We recently posted an article discussing lawsuits brought against financial services companies alleging prohibited ERISA “self-dealing” with respect to the use of proprietary funds and services for plans they maintain for their own employees. As we noted in that article, “regular” (that is, non-financial services) companies generally do not have the self-dealing issues raised in those cases – e.g., they don’t have proprietary mutual funds that could be included in their plan’s fund menu.
But some regular plan sponsors do bill their plans for the services the sponsor provides to them. And that practice – while permitted under certain circumstances – does present certain issues under ERISA. In this article we briefly review the rules under which a sponsor/fiduciary may be reimbursed for expenses, some of the pitfalls those rules present, and some recent litigation on the issue.
Focus on the prohibited transaction issue
As we discussed in our article on ERISA issues presented by in-house plans, cases involving the provision of services by the sponsor (or an affiliate) to the plan it maintains for its employees, and payment to the sponsor/affiliate for those services by the plan, generally present two sets of issues:
A possible violation of ERISA’s prohibited transaction (PT) rules (including the ERISA prohibition against self-dealing). Generally, these cases will involve a question as to whether the sponsor has complied with any applicable exemption from those PT rules.
A possible violation of ERISA’s loyalty and prudence standards. As we discussed in our prior article, even if there is an exemption for the prohibited transaction rules, payment for sponsor-provided services must still be prudent.
In this article, our focus will be primarily on the first issue – is the exemption available? This is a somewhat narrower, more technical and uncommon issue than the loyalty and prudence issue that has been a feature of nearly every 401(k) fee case brought in the last 10 years.
Structure of the exemption
Oversimplifying somewhat, where a sponsor-fiduciary (typically, the “named fiduciary” under a plan) provides services to, and is paid for those services from, a plan, there are (at least) two prohibited transactions involved: (1) a violation of ERISA’s prohibition against the transfer of plan assets to a party in interest; and (2) a violation of ERISA’s prohibition against self-dealing.
While ERISA provides an exemption for the provision of “services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefor,” that exemption is not available with respect to the second of these prohibitions, against self-dealing.
Regulations do provide, however, that such a fiduciary may receive “reimbursement of direct expenses properly and actually incurred in the performance of such services.” Thus, a sponsor/named fiduciary may in certain circumstances charge back “direct expenses” to its plan.
We would identify (at least) three pitfalls – issues that are “easy to miss” – with respect to this exemption for the reimbursement of direct expenses to sponsor/fiduciaries:
The Department of Labor (and the courts) generally hold sponsors to a strict accounting standard in these cases. For example, in City National (discussed below) the court, in finding for DOL and against the sponsor, stated that “City National should have kept contemporaneous time records so that it could calculate actual costs of administrating the Plan.”
The expenses must still be “reasonable.” Even if the sponsor-fiduciary can establish the direct cost, if the direct cost is unreasonable (e.g., as some plaintiffs have argued, if the same services could have been bought more cheaply from a third party), then there is no exemption for the first prohibited transaction – the transfer of plan assets to a party in interest.
As with the in-house plan cases, just because the sponsor/fiduciary-plan arrangement satisfies the PT rules does not mean that it satisfies ERISA’s loyalty and prudence standards. The PT rules require that the compensation be “reasonable” and a direct cost. In the 401(k) fee loyalty and prudence cases, plaintiffs lawyers are pushing for a much stricter standard – e.g., a standard established by the market through competitive bidding. And – as in the in-house plan cases – plaintiffs lawyers may argue that the self-dealing inherent in these transactions, even if it is exempt, supports a conclusion of disloyalty/imprudence.
Recent “direct expenses” litigation – City National
In Perez v. City National Corporation, DOL sued the plan sponsor (among others) claiming that an arrangement in which the plan sponsor provided trust and administrative services and was compensated through mutual fund revenue sharing violated both ERISA’s prohibited transaction and loyalty and prudence rules. City National is a financial services company, and it did (at the damages stage) raise the possibility of an exemption for this transaction from ERISA PT rules under Prohibited Transaction Exemption 77-3 (which we discussed in our prior article).
In granting DOL’s partial motion for summary judgment, the court rejected that defense, stating that “The Court resolved all issues regarding liability in its [decision on the merits].”
The sponsor and sponsor fiduciaries (apparently) also asserted a “direct expenses” defense to the PT claim, arguing that “because (1) [DOL] did not provide evidence of direct expenses, (2) City National was entitled to ‘reasonable compensation’ for administering the Plan … and (3) even if City National was charging the Plan high fees, the provision of services to the Plan exceeded City National’s revenue from Plan administration.” The court rejected this defense, finding that evidence regarding direct expenses failed because it was based on averages and estimates. “City National should have kept contemporaneous time records so that it could calculate actual costs of administrating the Plan. By calculating the Direct Cost Analysis using averages and estimates, City National could have over or under charged the Plan. Accordingly, City National failed to produce evidence sufficient to raise a triable issue [with respect to its direct expenses defense].”
City National illustrates the first point we made above (under “Pitfalls”): DOL and the courts expect very specific information about the cost of sponsor-provided services, such as timesheets.
Northrop Grumman litigation
Northrop Grumman DC plan participants filed a complaint in September 2016 against Northrop plan fiduciaries, alleging (among other things) that the plan sponsor overcharged the plan for certain administrative services it provided. The complaint states: “Northrop … provided no valuable services, or services of only limited value, to the Plan … [and] failed to engage in a competitive bidding process for the services provided by Northrop employees, or consider outsourcing such services to an independent third party, to ensure that only reasonable and necessary expenses were incurred in the operation and administration of the Plan.”
In this regard, plaintiffs alleged (among other things) that:
Northrop fiduciaries failed to follow procedures for expense reimbursement in applicable administrative service agreements.
“Defendants never determined whether the services provided by Northrop were even necessary for the administration of the Plan or in the exclusive interest of Plan participants, whether any such services as were necessary for Plan administration should have been outsourced, or whether the charges for such services were reasonable expenses of administering the Plan.”
Defendants should have “put the services purportedly provided by Northrop out for competitive bidding to determine the market rate for such services for the Plan,” in order to establish the reasonableness of the charges made.
This 2016 litigation is a follow on to In Re Northrop Grumman Corporation ERISA Litigation, originally filed in 2006, and (in effect) covers the subsequent period not covered by that earlier litigation. That (2006) case, which made similar allegations (e.g., that the plan over paid the plan sponsor for administrative services), was settled in March 2017. The 2016 case has been referred for alternative dispute resolution.
Thus, while there is no question that charging back expenses to the plan is permitted in certain circumstances, there are relatively tight rules about what can be charged back and about how the arrangement should be documented. Sponsors charging back expenses (or considering doing so) will want to consult with counsel concerning compliance with those rules and the risks they present.