handle, disburse, or otherwise exercises custody orany control over plan funds or other property without being bonded inaccordance with ERISA section 412. Copyright 2012 by North American Professional Liability Insurance Agency, LLC. All rights reserved.
An ERISA section 3(38) advisor is required to be bonded Definition of “Handling”for each plan that they service up to $500,000 per plan, and relation to bondingor up to $1,000,000 if the plan has company stock. The The term “handling” carries aDepartment of Labor (DOL) has confirmed this coverage broader meaning than actual physical contact with “funds orrequirement and plan sponsors are obligated under other property” of the plan. AERISA to confirm bonding from each advisor that has any person is deemed to be “handling” funds or otherdiscretionary authority over plan assets. This means if property of a plan so as to require bonding whenever histhe advisor is paid directly from plan assets they are duties or activities with respectrequired under ERISA section 412 to be bonded. 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 ofExceptions: A person that provides investment fraud or dishonesty on the part of such person, whether actingadvice, but does not exercise, or have the right alone or in collusion with others.to exercise, discretionary authority with respect According to ERISA Attorney,to purchasing or selling securities or other Marcia S. Wagner, “the primary standard to determine whether aproperty for the plan and does not collect fees person should be bonded is whether plan funds could be lostdirectly from the plan, is not required to be as a result of that person’s dishonesty”>bonded solely by reason of providing suchinvestment 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 theevent 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 ofcoverage if the advisor were provided with individual bonds. In addition, some plans requiremore than the minimum bonding requirements under ERISA section 412. Copyright 2012 by North American Professional Liability Insurance Agency, LLC. All rights reserved.
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 thepremium is based on the cumulative totals. Any new plans added during the policy period areautomatically covered and at renewal a new schedule of plans and plan assets are reported tothe insurance carrier for the premium calculations. Certificates of insurance can be issued toplan holders meeting the notification requirements for plan sponsorsIndividual bonds are unique to a particular plan and often will have to provide protection inexcess of the minimum ERISA bonding requirements. Such plans are usually the mid-to-largersize plans. Most insurance carriers will offer up to $25 million in bonding capacity, andadditional coverage is available by requested excess coverage.ConclusionIt is an axiom that not all fiduciaries are alike; the same can be said for insurance policies. It isessential for an advisor to understand their exposure, identify potential gaps in coverage, andtake 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 BondThe importance of these items cannot be understated, but they do not represent all of thepotential coverage concerns for any one particular practice or policy. Whenever possible workwith an insurance specialist who is familiar with investment professional’s insurance policylanguage and has the experience of negotiating coverage enhancements. Copyright 2012 by North American Professional Liability Insurance Agency, LLC. All rights reserved.
ContactGary Sutherland is the Chief Executive Officer of North American Professional Liability Insurance Agency,LLC (NAPLIA). He can be reached at firstname.lastname@example.org or 508-656-1350.About NAPLIAEstablished in 1998, North American Professional Liability Insurance Agency, LLC (NAPLIA) specializes inproviding professional liability insurance, errors and omissions insurance and related products to thefinancial industry. Our focused approach makes us leaders in the industry. NAPLIA has been named tothe INC 5000 list of the fastest growing private companies in America every year since 2008.Additional ResourcesUsing your Insurance as a Marketing Tool (for Investment Advisors)http://www.investmentadvisorinsurance.com/white_papers/index.htmHow to inform your clients about Fiduciary Insurancehttp://www.investmentadvisorinsurance.com/fiduciary-insurance/why_fiduciary_insurance.htmThe information provided in this paper is intended solely for general educational purposes. It is not intended for thepurpose of providing specific legal, insurance, or other professional advice to any particular recipient or with respect to anyparticular jurisdiction. The author, publisher, and distributor of this document (1) make no representations, warranties, orguarantees 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, includingchanges in any law or professional standard. You should formally retain the counsel of an attorney knowledgeable as toyour industry, your practice, and the laws of any jurisdiction(s) within which you conduct your practice to ensure thedocument’s maximum usefulness and compliance with applicable laws and professional standards. Copyright 2012 by North American Professional Liability Insurance Agency, LLC. All rights reserved.