The ACE Report is a periodic publication distributed to policyholders and other interested parties as a service by ACE. Its purpose is to address insurance concerns worldwide, as well as present timely information on current developments in liability issues surrounding directors and officers. The Editor of The ACE Report is Dan A. Bailey, a lawyer at Arter & Hadden in Columbus, Ohio, USA and a respected voice in the complex area of directors and officers liability.

Although prepared by professionals, this publication should not be utilized as a substitute for legal counseling in specific situations. Readers should not act upon the information contained herein without professional guidance.

THE ERISA FIDUCIARY LIABILITY GIANT: LOOK WHO'S WAKING UP
Since its enactment in 1974, ERISA has imposed stringent duties of care and loyalty upon employee benefit plan fiduciaries. Because any person who exercises discretionary control with respect to the management or administration of a plan or its assets may be personally liable as a fiduciary for violation of any of those duties, ERISA fiduciary liability insurance has been a common component of the insurance portfolio for most large U.S. companies in recent years. However, the frequency and severity of fiduciary claims have historically been modest despite the strict legal standards applicable to fiduciaries and the enormous amount of assets controlled by those fiduciaries. As a result, the pricing and terms of that insurance coverage has historically been quite favorable for insureds.

There is now increasing evidence that this somewhat sleeping giant is stirring and that companies (and their insurers) should expect increased fiduciary liability exposures in the future. Some of the factors supporting this conclusion include the following:

• The frequency of fiduciary claims appears to be significantly increasing.
• The circumstances giving rise to the claims are quite varied and are not attributable to isolated economic or other temporary developments.
• To the extent securities and tort litigation reform succeeds in reducing litigation activity, plaintiff lawyers will be searching for new areas of litigation expertise and are likely to find class action ERISA litigation quite attractive.
• With increasing regularity, courts are now broadly interpreting the scope and effect of fiduciary duties under ERISA.

Two recent court decisions particularly demonstrate this increasing liability exposure and the need for careful loss prevention and comprehensive financial protection for ERISA fiduciaries.

In March 1996, the U.S. Supreme Court ruled that individual plan beneficiaries (not just the plan itself) may directly assert certain breach of fiduciary duty claims under ERISA. Varity Corp. v. Howe, 64 U.S. L.W. 4138 (1996).

In that case, the employer formed a new subsidiary that was insolvent from its inception. To encourage employees to transfer to the new subsidiary, the employer convened a meeting of its employees to assure them that the new subsidiary had bright prospects and a solid financial foundation and that they would continue to receive similar benefits if they agreed to transfer their employment and benefit plan participation to the new subsidiary. Two years later, the new subsidiary filed bankruptcy and the employees who transferred lost their health benefits and then sued the employer. A jury awarded the employees $46 million in damages and the District Court Judge reduced the award to $8.3 million.

In upholding the liability of the employer, the Supreme Court addressed two issues, in both instances delivering a potentially major defeat to employers and plan fiduciaries.

First, the Court ruled that the employer, which also served as plan administrator, acted "in significant part" in the capacity as plan administrator when it convened the meeting of employees to inform them about the post-reorganization benefits. The employer argued that it was acting as an employer, not as a plan fiduciary, when it disclosed to the participants the deceptively rosy financial forecast and the misleading assurance of unchanged benefits. Because the company could have canceled the benefit plan in its capacity as employer, the company argued that disclosures about the future of the plan and its benefits were made in an employer capacity, and thus not subject to ERISA fiduciary duties. However, the Court ruled that reasonable employees could have thought that the company was communicating with them both in its capacity as employer and in its capacity as plan fiduciary. Accordingly, the Court found that the company did not act solely in the interest of the participants (as required of fiduciaries by ERISA) because the company deceived the participants in order to save money at the expense of the participants.

This aspect of the opinion is potentially troubling in at least two respects. First, the high fiduciary duties of ERISA now apply to any company action even if the company only acts in part in the capacity as a fiduciary. Second, in determining whether the employer is acting as a fiduciary, the Court examined the subjective intent and expectations of the participants, thus greatly expanding the participants' ability to seek relief under ERISA.

The second, and even more troubling, issue decided by the Court relates to the ability of plan participants to bring a direct claim against fiduciaries for breach of duty. Many lower court decisions have ruled that only the plan, not individual plan participants, may assert a claim against fiduciaries for breach of an ERISA-imposed duty. The Court, though, authorized such direct claims by individual participants.

As explained in the Court's dissenting opinion, this decision, if applied to the many disputes in which it may logically apply, could result in significantly increased fiduciary liability, or at the very least heightened litigation costs. This new exposure for direct claims alleging misrepresentation is particularly problematic in the employee benefit context since benefit plans are in many respects largely unintelligible as a result of their strict adherence to ERISA and IRS regulations. Participants frequently seek clarification of their rights and benefits under plans. Incomplete and inaccurate representations to individual participants are inevitable, particularly with large plans. This decision could result in an explosion of participant claims for misrepresentation, particularly if courts allow claims for negligent misrepresentation (an issue not addressed by the Supreme Court).

This opinion will also likely result in more claims against companies in their fiduciary capacity rather than in their employer capacity, thus increasing their liability exposure. Because ERISA fiduciary liability insurance policies cover the company only in that fiduciary capacity, the opinion will also result in a larger portion of ERISA claims against the company being covered under the policy.

From a loss prevention standpoint, this opinion reinforces the need to assure that all communications to participants, including responses to individual inquiries, are truthful, accurate and complete. Persons without sufficient training and knowledge should not be involved in those administrative responsibilities. In addition, companies should seek to separate their actions and communications as employers from their actions and communications as fiduciaries. For example, persons serving as plan fiduciaries should be independent from, or at least separately identifiable from, the employer's management.

In another major defeat for fiduciaries, the Third Circuit U.S. Court of Appeals ruled in January 1996 that an employer and its investment committee members were not entitled to dismissal of claims which alleged that they violated ERISA in connection with the purchase of guaranteed investment contracts (GICs) from Executive Life Insurance Company for employees' savings plan accounts. In re Unisys Savings Plan Litigation, 74 F. 3d 420 (3rd Cir. 1996). Participants in the company's individual account pension plans and their unions alleged that the defendants breached ERISA's fiduciaries duties of prudence, diversification and disclosure by permitting the investment of plan assets in the GICs and by providing participants with misleading and incomplete information regarding that investment.

The defendants raised two defenses, both of which are frequently relied upon by ERISA fiduciaries and both of which the Court refused to accept as a basis for dismissal of this litigation. First, the defendants argued that because the plan participants selected the Executive Life GICs from various investment options offered to them by the defendants, the defendants should not be liable for loss resulting from the participants' investment decisions. The Court ruled that this is a valid defense only if (i) the plan fiduciaries offered to the participants a broad range of investments; (ii) the investment options selected by the fiduciaries are reasonable under the circumstances; and (iii) the fiduciaries disclosed information sufficient for the average participant to understand and make informed decisions regarding the investment options. The Court found insufficient evidence to establish the existence of any of these elements to the defense.

With respect to the available investment options, the Court ruled that the descriptions of the plan's six funds did not evidence the existence of investment options sufficiently different from the Executive Life GICs.

With respect to selection of the investment options, the Court rejected the defendants' argument that it relied upon the advice and recommendations of an outside consultant regarding the prudence of the investment options. The Court recognized that fiduciaries may not overly rely upon outside consultants and experts:

The Court ruled that a reasonable fact finder could conclude that the defendants passively accepted the consultant's positive appraisal of Executive Life without conducting the independent investigation that ERISA requires.

With respect to the duty to disclose information, the Court demonstrated the expansive nature of this duty by requiring disclosure of information sufficient for the average participant to understand and assess:

• The control a participant is permitted to exercise under the plan and the financial consequences assumed by exercising that control;
• The rights that ERISA provides to participants and the obligations that ERISA imposes upon fiduciaries;
• The plan's terms and operating procedures;
• The alternative funds the plans offered;
• The investments in which assets in each fund are placed;
• The financial condition and performance of the investments; and
• Developments which materially affected the financial status of the investments.

As this case demonstrates, many plan fiduciaries have falsely believed that requiring participants to select their investments from a menu of options relieves the fiduciaries of liability exposure for imprudent investment decisions. Although such a practice can theoretically reduce fiduciary liability exposure, the conditions imposed by ERISA and the courts to qualify for that defense effectively preclude its applicability in most situations.

This Court decision also emphasizes the importance of adequate loss prevention practices by plan fiduciaries. Regardless of how a plan is structured and what professional advice is obtained, fiduciaries must undertake seemingly extraordinary efforts to assure the plan is operated cautiously and participants are protected to the maximum extent reasonably possible. When the plan and its participants incur significant losses, courts can and frequently do find personal wrongdoing. The liability created by that wrongdoing can be potentially enormous in light of the large amount of assets held in most benefit plans.

NEED FOR AN UMBRELLA IN THE SEXUAL HARASSMENT STORM
As sexual harassment claims continue to increase in both frequency and severity, the importance of adequate insurance coverage for that and other types of employment-related claims becomes more obvious. As explained in the October 1993 edition of The ACE Report, the employment practices liability insurance policy (EPLI) was developed to provide for the first time comprehensive coverage for those claims. An important milestone in the development of that product occurred in March 1996 when XL, ACE and Zurich Insurance Companies announced the availability of a $100 million cooperative EPLI policy, thereby affording for the first time catastrophic limits to large corporations.

Although an EPLI policy can provide valuable coverage for otherwise uninsured risks, D&Os may still face an arguably uninsured exposure particularly for certain types of sexual harassment claims. Both the standard D&O and EPLI policies insure directors and officers for alleged wrongful conduct in their capacity as such. Depending upon the circumstances, a sexual harassment claim against a D&O arguably could allege wrongdoing in a personal capacity rather than in the capacity as a director or officer. For example, wrongful conduct by an officer at an evening social event unrelated to company business may not constitute conduct in a D&O capacity even if the victim was an employee.

Some courts have broadly applied this capacity issue in the context of insurance coverage for sexual harassment claims. For example, the Ninth Circuit Court of Appeals in 1995 ruled that an executive director of a Big Brothers organization who was sued for sexually abusing a "little brother" was found to be sued in an insured capacity and therefore entitled to insurance coverage under the organization's professional liability policy.

However, two California Supreme Court decisions in December 1995 cast some doubt on that issue. In one case, the Court ruled that a male deputy sheriff who sexually harassed female deputy sheriffs did not act within the scope of his employment even though the wrongful conduct occurred during work hours and in the workplace. As a result, the Court ruled that the county was not required to indemnify the defendant harasser.

In the other case, the Court ruled that a hospital was not vicariously liable for its employee's sexual assault of a patient because the employee's acts did not derive from any events or conditions of employment even though the wrongdoing occurred during work hours and in the workplace.

Although it is doubtful that an EPLI insurer would seek to deny coverage for a sexual harassment claim based upon this capacity issue in most claims, the potential for alleged sexual harassment wrongdoing in an uninsured capacity serves as another justification for individual D&Os purchasing personal umbrella liability policies. As President Clinton demonstrated, some umbrella policies may cover at least the defense and perhaps settlements or judgments in a sexual harassment claim that alleges mental anguish or emotional distress. Because umbrella policies typically exclude loss arising out of business pursuits (including service as a director or officer of a for-profit company), the policies should closely dovetail with the EPLI and D&O policies, which respond to the extent the defendant is sued in the capacity as a director or officer.

SECURITIES LITIGATION REFORM: INITIAL EXPERIENCES
The January 1996 edition of The ACE Report summarized the highlights of the Securities Litigation Reform Act of 1995, which significantly changed how securities claims against D&Os and others are prosecuted. Although it is still far too early to identify any trends or actual consequences from the new legislation, one new tactic by the plaintiffs' bar is beginning to emerge which may have intriguing consequences. Plaintiff lawyers are now filing a significant number of shareholder class action claims in state court rather than federal court.

Some of the motivations and consequences of this development include the following:

1. Circumvent New Legislation. The new legislation applies only to claims brought under the 1933 and 1934 federal securities acts and does not apply to any claim brought solely under state or common law. Therefore, by filing a state court class action case, plaintiffs can completely circumvent any protective provision in the new legislation.
2. Multiple Plaintiffs' Counsel. The new federal legislation eliminates the practice of various plaintiff attorneys filing copycat lawsuits in order to become co-counsel in the prosecution of the class action. Under the new statute, the court selects the lead plaintiff based upon the size of shareholdings of each lead plaintiff candidate, and the court-approved lead plaintiff then selects a single law firm to prosecute the claim. A plaintiff lawyer who does not represent a large class member and therefore who will not likely become counsel for the lead plaintiff in the federal litigation can still file a class action in state court with the expectation of leveraging a settlement and fee separate from the federal proceeding.
3. Race to Settle. If parallel federal and state class actions are being prosecuted, the plaintiffs' counsel in each proceeding will have a strong incentive to settle his case first. According to a February 1996 U.S. Supreme Court ruling, a settlement in a state class action can resolve not only the claims asserted in the state court, but also any claims which are pending or could be asserted in a federal securities class action. Therefore, the plaintiffs' counsel in whichever case is first settled could be the only plaintiff counsel to receive a fee. This race to settlement by plaintiffs could inure to the benefit of the defendants under some circumstances.
4. Tag-Along Derivative Suit. D&O derivative suits have been somewhat less common than class actions in recent years because those suits frequently must be brought in state court separate from the federal court class action and because defendants typically have several meaningful defenses which are not available in a securities class action. As state class actions increase in popularity, it appears likely that many of those class actions will also include a tag-along state derivative claim, thus increasing the frequency of derivative suits. Because indemnification of various types of loss in derivative suits may be non-indemnifiable, this development could have a meaningful impact upon D&O insurance coverages and loss experience.

Several important issues will need to be resolved as plaintiffs popularize state class action proceedings. For example, which state laws are most attractive for plaintiffs; will the "fraud-on-the-market" presumption of reliance be adopted by state courts; what level of intentional or reckless conduct by defendants will be required; and will non-resident D&O defendants be subjected to the jurisdiction of the selected state court? These and many other issues will, at a minimum, keep the lawyers and courts busy for years to come and will further delay the time by which one can fully assess the true impact of the new legislation.