Morgan Stanley Dodges a Bullet: ERISA Lawsuit Dismissed

by Thomas E. Clark, Jr. JD, LLM – February 25, 2014

Yesterday, February 24, 2014, a proposed ERISA class action lawsuit filed against Morgan Stanley was dismissed in the Southern District of New York. Morgan Stanley, the broker to the Skin Pathology Associates, Inc. 401(k) Profit Sharing Plan, was alleged to have received unreasonable compensation because of a “pay to play” or “kickback” scheme involving the plan’s recordkeeper. The court, citing the new ERISA 408(b)(2) regulations, found that although a claim could be brought against a non-fiduciary broker like Morgan Stanley, here the additional compensation had been disclosed to the plaintiffs. Thus, as a consequence, no claim could be brought against Morgan Stanley as a party in interest.

Allegations

The case, Skin Pathology Associates, Inc. v. Morgan Stanley & Co. Inc., is different than many of the more recent ERISA breach cases. First, the case was filed by the plan sponsor as a fiduciary to a 401(k) profit sharing plan client of Morgan Stanley, rather than by a participant on behalf of the plan. Second, the plaintiff did not allege that Morgan Stanley was a fiduciary at all, but instead claimed that Morgan Stanley violated the prohibited transaction rules under ERISA as a “party-in-interest” that received unreasonable compensation due to a “pay to play” or “kickback” scheme with ING Life Insurance and Annuity Company (“ING”). The case originally was brought against ING as well, but was dismissed by the plaintiffs last year without explanation.

The court’s summary of the background and allegations is helpful:

The Plan retained Morgan Stanley to serve as broker in procuring a bundled investment/recordkeeping program appropriate to the Plan’s size, service requirements, and investment option preferences. As a result of Morgan Stanley’s actions, [ING] was retained by the Plan as its investment/recordkeeping platform provider.

Morgan Stanley established and administers an Alliance Partner program where certain financial institutions, including ING, are designated as its Alliance Partners. Morgan Stanley promotes and sells to its retirement plan customers, such as Plaintiff, the investment/recordkeeping programs offered by its Alliance Partners.  As consideration for serving as broker in finding an investment/recordkeeping platform, Morgan Stanley receives compensation from Plaintiff and other clients. Over and above this compensation, some (but not all) of the Alliance Partners pay Morgan Stanley additional compensation (“Additional Compensation”). The Additional Compensation is based solely on the amount of plan assets invested with the Alliance Partner, and is purely a “pay-to-play” fee, or kickback.

Plaintiff alleges that Morgan Stanley’s Additional Compensation arrangement constitutes a conflict of interest, because instead of finding the best fit for the Plan, Morgan Stanley promoted Alliance Partners, like ING, that provide the “pay-to-play” fee. Plaintiff alleges that Morgan Stanley’s receipt of Additional Compensation is a ‘prohibited transaction’ under ERISA § 406(a)(1)(c).

(Quotations and citations omitted)

Novel Claim Brought under ERISA 502(a)(3)

Having just taught a class full of 30 law students and tax LLM students in my role as an adjunct law professor teaching ERISA fiduciary law, this case would make a great classroom hypothetical. Because the plaintiffs were not alleging that Morgan Stanley was a fiduciary, much of the enforcement scheme under ERISA was unavailable to it. The ERISA 404 fiduciary duties were unavailable, as well as the ERISA 406(b) prohibited transactions, as both require the defendant to be a fiduciary. Even ERISA 409(a) and 502(a)(2) were unavailable, because 502(a)(2) points to 409(a), and 409(a) requires the defendant to be a fiduciary.

Instead, the plaintiffs brought their claims against Morgan Stanley under ERISA 502(a)(3), which allows a participant, beneficiary, or fiduciary to “obtain other appropriate equitable relief” to enforce ERISA. The alleged breach, given that 404 was unavailable, was a claim under ERISA 406(a)(1)(C) with reference to 408(b)(2). The complaint stated:

The provision of services to a Plan by a party in interest is a ‘prohibited transaction’ if the party in interest receives compensation that is ‘more than reasonable.’ 29 U.S.C. 1106(a)(1)(C), 1108(b)(2). That is, a transaction is prohibited if it ‘constitutes a direct or indirect furnishing of goods, services or facilities between the plan and a party in interest,’ unless ‘no more than reasonable compensation is paid therefor.’ 29 USC 1106(a)(1)(C), 1108(b)(2).

By receiving Additional Compensation [from ING] for which it did no work other than the brokerage services for which it was already being compensated, Morgan Stanley is receiving ‘more than reasonable compenation,’ especially since Morgan Stanley would have done the work for no Additional Compensation as it did in other Alliance Partnership relationships.

 The Court’s Decision

The court first addressed Morgan Stanley’s defense that the statute of limitations applied because Morgan Stanley had disclosed this pay to play arrangement to the plan sponsor in 2007. The court declined to rule on this issue because it instead ruled on the merits.

In finding that no breach of ERISA 406(a)(1)(C) occurred, the court made 4 separate findings:

First, “the fact that §406(b) explicitly prohibits kickbacks from third parties, but §406(a) does not, suggests that §406(a) was not designed to prohibit third-party kickbacks to parties in interest like Morgan Stanley;”

Second, “although a fiduciary and a party in interest on the opposite side of [a] transaction can both be held liable for a violation, it would make no sense for a statute to impose a duty on a fiduciary to stop a transaction over which it has no control. The plan fiduciary here, Plaintiff, has no power to prevent ING from paying Morgan Stanley Additional Compensation; thus, logic dictates that§ 406(a) does not prohibit the arrangement, as Plaintiff cannot block a transaction in which it has no involvement.”

Third, the law is unclear as to whether a 406(a)(1)(C) requires plan assets to be used in the kickback, but ultimately need not be resolved here.

Fourth, “fee-sharing arrangements, kickbacks, ‘soft dollars,’ etc. between service providers (like Morgan Stanley) and third parties (like ING) make a contract for services between plans and service providers unreasonable under§ 408(b)(2) if they are not disclosed. See 29 C.F.R. § 2550.408b-2(c)(l)(i). Put differently, the cover-up is worse than the crime. Fee-sharing arrangements or kickbacks do not in-and-of themselves create a violation, but their non-disclosure does.”

Thus, the court found that a claim against the service provider/party in interest itself would require a claim that the kickbacks were undisclosed. Here, the plaintiffs made no such claim, and the court held that even if they had, the evidence suggested that the Additional Compensation was disclosed.

Our Thoughts

To my knowledge, a 502(a)(3) claim filed against a service provider by the plan sponsor fiduciary itself was a first of its kind case under the umbrella of excessive fee cases. But ultimately, what are the lessons learned here?

First, just because you are not a fiduciary, does not mean you can’t be sued under ERISA. If Morgan Stanley hadn’t disclosed their compensation, we probably would have seen a very different result. Although there are a lot of very uninformed people in this industry claiming you or they are bullet proof because they aren’t fiduciaries, this should be a wake up call. The Supreme Court opened the door to suits against parties in interest in 2000 in a case called Harris Trust and Savings Bank v. Salomon Smith Barney, Inc. and with the recent expansion of remedies under 502(a)(3) in the CIGNA v Amara case from 2011, this will not be the last time we see something like this.

Second, just because the case was dismissed against Morgan Stanley does not mean that no ERISA violation has occurred or that they received reasonable compensation. At the early stages of a case, there is usually not an opportunity to argue that fees paid are reasonable because it requires evidence outside what’s in the complaint, which is supposed to be the only source of “facts” the court uses to make its decision. So Morgan Stanley may well have been able to show that the compensation it received was reasonable. But here, we have the fiduciary itself arguing that the compensation paid was unreasonable because Morgan Stanley wasn’t doing any additional services for it and would often not receive a kickback with other plans that didn’t use ING that they provided the same services to. Thus it seems to me, a very risky bet was placed by the plaintiff in this case because IF a harm occurred, they may end up having to answer for it if a plan participant turns around and files a lawsuit. Especially so IF it turns out as true that they knew OR SHOULD HAVE KNOWN  in 2007 that Morgan Stanley was receiving the Additional Compensation for no additional work.

Third, some may take the court’s pronouncement that because 406(a) doesn’t cover such transactions because the plan fiduciary can’t control it means that there is nothing wrong with such “pay to play” schemes. In fact, the court addressed this by pointing out that “a fiduciary may avoid fee-sharing arrangements between third parties and parties in interest because parties in interest are required to disclose to plan fiduciaries all direct and indirect compensation they receive. See 29 C.F.R. § 2550.408b-2(c)(l)(iv)(A)-(C).” Thus, the court made clear that avoiding harmful scenarios as alleged by the plaintiffs, is in fact, the fiduciary’s responsibility as long as it is disclosed.

Fourth, for the service providers out there, this case should illustrate very clearly why compliance with the new 408(b)(2) regulations is so important. If the disclosure was less clear, as so many of the recent 408(b)(2) disclosures I review for my clients are, no dismissal may have been available, and Morgan Stanley would have been forced to defend themselves through lengthy and expensive discovery, motions practice, and possibly trial. Further, if the court hadn’t ruled the way it did, there is a very real possibility it would have dismissed the case based on a statute of limitations argument. Another reason to make sure your disclosures are accurate.

Fifth, for the fiduciaries out there, it cannot be stressed enough that the 408(b)(2) regulations are here to stay and the consequences from failure to follow them are swift and severe. You must have a deliberative process to understand and ensure that only reasonable fees are paid from plan assets for necessary plan services. If you don’t know how to do that, we can help. This is especially so given the realities of the market place where providers such as Morgan Stanley can receive compensation from multiple sources that don’t include the plan itself.

Risk Mitigation Starts with Retaining Demonstrated Experts

by David J. Witz AIF®, GFS™ – February 17, 2014

It is widely understood that a plan sponsor that lacks expertise is obligated to seek the advice of qualified experts to assist them in their fiduciary duties. But to what extent can a plan sponsor rely on their expert’s advice? According to Clark v. Feder Semo and Bard, P.C., No. 12-7092 (D.C. Cir. Jan. 7, 2014), reliance on an expert is consistent with a fiduciary’s obligation to act with loyalty and prudence.  While this case focused on reliance on legal counsel, it provides important direction for both plan sponsors and service providers.   

The suit was filed on behalf of Clark, an attorney/employee/plaintiff, against her employer/law firm for assumptions used when calculating Clark’s distribution upon termination of the retirement plan. Clark argued that the plan’s fiduciaries were not entitled to rely on outside counsel’s advice but instead should have undertaken an “independent investigation.”

The D.C. Circuit ruled in favor of the plan sponsor. According to the court, the plan sponsor:

  1. “Properly” relied on the advice of outside counsel,
  2. Was “reasonably justified under the circumstances” to rely on counsel’s advice,
  3. Made a reasonable decision that any prudent trustee would have made under similar circumstances, and
  4. Made a prudent decision “based on the circumstances at the time of the challenged decision”

The court came to this conclusion based on ERISA’s adoption of the common law’s standard of fiduciary care in Section 404(a)(1)(B) which the court has interpreted to mean a plan sponsor can rely on counsel’s advice in “appropriate circumstances” when making important decisions. In coming to this conclusion, the court relied on several other decisions, including:

  1. Roth v. Sawyer–Cleator Lumber Co., 16 F.3d 915, 918 (8th Cir. 1994);
  2. Howard v. Shay, 100 F.3d 1484, 1489 (9th Cir. 1996);
  3. Bussian v. RJR Nabisco, Inc., 223 F.3d 286, 300–01 (5th Cir. 2000);
  4. Gregg v. Transp. Workers of Am. Int’l, 343 F.3d 833, 841 (6th Cir. 2003).

Important to all covered service providers (CSP) is the court’s conclusions in Clark that reliance on counsel’s (an expert) recommendation was “reasonable” because counsel:

  1. Had expertise in ERISA…the CSP was “qualified”
  2. Had been advising the plan since the 1990s…the CSP was “familiar” with the plan
  3. Had conducted a thorough review of the relevant documents…the CSP was “deliberate”
  4. Made recommendations based on a reasonable investigation…the CSP adopted “procedural prudence”
  5. Documented their recommendations…the CSP adopted “substantive prudence” and
  6. Made recommendations consistent with the plan sponsor’s understanding…the CSP was “collaborative”

Because the plan sponsor’s expert made recommendations based on procedural (process) and substantive (merits) prudence, the court concluded the plan sponsor did not need to conduct any further investigation as claimed by Clark. The moral of this case: there is value in retaining qualified expert CSPs. Unfortunately, many CSPs provide counsel to plan sponsors beyond their education, experience, or skills. There is liability for both the plan sponsor and the CSP in this situation. Plan sponsors should engage in a documented process to select their CSPs and CSPs should provide plan sponsors with validation they are capable of doing the job.

Bottom line, a plan sponsor should trust but verify and a CSP must not misrepresent their expertise. In fact, the court noted that a plan sponsor’s reliance on a CSP would be “improper” if there are “significant reasons to doubt the course counsel suggested.” This suggests that a plan sponsor should not blindly rely on their CSPs in all circumstances especially when they counsel a plan sponsor about issues they lack expertise in. This is when a plan sponsor is obligated to investigate or seek additional experts depending on the circumstances.