How Not to Operate a 401(k) Plan

Recent ERISA case offers key takeaways for plan fiduciaries that receive revenue in exchange for providing services to their own retirement plan.

W. Scott Simon


To keep myself from going cross-eyed permanently, I thought it might be a good idea to take a break from reading the 1,023 pages of the new conflict of interest rule issued on April 6 by the U.S. Department of Labor (DOL) plus the widespread commentary it has generated.

Instead, I’d like to write about a case that crossed my desk last week. Apart from the case’s startling facts, what caught my eye was the name of the defendant: City National Bank (CNB). Back when I practiced law in Los Angeles, I had the opportunity at one point to interview for a job in CNB’s legal department in Beverly Hills. CNB was known as “The Bank to the Stars” for its many ties to the movie industry–perhaps in the most literal sense when CNB purportedly advanced the ransom money that Frank Sinatra paid to (successfully) rescue his kidnapped son. I didn’t get the job at CNB, but throughout that process was very impressed with the professionalism of all I had come into contact with there.

So imagine my surprise when last month a federal district court judge nailed CNB for incomplete record-keeping concerning the bank’s own 401(k) plan–sloppiness that one would expect more from a mom-and-pop business operating a plan. The judge found that the bank had engaged in self-dealing (among other things), which is strictly verboten under the Employee Retirement Income Security Act of 1974, as amended (ERISA).

The Facts

In April 2015, the DOL filed a complaint against a number of defendants concerning the City National Corporation Profit Sharing Plan (the Plan). (As of Dec. 31, 2014, the Plan had $660 million in assets with just over 4,300 active, retired, and separated participants as well as beneficiaries.) The Plan is a 401(k) defined contribution plan created for the benefit of employees of CNB and those of City National Corporation (CNC), and funded by employee and employer contributions. CNC is the parent company of CNB. City National Asset Management (CNAM), a division of CNB, provided investment advisor services to Plan participants. City National Securities, Inc. (CNS), a wholly owned subsidiary of CNB, provided broker-dealer services.

In April 2000, CNC and CNB agreed that CNB would provide trust and record-keeping services to the Plan. This agreement permitted CNB to receive “reasonable fees” for its services based on published fee schedules or as agreed to by CNC and CNB. The fee schedules also allowed CNB to receive “additional reasonable compensation” for its services in the form of mutual fund revenue-sharing payments garnered from mutual funds offered as investment options in the Plan.

According to the Plan documents, CNC was the Plan’s “Sponsoring Employer,” named fiduciary, and Plan Administrator with the authority to control and manage the Plan’s operation and administration. Also pursuant to them, CNC appointed a Benefits Committee to take actions to administer the Plan as it deemed appropriate in its sole discretion, including selecting the Plan’s investment options. The Plan’s trust agreement identified CNB as the Plan’s Trustee and, in that capacity, CNB was entitled to “reasonable compensation for its services” at a rate to be agreed upon by CNB and the Benefits Committee.

In July 2009, the DOL notified CNC that it was conducting an investigation into possible ERISA violations relating to the Plan. Although, as noted, the DOL described events as far back as 2000, it focused on an investigative period from Jan. 1, 2006, through June 1, 2012 (almost 6 1/2 years).

From 2000 to 2008, CNB received mutual fund revenue directly from those funds in which the Plan was invested on a monthly or quarterly basis. During this period, CNB kept track of mutual fund revenue it received per fund–but not for the Plan itself. In addition, CNB received its mutual fund revenue largely on an automated basis and, as a matter of course, wasn’t required to provide formal documented requests in order to receive this revenue nor did it have to show proof of its direct expenses incurred in servicing the Plan.

In 2008, Fidelity became the custodian of the mutual fund assets in the Plan. It received mutual fund revenue on a periodic basis, retained its commission of 2.5 basis points, and passed the remainder to CNB. Once Fidelity became involved, the process by which CNB received mutual fund revenue-sharing became even more automated. CNB viewed mutual fund revenue-sharing as its compensation for providing services to the Plan.

The Benefits Committee had fiduciary responsibility for overseeing and approving the Plan’s fees. At a meeting in February 2008, a Committee member noted that CNB’s service provider fees “may be high for this Plan” vis-à-vis the market, and suggested reducing the Plan’s fees from an average of 32 basis points to 26. This was approved, as was a further reduction of 2 basis points in July 2009.

The Benefits Committee also had fiduciary responsibility for selecting the mutual fund investment options for the Plan. Since 2000, CNAM (as noted, a division of CNB) provided investment advice and recommendations to the Benefits Committee about which mutual funds to select for the Plan. Although CNAM didn’t specifically charge the Benefits Committee for these services, nonetheless its fees were incorporated into the mutual fund revenue-sharing that CNB received for its work as a Plan service provider. From 2006 through 2010, the Benefits Committee never discussed any potential conflicts of interest in having CNB, a Plan fiduciary, service its own Plan in exchange for compensation approved by its high-ranking, salaried employees serving on the Benefits Committee. Nor did the Benefits Committee discuss that CNB, as fiduciary, was only entitled to reimbursement of direct, verifiable expenses it incurred in servicing the Plan.

In October 2010, CNB retained Mercer Consulting to independently review the Plan, its investments and fees. The result was the “Mercer Report” presented to the Benefits Committee in December 2010. Among other things, it found that CNB received an average of 21 basis points in mutual fund revenue-sharing for its Plan service provider fees compared to other like entities that charged an average of 9-11 basis points for plans of equivalent size and number of participants. The Mercer Report also found that a) none of Mercer’s clients or affiliates that provided record-keeping services to their own plans did so for a profit; instead, they charged only direct expenses back to the plans; b) DOL Advisory Opinions 89-09(A) and 93-06(A) state that when a plan receives services from a plan fiduciary, the fiduciary is responsible for documenting that the plan has paid no more than “direct expenses” and that these services will often be provided at a significantly lower price than those provided by a third party, which is usually why a plan fiduciary goes in-house to provide such services; and c) a plan fiduciary’s business expenses may constitute reimbursable direct expenses from the plan but only if detailed records are maintained to determine the appropriate amount allocable to the plan.

At the end of 2011, the Benefits Committee decided to bring all of CNB’s mutual fund revenue for the Plan in line with market rates and lower CNB’s average fees for that year down to 10-12 basis points. At no time, however, did CNB ever retroactively refund to the Plan the fees that had been paid to CNB. This was even true for the year 2008 when CNB’s own analysis showed that it received fees in excess of the expenses that it incurred.

The DOL’s Argument and CNB’s Counter-Argument

The DOL framed the case as one where the proverbial fox was guarding the chicken coop. That kind of situation, according to the DOL, was precisely why ERISA was enacted: to protect employee benefit plans and their participants. (The DOL’s view comports with my own as described in my October 2013 column: “[A] fiduciary is someone who protects those (with whom the fiduciary has a legal relationship) that are not in a position, for whatever reason, to protect themselves.”)

To paraphrase the DOL’s complaint: CNB contracted with its own parent company, CNC, to provide in-house record-keeping and trust services to their own Plan and then charged millions of dollars in fees that were rubber-stamped by a Benefits Committee consisting entirely of salaried CNB employees who repeatedly remarked about the Plan’s high fees but did nothing to refund years of overpayment to CNB. This self- dealing arrangement continued unchecked for a decade until a third-party consultant informed CNB that the fees it charged the Plan were twice as high as the market, and that a fiduciary cannot make a profit from its own Plan but is able to receive only reimbursement for limited, verifiable direct expenses.

Note that the DOL didn’t take the position that Plan fiduciaries cannot provide services to their own retirement plan. On the contrary, it said that Plan fiduciaries may freely do so–but only if that decision was not made lightly–that as in-house fiduciary service providers, they met rigorous requirements to show compliance with ERISA’s stringent fiduciary obligations, acted prudently, did not profit off their own plan, and that any revenue they chose to receive from their plan for Plan services are reimbursable only to the extent of the verifiable, direct expenses they incurred in servicing the plan.

These strict requirements exist to avoid the obvious problem presented by a fiduciary selecting itself to provide a service to its own plan and then deciding on its own how much it should be paid for that service. A Plan fiduciary is simply not permitted to determine whether or not its own compensation is “reasonable” in relation to the value of the services for which they’re expended pursuant to ERISA section 404(a)(1)(B).

That’s just ERISA 101.

CNB countered by noting that the DOL’s “core theory of fiduciary breach is that CNB and its affiliates received more in mutual fund revenue sharing and other fees from the Plan than those same entities incurred in direct expenses when providing services to the Plan.” In short, [t]he only materially relevant facts in determining liability are the amount of fees, the amount of direct expenses, and whether the former exceeds the latter.” Further, “[t]he direct expenses incurred by CNB, CNS, and CNAM here are thus potentially dispositive of all of [the DOL’s prohibited transaction] claims–for, if it can be shown that [the] direct expenses [of CNB, et al.] exceeded Plan-related administrative revenues over the relevant time period, no [prohibited transaction] claim can be sustained.”

According to CNB, the problem here lies with the DOL in that it failed “to offer any evidence regarding either the amount of revenue sharing paid or the amount of direct expenses incurred by CNB, CNS, and CNAM in providing administrative services to the Plan (e.g., recordkeeping, trust, brokerage, investment consulting)–and the evidence offered by defendants shows that direct expenses, which would not have been incurred but for their provision of services to the Plan, far exceeded Plan-related administrative revenues over the relevant time period.”

The DOL replied to CNB’s complaint that the DOL offered no evidence of CNB’s revenue or expenses. With respect to direct expenses, the DOL didn’t present such evidence simply because it’s CNB’s obligation as Plan fiduciaries to ensure that if they receive money for Plan work, they receive not a penny more than actual and proper direct expenses incurred in servicing the Plan. It’s not the DOL’s role to tell CNB what their direct expenses are or should be. With respect to revenue, the DOL showed clearly that CNB received compensation for Plan work by presenting CNB’s internal records of fees paid by the Plan. Any additional information regarding revenue received by CNB can be secured readily by the accounting the DOL requested as a remedy.

I think the real problem in this case was sloppy bookkeeping by CNB. CNB failed to provide any records (such as contemporaneous time records) that could identify with specificity the direct expenses actually incurred by it in servicing the plan. Instead, CNB created a “Direct Cost Analysis” that was based merely on averages and estimates of expenses–not specific, direct expenses that it actually incurred. In short, then, CNB presented no evidence of direct expenses actually and properly incurred by CNB in servicing the Plan. And yet, it was CNB that was in the best position–not the DOL–to calculate Plan losses given their internal records of compensation from the Plan. Moreover, given that these losses occurred as a result of CNB’s fiduciary failure, CNB should bear the expense of the accounting.

The Court’s Decision

The federal district court judge granted the DOL partial summary judgment against CNB, CNC, and seven members of the Benefits Committee for:

  1. Failing as Plan fiduciaries to act prudently and for the exclusive purpose of providing benefits to the participants (and their beneficiaries) in the Plan (ERISA section 404(a)(1)(A) and (B));
  2. Violating ERISA’s prohibitions against fiduciary conflicts of interest (ERISA section 406(b)(1) and (2));
  3. Being jointly and severally liable as co-fiduciaries for the foregoing violations (ERISA section 405(a) and section 409(a)).

The Court’s Remedy

The monetary remedy fashioned by the judge was a return of all CNB’s compensation to the Plan plus lost opportunity costs. More specifically, CNB’s compensation included 1) all mutual fund revenue that CNB received from the Plan for its service provider work from Jan. 1, 2006, to June 1, 2012; and 2) all IDA fees CNB received from Plan participants from Jan. 1, 2006 through Dec. 31, 2010, for CNAM and CNS services. The DOL estimated this compensation to be in excess of $6 million. CNB and the other defendants were also ordered to perform an accounting on the Plan’s losses with the assistance of an independent fiduciary, subject to review and amendment by the DOL, and approval by the judge.

The Moral of the Story

When the DOL comes knocking at your door, pay attention to them. If the DOL has been investigating you for some time–like seven years but reaching back a decade– and then demands that you pay up, bite the bullet and do so. Don’t rely on legally incorrect arguments and silly defenses, especially when two of your Plan fiduciaries admit in deposition testimony in 2010/2011 that they had no idea that CNB, as a Plan fiduciary service provider, couldn’t receive reimbursement of direct expenses it had incurred in servicing the Plan unless it provided verifiable evidence of same instead of just estimates and averages. Bite the bullet, apologize to your employees (while reminding them that you have always been generous in your employer matches) and avoid the headline risk of a federal district court judge in your own backyard upbraiding you in a written legal opinion that could make you look incompetent in the eyes of the world, including your customers and own employees.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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