BNA Pension and Benefits Blog

Section 404(a)(1) of ERISA generally requires a fiduciary to act in the interest of participants and beneficiaries and to act prudently. ERISA also requires, under Section 103(b)(3)(A), an annual report which includes a financial statement containing, among other things, a statement of assets and liabilities "valued at their current value." Current value is to be determined in good faith by a trustee or named fiduciary.

A July 1, 2008, letter from James Benages of the DOL's Boston office has made its way around the market. There, he considers a plan which was invested in a number of alternative investments ("AIs" (no relationship to the Kubrick/Spielberg movie, at least I don't think so)), and which apparently took a fairly common approach to the Form 5500 reporting thereof. For example, one particular AI was valued at cost by the applicable committee "based on the general partner's unaudited Capital Account Balance Statement" for the period in question "and the accompanying audited financial statements." Another was valued according to the general partner's unaudited determination of fair market value.

The July 1 letter states that (i) not only has the committee "failed to establish a process to determine the most accurate fair market value," but cost and fair market value have been "equate[d]," (ii) such failure violates ERISA's "solely in the interest" requirement, and (iii) as a result, in the DOL's view, the committee "is in violation of ERISA and will remain so until it takes corrective action." Before discussing Section 502(l) and the possibility of action by other governmental agencies and third parties, the July 1 letter kindly comforts that, if corrective action is taken, no lawsuit will be brought by the DOL.

The issues implicated by the July 1 letter are significant. Many private equity and other investment funds provide valuations on the bases noted in the letter, and plan fiduciaries would not ordinarily be expected to have the information required to second-guess the available valuations or the expertise to do so even if they had the information.

The DOL's approach seems to raise the specter that making an investment not practically susceptible to ready valuation is somehow a per se violation of Section 404(a)(1) of ERISA. The July 1 letter seems expressly to tie the "sole purpose" requirement to the reporting requirement, although the connection isn't particularly clear. There's also a more oblique reference to the Section 404(a)(1)((B) prudence requirement, not tied specifically to the reporting issue. Is the DOL implying that it is per se imprudent for a fiduciary to invest in a difficult-to-value investment, without special valuation efforts?

What would be the effect of there being a Section 404(a)(1) violation merely because an investment is not subject to valuation? Several alternatives seem possible.

Maybe the plan would demand that the fund provide appraised valuations. A number of funds, however, would presumably not be anxious to engage an appraiser, whether because of an unwillingness to develop and distribute the valuation, an unwillingness to spend the time and money on the valuation or an unwillingness to share the underlying information with the appraiser.

Maybe the plan would do its own analysis. However, any number of plans presumably would not have the time or inclination to do so.

Maybe the plan would ask for additional factual information to facilitate the plan's valuation efforts. It is by no means clear that the fund would provide such information.

Or maybe the plan would simply decide it's not worth the effort. To someone who does not appreciate AIs, maybe this result is somehow acceptable.

But is it? It is not up to non-experts to decide that a class of investments is suboptimal, whether or not there are experts out there who might agree. Clearly, AIs have enthusiastic support as a part of an overall portfolio from a wide range of investment professionals, and it is up to the responsible fiduciary to make the actual investment decision. The fact that support is not unanimous is a fact to be taken into account by the responsible fiduciary.

I recognize that there are those who will disagree, even vehemently. (I'm ducking already.)  Some have made the argument that there is no possible way that an unvalued/unvaluable investment can be prudent. I would point out that almost by definition such a conclusion has been rejected as a business matter by substantial portions of the market - the investments are in fact being made, often by the most sophisticated of investment professionals. (If Warren Buffett were to offer me the opportunity to invest in a black box of managed investments for a 10-year term with no information and a de minimis fee, would I be imprudent to make the investment? Maybe I'd be imprudent not to do so.)

To me, one of the areas (the only one?!) in which ERISA has consistently been lauded is its use of modern portfolio theory and deference to the expert fiduciaries regarding portfolio choices. Notwithstanding the apparent trend of some in the government to pretend that they are competent to decide what plans can invest in, as evidenced by the recent and possibly continuing commodities-legislation debacle, ERISA arguably has no legitimate role in trying to identify specified types of investments as imprudent per se. ERISA should not be responsible for depriving the most sophisticated managers from being unable to access, on behalf of ERISA plans, the most sophisticated investments.

A potential gut reaction is that this whole issue is a tempest in a teapot - if plans are made unable to invest in AIs in the absence of developed valuation information, the funds will naturally come up with improved information. However, the dust-up of several years ago where governmental investment put funds' confidentiality at risk, resulting in an unwillingness of some funds to accept government-plan investment, shows that there could come a point at which funds will indeed turn their back on money over regulatory issues. Further, even if the market would adjust, there is a question of whether it should have to adjust.

To me, the first step is to limit the analysis to where it belongs. The level of valuation information to be given over time by a fund should be considered another factor, not some super-factor, taken into account by a court in analyzing whether, on all facts and circumstances, the fiduciary has satisfied its Section 404(a)(1) obligations. It is suggested here that the lack of a draconian penalty for violating Part 1 requirements doesn't mean that those violations are somehow magically converted into Part 4 violations (any more so than would be in the case of, for example, a failure to distribute an SPD).

That still leaves Section 103(b)(3)(A), which applies on its face to require fair-value reporting. The reporting obligations help get information out to participants and beneficiaries, and bear upon the plan's funded status. In this latter regard, if the valuation information is inaccurate, the entire funding regime is potentially compromised. If I invest in a company with $100 million in reported assets, and the company assets are "really" only worth $1 million, my investment may well not be all I thought it was.  A plan's funded status could be similarly misrepresented. 

One possible interesting solution would be to focus on the practicalities of the situation (thanks to Andrew Gaines for talking this through with me). As a practical matter, AIs are likely to constitute only a small percentage of a plan's total portfolio, being there to provide a potential large maximum return as to a portion of the portfolio deemed suitable by the experts for investment at higher risks. If a concern is that overreporting of asset value could somehow place a plan at risk (or, in the case of underreporting, give rise to excessive deductible plan contributions), maybe an answer could be to allow reasonable reporting based on information disseminated in accordance with market practice (e.g., historical cost or GP estimates), but only as to a portion of the plan's portfolio not to exceed certain percentages. Presumably, given the role of AIs in most portfolios, this percentage could be made fairly low without excessive market dislocation.

AIs can form a critical part of a plan's investment strategy, and in some cases probably account in part for superior overall performance. The point here is not to argue that AIs are or are not smart investments; rather the point is to argue that the question of investment choice is for the investment professional, and that it would be unfortunate if the reporting rules were to serve as an impediment to the making of an otherwise permissible investment at the direction of a responsible plan fiduciary.

Issues relating to fees to service providers have become high-profile issues, with a proliferation of indirect-fee class actions and the inevitable follow-on press reports. These issues have given rise to a four-piece puzzle, with activity regarding (i) regulations under ERISA Section 408(b)(2), (ii) the rules governing Form 5500, Schedule C, (iii) the "404(c)" rules for covered plans with participant-directed investments, and (iv) a number of legislative proposals in Congress.

The issue is clearly front-burner for the DOL, which is trying to proceed with a coordinated new regime that would have a real impact on the quantity and quality of information available to participants. There has already been movement in the first two arenas, with proposed 408(b)(2) regulations and new rules for Form 5500, Schedule C, both of which have been controversial. Congress has proceeded, too, with the proposed Miller bill. The only theater that had remained dark was the one relating to the 404(c) rules.

Section 404(c) is the section that gives plan fiduciaries the opportunity to limit their liability in the case of plans which provide for participant-directed investments and which satisfy the regulatory Section 404(c) requirements. Thus, the DOL had broad discretion to impose such informational requirements as it saw fit under Section 404(c). Showing how much attention it is giving to the question of participant information, though, the DOL took this opportunity to expand the expected scope of its rulemaking and issue rules proposed to apply under ERISA's general prudence rules, whether or not the protection of Section 404(c) is sought. The general prudence rules, like the 404(c) rules, give the DOL a fairly free regulatory hand, as there is no clear limitation on the abilty to add regulatory color on what it means to be proceeding in accordance with general prudence-type considerations.  Thus, the new proposals would generally apply to all plans under which participants have the right to direct investments, even if the plan sponsor is willing to forego Section 404(c) relief. It is clear that that the DOL is making a concerted effort to establish a set of rules that will significantly change the nature of the information that is broadly available to participants in plans where they direct their own investments.

It remains to be seen whether the market will view the balance that has so far been struck by the DOL as being the right one. I expect the comment process regarding this particular piece of the puzzle to be extremely active in terms of submissions on all sides of the market, including participant-advocacy groups, employers, financial services organizations and administrators. One thing seems certain - the old rules, with a much more generic approach to the provision of information, seem eventually to be a thing of the past.

Issues relating to fees to service providers have become high-profile issues, with a proliferation of indirect-fee class actions and the inevitable follow-on press reports.  These issues have generated activity in four theaters: (i) the regulations under ERISA Section 408(b)(2), (ii) the rules governing Form 5500, Schedule C, (iii) the "404(c)" rules for covered plans with participant-directed investments, and (iv) a number of legislative proposals in Congress.  The DOL has moved forward in the first of these two arenas with proposed 408(b)(2) regulations and new rules for Form 5500, Schedule C, which have turned out to be flashpoints in the market for a firestorm of controversy affecting financial services organizations and plan sponsors alike.  Much (but not all) of the controversy has centered around the DOL's attempt to expand certain rules to a variety of types of indirect compensation and, apparently, in some cases, compensation for supposed indirect services, particularly in the context of fees surrounding "investment funds."

On July 14, the DOL issued FAQs intended to help with the administration and implementation of the new 5500 rules.  To its credit, using the efficient FAQ mechanic, the DOL is reacting quickly to a real need in the marketplace for guidance as to how these rules will work.  Putting aside the question as to whether everyone will agree with everything the DOL has done in the FAQs, it was critical that the DOL start to get on the record as to a range of seminal interpretive questions.  (And, thankfully, the FAQs were released almost a full week before the release of the The Dark Knight, so that I could read them without being distracted by what I'm anxiously hoping will be One of the Greatest Movies Ever Made.)

I'm writing here to take note of an arguably arcane but ultimately critical and interesting feature of the FAQs, relating to the nature of what is an "investment fund" for purposes of the new 5500 rules.  It did not go unnoticed by some that the new rules seemed to latch onto the concept of "investment funds" as a major underpinning of when the new indirect-type rules apply; however, the concept appeared to spring suddenly from within the authority, and didn't have a firm express basis is that which had come before.  (Yeah, it's a "lawyer point," I guess, in a group of FAQs with more direct practical implications, but, then again, I'm a lawyer.)  The issue was made more vexing by the fact that the new rules did not tap into the existing regime for look-throughs to investing plans, the so-called "plan asset" regulations (as modified by ERISA as recently amended), but rather went down this new, undefined "investment fund" road.

Thus, the scope of the "investment fund" concept, and by extension the very scope of a substantial portion of the new rules, became subject to something of a cloud right from the get-go.  For example, what is an "investment fund" anyway?  How do hybrid entities, like REOCs (real estate operating companies) and VCOCs (venture capital operating companies) under the "plan asset" regulations fit in?  How does the general "operating company" concept overlay on top of the fund analysis?  These questions, and the lack of any answers (or even discussion) regarding them, resulted in a significant analytical detour right out of the interpretive gate.

Well, Q&A 7 of the new FAQs is packed with a lot of information and goes a long way towards shedding light on how the DOL views these matters.  There is the description by example of what "investment fund" means, where the DOL says in a parenthetical: "e.g., mutual funds, collective investment funds."  (It may not seem like much, but it was more than we had.)  There is the posing of the basic question of whether compensation received in connection with the management of VCOCs, REOCs and other operating companies needs to be reported, and there is the DOL's pithy and straightforward (and, to me, clearly correct and appropriate) answer, "No."  There is the clarification that, notwithstanding the foregoing, fees or commissions received by a manager or adviser in connection with an investment in an operating company could be reportable.  And, underscoring the extent to which the DOL really seems to have created a whole new quasi-"plan asset" framework in the context of the reporting rules, the DOL states: "This answer would not be affected by whether the VCOC, REOC, or other operating company were wholly owned by a plan such that [under the "plan asset" regulations] the assets of the entity would be deemed to be plan assets."

This last nuance indicates that the formalistic approach under the bedrock "plan asset" rules falls, in the reporting context, to what may be a more intuitive analysis.  As a result, essentially all that matters here is whether there is an operating company present effectively to block the look-through, not whether the entity's assets technically are "plan assets." (The need to apply the technical rules to determine whether an entity is a VCOC or REOC (or other operating company) is still present.)  It remains to be seen whether this new conceptual approach will eventually be given application for other ERISA purposes.

The foregoing is just one small aspect of an important set of FAQs, and shows, even standing alone, how interesting the development of the reaction to the fees issue has been and probably will continue to be.  In this regard, note also that, in Q&A 40, the DOL states: "In an effort to address the concerns of both service providers and plans, the Department has decided that, with respect to those employee benefit plans which are dependent on service providers for information necessary to complete the Schedule C, the plan administrator will not be required for 2009 plan year reports to list a service provider on line 4 of the Schedule C [which basically calls for the listing of uncooperative service providers] as failing to provide information necessary to complete the Schedule C if the plan administrator receives from the service provider a statement that (i) the service provider made a good faith effort to make any necessary recordkeeping and information system changes in a timely fashion, and (ii) despite such efforts, the service provider was unable to complete the changes for the 2009 plan year."  Bravo - this relief (which presumably will spawn quite a lot of "statements") is extremely welcome in light of the fact that, as shown above, on even the most basic gateway issues there is a great deal of new concepts, analyses and information to digest.   

   There appears to be a continuing debate, with the Department of Labor’s involvement, between the AFL-CIO and the U.S. Chamber of Commerce concerning use of plan assets in proxy voting and shareholder related activities as well as in connection with union organizing campaigns and union goals in collective bargaining negotiations.  The debate takes place in the context of two recently published Advisory Opinions, both issued to the U.S. Chamber of Commerce, one in response to an inquiry by the Chamber as to whether the fiduciary rules of ERISA prohibit the use of plan assets to promote union organizing campaigns and union goals in collective bargaining negotiations (Advisory Opinion 2008-05A) and another concerning whether pension plan assets may be used by plan fiduciaries to further public policy debates and political activities through proxy resolutions that “have no connection to enhancing the value of the plan’s investment in a company”  (Advisory Opinion 2007-07A).

     The DOL’s response in both cases appears to be consistent with earlier Advisory Opinions concerning use of plan assets for what was once described as “social investment.”  Earlier advisory letters on social investing were issued in the 1980s to Gregory Ridella, Chrysler Corp. (AO 88-16A), Jim Ray (July 8, 1988), Mr. Reed Larson (July 14, 1986) and Mr. Ralph Katz (March 15, 1982).  These 1988 opinions state, in general, that fiduciaries, in deciding whether and to what extent to invest in a particular investment, must consider only factors relating to the interests of plan participants and beneficiaries.  A decision to make an investment may not be influenced by non-economic factors unless the investment when judged solely on the basis of its economic value to the plan, would be equal or superior to alternative investments available to the plan.

     The DOL’s responses to the Chamber also represent a further clarification of Interpretive Bulletin 94-2 (concerning a fiduciary’s role in voting proxies) in which the DOL said that an “investment policy that contemplates activities intended to monitor or influence management of corporations in which the plan owns stock is consistent with fiduciary obligations under ERISA where a responsible fiduciary concludes that there is a reasonable expectation that such monitoring or communication with management…. is likely to enhance the value of the plan investment….”  (emphasis added)

     Query:  Has the DOL’s position on shareholder activism and social investment changed since 1988 or are Advisory Opinions 2007-07A and 2008-05A no more than the DOL’s effort to reiterate its earlier positions when asked by the Chamber to reflect on what the Chamber seems to suggest are questionable new AFL-CIO positions concerning the permitted use of assets?

     The issue is important in light of concerns about providing investment education to plan participants and given that there may be a new movement on the part of institutional investors to boycott investments in certain companies and countries.

     See the attached links for the two recent advisory opinions to the Chamber of Commerce and a letter issued by Alan Lebowitz, DOL Deputy Assistant Secretary for Program Operations, to the AFL-CIO (May 3, 2005). https://www.dol.gov/ebsa/pdf/ao2007-07attachment.pdf;    http://www.dol.gov/ebsa/regs/aos/ao2008-05a.html; http://www.dol.gov/ebsa/regs/aos/ao2007-07a.html

Hopefully, the Supreme Court's MetLife decision will turn out to be a welcome clarification of the Firestone case, even if it generates some new uncertainty. Firestone left open the question of how much a conflict of interest in the administrator should affect the level of a court's deference to the administrator's decision. After Firestone, the lower courts went in all different directions on this question, ranging from engaging in a slippery-slope analysis, where there would be less deference, to a de novo approach, where the court would essentially ignore the administrator's decision altogether. MetLife now provides the answer, but in a way that does not provide certainty. Under MetLife, the standard continues to be the abuse-of-discretion standard. However, the degree and nature of any conflict of interest is taken into account as a factor in determining whether there has a been an abuse of discretion. Thus, the governing rules are clear, but the application of those rules may vary with the facts and circumstances of each case. The Court in MetLife recognizes the lack of certainty its decision brings, but asserts that the result is a workable one. As with the fallout from so many Supreme Court decisions, we'll have to wait and see. One interesting passage from the case may give a hint as to how lower courts will proceed. MetLife notes that a conflict may become less important to the analysis as active steps are taken to reduce potential bias and promote accuracy, for example by walling off claims administrators from those interested in firm finances, or by imposing management checks that penalize inaccurate decisionmaking regardless of who benefits. It will be interesting to see if players in the market seize upon steps like this to try to increase the extent to which internal decisionmaking will be entitled to deference in the post-MetLife world The fun never stops . . .

Andrew L. Oringer
White & Case LLP
Andrew.Oringer@whitecase.com

Trying to be somewhat current and topical, with a vote scheduled this week in the House Education and Labor Committee on Rep. Miller's 401(k) Fair Disclosure for Retirement Security Act bill (HR 3185) and the DOL moving forward with proposed rules addressing these issues, I just wonder what the ultimate impact will be at the participant level.  While there will be much gnashing of teeth at the disclosure pains by the investment and plan community, will participants perceive this as something beneficial and worth all the effort?  My guess is no.  Given my experience with most participants, their focus is first on a relatively safe investment (which is not necessarily good) and second on an acceptable rate of return.  While they may be interested in knowing what the true expenses of operating a plan might be and to what extent revenues from their investment decisions are being used to pay these amounts, it will probably have little impact on their investment decisions.  Granted there may be a focused minority of participants who will pay close attention to this and will alter their decisions based on what they perceive, but I suspect the majority will not do much.  I'm interested in what others may feel on this point.  Are wheels spinning for not that much good?

Last month the Supreme Court resolved, at least for one case, this question: Do individual employees have a cause of action when a fiduciary violates its responsibilities with respect to the assets in an individual’s defined contribution account? In the case, LaRue v. Dewolff, Boberg & Associates, Inc. (42 Empl. Benefits Cas. 2857), the Court held that an individual does have a cause of action. The judgment was unanimous, but Justice Roberts wrote a mystifying and mischievous concurring opinion, joined by Justice Kennedy, which might raise a question as to whether the issues purportedly addressed by the Court are really settled.

The case involved straightforward facts: a participant in a defined contribution plan gives investment instructions with respect to his account. The plan fiduciary, to whom the instructions were given, does not follow them. The account suffers a loss, and the participant brings a civil action against the fiduciary to recover the loss. Does ERISA provide jurisdiction for such a civil action?

The fiduciary argued no, because relief against a fiduciary (except for equitable relief) is available only if the fiduciary caused harm to the entire plan , as opposed to this situation in which the harm was to a participant. This argument was quite plausible given earlier Supreme Court decisions interpreting the scope of ERISA Sections 502(a)(2) and 409. (Section 409 provides, in part, that a fiduciary “is liable to make good to [the] plan any losses to the plan resulting from” the fiduciary breach.)

The Court, though, said that the loss in this case--even though felt by only a single plan participant--was still a loss to the plan under Section 409.

My initial reaction to the decision recalls a quote from “The Godfather,” when Marlon Brando, presiding over a meeting of the five families to establish a peace, asks “How did things ever get this far?” How could we, more than 30 years after ERISA, still be debating whether a participant in a defined contribution plan has a cause of action against a fiduciary whose breach reduced the value of the employee’s account?

But now, thanks to LaRue, the issue is settled. Or is it?

Justice Roberts wrote separately. His opinion says that LaRue’s true claim was a claim for benefits under Section 502(a)(1)(B) of ERISA and that “it is at least arguable that a claim of this nature properly lies only under § 502(a)(1)(B). . . . If LaRue may bring his claim under § 502(a)(1)(B), it is not clear that he may do so under § 502(a)(2) as well.”

Justice Roberts says this is important, because under Section 502(a)(1)(B), it is clear that a participant ordinarily has to exhaust administrative remedies and that a plan can grant a fiduciary a significant degree of discretion in determining benefit eligibility and the meaning of plan terms.

Although Justice Roberts does not expressly say so, it is also possible that if the action is under section 502(a)(1)(B), there may be no relief at all—LaRue’s action was an attempt to get the fiduciary to make good the plan’s loss; how would that be possible under section 502(a)(1)(B), where the fiduciary would not even be the proper defendant? (Maybe if there is a loss, the loss would have to be recovered ratably from the accounts of all participants. Now that would be a happy result for the other participants. Now could they bring an action against the plan fiduciaries for not suing the fiduciary responsible for causing LaRue a loss? And would that be actionable only under section 502(a)(1)(B), since they are basically saying the same thing that Justice Roberts says Larue is saying: “My benefit should be larger”? I can see an endless cycle of complaints here.)

The most unfortunate thing about Justice Roberts’ concurrence is that it ensures us a new period of uncertainty. Certainly every fiduciary defendant will seize on Justice Roberts' words, and courts will have to figure out just what the concurrence means and if any Justices, other than Justices Roberts and Kennedy, may in the future be sympathetic to the concurrence’s rather odd position.

I should add that it is particularly odd, given that Justice Roberts, at least in his confirmation hearings, suggested that he wanted the Court to speak, as often as possible, with a single voice. In LaRue, he opts for point, counterpoint.

[Ed. Note: For coverage of the LaRue decision see 34 Pens. & Ben. Daily (Feb. 21, 2008); 35 Pens. & Ben. Rep. 467  (Feb. 26, 2008); and 42 Empl. Benefits Cas. 2857.]

As expected, the 401(k) fee disclosure case against Deere & Company was the first to be decided, since the District Court for the Western District of Wisconsin has a reputation as a "rocket docket."  Many people, myself included, had thought the complaints in these 401(k) fee cases contained sufficient fact allegations that courts would wait until after discovery to decide them. Unexexpectedly, the court dismissed the case based on the complaint and the plan documents. Hecker v. Deere & Co., Case No. 06-C-719-S (W.D. Wisc. June 21, 2007). The facts of the Deere plan may, however, distinguish it from most other plans and make it less significant as a precedent in the other pending 401(k) fee cases, at least at the motion to dismiss stage.

The SPD provided that:

The costs of administering the Plan are paid by the Company. Participants incur no transaction fees or sales loads on funds purchased and sold through the Plan’s standard plan options.... All fund investors indirectly pay any fund-level expenses, such as management fees, asset-based sales charges (12b-1 fees), and other fund expenses, as detailed in the fund’s prospectus....

Of the 26 funds specifically offered by the plan, 23 were Fidelity Funds. However, the plan also offered a mutual fund brokerage account through which participants could select from among 2500 other mutual funds unaffiliated with Fidelity. Fidelity received direct payment for its trust services from Deere; the plan paid no additional fees to Fidelity.

The court concluded that:

The disclosure in the reports and prospectuses accurately reflect the expenses actually paid to the fund manager for fund management as evidenced by the allegations that the same fees are charged to all retail fund customers. To the extent that the charge includes profit, it is unlikely that the fund sponsor would know or be in a position to control its redistribution among related corporations, corporations, a fact conceded in defendants’ brief. There is no evidence of intent in the statute or regulations to reach this type of detail.

The court found that the recent proposals to expand disclosure of indirect fees and provide additional disclosure supported the conclusion that such expanded disclosure is not required under current law.

There appears to have been no dispute that the Deere plan satisfied the ERISA section 404(c) requirements other than requirements related to fee disclosure. The court concluded that the existing regulations do not require disclosure of revenue sharing, only the amount of the fees which were adequately disclosed. Nor did the court feel that disclosing the revenue sharing arrangements would have enhanced the participants' investment decisions:

In assessing the likely return on an investment the fees netted against the return are certainly relevant, but knowing the subsequent distribution of those fees has
no impact on the investment’s value.

The court concluded that the participants had adequate opportunity to choose funds other than the designated Fidelity Funds because of the mutual fund brokerage window and therefore their investment in the designated funds and therefore they exercised the requesite control over the investments in selecting the Fidelity Funds to insulate the Deere fiduciaries from any liability under section 404(c)'s safe harbor even if the plaintiffs could prove that the fees in the Fidelity Funds were excessive.

Most plans don't offer a brokerage window, so the Deere case is clearly distinguishable. However, the court's conclusions about the extent of disclosure required under current law, both under the general ERISA provisions and section 404(c), would protect most plan fiduciaries if followed by other courts. Stay tuned for the rest of the story, since there are still a number of these cases pending.

Uncertain Tax Positions and Compensation

As if there isn’t enough change going on – revised SEC disclosures, potentially 400 pages of “final” 409A regulations, revised accounting standards for equity compensation, proposed legislation limiting the amounts of deferred compensation, ad nauseum. Benefit’s advisors must also deal with subtle and unexpected changes, like “FIN 48.”

Like many other recent accounting standards, this new requirement has developed in response to what many perceived as “abuses” in business tax and accounting practices. You may agree or disagree with that perspective, but the reporting position is now fact and you or your clients will have to deal with it.

Basically what this standard requires is that each entity subject to audit under generally accepted accounting principles assess their income tax position on all material items of income and expense.  Any position taken on the tax return must generally satisfy a more likely than not standard of success. In assessing the likelihood of success, it is assumed that the applicable tax enforcement group is reviewing the position, has all the facts available and is familiar with the applicable law.

If a tax return position does not meet the more likely than not standard, the company must measure the potential impact on their tax liability and adjust their financial statements accordingly. There is also additional financial statement disclosures required relative to this standard.

This statement has very comprehensive impact. It applies to any entity that MAY owe a tax liability. That means it can apply to taxable entities, certain pass-through entities and tax-exempt entities (either because of unrelated business tax issues or the potential loss of tax-exempt status.)  That means that this standard applies not just to employers, but also to their benefit plans. That is an important point because an issue may be immaterial to the employer, but significant to the plan.

The standard is currently effective for publicly traded companies and will apply to private enterprises for year beginning on or after December 15, 2006.  However, the standard does effectively apply to positions taken on returns that are currently in process, as the liability assessment is based upon all open years, not just the current year.  Also, in assessing any potential liability, the amounts of interest or penalties are also to be included.

This posting is not intended as a detailed analysis of the new standard. This is not the appropriate medium for that.  Most accounting firms have been doing web based training on this standard and you can check those out to get detailed information. What I intend to cover over this week is various areas of compensation planning that can result in issues that must be reviewed for potential measurement under this standard. There are many, many areas related to compensation and benefits.  Some of which are so familiar, that we may have forgotten that they do not reflect settled law where it is easy to get to a more likely than not standard. Also, this will help explain some of the calls you may be receiving from your clients.

Caveat:  My background is largely private companies. I am hoping that other members of the advisory board will chime in on public company concerns.

The Basics

1. Reasonable compensation:  The deduction under IRC Section 162 is limited to reasonable compensation for services. Amounts paid in excess of this reasonable limit are not deductible. How much work have you or your client done to get comfortable that the level of compensation being paid is reasonable at a more likely than not standard of success?
2. Deduction for accrued bonuses:  The temporary regulations under IRC Section 404, as well as the proposed regulations under IRC Section 409A, provide a haven from the classification of a payment as deferred compensation, if it is paid within 2 ½ months of the end of the tax reporting period. But, many employers take that as a safe harbor and fail to take other steps to demonstrate that the bonus was, in fact, accrued as of year-end. If reasonable, the risk associated with this matter may just be a timing different, but it still must be analyzed under FIN 48.
3. Entertainment Expenses:  IRC Section 274 sets some very rigorous and mechanical standards controlling the deductibility of travel and entertainment expenses. Amounts outside of these limits are not deductible.  Frequently employer’s programs fail to capture this information and apply the appropriate limits on the tax return.  There are also some soft issues in this area with respect to the allocation of costs, etc.

Tomorrow we will cover some of the executive compensation issues.

As 401(k) plans become the major source of retirement savings,  Congress, GAO, DOL and the SEC are all turning their attention to the issue of 401(k) fees. Last fall, Gao issued a reprt on Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees at the request of Congressman George Miller, now Chair of the House Education and Labor Committee.  Last week, the Committee held a hearing on "Hidden 401(k) Fees Undermining Retirement Security?"  If you missed the hearing, you can view it on line at the Committee's website, where the written testimony of the witnesses is also posted.

The DOL has indicated that they will be launching a number of new initiatives to increase disclosure of 401(k) fees, particularly the payment of indirect fees to service providers. The DOL has already proposed a revision of  Schedule C of the Form 5500 which would require annual disclosure of indirect fees. Recognizing that plan fiduciaries often have difficulty getting information about indirect fees, the Department is planning to propose an amendment to the statutory prohibited transaction exemption that permits service providers to be paid (ERISA section 408(b)(2)) to require service providers to provide information about indirect compensation so that plan fiduciaries can determine if their total fees are reasonable. The Department is also expected to issue a request for informtion about 401(k) disclosure of fees, both direct and indirect, to plan participants.

Meanwhile, in a speech to the ABA Business Law Section last week, Andrew Conohue, Director of the SEC's Division of Investment Management, indicated that the SEC is working with the DOL to determine how fee disclosure should be made to 401(k) plan participants. He also indicated that the Commission staff is reviewing the rule that permits mutual funds to pay 12b-1 fees.

Plan fiduciaries should be continuing to request information about indirect fees from service providers such as investment managers, investment consultants, recordkeepers and trustees to determine whether the fees paid by their 401(k) plan are reasonable. Since many fees paid by 401(k) plans are asset based, fiduciaries should review the total paid annually as plan assets grow. Also, fiduciaries should move to institutional shares of mutual funds as their investments reach the minimums for such shares. Finally, fiduciaries should benchmark the fees they are paying against industry averages.

Fiduciaries shouldn't lose sight of the fact that the key is the return participants are getting net of fees, so fees shouldn't be the only consideration. However, compared on a net basis, lower fees will often result in better performance.