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.
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.
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.