8.3 Fiduciary Standards, Duties & Prohibited Transactions

Fiduciary Standards, Duties & Prohibited Transactions

Quick Answer: Under ERISA Section 3(21)(A), fiduciary status is functional—anyone who exercises discretionary authority over plan management, controls plan assets, or provides investment advice for compensation is an ERISA fiduciary. Plan actions are strictly bifurcated into Settlor Functions (business decisions like plan design and amendment, not subject to ERISA) and Fiduciary Functions (plan administration and asset management, subject to strict fiduciary duties). Under ERISA §404(a), fiduciaries must satisfy four core duties: Loyalty, Prudence (Prudent Expert rule), Diversification, and Adherence to Plan Documents. ERISA §406 strictly prohibits party-in-interest transactions and self-dealing, while ERISA §412 mandates a fidelity bond equal to 10% of plan funds handled.

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1. Defining the ERISA Fiduciary: Named vs. Functional Fiduciaries

Under ERISA, fiduciary status is not determined solely by corporate titles, committee appointments, or contractual disclaimers. Instead, ERISA establishes a functional definition of fiduciary status under ERISA Section 3(21)(A).

┌────────────────────────────────────────────────────────────────────────┐
│               THE THREE PRONGS OF ERISA FIDUCIARY STATUS [§3(21)(A)]   │
├────────────────────────────────────────────────────────────────────────┤
│ A person is a fiduciary to the extent they:                            │
│                                                                        │
│  1. Discretionary Management & Control:                                │
│     Exercise ANY discretionary authority or control respecting plan    │
│     management, or ANY authority/control over plan assets.             │
│                                                                        │
│  2. Investment Advice for Direct/Indirect Compensation:                │
│     Render investment advice regarding plan moneys or property for a   │
│     fee or other direct/indirect compensation.                         │
│                                                                        │
│  3. Discretionary Administration:                                      │
│     Exercise ANY discretionary authority or discretionary              │
│     responsibility in the administration of the plan.                  │
└────────────────────────────────────────────────────────────────────────┘

Named Fiduciaries vs. Functional Fiduciaries

• Named Fiduciaries (ERISA §402(a)(1)): Individuals or corporate committees explicitly identified in the written plan instrument (e.g., the "Plan Benefits Committee" or "Chief Financial Officer") who possess overarching operational and management authority.
• Functional (De Facto) Fiduciaries: Any individual or entity that actually performs fiduciary functions or exercises discretionary decision-making, even if the plan document explicitly states they are not a fiduciary.

Ministerial (Non-Fiduciary) Functions (29 CFR §2509.75-8)

The Department of Labor's Interpretive Bulletin 75-8 clarifies that individuals who perform purely ministerial, administrative, or clerical duties within a framework of policies, rules, and procedures established by others are NOT fiduciaries. Non-fiduciary ministerial activities include:

• Applying rules determining eligibility for participation or benefits.
• Calculating service and compensation credits based on plan formulas.
• Preparing government filings (Form 5500) and employee communication materials.
• Collecting contributions and processing routine benefit claims within strict guidelines.
• Orientation of new participants and advising employees of their rights.

Investment Governance Fiduciary Tiers: 3(21) vs. 3(38) vs. 3(16)

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2. Settlor Functions vs. Fiduciary Functions

Under established Supreme Court doctrine (Lockheed Corp. v. Spink, 1996; Hughes Aircraft Co. v. Jacobson, 1999), employers wear two distinct hats when sponsoring employee benefit plans: the hat of the Settlor (business owner/employer) and the hat of the Fiduciary.

┌────────────────────────────────────────────────────────────────────────┐
│                     SETTLOR VS. FIDUCIARY DUALITY                      │
├───────────────────────────────────┬────────────────────────────────────┤
│ Settlor Functions (Business)      │ Fiduciary Functions (Plan Trust)   │
├───────────────────────────────────┼────────────────────────────────────┤
│ • Deciding to establish a plan    │ • Selecting and monitoring vendors │
│ • Choosing plan design & features │ • Investing plan assets            │
│ • Setting eligibility rules       │ • Interpreting plan provisions     │
│ • Amending benefit formulas       │ • Adjudicating claims & appeals    │
│ • Terminating the plan            │ • Distributing SPDs, SMMs, 5500s   │
├───────────────────────────────────┼────────────────────────────────────┤
│ NOT subject to ERISA fiduciary    │ STRICTLY GOVERNED by ERISA §404(a) │
│ standards; expenses CANNOT be     │ standards; reasonable expenses     │
│ paid from plan assets.            │ CAN be paid from plan assets.      │
└───────────────────────────────────┴────────────────────────────────────┘

Allocation of Plan Expenses: The Fiduciary Asset Rule

Plan assets held in trust can never be used to defray expenses associated with settlor functions (e.g., corporate legal fees for drafting plan formation documents, union bargaining analysis, or consulting studies on corporate restructuring). Paying settlor business expenses from plan trust assets constitutes an immediate breach of the Duty of Loyalty and an illegal transfer of plan assets under ERISA §406(a)(1)(D).

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3. The Four Core Fiduciary Duties (ERISA §404(a))

ERISA Section 404(a)(1) codifies the four bedrock duties that govern all fiduciary conduct, drawing from traditional common law of trusts but establishing higher federal statutory standards:

┌─────────────────────────────────────────────────────────────────────────┐
│               THE FOUR BEDROCK FIDUCIARY DUTIES [§404(a)(1)]            │
├───────────────────────────────────┬─────────────────────────────────────┤
│ 1. Duty of Loyalty (§404(a)(1)(A))│ Solely in interest of participants; │
│    (Exclusive Benefit Rule)       │ Exclusive purpose of paying benefits│
├───────────────────────────────────┼─────────────────────────────────────┤
│ 2. Duty of Prudence (§404(a)(1)(B))│ Prudent Expert Standard; Procedural │
│    (Prudent Person Rule)          │ rigor and thorough investigation    │
├───────────────────────────────────┼─────────────────────────────────────┤
│ 3. Duty to Diversify (§404(a)(1)(C)│ Minimize risk of large portfolio    │
│    (Diversification Mandate)      │ losses across asset classes         │
├───────────────────────────────────┼─────────────────────────────────────┤
│ 4. Duty of Adherence (§404(a)(1)(D)│ Follow plan documents strictly      │
│    (Document Compliance)          │ insofar as consistent with ERISA    │
└───────────────────────────────────┴─────────────────────────────────────┘

1. The Duty of Loyalty (Exclusive Benefit Rule — §404(a)(1)(A))

A fiduciary must discharge all duties solely in the interest of the participants and beneficiaries and for the exclusive purpose of: (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan. Fiduciaries must subordinate all corporate, employer, and personal interests to the financial well-being of plan participants.

2. The Duty of Prudence (Prudent Expert Standard — §404(a)(1)(B))

A fiduciary must act "with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims."

• Prudent Expert Standard: Prudence is not judged by the standard of an ordinary layperson, but by the standard of a knowledgeable, experienced professional familiar with employee benefit operations.
• Procedural Prudence: Courts evaluate prudence based on the process followed rather than the ultimate investment outcome (Tibble v. Edison International, 2015). A fiduciary who follows a thorough, well-documented investigation, consults qualified independent experts, and monitors ongoing performance will not be held liable simply because an investment underperformed.

3. The Duty to Diversify Plan Investments (§404(a)(1)(C))

A fiduciary must diversify the investments of the plan to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so. Fiduciaries must avoid over-concentration in single securities, asset classes, geographic regions, or industry sectors.

4. The Duty to Follow Plan Documents (§404(a)(1)(D))

A fiduciary must administer the plan strictly in accordance with the documents and instruments governing the plan, insofar as such documents are consistent with the provisions of Title I and Title IV of ERISA. If a plan document provision violates ERISA (e.g., an outdated vesting schedule), the fiduciary is legally required to follow ERISA over the plan document.

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4. Prohibited Transactions (ERISA §406) & Exemptions (§408)

To prevent conflicts of interest and self-dealing, ERISA Section 406 creates strict per se prohibitions against specific transactions, regardless of whether the transaction was executed in good faith or resulted in a financial gain for the plan.

┌────────────────────────────────────────────────────────────────────────┐
│                     ERISA PROHIBITED TRANSACTIONS                      │
├───────────────────────────────────┬────────────────────────────────────┤
│ Party-in-Interest Transactions    │ Fiduciary Self-Dealing             │
│ (ERISA §406(a))                   │ (ERISA §406(b))                    │
├───────────────────────────────────┼────────────────────────────────────┤
│ Prohibits direct or indirect:     │ Prohibits a fiduciary from:        │
│ • Sale, exchange, or lease of prop│ • Dealing with plan assets for own │
│ • Lending money or credit ext.    │   account or interest (§406(b)(1)) │
│ • Furnishing goods or services    │ • Acting in a transaction involving│
│ • Transfer / use of plan assets   │   an adverse party (§406(b)(2))    │
│ • Holding excess employer stock   │ • Receiving kickbacks/commissions  │
│   (10% DB limit under §407)       │   from third parties (§406(b)(3))  │
└───────────────────────────────────┴────────────────────────────────────┘

Who is a "Party in Interest" (ERISA §3(14))?

A party in interest includes: (1) any plan fiduciary, counsel, or employee; (2) any person providing services to the plan (TPAs, brokers, recordkeepers, actuaries); (3) the sponsoring employer; (4) an employee organization (union); (5) a 50%+ owner of an employer/union; and (6) relatives (spouses, ancestors, lineal descendants) and business affiliates of the above.

Statutory Exemptions (ERISA §408) & Service Provider Disclosures

Because §406(a) would technically ban a plan from hiring any service provider (as furnishing services is prohibited), Congress enacted statutory exemptions under ERISA Section 408:

• ERISA §408(b)(2) Service Contract Exemption: Permits plans to contract with parties in interest for office space, legal, accounting, TPA, or other necessary services, provided: (1) the service is necessary for the operation of the plan; (2) the contract is reasonable; and (3) no more than reasonable compensation is paid.
• Mandatory Fee Disclosures under §408(b)(2) & CAA 2021: Covered service providers (pension recordkeepers, investment consultants, health insurance brokers, and PBM consultants) must provide detailed advance written disclosures of all direct compensation (fees paid directly from plan assets) and indirect compensation (commissions, finder's fees, 12b-1 fees, or revenue-sharing paid by third-party carriers) exceeding statutory thresholds ($1,000 for health brokers under CAA 2021) prior to entering or renewing a contract.

Penalties for Prohibited Transactions (IRC §4975)

Under Internal Revenue Code §4975, the IRS assesses a mandatory two-tier excise tax on disqualified persons engaging in prohibited transactions:

1. First-Tier Tax: An excise tax equal to 15% of the "amount involved" for each year in the taxable period.
2. Second-Tier Tax: If the transaction is not corrected within the taxable period, an additional excise tax equal to 100% of the amount involved is assessed.

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5. Liability Mitigation: Co-Fiduciary Liability, Bonding & Insurance

┌─────────────────────────────────────────────────────────────────────────┐
│               CO-FIDUCIARY LIABILITY TRIGGERS [ERISA §405(a)]           │
├───────────────────────────────────┬─────────────────────────────────────┤
│ 1. Knowing Participation          │ Knowingly participates in or        │
│                                   │ conceals a co-fiduciary's breach    │
├───────────────────────────────────┼─────────────────────────────────────┤
│ 2. Enabling Breach                │ Fails to comply with §404(a),       │
│                                   │ enabling another fiduciary's breach │
├───────────────────────────────────┼─────────────────────────────────────┤
│ 3. Failure to Remedy              │ Has knowledge of a breach and fails │
│                                   │ to make reasonable remedial efforts │
└───────────────────────────────────┴─────────────────────────────────────┘

Co-Fiduciary Liability (ERISA §405(a))

A fiduciary cannot escape liability by ignoring the misconduct of fellow trustees. If a fiduciary knows that a co-fiduciary has breached a duty, they must take reasonable steps to remedy the breach (e.g., formally protesting, refusing to execute transactions, or notifying the Department of Labor).

ERISA §412 Mandatory Fidelity Bonding vs. Fiduciary Liability Insurance

One of the most critical legal distinctions tested on CEBS examinations is the difference between mandatory fidelity bonding and optional fiduciary liability insurance:

Exculpatory Clauses Void (ERISA §410(a)): Any provision in an agreement or plan document that purports to relieve a fiduciary from responsibility or liability for any fiduciary breach is completely void as against public policy.