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Fiduciary Update

Fiduciary Update | November 2017

In this quarter’s Fiduciary Update, CAPTRUST’s Drew McCorkle provides an update on the DOL’s conflict of interest rule for other investor protections, late loan payments as taxable distribution, pension overpayments, and other fee related litigation.

DOL Fiduciary Rule: A Catalyst for Other Protection (and an Update)

The Department of Labor’s much-written-about and hotly debated regulation expanding the range of activities subject to ERISA’s fiduciary standards has apparently been the catalyst for other investor protections.

Current Status

Limited aspects of the rule are in force. Those subject to the new rule must act in their clients’ best interests, receive only reasonable compensation, and make no misleading statements. Implementation of the rule’s detailed notice and contract requirements has been formally delayed until January 1, 2018, and a further delay until July 1, 2019, is expected. The DOL has announced that it will not enforce the regulation’s requirement that aggrieved investors be permitted to file class action lawsuits.

States Adopting Broader Fiduciary Rules than the DOL’s

Following rollback of the DOL’s rule, Nevada and Connecticut recently enacted laws establishing fiduciary requirements for investment service providers to non-ERISA plans and other portfolios. The Nevada rule went into effect on July 1 and covers virtually all investment advice. The Connecticut law is limited to 403(b) plans sponsored by political subdivisions in that state.

Legislation is reportedly pending in New Jersey and New York. Other states, including California, Missouri, South Dakota, and South Carolina already had fiduciary rules on the books. Reconsideration and possible expansion seem likely.

SEC Fiduciary Breach Action Secures Recoveries for Investors

The Securities and Exchange Commission’s fiduciary rules are less stringent than ERISA’s. As debate on the new DOL rule has raged on, the SEC’s possible role in fiduciary enforcement and the prospect of a unified fiduciary standard by the DOL and SEC has been discussed.

Although not directly related to the new DOL rule, it is notable that, in September, the SEC entered into a settlement agreement with an investment advisor who accepted undisclosed 12(b)-1 fees from investments it recommended to ERISA-covered 403(b) plans and individual retirement account investors. The investment advisor agreed to rebate the undisclosed fees to its clients.

Fee Litigation Expands to Smaller Plans

Fee litigation continues to expand to smaller plans, with Gucci America, Inc., and Novitex Enterprise Solutions being recent targets. The Gucci 401(k) plan reportedly has just under $100 million and the Novitex 401(k) plan just under $150 million. Most fee litigation suits have targeted much larger plans with billions of dollars in plan assets.

These recent cases are a reminder that even smaller plans must be diligent in the monitoring of plan fees and investments. As previously noted, plan fiduciaries with thorough and thoughtful review and monitoring processes in place should be well positioned in the event of a challenge.

Late Loan Payments Result in Taxable Distribution

A significant majority of 401(k) plans permit participants to take loans from their 401(k) plan accounts. In effect, the loan is a plan investment, with the plan holding a promissory note and the participant repaying principal and interest to his or her account. If a plan loan is not repaid according to the loan document’s terms, the loan’s outstanding amount is deemed to be distributed to the participant. As a distribution, the amount of the defaulted loan is taxable as ordinary income. If the participant is less than 59 1/2 years old, the distributed amount is also subject to a 10 percent early-distribution penalty tax.

In an unfortunate situation, a plan participant took a $40,000 plan loan just before going on maternity leave. As part of the loan process, she completed a payroll deduction agreement for her loan repayments. During the first five weeks of her maternity leave, the participant was paid using accumulated sick, personal, and vacation leave. However, her employer did not withhold loan repayments from these paychecks.

When the participant returned to work, she realized that the loan repayments had not been made. She immediately made a $1,000 payment and increased her biweekly payroll-deduction loan payments until she caught up with the original payment schedule. The loan was eventually paid in full, and she received confirmation of that from the plan recordkeeper. Although the participant did her best to make up her initially delinquent payments, she had violated the terms of the loan agreement.

Unknown to the participant, the recordkeeper issued her a Form 1099-R showing taxable income of $40,065 in 2012. Apparently, a $65 loan fee was added to the loan amount. The 1099-R was available on the recordkeeper’s website, but was not mailed to the participant. In 2014, the participant received an IRS notice of deficiency for failure to pay income tax on the $40,065 and the 10 percent penalty tax. She was also assessed a 20 percent penalty on the unpaid taxes for substantially understating her income tax.

The participant paid the tax and appealed to the U.S. Tax Court. The court was not moved by the participant’s situation and upheld the Internal Revenue Service decision that the loan be deemed a distribution subject to income tax and the 10 percent early-withdrawal penalty. However, the Tax Court reversed the underpayment penalty assessment, concluding that the participant had reasonable cause for her actions and acted in good faith. Frias v. Commissioner (US Tax Ct July 11, 2017)

(Most) Plan Participants Not Permitted to Retain Pension Overpayments

A company with a pension plan decided to cease operations in one of its locations. Plan participants whose employment was terminated as part of the plant closure were offered the opportunity to immediately receive their pension benefits in an actuarially equivalent lump sum. The plan actuary calculated the lump sum amounts, and participants were given the choice of taking the immediate lump sum or waiting to receive a monthly life annuity benefit beginning on their early retirement or normal retirement dates.

Unfortunately, the actuary miscalculated the lump sum benefits, overstating the lump sum benefits by 36 percent. The error was not realized until six weeks after distributions had been made. After being informed of the error, most participants either returned the overpayment amounts or changed to the annuity benefit option. Five participants did not return the overpayments, and the plan fiduciary filed suit to force return of the overpayments.

The overpaid participants alleged that they should be permitted to retain the overpayment because the error in payment somehow caused them harm. With one exception, the court was not persuaded and required return of the overpayments. One employee at the closing plant had been offered a position at one of the company’s other locations. However, based on the size of the lump sum he was initially promised, the employee declined the other position and retired. After the lump sum error was identified, the employee was not offered another position. The judge concluded that, for this employee, the misstated lump sum amount had indeed caused a potential injury, and his claim was not dismissed. Retirement Committee of DAK Americas v. Brewer (4th Cir. Aug 4, 2017)


  • Nonqualified Plan Participants Try to Save Benefits from Bankruptcy Trustee—Assets in nonqualified plans are generally subject to the claims of the employer’s creditors. That is, the claims of nonqualified plan participants are subordinate to the claims of general creditors. When Lehman Brothers field for bankruptcy in September 2008, assets in its nonqualified plan were subject to the claims of creditors. In a bankruptcy court proceeding in the Lehman Brothers bankruptcy, a group of disappointed former Shearson Lehman Brothers employees argued that their nonqualified plan assets should not be considered to be part of the Lehman Brothers, Inc., nonqualified plan. Rather, because there had been such significant corporate change in the Shearson organization since 1985, it should be considered a separate entity, and these employees’ deferred compensation claims should not be subordinate to the claims of Lehman Brothers’ general creditors. The court traced the corporate developments and found a direct link of these former employees to the Lehman Brothers nonqualified plan. As a result, these former employees will remain at the back of the line of claimants to the bankruptcy estate of Lehman Brothers. Giddens v. 4 individuals (In re Lehman Bros) (BRCY SD NY July 13, 2017)
  • Employer Stock Case Challenges Suitability of Sears Stock for a 401(k) Plan—The vast majority of employer stock cases have alleged that plan fiduciaries should have known the stock was overpriced or foreseen a stock price drop and sold in time to preserve participant account values. Following the Supreme Court decision in Fifth Third Bank v. Dudenhoeffer, these cases have been very difficult for participants to sustain. Making a different argument, participants in the Sears plan have sued plan fiduciaries for failure to have a prudent process for monitoring the company stock fund. The complaint alleges that such a process would have found company stock to be unsuitable as an investment for 401(k) plan participants. This case appears to apply the Supreme Court’s Tibble v. Edison holding that plan fiduciaries have an ongoing duty to monitor plan investments and whether they continue to be appropriate for inclusion in a retirement plan. Meriwether v. Sears Holdings, Corp. (N.D. Ill. Pending)
  • No Jury Trials in ERISA Fiduciary Breach Cases—In one of the many recently filed lawsuits against university retirement plan fiduciaries, the plaintiffs requested a jury trial. Consistent with other decisions in this area, the judge noted that ERISA fiduciary breach cases are equitable in nature. That is, they require a judge to weigh the situation and arrive at an appropriate remedy. As a result, the request for a jury trial was denied.