Kim Shaw Elliott, Esq.
Kimberly Shaw Elliott is an ERISA investment lawyer, helping clients successfully navigate rules founded in ERISA/employee benefits, securities law, broker dealer regulation and tax. Her legal guidance takes into account many nonlegal facets of running an enterprise, including sales, operations, product development, customer service and the corner office's need for results.
Kim represents broker dealers, investment advisers, insurance companies and others nationwide, with a focus on fiduciary responsibility. She worked many years for financial services companies as chief in house counsel and as an executive with full P & L accountabilities so she brings the client's perspective to her private law practice. She is a three-time graduate of Washington University in St. Louis, having earned her JD, LLM, and executive MBA there. Her bachelor's degree in Mass Communication - Radio Television was awarded by Southern Illinois University at Edwardsville. Kim holds FINRA Series 7, 63, 65 and 24 registrations with Calton & Associates and the Fellow, Life Management Institute designation. She was named President Emeritus of the Association of Corporate Counsel (St. Louis), chaired the Employee Benefits Committee of the Missouri Bar and is a frequent speaker and writer on ERISA and securities topics.
A partner with the Chicago-based law firm of Baugh, Dalton, Carlson & Ryan, LLC, Kim welcomes your call at 314-202-5175, or email@example.com.
3(16): A Legal Perspective with Attorney Kim Shaw Elliott
The following is a conversation between NAPLIA CEO, Gary Sutherland, and ERISA Attorney, Kim Shaw Elliott relevant to the legal perspective on ERISA 3(16).
Gary Sutherland: Tell me a bit about you professionally and your experience with law in the financial services sector.
Kim Shaw Elliott: I have been an attorney for over 30 years, almost since ERISA was enacted. During that time, I have had the opportunity to be part of nearly all segments of the financial services industry, serving insurance companies, broker dealers, investment advisors, and bank affiliates of those types of entities, both as an in-house lawyer, as a business leader and as outside counsel. This practice area, ERISA investment law, requires successfully navigating complex rules founded in ERISA/employee benefits, securities law, broker dealer regulation and tax.
Can you provide me with a quick rundown about the firm you're with, Baugh, Dalton, Carlson & Ryan, LLC?
KSE: I'm a partner at Baugh, Dalton, Carlson & Ryan, LLC, which is primarily a securities litigation firm. We defend, through their insurance companies, many broker dealers, investment advisors, and insurance agents. We also provide professional liability defense for accountants and other types of professionals. When I joined the firm in January, it was a nice blending of skillsets, in that I can offer both a securities regulatory perspective and bring in the ERISA perspective, which was new to the firm. We have about 25 lawyers, with offices in Chicago, Phoenix, Dallas, Atlanta, and St. Louis.
What changes are you seeing in ERISA compliance?
KSE: ERISA, of course, is constantly evolving and we must be constantly vigilant about new interpretations on the regulatory front. Over recent years, the trend has been toward heightened awareness of the responsibilities of fiduciaries, both as plan sponsors and as service providers to plans.
What do you see as the greatest vulnerabilities and how can service providers protect themselves?
KSE: Currently the greatest risks seem to arise from inappropriate or what regulators would call "unreasonable" compensation arrangements, whether receiving them as a vendor or approving them as a plan sponsor. Financial advisors can protect themselves -- and certainly help their plan sponsor clients -- by understanding what is competitive in the marketplace, by providing full disclosure of both their services and their compensation, and putting a laser focus on continuing to provide true value to their customers.
Any personal experiences or war stories you can share with us that might help to elucidate current areas of risk?
KSE: I had the good fortune of leaving corporate practice and entering private law practice six months before the 408(b)(2) disclosures were due. Providers were very concerned about doing the right thing and wanted help drafting compliant disclosures. Their concerns provided me a very nice start in private practice.
Now getting into the 3(16) specific questions, what should a well-crafted 3(16) service agreement include? Can you identify and spell out fiduciary services versus non-fiduciary services?
We frequently see claims when the contract is somewhat vague on the services the advisor is not providing, or when the language is not specific about what are fiduciary or what are non-fiduciary services. Plan sponsors may assume that all services are being covered.
KSE: That was a pretty insightful question, and I absolutely think it is important to spell out which services are fiduciary and which are not. It is critical for the parties to know when the provider is acting as a fiduciary and when it is not acting in that way. The appropriate legal standard of care can be then applied to each activity.
Can you identify and spell out the provider's duties and the duties of the plan sponsors?
KSE: This is very important. I suggest that the services be described in a 'check-the-box' menu format so that it is clear who should be doing what. Failure to check a box should be an express statement that the service provider is not performing that particular service .The plan sponsor typically is appointed to act as the plan administrator in the plan document. How those plan administrator duties may be allocated to others, like through a 3(16) agreement, as well as the liability that goes with those duties, should be carefully and clearly spelled out.
I think one of those things that I have seen -- and I am sure you have seen it too -- is the tendency to use a boilerplate-type contract which really doesn't fit in these circumstances.
KSE: That's right and frankly I have recently drafted a flexible template. It was a bigger drafting task than it might at first seem because we must really think through what does a plan administrator actually do? What are all the possible functions? How do we put this in a menu of choices that includes all of those we think are appropriate? How do we wall off those we don't think are appropriate for this type of an arrangement?
Who becomes responsible for the hiring and firing of a 3(21) discretionary or non-discretionary advisor and/or investment manager under 3(38) and/or any other service providers? And, in this question I'd like to know if you're seeing movement in one direction or another.
KSE: When you're talking about any given plan, the starting point of analysis is always the plan document. For any named fiduciary to be relieved of the fiduciary responsibility -- which is what these service agreements are all about -- the plan document must provide a procedure for that named fiduciary, the one that has the original responsibility, to either designate someone else to perform a function or tp allocate her duties among the other fiduciaries. So, If the plan does provide for this, then the plan sponsor can make someone else responsible for selecting and overseeing the investment fiduciary, whether that's the 3(21) fiduciary, who is giving advice or recommendations only, or if it is acting as the 3(38)investment fiduciary and has full authority for discretionary management. I suggest that any agreement to delegate authority to choose a vendor, whether it be an investment fiduciary or a 3(16) plan administrator or for any other reason, also include a representation from that plan sponsor or responsible fiduciary that they in fact have the the authority to make that appointment. That way the vendor should not be trying to interpret the plan documents him or herself. Frankly I like to keep those documents out of vendors' files so that they can't be charged with knowledge about other things that may be in the plan documents.
So essentially you're looking for an affirmative statement by the original plan sponsor that dictates the designation of hiring and firing of other vendors.
KSE: Yes, you have an actual representation saying, "Here I am. I'm the named fiduciary and have the authority to make this appointment." And the provider can then rely on that representation.
As a side note to the 3(16), the Pros and Cons, one major con heard is that they feel the 3(16) is eligible to hire the 3(21) or 3(38) and is giving them keys to the kingdom. I hear what they're saying, but I don't necessarily agree with them, however I understand where they're coming from. I believe that's what we're going to hear a lot about regarding 3(16).
KSE: I see some arrangements where that works quite well -- particularly if it is in a packaged arrangement. In the more routine situation -- where you're looking at a one-off, with a single plan sponsor worried about how do I deal with my fiduciary responsibilities? If you are appointing someone else to provide fiduciary investment advice, then you have the authority to appoint that investment advisor, and then you also have to look at any potential conflicts so that that same person isn't employing themselves or influencing their own compensation.
We're seeing that now. I have written several clients that called are aggregators, who are aggregating hundreds of plans, and they're providing both the 3(16) and outsourced 3(38). They're independent and they bring the 3(38) to table as a package deal.
KSE: And I think in those situations it works well. So basically, the plan sponsor is buying that package and they are offloading those fiduciary responsibilities to experts that are allegedly conducting the right due diligence and making the right choices in conducting proper oversight of the activity. The plan sponsor must still exercise appropriate due diligence in selecting the package and in continuing to assess whether it remains a reasonable arrangement.
Moving on to indemnification. We see a lot of them that are very badly worded. They really favor the investment advisor over the plan. What are you seeing in that area? Should the contract spell out indemnifications and cross indemnifications?
KSE: Indemnifications are probably the most negotiated provisions I have dealt with in advisory contracts. How you use indemnifications and how they are described is really a matter a personal preference. In considering indemnifications, one should obviously define who is indemnifying who and for what activity. An important factor is the relative bargaining power of the parties. For instance some highly desirable, large providers or even some large plan sponsors are able to include broad based indemnifications as non-negotiable boiler plate. These big players believe "you are going to do business with me the way I want or I am not playing". Others use reciprocal, balanced indemnifications as a matter of fairness and company policy. Many service providers may want indemnification for claims brought against them for actions taken by other providers selected by the employer. Some companies will never indemnify for simple negligence. All of these preferences need to be worked through with the help of a skilled lawyer.
Can you comment on the length of agreement? This can be problematic. I know that the DOL is concerned about length of agreements regarding fees. What are you seeing and what are you recommending?
KSE: To my mind, shorter is typically better because you want the parties to the agreement to actually understand what their contract means -- and be able to refer to it for guidance. That said, there are many standard terms that are difficult to cut. This is particularly true when we are dealing with an advisory contact because you have to comply both with the ERISA requirements and the Investment Adviser Act requirements, while at the same time meeting the contractual needs of the parties. With all those considerations in play, there are some somewhat standard terms that are difficult to cut. You may be familiar with the old adage about the lawyer who said that "I would have made the document shorter but I just didn't have time." It is sometimes very difficult to draft cleanly and with a lot of precision.
Getting to the regulator's concern, probably more important than length is that the document should be in Plain English. A good lawyer today should be able to write in terms that the parties to the agreement can actually read and understand. You should not have to translate "legalese."
One of the concerns about terminating an agreement as a 3(16) is often similar to an accountant who disengages a client, but needs to notify the client in writing of any deadlines or issues that require attention by the client. For the 3(16) fiduciary to untangle it, he/she might not always do so with a termination date specified.
KSE: It is of course important for the parties to spell out how either side can terminate an agreement if they choose to do so. Nobody should be bound forever. If the deal isn't working well then either party should have the right to remove themselves from the situation. That said, once you include some clear notice provisions and how to actually terminate the agreement, I prefer that most agreements be perpetual in duration, unless terminated by one of the parties. The parties don't have a set ending date, any party can choose to end it, but there is no set duration, such as a one-year term, that would require the agreement to be renewed on an annual basis. Among some of the other reasons for this, is that if it is ongoing you don't have to provide new 408(b)(2) disclosures because the document isn't being "entered into, extended or renewed."
So you don't feel that you don't have to justify the fees on a regular basis?
KSE: The plan sponsor certainly has an obligation to make sure the arrangement is reasonable on an ongoing basis and they do have to provide some oversight over their fiduciaries and their appointees to show that the services are actually being performed. But there is no set time for that. I think as long as the service provider is out there doing good work, they have a good sense of what their services are worth, and they've benchmarked them to understand what's out there in the marketplace, if they continue to charge those same fees and are providing good service then you're good.
Let's talk about arbitration and mediation. There is one school of thought that you only include mediation, because both sides can share what's happening, and it's not an arbitrator deciding 50 percent of the time it goes to one party or the other. Or do you believe that they should have both? Or none?
KSE: The question is to require arbitration or mediation or nothing, and leave the dispute to be resolved by litigation. This is really a matter of personal choice. People have different views and attitudes about this. In mediation there sometimes tends to be a 'split the baby' approach. If people feel they have a really winning case, they may go into mediation sometimes with the view that they're going to have to give up something. So some people might not like that arrangement. Arbitration has historically been viewed as cost effective and a faster process than litigation, but others are finding that is not always the case. They believe that arbitration is becoming very complex, that there is more discovery involved than there used to be and that it is now both expensive and lengthy. Arbitrators don't always apply the law, so you don't have the predictable outcome, and there are no appeal rights. Despite this, some people want to stay as far away from the courthouse as they possibly can. So really it's a matter of personal preference. Most large employers have a policy about which way they're going to go. They are going to insist that their chosen method for dispute resolution be in their service document.
So the follow-up question would be: if you're writing the 3(16) agreement for the third party vendor as opposed the plan sponsor, would you recommend that they include arbitration or mediation? Clearly the insurance companies see it as a win over not having it.
KSE: My standard contracts have both an arbitration and a mediation provision in them. The parties will try mediation first and if that fails, then go to arbitration.
Over a period of time, as the work changes or the plan grows, how are fee increases handled within the agreement? Do you like to always see a flat fee? Do you like flat fee with some variances? Annual review?
KSE: That's a tough point in the plan administration arena because every possible payment arrangement is out there. As you said, there is flat fee, flat fee with something else, head counts, asset-based fees. It is all across the board. But at least as far as any increases are handled, obviously notice must be given, and new disclosures must be provided prior to a change to the fees. Consent is required. I advise that clients adopt a negative consent procedure so that their customers, the plan sponsors, can "vote with their feet" if they don't like any change with the fees, or just continue the arrangement.
So, if the plan sponsor doesn't challenge it, then it after a period of 30 or 60 days the new fee structure goes into effect.
KSE: Right. And that's a big cost saver for the service provider. The firm can announce its fee increase and put it into effect without individually negotiating with all the customers. In most cases people understand that costs tend to increase over time and don't protest. If they don't like it they can leave.
This next issue is obviously geared to what we do, but I think it has an impact regarding insurance and bonding issues (first party and third party). If I'm the plan sponsor, then one of my due diligence processes is to make sure that if I am outsourcing the 3(16) that the provider have the appropriate E&O insurance if they make a mistake, specifically covering them as a named fiduciary and that they be bonded for any theft. Not necessarily that they have access to the plan's funds, but we all know these signatures can be forged and we've seen claims like that. On the flip side, if I am the outsourced 3(16) and I am responsible for the fiduciary duties of the 401(k) but not anything else, I'm not responsible for any of the health and welfare plans that they entity has. I want them to have first party fiduciary because I only handle some portion of the fiduciary exposure. I just wondered if you get into that at all within your agreement. Or is it left out and you just recommend different things.
KSE: We usually include a representation the provider will obtain an ERISA bond because obviously if it is serving as the 3(16), then it is a plan administrator and they will likely be handling funds. I think the service provider would be more comfortable having its own bond rather than trying to get named on the plan sponsor's bond. As a skilled broker, I know that you have many great techniques for how to schedule a variety of plans that are customers of the service provider. They can be scheduled for both the fidelity bond and the E&O.
So if you are representing a plan sponsor and asking to review a service contract for an outsourced 3(16), then would part of your due diligence be to review both insurance and bonding for the plan sponsor?
KSE: Absolutely. The plan administrator is likely handling funds and therefore must have an ERISA bond. If a third party is serving as the plan administrator, it may want to have its own bond, rather than trying to be part of the plan sponsor's bond. Various customers can be scheduled onto a single bond. I also advise all plan administrators to have their own E&O coverage. Fiduciary services are often excluded from the policy and must be added through separate rider. No one should work in this business without coverage. NAPLIA offers great brokers who can help advise about insurance needs.
Who is responsible for making the initial plan changes? For example, the plan has to be changed, there is a cost of doing that, does the plan sponsor pick up that cost? Is it their responsibility? Or does the 3(16) make the recommended changes? Is there a conflict if they both make the changes and get them approved?
KSE: That's an interesting question. Typically any plan design changes belong with the plan sponsor, unless that authority has been designated to someone else in the ways we've talked about. Either the plan document provides for someone else to have the ability to make the plan changes or someone's been designated and allocates that authority to another. We have to keep in mind that plan design changes, and the ability to appoint other providers, are a design change. Those are what are called settlor functions. This means that the resulting expenses belong to the plan sponsor and cannot be charged against plan assets.
So, let's say you're representing the third party that's looking at doing outsourced 3(16) on behalf of the plan entity. You're clearly the legal representative for that individual. As part of your due diligence would you recommend they run any plan changes by their attorney?
KSE: Absolutely. I know it's difficult because the
plan administrators often have templates for plan
amendments. They might offer prototype documents. The
provider can certainly offer a specimen document of some
sort, but the actual responsibility to adopt the plan
amendment typically lies with the plan sponsor. So, if
the provider does give the plan sponsor a proposed
amendment of some sort, then it needs to be clearly
specified and understood by everyone that the provider
is not amending the plan. The plan amendment belongs to
the plan sponsor, and the sponsor should be doing it
only with the advice of their own counsel and only when
they are comfortable moving forward.