Beware the Pitfalls in Shopping for Fiduciary Liability Insurance

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By Michael G. Kushner, Esq. Curtis, Mallet-Prevost, Colt & Mosle LLP, New York, NY

This is the time of year when many companies are in the process of renewing their executive insurance policies, including their ERISA fiduciary liability insurance coverage. Although many companies assume that this coverage already is included under their general directors' and officers' (“D&O”) liability policies, often such coverage either is inadequate to cover fiduciary acts under ERISA by such persons or excludes ERISA claims entirely. In general, companies and their sponsored plans will need to purchase separate fiduciary liability insurance to make certain that fiduciary acts performed by officers, directors and employees of either the employer, its subsidiaries or its sponsored pension and welfare benefit plans are covered.

Due to the rapidly increasing volume of litigation against ERISA fiduciaries, beginning with cases like Enron and escalating rapidly due to participants' massive pension and 401(k) losses incurred during the 2007-09 market collapse, however, fiduciary liability insurers have been dramatically cutting back coverages that used to be routine, often by adding exclusionary endorsements as old policies come up for renewal. In some cases, alternative coverage cannot be obtained; in other cases it can, but at the cost of an additional premium charge.

Quite simply, many of today's fiduciary liability policies often do not cover what employers believe they do and it is important to scrutinize their coverage closely before renewing. The problem of determining what a fiduciary policy does and does not cover is further exacerbated by the fact that certain exclusions or limitations often are placed in sections of a policy where one ordinarily would not expect to find them. This can give insureds a false sense of security. For example, a provision that operates like an exclusion might not appear in the policy's exclusions sections but instead appear in the policy's definitions section, declarations section, coverage section or in endorsements to any of a number of provisions. In addition, most fiduciary insurance policies today contain so many endorsements that it is difficult to examine the policy as a whole to determine what is and is not covered. I generally recommend that, rather than dealing with this unwieldy mass of paperwork, clients and their advisors create their own unofficial “integrated” version of the policy document, incorporating all of the amendments and endorsements to provide a clear picture of what the policy actually provides. Often, this exercise yields surprising results. Sometimes, it will reveal significant gaps in coverage. Sometimes, endorsements will have been added in a confusing manner and may seem to contradict, or be irreconcilable with, other provisions of the policy endorsements. It is not uncommon for endorsements to amend other endorsements repeatedly and imprecisely.

As an insured, the last position that one wants to be in when defending a fiduciary liability claim against a company's employees, officers or directors is to first have to sue the insurer to make sure the claim is covered. Since insurers generally have wide latitude in interpreting the terms of their own policies, so long as their interpretations are not unreasonable, the insured can be at a significant disadvantage. I remember arguing one claim and pointing out to the claims representative that the claim clearly was not excluded under the policy's language. The representative insisted that it was excluded. I pointed out that, if that was the intent, it certainly appeared nowhere in the policy or its endorsements, nor was it reasonably inferable from the language. His response, forever burned in my memory, was “listen, the policy says what we says it says.” It was an eye-opening experience, even for a lawyer to hear this level of bluntness. I stated that a court likely would view this quite differently. He shrugged and gave me one of those “so sue me” looks. And, indeed, if my client wanted to collect, he would have had to do exactly that, in which case it would be necessary to evaluate the potential costs and risks of suing one's own insurer as well as defending the actual claim. Often, it may be less expensive to simply settle or pay the claim. It is therefore important to get things clear upfront, before signing a policy and paying the premium, for in many cases, as a practical matter, the policy says what the insurer says it does unless you are prepared to litigate the matter, which not only is costly and time consuming, but also involves suing the very party you are counting on to be your ally in defending a claim. This is not a good position to find yourself in.

It is therefore imperative to bear in mind that insurers do not add amendatory endorsements lightly. When they are added, they usually cover areas in which an insured is more likely to incur a claim than under a policy's general exclusionary provisions and reflect recent trends in fiduciary litigation.

With that in mind, the following is a list of some of the questions and considerations to consider when negotiating with an insurer over the terms of a fiduciary liability insurance policy covering employee benefit plans and their fiduciaries.

1. Occurrence vs. Claims-Made Basis.Does the policy provide coverage on an occurrence basis or a claims made basis? An occurrence basis is preferable, since it covers all occurrences within a specified time period, regardless of when the claim was made. Claims-made policies only cover claims made during the policy period. Most policies, however, are written on a claims-made basis and obtaining a policy on an occurrence basis can raise the premium significantly.

2. Insurer's Right to Cancel.Policies generally grant the insurer the right to cancel coverage in the middle of a policy term. Formerly, absent fraud or criminal acts, most policies only allowed the insurer to cancel during the policy period if the insured did not pay the premium on time and, even then, after being given notice and an opportunity to cure. Policies now, however, often permit an insurer to cancel for any reason and with little or no notice. Theoretically, an insurer could cancel a policy simply because the insurer viewed the insured as a bad risk. Even the insured's traditional right to purchase an extended reporting period for canceled or expired policies has been undercut as most extended reporting periods now only cover claims made in the extended reporting period that relate back to acts committed before a cancelation or expiration date. Furthermore, lack of adequate notice prior to cancelation (or non-renewal) gives an insured little or no time to obtain alternative coverage and can result in gaps in coverage just when the insured is most vulnerable.

3. Renewal Terms.As few as five years ago, fiduciary liability policies commonly guaranteed the insured the right to renew the policy when coverage expired and guaranteed that the premium for the renewed policy would not exceed the premium for the prior policy term. Although many policies still provide a right to renew, they now often allow the insurer to offer “renewal” at a different premium and on different terms than the prior policy, making the right to renew relatively meaningless.

4. Aggregation of Wrongful Acts.Many newer policies permit the insurer to treat multiple wrongful acts as part of the same wrongful act or as part of an interrelated series of wrongful acts. Usually the terms “wrongful act” and “interrelated series of wrongful acts” are either not defined in the policy or are, at best, vaguely defined. Given that the insurer has first crack at interpreting the policy, this gives an insurer great latitude to determine, on a facts-and-circumstances basis, that a new claim is part of the same claim or series of claims as a prior claim and thereby allocate the new claim back to the period of coverage in which the “first” act occurred. Often, the coverage for such prior period has expired or, even if still in effect since the first claim has already been made, very little of the policy's annual policy limit may remain available to pay this claim. Insureds should either attempt to negotiate the elimination of such aggregation provisions or insist upon clearer, more objective, definitions of “wrongful act” and “interrelated wrongful acts.”

5. Recourse Riders. Insureds should make certain that the policy is written to not give the insurer recourse rights against individual fiduciaries. It is not uncommon for issuers of fiduciary liability insurance who have to pay claims on behalf of an insured company or plan to exercise their subrogation rights against a fiduciary who is a current or former corporate officer, director or shareholder. Where the insurer does not waive recourse against individual fiduciaries, it is imperative that the individual fiduciaries purchase “recourse riders,” under which the insurer waives its subrogation rights against them, at least in cases that do not involve fraud, willful neglect or criminal wrongdoing. Recourse riders, although more expensive than in the past, are still a relatively low ticket item. Remember, however, that recourse riders cannot be purchased with plan assets, without triggering a breach of fiduciary duty. Section 410 of ERISA, however, does allow individual fiduciaries to purchase such riders with their own funds. Alternatively, the plan sponsor can purchase recourse coverage on behalf of its individual fiduciaries.

6. Transactional Definition of Fiduciary. Under §3(21) of ERISA, a fiduciary is defined by the acts or transactions that an individual or entity performs rather than by reference to any official title. Today's fiduciary policies, however, do not generally incorporate the ERISA definition, but rather require the plan sponsor or the plan to specifically name which of its employees, officers or directors are fiduciaries. This can mean that someone who the insured thought was not a fiduciary, but who becomes a fiduciary by exercising discretionary authority or control with respect to the administration of a plan or the investment of its assets (a so-called “inadvertent fiduciary”) may not be covered. One example of this would be when a member of a company's Compensation Committee who is not part of the Plan Committee, nonetheless gives “avuncular” advice to members of the plan committee regarding plan investment policy. Even though the company may not think of this individual as a fiduciary, his actions may have turned him into a one, but not one who is covered under the company's fiduciary policy. If possible, it is always better to negotiate for a policy with a transactional definition of fiduciary to avoid this type of unpleasant surprise.

7. Co-Fiduciary Liability.A fiduciary insurance policy should specifically state that it covers imputed liability under ERISA. Under §405 of ERISA, a fiduciary who aided and abetted another fiduciary in committing a breach or who knew of such a breach and failed to report it or take actions to stop it, can be found jointly and severally liable with the breaching fiduciary. Unless the policy specifically states that it covers co-fiduciary liability, the insured should assume that it does not.

8. Defense Costs.Many fiduciary policies now count any costs of defending an action against the overall policy limit. This means that the insured never can be sure how much of the overall policy limit will be available to any pay damages that may be due. In addition, many policies require the insured to accept defense counsel appointed by the insurer, whose interests may not be fully aligned with those of the insured. Purchasers may wish to consider purchasing a separate defense cost policy with its own limitations. This will both assure that the full limit on liability coverage will be available to pay any claims and can provide the insured the right to name its own defense counsel. Note also that some policies require the insurer to defend a claim even if it later becomes apparent that any liability award will fall outside the scope of the policy, for example, by virtue of one of the policy's exclusionary provisions. Today, however, many policies do not provide separate rules for defense costs and indemnity claims. It is not unusual to see a policy today that allows the insurer to stop paying defense costs once it has become apparent that the action falls outside the policy's indemnity provisions. Again, the initial determination will be made by the insurer and can turn on the interpretation of the surrounding facts and circumstances. This is yet another argument for purchasing a separate defense cost policy; preferably one that operates independently of the fiduciary policy's indemnity provisions.

9. Coverage of New Plans. Formerly, many fiduciary policies were written to automatically cover newly acquired plans if the insured gave advance notice. Many policies no longer include such automatic coverage. Newly acquired plans can come about either through corporate transactions such as mergers and acquisitions or by an employer simply adopting a new plan. If a policy does not provide automatic coverage to new plans, it may be possible to either negotiate this language or to purchase an endorsement that will provide such coverage. Along similar lines, the insured should make certain that when a plan that is spun off, merged or terminated, coverage will continue for all wrongful acts up to and including the time that the plan went out of existence. Again, it may be necessary to purchase a special endorsement to achieve this result.

10. Naming Specific Plans. Many policies are unclear about which plans they cover. For example, it may be clear that a fiduciary policy covers plans that are subject to Title I of ERISA, but not others, such as nonqualified compensation arrangements, certain severance plans and certain welfare benefit plans. Purchasers should attempt to negotiate the right to name specific plans as being covered to make certain they are covered in the event that the general policy coverage language is ambiguous.

11. Punitive Damages and Fines.Most policies will not pay punitive damages, despite the fact that such damages are awardable under ERISA. It may, however, be possible to negotiate coverage of punitive damages with the insurer or to purchase an endorsement covering such damages which, when rewarded, can exceed actual damages under ERISA. Furthermore, many policies no longer cover fines and sanctions under ERISA. Others cover the 20% penalty tax on fiduciary violations that may be imposed under §502(l) of ERISA. Even if a policy covers the 20% penalty tax, this may not be as meaningful as it appears, as most fiduciary violations also constitute prohibited transactions under ERISA and the Internal Revenue Code. Such transactions, among other things, will be subject to the 15% initial excise tax on prohibited transactions under Code §4975(b), which generally is not covered. As any dollar paid to satisfy the initial excise tax on prohibited transactions counts dollar-for-dollar against the 20% penalty of ERISA §502(l), it is possible that the bulk of the penalty will be paid in uninsured prohibited transaction excise taxes rather than under §502(l). Insureds should attempt to clarify that coverage of the §502(l) penalty tax includes coverage of any prohibited transaction excise taxes that are offset against it.

12. Penalties under VCR and CAP. Many policies either do not cover, or contain substantially lower limits on, fines and sanctions that may be imposed if a plan defect is submitted under the IRS's voluntary compliance resolution (“VCR”) program or closing agreement program (“CAP”), two programs available under the employee plans compliance resolution system (“EPCRS”). While it may appear on its face that a policy's VCR/CAP coverage limit should be sufficient to cover most such submissions, this is the case only if the insurer views the fine or sanction as being limited to that imposed by the IRS and not as including any remedial actions that the employer, the plan or a fiduciary may be required to take to first cure the plan defect, such as a requirement to make the plan whole for any losses incurred as a result of a breach or defect. Insureds should clarify with insurers that the “make whole” portion of relief under CAP and VCR is considered part of the general remedy required by ERISA and therefore is fully subject to the policy's overall coverage limitations and that the lower VCR and CAP limits apply only to IRS fines and sanctions over and above such ERISA “make whole” remedies, or else the CAP and VCR limits may provide insufficient coverage to pay the claim.

These are some of the key areas of which customers should be aware in purchasing fiduciary liability insurance. In today's litigious environment, it is difficult to duplicate the scope of coverage that has been available in the past and such coverage may only be obtainable at a significantly higher premium. Insureds should be particularly careful to scrutinize policy endorsements to determine which rights are either being eliminated or limited by the insured and how much of a problem this is likely to be for the purchaser. As a practical matter, as well as a matter of fiduciary duty, it is important to solicit competing bids and question insurers closely before purchasing or renewing fiduciary liability coverage.

For more information, in the Tax Management Portfolios, see Kushner, 359 T.M., Multiemployer Plans -- Special Rules, and in Tax Practice Series, see ¶5520, Plan Qualification Requirements.