A 408(b)(2) Claim: Now What?


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This White Paper is written by Paul J. Smith, AIF and Gary Sutherland, CIC, MLIS from NAPLIA.

The paper discusses E&O Coverages basic procedures and how the industry has arrived at this point.

Published in: Economy & Finance, Business
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A 408(b)(2) Claim: Now What?

  1. 1. INVESTMENT ADVISOR SERIES A 408(b)(2) Claim: Now What? Paul J. Smith, AIF Gary Sutherland, CIC, MLIS North American Professional Liability Insurance Agency, LLC (NAPLIA) PART 1: Will my E&O Insurance Policy Provide Coverage? WWW.NAPLIA.COM161 Worcester Road, Suite 504, Framingham, MA 01701 Tel 866.262.7542 Fax 508.656.1399
  2. 2. Copyright 2013 by North American Professional Liability Insurance Agency, LLC. All rights reserved. You have just been served under 408(b)(2) and are trying to understand what it all means. The suit alleges excessive fees and seeks damages of $800,000 from one of your larger 401k plan clients. Multiple parties are listed. You skip to the pages that specifically reference your firm and read: breach of fiduciary duty, unreasonable fees, and engorged profits. Will your errors and omissions insurance policy cover the claim? You make several calls. One to your partner on vacation, one to your lawyer, and one to your professional liability insurance agent. Copies of the suit papers are quickly scanned and sent via e-mail to the appropriate parties, and now you wait. Your agent explains that they will send it your E&O insurance company, and tells you to give them a few days to process the paperwork, and they will notify you in writing about the next steps. Skip ahead to later in the week and an official looking letter arrives. It is not the simple, supportive letter you hoped for, but a letter saying, "We are reserving our rights under the policy and there may not be coverage under the following conditions." The Insuring Agreement of your policy states: Subject to all terms and conditions of this policy, we will pay on your behalf those sums in excess of the Deductible stated in the Declarations that you become legally obligated to pay as Damages and Defense Expenses, including Cost of Corrections, arising out of a Claim first made against you and reported to us during the Policy Period, or Extended Reporting Period, if applicable, as a result of a Covered Act, provided that:  You report the Claim in writing to us as soon as practicable, but in no event later than sixty (60) days after expiration or termination of this policy as further set forth in Clause 6.1 of this policy, or during an Optional Extended Reporting Period, if applicable; and  The Covered Act was committed on or after the Retroactive Date and before the end of the Policy Period; and prior to the inception date of this policy you did not know, or have a reasonable basis to believe, that such Covered Act might give rise to a Claim. Please note your policy contains the following exclusions:  Any criminal, dishonest, fraudulent or malicious act or omission, deliberate misrepresentation, or any intentional or knowing violation of law, including the use of, for any purpose, non-public information.  Disputes over the amount of, return of, restitution, disgorgement, forfeiture or rescission of any of the following: profit, fees, commission, remuneration or other monies to which an Insured was not entitled, including any actual or alleged commingling of funds. Please note your policy contains the following definitions:
  3. 3. Copyright 2013 by North American Professional Liability Insurance Agency, LLC. All rights reserved.  Damages means a monetary judgment or award which you are legally obligated to pay, or a monetary settlement to which we agree on your behalf, but does not include fines, penalties, court imposed sanctions or return of commissions or other fees. You start to panic, quickly dialing for your insurance agent. They are not going to cover my claim. You begin to have serious concerns. I have been paying premiums for 10 years and now this letter says: sorry, possibly no coverage. Letters like this are becoming increasingly more common. The insurance company is trying to say it pays claims "but not for all claims." There may be restrictions in your policy that make excessive fee suits difficult to secure defense and damages coverage. Let's break down this reservation of rights letter into three salient points that may support denial of your claim. Knowledge that you or any members of your firm were aware of the possibility that this incident could turn into a claim prior to binding or renewing coverage with your current insurance company. Did you or any member of your firm commit fraud or an intentional violation of an ERISA law? Lastly, we may defend you and your firm, but return of fees are not considered payable damages. Excessive fee claims are increasing. And as case law builds and successful suits lead to copycat claims, it is only a matter of time before lawyers begin looking at smaller plans. Next: What you and your firm can do to avoid these types of claims? The path we recommend is that you immediately benchmark all your fees against the industry standard (for asset levels of equal size). Then share that benchmarking with the Plan Sponsor or Plan Committee, and have them sign off on a Reasonableness Agreement. There are several high quality, independent benchmarking firms you can engage. Or there are independent providers of software that will benchmark the cost of the total package of services you are bringing to the relationship against industry standards. Be sure to break out the different services where you are providing value in your written contract with the client, and have them sign off on the arrangement on an annual basis. The key is to make sure the cost of your services is never an issue. There are a multitude of areas where mistakes can be made (errors and omissions) and clients harmed. Most of these will be covered in your Errors and Omissions Policy (if well designed), but it's incumbent on you to avoid a fee-based claim where the return of excessive fees is the sole basis of the claim. PART 2: How did we get here?
  4. 4. Copyright 2013 by North American Professional Liability Insurance Agency, LLC. All rights reserved. The common return of fee exclusion in E&O policies makes sense when viewed from a historic perspective. The insurance carrier’s position is easily understood: we’ll pay for errors and omissions (wrongful acts) in the delivery of your Professional Services that caused harm to others, but “let’s all agree that the return of your compensation (fee) for those services is not covered, and is not part of ‘damages.’” In a retail relationship this exclusion made even more sense. In most cases the wrongful act or harm done was not the ‘fee itself’, but the sale of an unsuitable product resulting in client loss of capital or liquidity, and the client was demonstrably harmed by your unprofessional delivery of service and product. It was never assumed — or even considered — that your commission or fee would be reimbursed by the insurance company. Many readers will not recall or were not practicing yet when commissions were regulated on Wall Street. In the 1960s there was no discussion or negotiation of fees; they were set by regulation and were not an issue. Participants managing their own pension assets were not yet commonplace with the advent of the 401(k) Plan, and life on Wall Street was in many ways much simpler. There was no ‘fiduciary’ status in the client-broker relationship, and barring the sale of a “clearly unsuitable” investment product, there appeared to be little room for client claims. The world has changed significantly since then. Advisors and Registered Representatives routinely negotiate fees and commissions with clients, and they have significant leeway to set the cost of services — often engagement by engagement — either by the use of share classes or the fee itself. The advent of participant-directed (managed) Defined Contribution Plans has exploded this unregulated moving part of both the retail and institutional relationship. Additional uncertainty has been inserted into the mix, with fee-based IARs moving into the ERISA space and taking on a fiduciary role. This development brings the fee issue front and center, creating a significant contrast to their commissioned colleagues where the revenue stream is significantly more opaque and internally complex. Prior to the introduction of required 408(b)(2) disclosures in the qualified plan space, The Pension Protection Act (PPA) addressed the built-in existence of Prohibited Transactions in the qualified plan world (ERISA), driven by unclear and uneven income streams. It allowed Advisors and Registered Reps to arrange differing levels of income, depending on their specific investment recommendations – a clear violation of their “fiduciary status” requirement to always act in the clients ‘best interest’. And as important, it compromised the fiduciary status of the Plan Sponsor that hired them. Prior to PPA, this inherent contradiction or violation was the elephant in the room that went unaddressed for years, until PPA put the fee issue front and center. However, following the Act, there were clear guidelines for structuring fees in a fiduciary/qualified plan relationship. The portfolio had to be computer-model driven and/or the fee had to be flat, with all Advisor recommendations paying the same compensation to the Advisor/Rep. And they had to be reasonable. The requirement that fees be reasonable is nothing new to ERISA, but prior to PPA and the 408(b)(2) disclosure law, plan sponsors had no way of benchmarking the fees their participants were paying, and getting their arms around the ‘what’s fair’ challenge seemed insurmountable to a business owner with little or no experience with investments.
  5. 5. Copyright 2013 by North American Professional Liability Insurance Agency, LLC. All rights reserved. Now that the focus and law has abruptly shifted to ‘full disclosure’ of fees in the qualified plan space, for the first time we are seeing ‘the fees’ become the harm or wrongful act driving claims. In effect, the now disclosed fees themselves have become the single driver of claims against the Plan Advisor/Rep and others connected to the perceived fiduciary breach of excessive compensation. This change has put the ‘return of fee’ exclusion in the Professional Liability Policy in a much different light. No longer is it an incidental exclusion — but a significant gap in coverage — as the fee-based claims start adding up. Complexity is added when the claim is characterized as a fiduciary breach (which is not excluded in a quality IAR Policy), but the underlying issue is ‘excessive fees’. A somewhat simplified example might look like this: your team has managed the assets of a pension trust for the last 20 years and achieved market rate returns for the entire period, less your 1% flat asset based fee. On the 21st year of the engagement the participants sue the Plan/Trustees for a fiduciary breach based on your unreasonable fees. The participants claim the Plan could have achieved the same returns by investing in a no-load index fund. The plaintiffs ask that your unreasonable fee be returned to the trust. Given the average balance of $10 million over the last 20 years, that’s a $2 million claim in a return of fee case that the E&O carrier may fight paying. It’s easy to see how a standard exclusion in your Professional Liability Policy could turn into a nightmare in today’s fee-focused qualified plan space. Removing the exclusion is unlikely as the fee-based claims pile up.
  6. 6. Copyright 2013 by North American Professional Liability Insurance Agency, LLC. All rights reserved. North American Professional Liability Insurance Agency, LLC – NAPLIA About Gary Sutherland, CIC, MLIS Gary B. Sutherland has nearly 30 years of insurance industry experience and founded North American Professional Liability Insurance Agency, LLC (NAPLIA) in 1998. NAPLIA has grown to be one of the leading writers of professional liability insurance, specializing in financial professionals. Mr. Sutherland holds the prestigious designation of Certified Insurance Counselor (CIC), an honor attained by only 2% of all insurance brokers, as well as certification as a Management Liability Insurance Specialist (MLIS). He previously held the position of National Sales Manager for a leading provider of professional liability insurance. Mr. Sutherland’s expertise is well acknowledged and he regularly speaks at national conferences, including fi360 and Center for Due Diligence programs, and for large accounting firms. About Paul Smith, AIF Paul Smith is a seasoned investment professional working with Financial Advisors, TPAs, RIAs, BDs and corporate clients to build fiduciary risk management strategies via professional liability insurance and appropriate bonding. At NAPLIA, Paul heads up the firm’s Fiduciary and Professional Liability E&O insurance programs, focusing on RIAs, Advisors, TPAs, Broker/Dealers and Plan Sponsors, in addition to Advisor and Plan Sponsor Bonding. Paul has earned the Accredited Investment Fiduciary® (AIF®) professional designation, awarded by the Center for Fiduciary Studies, which is associated with the University of Pittsburgh's Center for Executive Education. Paul earned the Accredited Retirement Plan Consultant® (ARPC®) designation from the Society of Professional Asset-Managers and Record Keepers (SPARK) and holds Series 6.7, 63 and 65 licenses.