In Jenkins v. Yager, the Seventh Circuit created an implied right for fiduciaries to transfer legal responsibility and liability for investment decisions to plan participants without complying with the conditions of ERISA Section 404(c). The court points to language from the 404(c) preamble as a basis for creating the implied exception, which misreads the intent of that language.
Earlier this year, the US Court of Appeals for the Seventh Circuit took a wrong turn on its way to deciding a potential milestone case. Rather than clarifying the issues surrounding ERISA Section 404(c), the court created a new "implied exception" to the fiduciary rules, the implications of which are unsupported by the statute. In fact, the court's opinion can be viewed as reading Section 404(c) out of the law altogether.
In essence, the court created two "implied exceptions":
- The court recognized an implied right to transfer to participants the authority or right to direct their accounts. We agree that this may be properly implied from the law.
- The court created an implied right for fiduciaries to transfer the legal responsibility and liability for investment decisions to the participants without complying with the conditions of ERISA Section 404(c). In effect, the court concluded that fiduciaries can get the same level of protection from imprudent participant investment decisions by satisfying:
- a. The conditions in the DOL's regulation under ERISA Section 404(c); or
- b. Some, but not all, of those conditions under an alternative approach approved by the court (but found nowhere else in the law).
- a. The conditions in the DOL's regulation under ERISA Section 404(c); or
As discussed in more detail later in this article, in our view Congress and the Department of Labor have acknowledged that ERISA permits employers to establish participant-directed plans in which investment control is shifted to the participants, but that the fiduciaries are protected for imprudent participant investment decisions only if a plan complies with Section 404(c). The court in Jenkins v. Yager ignored this distinction.
Given the current cultural expectation that each of us is responsible for his own actions, we can sympathize with fiduciaries who take a position similar to Mr. Yager's: The participants were given the right to direct their own investments, and just because things did not turn out the way they wanted, they should not be able to hold someone else responsible. That said, as lawyers, we are bound by the law, and the same is true for fiduciaries; the law contains a clear mechanism—-Section 404(c)-—for fiduciaries to obtain the protection that Mr. Yager sought.
The facts of the case are simple. Earlene Jenkins participated in the Mid America Motor Works Employee Savings and Profit Sharing Plan. Michael Yager was the company president and the trustee of the plan. The company made annual profit sharing contributions to the plan that were invested by Mr. Yager, as the trustee. Eligible employees could make 401(k) deferrals, which were matched by the company. Participating employees had the right to direct the investment of their deferrals and the matching contributions among four mutual funds selected by Mr. Yager. Initially, they could do so yearly and later twice yearly. The plaintiff, Ms. Jenkins, deferred into the plan and directed the investment of those monies and the related matches.
The plan made no effort to comply with ERISA Section 404(c).
From 2000 through 2002, the profit sharing portion of the plan lost $400,000 and the 401(k) portion lost $700,000. Ms. Jenkins sued Mr. Yager for breach of fiduciary duty in connection with both losses. The trial court granted a summary judgment in favor of Mr. Yager (the fiduciary) on both counts. On appeal, the court of appeals upheld the judgment on the 401(k) losses, but reversed as to the profit sharing funds, directing the lower court to hold a trial on the question of whether Mr. Yager had breached his ERISA duties as to those losses.
Pretty routine stuff so far. How the court reached these conclusions is what makes the case important. . .and unfortunate.
The court observed, correctly, that under ERISA Section 403 a trustee has the duty to invest the assets of a plan. That section creates only two exceptions:
- The plan can designate another fiduciary (a "named" fiduciary) from whom the trustee must take investment direction;
- Investment decisions can be delegated to an investment manager.
In the case of allocation to a named fiduciary, the trustee is not fully relieved of all responsibility with respect to investment decisions. As a directed trustee, it retains the duty to determine that the instructions of the named fiduciary are proper. [See, e.g., Field Assistance Bulletin 2004-3.] Delegation to an investment manager does relieve the trustee (and any named fiduciary) of investment responsibility, though the trustee (or other named fiduciary) retains the obligation prudently to select and monitor the investment manager.
ERISA creates an important distinction between authority and responsibility-—a distinction that, in our view, the court failed to see. If investment authority is granted, the holder of that authority has the right to make investment determinations, but the plan fiduciaries may still have the ultimate responsibility to ensure that the use of those investments by the participants is prudent-—and may be liable if they are not. If a fiduciary is also able to shift the legal responsibility for the investing, it may avoid liability for imprudent investment decisions.
Nowhere does ERISA expressly provide that the trustee (or other named fiduciary) may delegate investment duties to the participants of the plan. The Yager court points out that ERISA Section 404(c) does provide that, if participants are given the right to control their accounts (and certain conditions are satisfied), the fiduciaries will not be liable for losses resulting from their exercise of control. Based on this "liability shield" (as the court called it), the court characterized the issue before it as follows:
Therefore, we must determine whether compliance with section 404(c) is the exclusive method of creating a participant-directed exception to sections 403 and 405 [the sections of ERISA that provide for the trustee duty to invest plan assets as well as the named fiduciary and investment manager exceptions to that duty].
Until the Yager case, the courts and the DOL seemed uniformly to take the position that 404(c) compliance was the exclusive way in which fiduciaries could be relieved of liability for imprudent participant investment decisions. For example, in the court's order denying the defendants' motions to dismiss in Tittle v. Enron Corporation, [2003 WL 22245394, at 24 (S.D. Tex. Sept. 30, 2003)] the court said, "If a plan does not qualify as a 404(c) [plan], the fiduciaries retain liability for all investment decisions made, including decisions by the Plan participants." [Emphasis added.]
The DOL's brief in the same case pointed out that, "The only circumstances in which ERISA relieves the fiduciary responsibility for a participant-directed investment is when the plan qualifies as a 404(c) plan." [Emphasis added.]
On the contrary, the court in Yager stated that Section 404(c) and the accompanying Department of Labor regulation "create a safe harbor for a trustee." This is a curious characterization in light of language in the Preamble to the final 404(c) regulation (appearing slightly before other language quoted by the court) in which the DOL expressly stated that it was not adopting a safe harbor:
a number of commentators on the 1991 proposal suggested that the Department adopt the regulation as a "safe harbor" under ERISA section 404(c), thereby providing a fiduciary of a plan which fails to comport with the requirements of this regulation the opportunity to argue that the particular plans and any particular participant-directed transaction executed pursuant to such plan falls within the statutory definition, and, as such, should be afforded the exception to fiduciary liability described in ERISA section 404(c). After due consideration, the Department has decided not to adopt this suggestion. [57 Fed. Reg. 46,906,46,907]
The court then went on to state, "we see no evidence that these provisions necessarily are the only possible means by which a trustee can escape liability for participant-directed plans."
Thus, after carefully explaining the ways in which ERISA explicitly permits investment responsibility (as opposed to mere authority) to be shifted (e.g., the named fiduciary and investment manager methods), the court concluded in essence that the recognition of participant-directed plans in Section 404(c) means that both the authority and the responsibility may be shifted to participants-—the fiduciaries may obtain protection from imprudent participant investment decisions-regardless of whether the plan complies with that section and the related DOL regulation. The decision points to language in the preamble to the final 404(c) regulation indicating that the standards set forth in the regulation were not intended to be applied in determining whether or to what extent a plan not meeting the 404(c) requirements satisfies the fiduciary provisions of ERISA and that "non-complying plans do not necessarily violate ERISA; noncompliance merely results in the plan not being accorded the statutory relief described in section 404(c)." [Preamble to Final Regulation, 57 Fed. Reg. 46,906, 46,907 (Oct. 13, 1992)]
Based on its reading of ERISA, the 404(c) regulation, and the preambles, the court concluded that, "a plan trustee [may] delegate decisions regarding the investment of funds to plan participants even if the plan does not meet the requirements for the section 404(c) safe harbor."
First, the court recognized an implied right to shift investment authority to participants. If the court had stopped with this statement, we would have little objection. But the court went on to create a second implied provision of ERISA...one that, if accepted by other courts, could render 404(c) meaningless:
Therefore, there is an "implied exception" to sections 403 and 405 for participant-directed plans, allowing plan participants to direct the investment of their own plan funds. If a participant-directed plan does not meet the conditions set forth in the [404(c) regulation), the plan trustee and fiduciaries simply do not receive the benefits of section 404(c), and they are not shielded from liability for losses or breaches of duty which result from the plan participant's exercise of control. It does not necessarily mean that such a plan violates ERISA; instead, the actions of the plan trustee, when delegating decision-making authority to plan participants, must be evaluated to see if they violate the trustee's fiduciary duty. [Emphasis added.]
To the extent this conclusion is based on a reading of the language in the preamble to the 404(c) regulation quoted earlier, in our view the court has misconstrued the meaning of the DOL's statements. We discuss this in the next section of this column. Suffice it to say here, the court focuses on only part of a fiduciary's duty—-the duty to act prudently in delegating responsibility to others—-and completely ignores another, which is the responsibility for the prudence of investment decisions respecting plan assets. The failure to address this second, critical aspect of a fiduciary's duties is a fundamental flaw in the opinion.
Having side-stepped 404(c) and shoe-horned the issue into a more or less traditional breach of fiduciary duty question, the court then analyzed whether Mr. Yager had breached his duty in delegating investment responsibility to the participants and concluded that he had not. The court divided the inquiry into three elements:
- Did Yager breach his duty in the initial selection of funds (the court said he did not);
- Did he breach his duty in monitoring the funds (the court said he monitored properly);
- Did he breach his duty in the information provided to plan participants to assist in their investment choices?
As to the last issue, the court concluded that Yager had provided "the necessary information to enable [the participants] to direct the investment of their 401(k) funds among four different funds." As to the more critical issue of whether Yager had any responsibility for overseeing the investment decisions made by the participants, for monitoring their decisions, and for making sure that the investment decisions made with respect to the participant accounts were prudent, the court dismissed this issue virtually without comment. Later in the opinion, however, the court did recognize the fact that a fiduciary cannot delegate away its monitoring duties when it stated with respect to the profit sharing funds that Yager would not be "fulfilling his trustee duty of care and prudence" if he had delegated the decision-making authority over the profit sharing funds to anyone else. Delegating investment duties to the participants with respect to the 401(k) funds is functionally equivalent to delegating those duties over the profit sharing funds, but the court failed to consider this parallel.
The Court's Errors
As noted, we do not disagree with the court's conclusion that trustees may delegate the authority to make account-level investment decisions to participants. Indeed, we accept the court's concept of an implied exception regarding this right to delegate . . . up to a point. After all, by creating a "liability shield" in Section 404(c) for participant control of their own accounts, it seems apparent that Congress intended that participants could be given the opportunity to manage the investments in their accounts, even though this right to delegate control is not stated explicitly in ERISA.
Where the court goes astray, in our view, is in the breadth of its "implied exception." That is, what the court seems to mean by the implied exception is not just that the fiduciaries may permit the participants to make asset allocation decisions, but that this shifts the responsibility-—and thus the liability-—for the prudence of those decisions to participants in the same way the responsibility may be explicitly shifted to an investment manager. In the Seventh Circuit court's view, this shift occurs regardless of whether the plan complies with 404(c) or not.
The 404(c) regulation sets out numerous requirements for a plan to be 404(c) compliant, including the obligation to provide a broad range of investment alternatives and disclosure of certain information to participants. If a plan meets all of these requirements, then the statutory shield may be relied on by the fiduciaries. But, as explained below, the court points to language from the 404(c) preamble as a basis for creating the "implied exception" that 404(c) is not the exclusive means by which fiduciaries may obtain relief from liability for imprudent investing by participants.
This is a misreading of the DOL's intent in the preamble. The quoted language was intended to clarify a number of things:
- The Yager court misinterpreted the provision in the 404(c) preamble that non-complying plans did not violate ERISA. The reference to whether the failure to comply with the 404(c) conditions is a violation of ERISA and not to whether imprudent participant investing is a fiduciary breach...it is. The failure to comply with the DOL regulation is not, and cannot be, a violation of ERISA; instead, 404(c) is a defense to a claim of a breach of fiduciary duty that is available to fiduciaries should they avail themselves of it...by satisfying the 20 or more conditions in the regulation.
- If participants invest prudently even though a plan does not comply with 404(c), there is no ERISA violation. That is, the breach in this case could only arise if the participants invested imprudently.
- Compliance with the regulation's requirements does not relieve the fiduciaries of their obligations under ERISA prudently to select and monitor the investment options offered by the plan to the participants. Thus, even with 404(c) compliance, there could be losses attributable to fiduciary breaches because of the failure to select prudently and monitor the investment options.
- Even if the fiduciaries comply with the 404(c) requirements, this does not necessarily mean that the fiduciaries have met their obligations under ERISA Section 404(a), which sets forth the general duties of fiduciaries.
The quoted language from the preamble notes that "noncompliance. . . results in the plan not being accorded the statutory relief described in Section 404(c)." The court construes this to mean that Section 404(c) is nothing more than a safe harbor, and, therefore, that it is one (but not necessarily the only) way for fiduciaries to avoid liability in connection with the transfer of investment direction to the participants. What the court fails to understand is that the DOL’s statement meant that the result of the consequences of the failure to comply with the 404(c) requirements is that the fiduciaries do not get relief from liability for imprudent investment decisions by the participants. Rather than describing a safe harbor, the 404(c) regulation describes the only way to obtain relief from liability, not one way to obtain it.
More importantly, the relief granted by 404(c) is relief from imprudent decision-making by the participants for which the fiduciaries would otherwise be responsible. Nowhere does the court address the issue of the prudence of the participant investment decisions and who is responsible for those decisions. Indeed, it ignores this issue, focusing instead on whether the fiduciary breached his duty in delegating the investment responsibility in the first place and whether, in doing so, he gave the participants adequate information with which to make decisions. The quality of those decisions and who must bear the ultimate liability for those decisions is not addressed. This is a fundamental flaw in the court's decision.
Although we disagree with the court's conclusion that 404(c) compliance is not necessary in order to shift liability to participants for their asset allocation decisions, even if we were to accept the court's rationale, there is another flaw in the decision. The court noted that the issue comes down to an analysis of whether Yager breached his fiduciary duties in delegating investment direction to the participants, but it dismisses without comment the most fundamental aspect of that duty: the obligation to select prudently and thereafter monitor the performance of another fiduciary to whom investment responsibility has been delegated. That is, the general proposition under ERISA is that the delegating fiduciary remains responsible for the investment decisions made by another fiduciary, unless the delegation is made to an investment manager or, in the case of participant-directed plans, the plan complies with Section 404(c) and the related regulation.
The court missed several important concepts in its analysis. First, under ERISA, anyone with discretion or control over plan assets is a fiduciary. This would include plan participants, were it not for a key feature of Section 404(c), which states that--if the 404(c) conditions are satisfied—-participants who are permitted to control their accounts are not considered fiduciaries. As other courts have held, the appointment of a fiduciary is a fiduciary act, and the appointing fiduciary has the duty to select prudently and monitor those whom it appoints. [See, e.g., the opinion in Tittle v. Enron, referred to earlier.] Thus, unless the plan complies with 404(c), the participants who direct their accounts are fiduciaries; in this case, Yager had a duty to select them prudently and to monitor their performance. There is no discussion of whether this took place-—indeed, it is highly doubtful-—so, at a minimum, the case should have been sent back to the trial court for development of the facts and analysis of whether Yager breached his duty on this issue.
With respect to the issue of providing information to the participants to enable them to make informed investment decisions, the 404(c) regulation (as well as the preamble which the court quoted) makes it clear that participants must be given all information that is relevant to their investment decisions, then goes on to list, in detail, the information that must be provided to them, at a minimum. Although not entirely clear, Yager does not appear to have provided some of the information required by 404(c), but nowhere near the level of detailed information contemplated by the regulation. But the court concluded that he provided enough information. In essence, the court is substituting its view of "enough" for that of the DOL, even though under ERISA Section 404(c)(l) the DOL (and not the court) has the authority to make this determination. At the very least (even if the court's second implied exception is accepted), the statements of the DOL in the regulation regarding the information that must be provided to participants would seem to be the guide for a court in analyzing whether a fiduciary met his obligation to provide all relevant information to the participants. The Yager court makes no effort to conduct this analysis.
Further, courts have routinely held, and the Yager court acknowledges, that a fiduciary has an obligation to monitor the performance of plan investments and the use of those investments-—the investing. Under the statutory construct of ERISA, this is not the case only if the plan or fiduciaries has/have properly made a delegation to a named fiduciary, an investment manager, or the plan participants, if, in the latter case, the plan complies with 404(c). Because of the "implied exception," the court apparently concludes that Yager had no responsibility to monitor the prudence of the allocation decisions made by the participants even though the plan did not comply with 404(c). We disagree based on other court decisions, positions taken by the DOL, and our own reading of 404(c).
If the court's implied exception is followed, it makes 404(c) meaningless and irrelevant (as it provides fiduciary protection with less effort and less information than is required for 404(c) compliance). Under the court's view, a fiduciary may avoid liability for the prudence of participant investment decisions by providing the participants with a minimal level of information and then standing back and taking no further action; and fiduciaries may avoid liability by ignoring the outcome of the participants' investment decisions and without taking any action to monitor those decisions-—all without worrying about whether the plan complies with 404(c). If that was intended, then why did Congress go to the trouble of including 404(c) in the law and why did the DOL go to the trouble of drafting a detailed regulation explaining what is required in order for a participant to be deemed to be exercising control, going through two rounds of public comment and three separate iterations of the requirements in the process?
The Yager decision is fundamentally flawed. Nevertheless, it is the law in the Seventh Circuit, covering the states of Illinois, Indiana, and Wisconsin. Whether federal courts in other parts of the country will find the Yager court's reasoning to be persuasive is unclear, but bear in mind that it is not the law in the other 47 states. Fiduciaries in those states are well advised to follow the terms of the 404(c) regulation carefully if they wish to obtain relief from imprudent participant investment decisions.
The Seventh Circuit implies a feature of ERISA that at one level makes sense: there is an implied ability to transfer the right to make investment decisions to the participants even though ERISA does not explicitly so state. The court's second implied exception fails to follow other explicit features of the law and may render a section of the law meaningless. In a statutory scheme that the Supreme Court has said is "highly reticulated" and must be strictly interpreted, the Seventh Circuit court has detoured down a side road by reading into the law not only the ability to transfer a right but the ability to shift liability. In the process, the court ignored duties imposed on fiduciaries to monitor the performance of other fiduciaries and has allowed a shift in legal responsibility without compliance with an explicit section designed to address precisely the question that was before the court.