The Wrongful Distribution of Retirement Benefits to a Plan Fiduciary is Prohibited by ERISA Section 406(b)

This week’s featured bloggers at the National Law Review are from Cosgrove Law L.L.C.   In the ‘who knew’ category from Kurt J. Schafers:  the wrongful distribution of plan benefits to a Plan Fiduciary.  

Although the distribution of benefits to a plan participant is not a “transaction” as that term is used in Section 406(a), the wrongful distribution of benefits to a plan fiduciary is clearly prohibited conduct under Section 406(b). For example, inLockheed Corp. v. Spink, 517 U.S. 882 (1996), the plaintiff brought suit against his employer (administrator of his 401(k) plan) under Section 406(a)(1)(D) because the employer wrongfully allowed some of its employees to receive early retirement benefits that the plaintiff was unable to receive. Id. at 892-93. The respondent argued that the payment of benefits is not a “transaction” under Section 406(a). 892. In its holding, the Court agreed with the respondent, but made clear that its holding was strictly limited to the language of Section 406(a). Indeed, the Court clarified that “the payment of benefits is in fact not a ‘transaction’ in the sense that Congress used that term in § 406(a).” Id. at 892 (emphasis added).

The narrow scope of Lockheed becomes clear upon a review of subsequent federal caselaw. See Armstrong, 2004 WL 1745774, at *10 (holding “payments to participants in accordance with plan terms not to be transactions within the meaning of [Section 406(a)]”); Owen v. SoundView Financial Group, Inc., 54 F.Supp.2d 305, 323 (S.D. N.Y. 1999) (holding that “ERISA’s “Prohibited Transaction” rules, see 29 U.S.C. §§ 1106(a) [ERISA Section 406(a)]…are not applicable to the payment of Plan benefits to a Plan beneficiary, because the beneficiary is not a “party in interest”). The limited scope of Lockheed is confirmed by the equally limited scope of Section 406(a). For instance, Section 406(a), entitled, “Transactions between plan and party in interest,” is plainly intended to govern only those transactions in which fiduciaries cause a plan to engage. Indeed, Section 406(a)(1) begins with the following language: “A fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect. . . .” (emphasis added). Section 406(a)(1) then lists five narrow types of transactions in which a fiduciary should not cause a plan to engage. Courts have determined that the purpose of Section 406(a) is limited to “prevent[ing] plan fiduciaries from engaging in certain transactions that benefit third parties at the expense of plan participants and beneficiaries.” Armstrong v. Amsted Industries, Inc., 2004 WL 1745774, at *10 (N.D. Ill. 2004); Marks v. Independence Blue Cross, 71 F.Supp.2d 432, 437 (E.D. Pa. 1999).

The limited holding of Lockheed (and the subsequent federal court decisions) does not, however, apply in many cases. Indeed, a plaintiff’s prohibited transactions claim against a defendant may be brought under a completely separate ERISA provision: Section 406(b). This Section, entitled “Transactions between plan and fiduciary,” may more clearly apply to a defendant’s conduct. Importantly, unlike Section 406(a), Section 406(b) does not specifically limit which types of transactions apply to the Section. As such, the “transactions” contemplated under Section 406(b) are much broader in scope than those specifically set forth in Section 406(a). Moreover, rather than aiming to prevent plan fiduciaries from engaging in transactions that benefit third parties at the expense of plan participants and beneficiaries, Section 406(b) aims to prevent—among other things—plan fiduciaries from engaging in prohibited transactions for their own account. A plan fiduciary wrongfully using his or her power to obtain a higher distribution than is warranted, for example, obviously falls under the broad conduct contemplated under Section 406(b).

Finally, Section 408(c)(1) reads as follows:

Nothing in [ERISA Section 406] shall be construed to prohibit any fiduciary from—

(1) receiving any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries.

A plain reading of this Section establishes that Section 406 should be construed to prohibit a fiduciary from receiving a benefit that is computed and paid on a basis which is inconsistent with the terms of the plan as applied to all other participants and beneficiaries.

Copyright © 2011 Cosgrove Law, LLC.

Milestone or Millstone? Financing, that is.

The National Law Review included a great post  this week about the challenges for Milestone Financing  from Paul A. Jones of Michael Best & Friedrich LLP

As a lawyer, I’ve counseled many an entrepreneur, and even an occasional angel or venture investor, who thought so-called milestone-based financing rounds might bridge an especially irksome entrepreneur-investor gulf on valuation.  And, indeed, if you’ve been around the high-impact startup game awhile, you are bound to have seen some of these deals done.  You might even have seen some of them work out.  But as attractive as the idea of punting on valuation and/or funding timing pending the future achievement (or not) of some pre-defined milestone can be, more than a few words of caution are in order.

The kind of milestone financing I am talking about typically looks something like the following.  An investor agrees to put in some money up front, with the valuation thereof, and/or the provision of an additional sum of money, determined at some later time, when the company has (or has not) accomplished some defined milestone(s).  In theory, this structure can be a good mechanism for bridging otherwise intractable differences about valuation and funding requirements between entrepreneurs and investors.  In practice, though, this approach can be quite problematic.

The problems with milestone funding are basically as follows.  First, the parties too often leave the definition of what constitutes achieving the milestone subject to interpretation.  Some milestones are in fact hard to define with precision.  Beyond that, precision itself in terms of defining a milestone can be problematic if, as is often the case, success or failure in achieving a milestone can take forms not contemplated at the beginning of the enterprise.  Second, and particularly where the milestone is more distant in time, market conditions can change so that one party or the other inevitably ends up feeling like they are being held to a deal that no longer makes sense.  Finally – and this, for me, is the biggest issue with milestone funding – is that what seem like the best/most pressing milestones today might be overtaken by events before they are achieved.  Most technology-based startups evolve rapidly: what looks like the best use of limited resources at, say, the first closing of a milestone financing, might look like a less than optimal use of resources a day, week, month or quarter later.  But with a milestone financing clock ticking, the various parties – founders, managers and investors – can find themselves with confused and conflicting priorities.  At best, in this situation, you will have a serious management distraction on your hands.

Milestone financing structures can be good tools in the right situations.  Considering the real world risks, however, they should be considered as if not last at least late-in-the-day resorts.  And, when used, both sides should be careful to pick milestones that can be achieved sooner, rather than later, and defined, appropriately, with precision.  And then everyone should still cross their respective fingers that the business – technology, markets, competition, etc. – stays reasonably stable at least until the milestone is achieved.


Ninth Circuit Holds that Repayment for Training is Not an Illegal 'Kick-Back'

Judd H. Lees of William Kaster recently posted at the National Law Review information about a  recent 9th Circuit case involving the repayment of training costs for employees: 

Many employers provide expensive training to new employees only to see the newly trained employees disappear after a short tenure.  In order to recoup the costs associated with upfront training, some employers require repayment of training costs on a graduated scale based on the tenure of employment.  In Gordon v. City of Oakland, the Ninth Circuit Court of Appeals determined that such a written agreement did not violate the Fair Labor Standards Act as an unlawful kick-back.

In Gordon the City of Oakland’s police department required officers to repay a portion of their training costs if they voluntarily left the City’s employment before completing five years of service.  If they left prior to one year of employment, the departing officer owed 100 percent of the training costs and the percentage dropped by 20 percent every year until no repayment was required for a separation after five years of employment.  The written training reimbursement agreement was signed by employee Gordon.  Gordon resigned after completing her second year of service and received her full paycheck.  However, the City withheld her accrued unused vacation and compensatory time off as partial payment for the training costs and also served her with a demand for the remaining training costs which were not covered by the withheld amounts.

Gordon filed a lawsuit alleging that the City’s action violated the federal Fair Labor Standards Act.  Specifically, Gordon alleged that there was no legal difference between deducting the entire sum from her paycheck and directly demanding payment of the sum after receiving her paycheck.  Both resulted in a negative sum for her last week of work and therefore violated the minimum wage requirement of the FLSA.

The district court disagreed and held that the issuance of a paycheck exceeding the minimum wage amount complied with the FLSA and that the subsequent demand was, indeed, a distinction with a difference.  On appeal to the Ninth Circuit, the Court agreed and held that the City was free to both deduct a portion of the training costs and seek repayment of the remaining training costs as “an ordinary creditor” and that the agreement to repay the training costs did not constitute a kick-back under the FLSA.

Employers who choose to rely on such a repayment plan should note the following.  First, the employee signed a written agreement which provided the basis for recoupment of the training costs.  Second, and most importantly, the employer made sure that the employee’s last paycheck met the minimum wage requirements and did not subtract the entire amount due.  The Court suggested that its holding may have been different had the paycheck fallen below the minimum wage requirements.  Employers are cautioned to ensure that any and all deduction from wages are expressly agreed to ahead of time by the employee since both state and federal law require this.  In addition, if an employer contemplates satisfying such “loans” from final paychecks, this also needs to be specifically set forth in the agreement.  The wiser alternative is to make sure that the final paycheck at least results in payment of minimum wages for the final week accompanied by a demand for payment of the remaining amounts.

© 2002-2011 by Williams Kastner ALL RIGHTS RESERVED

Yes, It’s Data Privacy Day

Here’s some news – it’s Privacy Day !  The National Law Review was alerted to this news by Emily Holbrook of the Risk Management Monitor – read on: 

It may surprise you, as it did me, to learn that today is Data Privacy Day, an “international celebration of the dignity of the individual expressed through personal information.” But Data Privacy Day also highlights the need for individuals to protect their data and how they can go about doing so.

There are many organizations out there that aim to help individuals protect their personal information and help businesses comply with data protection laws and regulations. The Online Trust Alliance is one such organization, whose mission is to create an online trust community, promoting business practices and technologies to enhance consumer trust globally. They recently released their “2011 Data Breach Incident Readiness Guide” to help businesses in breach prevention and incident management.

According to their newest guide, the true test for organizations and businesses should be the ability to answer key questions such as:

  1. Do you know what sensitive information is maintained by your company, where it is stored and how it is kept secure?
  2. Do you have an incident response team in place ready to respond 24/7?
  3. Are management teams aware of security, privacy and regulatory requirements related specifically to your business?
  4. Have you completed a privacy and security audit of all data collection activities, including cloud services, mobile devices and outsourced services?
  5. Are you prepared to communicate to customers, partners and stockholders in the event of a breach or data loss incident?

With the White House, members of Congress, Commerce Department and the FTC calling for greater privacy controls and breach notifications, self-regulation by businesses is becoming more and more important.

Google, one of the supporters of Data Privacy Day and the initiatives of The Privacy Projects is hosting a public discussion on privacy later this afternoon with representatives from the Electronic Frontier Foundation, the FTC and the National Institute of Standards and Technology scheduled to attend. If you can’t stop by Google’s DC office for this event, don’t worry — it will be captured on video and posted to YouTube soon after.

Risk Management Magazine and Risk Management Monitor. Copyright 2011 Risk and Insurance Management Society, Inc. All rights reserved.

Wisconsin Tort Reform 2011: Governor signed the Omnibus Tort Reform Act

As posted on the National Law Review by Joseph Louis Olson and Adam E. Witkov of Michael Best & Friedrich LLP – implications of the Wisconsin Omnibus Tort Reform Act signed into law today by Wisconsin Governor Scott Walker:  

Governor Scott Walker signed the OmnibusTort Reform Act (the “Act”) today, January 27, 2011.  The Act addresses several areas of interest for Wisconsin companies.

Specifically, the Act:

Limits Punitive Damages.

  • Punitive damages are capped at to $200,000 or double the amount of compensatory damages, whichever is higher. The cap does not apply to lawsuits related to operating a motor vehicle while intoxicated.

Raises the Standards for Expert Testimony.

  • This Act adopts the standard set forth in Federal Rule of Evidence 702, also known as the “Daubert standard.” The Daubert standard allows the admission of expert testimony only if it is based on sufficient factors or data and is the product of reliable principles and methods.

Limits the Application of the Risk Contribution Theory.

  • This provision is a response to the Wisconsin Supreme Court’s 2005 decision in Thomas v. Mallett, 2005 WI 129, 285 Wis. 2d 236, 701 N.W.2d 523, where the Court permitted a case to proceed against seven paint manufacturers despite the fact that the plaintiff could not prove who made the lead-based paints that he claimed poisoned him as a child. The Act limits the holding in Thomas. If the claimant can not identify the specific product that allegedly caused the injury, a manufacturer, distributor, seller, or promoter of a product may be held liable only if all of the following apply: (1) the claimant proves: (a) no other lawful process exists for the claimant to seek any redress from any other person for the injury or harm; (b) that the claimant has suffered an injury or harm that can be caused only by a manufactured product chemically and physically identical to the specific product that allegedly caused the claimant’s injury or harm; and (c) that the manufacturer, distributor, seller, or promoter of a product manufactured, distributed, sold, or promoted a complete integrated product, in the form used by the claimant or to which the claimant was exposed, and that meets all of the following criteria: (i) is chemically and physically identical to the specific product that allegedly caused the claimant’s injury or harm; (ii) was manufactured, distributed, sold, or promoted in the geographic market where the injury or harm is alleged to have occurred during the time period in which the specific product that allegedly caused the claimant’s injury or harm was manufactured, distributed, sold, or promoted; and (iii) was distributed or sold without labeling or any distinctive characteristic that identified the manufacturer, distributor, seller, or promoter; and (2) the action names, as defendants, those manufacturers of a product who collectively manufactured at least 80 percent of all products sold in this state during the relevant production period by all manufacturers of the product in existence during the relevant production period that are chemically identical to the specific product that allegedly caused the claimant’s injury or harm.

Limits Strict Product Liability Claims.

  • Under the Act, Wisconsin is now in line with the majority of other states that have adopted the “reasonable alternative design” test instead of the broader “consumer expectation” test. Accordingly, a manufacturer will be liable for damages caused by the manufacturer’s product based on a claim of strict liability only if the injured claimant proves that the product was defective, the defective condition made the product unreasonably dangerous, the defective condition existed at the time the product left the control of the manufacturer, the product reached the user or consumer without substantial change, and the defective condition caused the claimant’s injuries. If the injured party’s percentage of total causal responsibility for the injury is greater than the percentage resulting from the defective condition of the product, the injured party may not, based on the defect in the product, recover damages from the manufacturer, distributor, seller, or any other person responsible for placing the product in the stream of commerce. If the injured party’s percentage of total causal responsibility for the injury is equal to or less than the percentage resulting from the defective condition of the product, the injured party may recover but the damages recovered by the injured party shall be diminished by the percentage attributed to that injured party.

Toughens State Rules Relating to Damages for Frivolous Claims.

  • In civil cases, a party or his or her attorney may be liable for costs and fees for actions that are done (1) in bad faith, solely for the purpose of harassing or maliciously injuring another; or (2) was without a reasonable basis in the law. If the offending party withdraws or corrects the improper conduct within 21 days of receiving the other party’s motion for fees, the court can decide whether to award actual costs taking into consideration the offending party’s mitigating conduct. If the offending party does not timely withdraw or correct the conduct, actual costs shall be awarded. If the decision is appealed and the appellate court affirms the award of fees, the offending party must also pay the attorney fees incurred in the appeal.  

In addition to the tort reform provisions outlined above, the Act includes several health care related provisions previously discussed in a client alert dated January 10, 2011, also available here.


Lender Liability and the Exception to CERCLA

Recently posted at the National Law Review by Joanne M. Schreiner and Matthew A. Whitlow of Dinsmore & Shohl LLP – explain possible liability under CERCLA for lenders in certain situations: 

Lenders are making loans again. Lenders are much more cautious about the loans they are making and much more thorough with their due diligence on every piece of property. Perhaps the biggest concern for a lender (aside from whether its borrower will default) is the environmental condition of the property. Now more than ever, lenders are fearful (and rightfully so) of exposure to liability for violations of environmental laws following foreclosure and transfer of possession of a commercial property. Generally, Lenders are insulated from such liability; however, they must be careful not to overstep the boundaries of the protections afforded them.

What is CERCLA?

It is mentioned in many commercial real estate loan documents, typically in connection with a representation by a borrower that they are in material compliance with it. “CERCLA” is an acronym for the Comprehensive Environmental Response, Compensation and Liability Act of 1980. This is the primary piece of federal legislation governing events related to the exposure of real estate to hazardous materials in the United States. Most state environmental laws are based on this law. When it comes to commercial real estate (or any real estate for that matter), the last place anyone wants to be is on the wrong side of CERCLA because CERCLA imposes strict liability upon “owners and operators” of real property for penalties and costs related to hazardous waste contamination and clean up. A lender can become an “owner and operator” of real property under CERCLA in several ways, with potential exposure to CERCLA strict liability. There are three exceptions to CERCLA strict liability: (i) an Act of God; (ii) an Act of War; or (iii) Secured Creditor Safe Harbor.

Initially, the Secured Creditor Safe Harbor allowed that a lender who owned or possessed real property for the sole purpose of protecting its security interest in the real property, and who did not “participate in the management of the real property,” was excluded from strict liability under CERCLA. Unfortunately, courts disagreed on how to interpret the Secured Creditor Safe Harbor (specifically, when did a lender “own or possess” the real property and what constituted “participating in the management” of the real property?). The Secured Creditor Safe Harbor was later narrowed and more clearly defined.

The U.S. EPA adopted guidelines (which were later codified in CERCLA) to test whether a lender and a lender’s actions were protected by the Secured Creditor Safe Harbor. These guidelines attempted to clarify what “participating in the management” of a property means. A two-part test was established to determine whether lenders met this factor:

  1. Did the lender exercise control over the management of the borrower’s environmental compliance program? In other words, did the lender tell the borrower what to do to comply with applicable environmental laws?
  2. Did the lender participate in the Borrower’s day-to-day decision-making process with respect to environmental compliance and other business operations? Simply collecting rent from tenants or advising the borrower on financial matters related to the property is not considered “participation in management.” Other lender activities that do not satisfy this second part include: (i) pre-loan investigations; (ii) loan servicing; (iii) loan workouts; and (iv) foreclosures.


If a lender can prove that: (i) it holds a security interest in real property to secure repayment of money or some other obligation; and (ii) it did not actually participate in management of the property, then the lender is protected by the Secured Creditor Safe Harbor.

What happens after a lender forecloses and becomes the actual owner of the property?

Under CERCLA, a lender must establish it has made commercially reasonable efforts to divest itself of the real property in a commercially reasonable time and on commercially reasonable terms, taking into account market conditions and legal and regulatory requirements. CERCLA does not define “commercially reasonable;” however, lenders can look to the EPA for guidance. The EPA provides that a lender makes “commercially reasonable” efforts to divest the property when the lender lists the property with a broker or advertises the property for sale in an “appropriate publication” (publication of general circulation) within 12 months of foreclosure. It is important to note that lenders who were not protected by the Secured Creditor Safe Harbor pre-foreclosure cannot be protected by the Secured Creditor Safe Harbor after foreclosure. A lender’s own acts or omissions during ownership or control of the real property are not protected by the Secured Creditor Safe Harbor provision.

A lender considering making a commercial real estate loan should consider the following “best practices” to avoid CERCLA liability

  • document everything;
  • avoid active participation in the operational affairs of the Borrower and the property;
  • if practical, have a receiver appointed to manage the property during default and foreclosure;
  • conduct pre-foreclosure environmental due diligence;
  • ensure good environmental management post-repossession or post-foreclosure; and
  • carefully document efforts to market the property for sale

© 2011 Dinsmore & Shohl LLP. All rights reserved.

Negotiating Your Law Firm’s Malpractice Insurance: How to Avoid Purchasing the “Never Pay Policy”

Recently posted at the National Law Review from Scott F. Bertschi of Arnall Golden Gregory LLP and John C. Tanner of  McGriff, Seibels, & Williams, Inc.- some very concrete things to look for when puchasing legal malpractice coverage: 

Far too many attorneys treat the purchase of malpractice insurance like that of an off-the-rack commodity.  The purchasing decision is guided largely by cost, advertising, or the relative ease of the application process.  Ironically, few attorneys actually read their own malpractice insurance policy until after they receive a claim. 

Instead, many law firms rely on assumptions in purchasing coverage and then set the policies aside, at least until a claim is made.  Then, the terms and conditions become all important, and that is precisely the time when you, as the insured, can do little to affect the coverage that may or may not be afforded under the policy.

The malpractice policies available in today’s commercial market vary greatly and insurance companies are more willing than ever to negotiate specific terms and conditions that can address the unique risks faced by you and your firm.  While the best way to take advantage of this opportunity is to use an experienced broker who will solely represent your law firm’s interests, this article provides a general roadmap for law firm administrators, general counsels, and managing partners to use in negotiating professional liability coverage.

1.         Don’t start off on the wrong foot.

The terms of coverage begin with the application process and, if you are not careful, coverage can end there as well.  The answers you provide on the application are used by the insurance company to determine the premium charged and the specific terms under which the insurance company is willing to insure you.  Of particular importance are questions regarding the areas of law in which your firm practices and whether any of the attorneys in the firm are aware of any circumstances that could result in a claim.

The temptation is to give these questions short shrift.  A full and complete answer usually requires a great deal of factual investigation, such as a review of past financial information to determine a break-down of revenues by type of work, and a polling of each attorney as to the knowledge of the existence of potential claims. 

Most off-the-rack malpractice insurance policies are written such that the insurer can rescind the policy in the event any of the application answers are incorrect.  Importantly, the insurance company doesn’t necessarily need to prove the firm intended to provide an incorrect answer.  Instead, an insurance policy can usually be rescinded for innocent mistakes in the application so long as the insurance company would not have offered the policy at the same premium or would have changed the terms if the correct answers were given. 

If the policy is rescinded, no claims made under that policy period would be covered, even if the claim is wholly unrelated to the mistake on the application.  Innocent insureds, not directly involved in the application process, are also at risk.  Additionally, rescission can make it challenging for the firm to obtain insurance in the future.

Accordingly, treat the application process like your coverage depends on it.  Specifically, the firm should commit the time and attention to the process necessary to get the answers correct.  If a question is unclear, ask for clarification.  Many insurers today will offer contract wording in the policy specifically protecting innocent insureds against rescission risk.  Once again, this is a process in which an experienced broker can greatly assist.

2.         What you know (or should know) can hurt you.

Legal malpractice policies, like most professional liability policies, are written on a “claims-made” basis.  Coverage under a “claims-made” policy depends primarily on when the claim was made, rather than when the error or loss occurred.  This creates a potential moral hazard: a prospective insured, knowing he committed an error, could purchase a claims-made policy before the claim is made and obtain coverage for a known loss.  Clauses called “prior knowledge provisions” are intended to protect insurers against this hazard. 

A typical prior knowledge provision states that claims based on errors occurring prior to the policy period are not covered if any insured had a reasonable basis to believe that a claim could be made.  Courts in many states apply an objective standard to determine whether an insured had such “prior” knowledge.   Thus, the question is not whether you specifically thought a claim would be made, but whether a ”reasonable insured,” knowing what you know, would believe that a claim is possible.  Moreover, depending on the policy wording, the knowledge of one attorney can eliminate coverage for all insureds, even those who do not have any “prior” knowledge.

When purchasing a legal malpractice policy, determine whether the prior knowledge provision contains a “continuity clause.”  This savings clause states the claim will be covered unless the insured had knowledge of the potential claim prior to the first policy issued by the insurer to your firm, rather than prior to the current policy period.  If possible, you should also seek policy language limiting the prior knowledge provision to a subjective standard requiring proof of fraud and otherwise protecting innocent insureds. 

In addition, most policies include provisions allowing insureds to provide a “notice of circumstance” to the insurer of potential claims – even if no claim has been made yet – specifically providing that any future claim arising out of that circumstance will be treated as a claim made during the current policy year.  Such a provision gives you greater flexibility when changing insurers, but pay close attention to the policy specificity requirements for reporting potential claims.     

3.         Prior Acts

Sometimes insurance companies also address the moral hazard inherent in “claims-made” policies by only covering claims based on errors occurring after a certain date, sometimes called a “retroactive” date or a “prior acts” date.  For previously uninsured firms or lawyers, most insurers will insist on a retroactive date equivalent to the policy inception date. 

Moreover, firms changing insurers often have the option of reducing the premium by agreeing to a retroactive date.  While this certainly limits the amount of coverage, the limitation can be offset by purchasing “tail” coverage from your current insurer.  “Tail” coverage, sometimes called an extended reporting period, extends the time in which a claim can be made and reported under an expiring policy for errors occurring prior to the policy expiration.  

Determining when an alleged error occurred is not always an easy task, however, and alleged breaches of care can span multiple policy periods.  If your firm nevertheless intends to change insurers, a qualified broker can help you calculate the most effective mix of retroactive date and tail coverage to maximize savings and minimize exposure to gaps in coverage.

4.         If a claim is made in the forest, and the insurer isn’t there to hear it, does it make a sound?

As discussed above, almost all legal malpractice policies on the market today are “claims-made” policies and apply only to claims made during the policy period.  Some, however, add the requirement that the claim be reported to the insurer during the policy period as well.  Such policies are aptly called “claims-made-and-reported” policies. 

In contrast to standard notice conditions that require the insured to report a claim “as soon as practicable,” numerous courts have  held that the reporting requirement in a claims-made-and-reported policy defines the scope of coverage, rather than states a condition for coverage.  What this means in practical terms is that the insurance company can disclaim coverage based on a failure to timely report the claim regardless of whether the delay caused the insurance company any prejudice.  Some policies flatly require reporting prior to the end of the policy period, while others provide that the claim must be reported within a 30 or 60 day time period after the policy expired. 

Another important consideration is the interaction of the reporting requirement and renewals.  Some policies specifically permit the reporting of a claim during the policy or any renewal policy, while others are silent on the subject leading to the possibility of a disclaimer, even when the renewal is with the same insurer.   

It is imperative that you establish a claim reporting procedure to ensure that all “claims” as defined in the policy are promptly brought to the attention of the firm’s risk manager or managing partner and reported prior to the policy reporting deadline.  Some insurers will agree to soften the claim reporting wording by requiring notice as soon as practicable after the individual in the firm charged with managing insurance and claims first learns of the “claim,” but few will agree to a prejudice standard or an unlimited timeframe for reporting post policy period.     

5.         Professional Services

As the name implies, a lawyers’ professional liability insurance policy covers just that: a lawyer’s professional liability.  Accordingly, it should not be surprising that such policies do not cover all liability a lawyer may face, merely because she is a lawyer.  Instead, it is well established that such policies only cover those risks that are inherent in the practice of law.  But what exactly does that mean?

Lawyers engage in a variety of law-related tasks that are not necessarily limited to lawyers.  For example, lawyers frequently act as title agents, trustees, conservators, administrators, arbitrators, and mediators.  Some firms today now have document management divisions or affiliated e-discovery and information technology companies.  The practice of law has expanded and continues to evolve over time.

Most legal malpractice policies specifically define the term “professional services.”  Be sure to check your particular policy definition against the activities your firm’s lawyers undertake.  Be especially careful when any of the lawyers in your firm have dual professional licenses, such as a lawyer who is also a CPA.  It is best to address such issues up front to avoid a surprise when the insurer disclaims coverage for a claim, contending that the alleged wrongdoing did not arise out of the lawyer’s rendering of “professional services.”

6.         Modern Day “Damages”

The typical legal malpractice policy limits coverage to claims for “damages.”  While that word seems innocuous, it frequently carries an express definition that serves to substantively limit what is covered. 

For example, many policies define the term “damages” to specifically exclude fines, penalties, sanctions, non-monetary relief, amounts demanded as the return of a payment of legal fees, or even the disgorgement of “funds wrongfully obtained.”  Most of these limitations are based upon the proposition that a liability insurance policy is designed to protect an insured from liability to another person, as opposed to a loss of the insured’s profit. 

One area usually open for negotiation is coverage for punitive or exemplary damages.  Of course, public policy places an outer limit on what types of punitive damages a policy can insure, but many states permit insurance for at least some types of punitive damages, such as those imposed vicariously. Many insurers today will provide coverage for punitive damages where insurable and subject to an insurability determination under the most favorable venue for such coverage. 

An emerging area of interest to law firms is coverage for Rule 11 or other discovery sanctions, as well as other “damages” arising out of claims of abusive or frivolous litigation.  While most insurers have historically excluded coverage for all fines, penalties, or sanctions, a few innovative insurers today have shown a willingness to offer a coverage sublimit to defend lawyers against such allegations.  Law firms can be jointly liable for an individual lawyer’s sanction-able conduct, and settlement exposure to claims of abusive or frivolous litigation is real.   Unfortunately, few firms today have adequate insurance protection in this area, and when available, it comes with an additional premium. 

7.         Intentional Acts Exclusion

Similar to the limitations on the insurability of punitive damages, public policy may limit an insurance company’s ability to cover liability based on an insured’s malicious, fraudulent, or dishonest acts.  Accordingly, every policy will invariably exclude such liability.  The problem is that legal malpractice claims frequently include intentional tort claims (such as breach of fiduciary duty) in addition to professional negligence.  The scope of coverage afforded such intentional allegations can vary greatly from one policy to the next. 

First, some policies exclude all coverage for such acts, including a defense to claims alleging fraudulent conduct even if the insured protests his innocence.  Under such policies, a common malpractice claim alleging both negligence and breach of fiduciary duty raises coverage issues at the outset because of the intentional breach of duty claim.

Other policies provide a so-called “courtesy defense,” under which a defense is provided until such time as the alleged fraudulent conduct is established by an adjudication or an admission.  Under such policies, the insurer may still insist on some allocation or insured contribution to a settlement of allegations of negligence when coupled with alleged intentional wrongdoing.  If possible, try to negotiate wording in your policy providing coverage for defense and settlement of alleged wrongdoing unless there is a final adjudication of such intentional wrongdoing in the underlying malpractice case, or in an action or proceeding other than a declaratory judgment proceeding brought by or against the insurer to determine the scope of insurance coverage.

Policies may also differ on the applicability of the exclusion to so-called “innocent insureds.”  Most exclusions apply to any claims “arising out of” the excluded conduct.  Courts generally hold that the “arising out of” language extends the scope of such exclusions even to negligence claims predicated on the intentional conduct, such as negligent hiring and supervision claims.  In other words, if your partner steals a client’s money, you are not covered even if you had no part in the theft.  Fortunately, many policies contain “innocent insured provisions” aimed at ameliorating this result.  These provisions waive the intentional acts exclusion for those insureds who did not actively participate in, and were not aware of, the excluded conduct.

8.         Business Enterprise Exclusion

Most lawyers familiar with the basic tenets of conflicts law know it is risky to represent a corporation in which an insured owns an interest.  Similarly, most seasoned lawyers know that such a situation can be rife with practical difficulty when the business enterprise fails. 

Insurers are aware of these problems as well and typically exclude claims made by any business enterprise in which any insured owns an interest or with respect to any enterprise operated, managed, or controlled by any insured.  The stated purpose of such an exclusion is to prevent an insured from transferring his own business loss to his legal malpractice insurer.  But the exclusions are not typically limited to claims against the particular lawyer who has the ownership interest and, instead, include claims by that enterprise against any lawyer in the firm.  Many insurers, however, are willing to negotiate this exclusion and give back coverage for some or all of such risks assuming the issue is raised and negotiated up front.   You should carefully evaluate the firm’s and its lawyers’ business interests each year in the underwriting process. 

9.         Coverage for Ethics Complaints & Disciplinary Proceedings

In addition to coverage for a lawyer’s monetary liability to a client or others, some legal malpractice insurance policies also pay for a defense to an ethics complaint or bar grievance.  Such coverage provides an obvious benefit over those policies lacking grievance coverage. 

Disciplinary proceedings and grievance coverage can differ between insurers as to whether the insured is permitted to choose his counsel, what control the insurance company retains over the defense, and whether there is a limit on the fees for such a defense. 

Many policies limit the coverage to a sublimit of $25,000-$50,000.  There is typically no retention or deductible applicable to such coverage, but the policy may only reimburse the insured after the successful conclusion of the proceeding.

10.       A defense by any other name does not necessarily smell as sweet.

Finally, but certainly not least important, all firms should carefully evaluate the defense provided by the insurance policy in the event of a claim.  The vast majority of legal malpractice claims are resolved with no payment to the claimant.  While this is good news for lawyers, it emphasizes the significance of the defense of such claims.  In short, the cost of the defense is often greater than the ultimate payment of the claim.  When you consider the fact that insurance policies vary greatly regarding the defense obligation, it becomes clear that this issue is rife with pitfalls.  Specifically, policies vary in two main respects. 

First, determine whether the limits of liability are “eroded” or “exhausted” by defense costs.  Under some policies, sometimes called “burning limits policies,” each dollar spent in the defense of the claim reduces by a dollar the amount available to pay a judgment or settlement.  Of course, purchasing a “burning limits” policy allows your firm to save on premiums, but it carries with it a risk that the limits will ultimately be insufficient should a claim involve a lengthy defense. 

Second, understand whether you or the insurance company chooses defense counsel and controls the defense.  Many legal malpractice policies are so-called “duty to defend” policies, which means that it is the insurance company’s right and obligation to defend the claim.  Typically, the right to defend carries with it the right to select defense counsel, and insurers often have negotiated volume discount rates with certain defense firms.  The “duty to defend” obligation is extremely broad, frequently said to require a defense of the entire claim if any part of the claim is potentially within the scope of coverage.  

On the other hand, so-called “indemnity for loss” policies simply reimburse your expenses incurred in the defense.  In such situations, the insured is generally afforded the right to select counsel and control the defense, but the insurer may require advance consent or agreement by your selected defense firm to negotiated lower rates or to predetermined litigation management guidelines.  The insurer may also take the position that it is not responsible for defending uncovered claims or allegations.

Many policies also include a “hammer clause” giving the insurer substantial leverage in the context of a potential claim settlement.  Such clauses in essence permit the insurer to withdraw its defense and cap its policy limit at any settlement amount recommended by the insurer and otherwise acceptable to the claimant.


Ultimately, there is no one “best” policy for all firms or any specific category of firms.  Instead, a firm’s legal malpractice policy should be carefully tailored to the specific activities undertaken by the firm and the firm’s individual financial situation.  Of course, insurance deals with the uncertainties of the future, and it is impossible to know now precisely what coverage you will need next year.  But you can maximize your odds by addressing your firm’s needs upfront and spending the time and effort to negotiate the scope of the policy before it is issued. 

© 2011 Arnall Golden Gregory, LLP and McGriff, Seibels, & Williams, Inc. All rights reserved.

Section 409A Again? Employers Need to Re-examine Executive Employment Contracts and Other Agreements Conditioning Severence Payments Upon a Release of Claims

Recently posted at the National Law Review by Nancy C. Brower and David L. Woodard of Poyner Spruill LLP – information for employers about the tax Consequences of employment agreements, retention agreements, severance agreements and change in control agreements: 

Agreements that provide for payments upon termination of employment, such as employment agreements, retention agreements, severance agreements and change in control agreements, often condition payment upon the return of an executed release of claims. Since Section 409A allows agreements to provide for a payment window of up to 90 days from separation from service, it was widely believed that an agreement could provide for payments to begin upon the return of a release, provided the release was required to be returned within the 90-day window period and the company determined the time of payment. In Notice 2010-6, the IRS stated that this type of provision is not Section 409A compliant. Fortunately, at the end of last year, the IRS came out with relief that will allow companies to correct this problem without employees incurring Section 409A taxation.

Action Step

Companies should immediately identify all employment agreements, retention agreements, severance agreements and change in control agreements that condition severance payments upon the return of a release. All of these agreements should be reviewed for Section 409A compliance based on the new guidance from the IRS. Companies should not rely on the fact that the agreements were previously reviewed for Section 409A compliance, since the 2010 guidance from the IRS was not anticipated by most practitioners. Companies should pay careful attention to the timing of payments made under impacted agreements during 2011, as payments made after March 31, 2011 must comply with the corrective guidance contained in Notice 2010-80. Further, any impacted agreements that are outstanding or have any payments still due after December 31, 2012, must be amended to correct the agreement provisions in accordance with Notice 2010-80 no later than December 31, 2012.

 © 2011 Poyner Spruill LLP. All rights reserved.

Verification Two-Step: One step forward, one step back—A review of the GAO report on the progress made to improve E-Verify

Recently posted at the National Law Review Kevin Lashus and Maggie Murphy of Greenberg Traurig provide some great insight(s) on the recently filed GAO Report on E-Verify and why employers should be concerned: 

Washington, D.C. (January 19, 2011) —  On January 18, 2011, the US Government Accountability Office (GAO) released its December 17, 2010 report entitled, “Employment Verification: Federal Agencies Have Taken Steps to Improve E-Verify, but Significant Challenges Remain.”  Provided is a summary of the GAO’s findings, and where we believe USCIS’ Verification Division may move to implement modifications to the existing system based upon the GAO’s recommendations.

The report is a summary of the review GAO conducted to assess how USCIS and SSA have been able to ensure accuracy of the verification process in E-Verify and whether either (or both) have taken measures to combat fraud.  Specifically, GAO examined efforts taken by both agencies to (1) reduce tentative nonconfirmations (TNCs), (2) safeguard private personal information submitted, and (3) prepare for the increased use of the program that may result from either increased state and local legislation (executive action) or a federal mandate.

Two of the conclusions of the report should be of great concern to employers:

(1) Because TNCs are more likely to affect foreign-born employees, the issuance of false TNCs (TNCs issued commonly because names are recorded differently on various ID and work authorization documents) will likely lead to increased allegations of discrimination; and

(2) E-Verify remains exceedingly vulnerable to identity theft and employer fraud.

Some of the other significant findings:

  • Employees are limited in their ability to identify the source of and how to correct information in the DHS and SSA databases (including the significant delay in the correction process—commonly taking an average of 104 days).
  • Long-term cost associated with the administration of the E-Verify program and complementary national systems and SSA databases do not reliably depict current budgetary allocations for the costs of administration.
  • Securing sufficient resources to effectively execute the program plans for the future has not been anticipated and may not be properly anticipated in budgetary projections.
  • Recommended fixes to the program will result in increased transactions costs, including the resolution of false TNCs, administrative leave for employees to allow them to resolve erroneous mismatches, and additional training costs to educate the employees about reducing the likelihood of name-related, erroneous TNCs.
  • USCIS should consider providing an employee-accessible portal that would allow employees to correct inaccuracies or inconsistencies within DHS databases.
  • USCIS and SSA should finalize the terms of the service-level agreement that defines the requirements of SSA to establish and maintain the capacity and availability of its system components.
  • USCIS should consider a budget for the life-cycle cost of the program that reflects the four characteristics of a reliable estimate consistent with best practices—essentially, that long-term there is enough resources to ensure the program is comprehensive, well-documented, accurate, and credible.

Notwithstanding the findings, there is a clear message contained in the report:  Comprehensive reform is required to root-out the incidence of document fraud. The use of biometrics in identification/authorization documentation is the only likely cure of the ills currently inherent in the system. 

Until that time, USCIS must reallocate resources to address fraud issues—doubling the number of monitoring and compliance staff to oversee employers’ use of E-Verify AND allocating resources to recognize and correct mismatched information in the various DHS databases. 

In other words, instead of addressing the defects of the verification paradigm, the Government is allocating additional resources to address problems with the process that cannot be cured with the current system.  Notably,

  • Senior E-Verify program officials reported that the Monitoring and Compliance Branch is limited in its ability to fully identify patterns and trends in the data that could signal employers’ noncompliance, but E-Verify will be committing $6M in implementing advanced data systems to gain the capacity to conduct complex analyses of E-Verify data.
  • Senior E-Verify program officials will also be reaching out to employers who fail to master the training tutorial—either with a compliance letter (a compliance failure notification) or a phone call—to further assist employers with the E-Verify process. They  will then follow up with the “targeted” employers to assess whether the prior non-compliant behavior has been adjusted.
  • Senior E-Verify and ICE worksite enforcement agents reported that they are currently coordinating to help USCIS better target its monitoring efforts because (1) login profiles to the E-Verify program are not monitored, (2) USCIS cannot currently monitor the extent to which employers follow the MOU provisions, and (3) employers who do not respond and remedy noncompliant behavior are not adequately sanctioned under the current program.

Ultimately, a great deal of the burden to address the deficiencies of the current verification system will fall to employers.  The current patchwork system cannot address the underlying reality that as long as 11 or so million unauthorized employees require employment to survive, a robust market of sophisticated, fraudulent documents will flourish.  Until the problems are adequately addressed, increased oversight and monitoring of the program will result in increased scrutiny of the employer by both ICE and USCIS, with the risk that compliance policy modification may result in increased allegations of discrimination.

Sure seems like one step forward, one step back.

This Alert is issued for informational purposes only and is not intended to be construed or used as general legal advice. 

 Media Contact: Lourdes Brezo-Martinez, Greenberg Traurig, PA 212-801-2131.

©2011 Greenberg Traurig, LLP. All rights reserved.

Reprieve For Fully Insured, Non-Grandfathered Group Health Plans From Complying With PPACA Nondiscrimination Rules

From featured guest bloggers Amy M. Christen and Gabriel S. Marinaro of Dykema Gossett PLLC – updates on the implementation of the Public Health Service Act: 

Notice 2011-1 states that the Treasury Department and the IRS, as well as the Departments of Labor and Health and Human Services (collectively referred to as the “Departments”), have determined that compliance with new nondiscrimination rules under Section 2716 of the Public Health Service Act (“PHS Act”) will not be required until plan years beginning after regulations or other administrative guidance has been issued. The Departments issued Notice 2011-1 in response to concerns raised regarding a plan sponsor’s ability to implement the new nondiscrimination rules without such guidance, and specifically held that a plan sponsor of a non-grandfathered fully insured group health plan would not be subject to the excise taxes for failure to comply with such new nondiscrimination rules, nor be required to file IRS Form 8928 until plan years beginning after the guidance has been issued.

The Patient Protection and Affordable Care Act (the “Affordable Care Act”) added Section 2716 of the PHS Act, which prohibits a fully insured, non-grandfathered group health plan from discriminating in favor of highly compensated individuals as to eligibility to participate in such plan, as well as to benefits offered to participants under the plan in accordance with the rules similar to the ones set forth under Code Section 105(h). Under Code Section 105(h), highly compensated individuals generally include the five highest-paid officers, employees at any time during the plan year with more than a 10 percent ownership, and all other employees who are among the highest-paid 25 percent of all employees. If a fully insured, non-grandfathered group health plan discriminates in favor of highly compensated employees as to eligibility to participate or as to providing benefits to participants, the employer will be the party to suffer the consequences. Specifically, the Affordable Care Act imposes an excise tax on employers that do not satisfy the market reform and consumer protection provisions of the Affordable Care Act equal to $100 per day for each affected participant, up to a maximum fine for unintentional failures of $500,000 per taxable year. The IRS (or HHS) has discretion to waive the tax in whole or in part to the extent the failure was due to reasonable cause and not to willful neglect, and small employers with no more than 50 employees may be exempt from such tax with certain exceptions. An employer also may be subject to a civil lawsuit filed by non-highly compensated employees. Until guidance is issued stating otherwise, it does not appear that highly compensated individuals will be subject to any adverse income tax consequences on the value of health benefits provided under a discriminatory fully insured, non-grandfathered group health plan. 

If a fully insured group health plan maintains its grandfathered status (within the meaning of Section 1251 of the Affordable Care Act and the Departments’ grandfathered regulations), then it is exempt from these new nondiscrimination requirements. A group health plan has grandfathered status only if it existed as of March 23, 2010, and it does not make plan design changes above certain threshold amounts set forth in the grandfathered plan regulations. Additionally, certain HIPAA-excepted benefits are not subject to the new nondiscrimination requirements, including a limited-scope dental or vision plan that is offered through a different insurance carrier than the medical plan or is offered separately to employees for an additional premium cost. Unless future guidance provides otherwise, HIPAA-excepted benefits that are not subject to the new nondiscrimination rules also may include a stand-alone retiree-medical plan that covers only former employees of an employer (and does not cover active employees).

Before the enactment of the Affordable Care Act, the nondiscrimination requirements under Code Section 105(h) only applied to self-insured group health plans. A self-insured plan is one in which the employer pays for the benefits out of its general assets as opposed to paying through a fully insured policy. IRC Section 105(h) prohibits a self-insured plan from discriminating in favor of highly compensated employees as to eligibility to participate or in favor of highly compensated participants as to benefits provided under such self-insured plan. A discriminatory self-insured plan produces adverse tax consequences to the highly compensated employees / participants (e.g., all benefit reimbursements made under a discriminatory plan will be taxable to such highly compensated individuals rather than any excise taxes on the employer).

The Departments have requested additional comments on PHS Act Section 2716 by March 11, 2011, and Notice 2011-1provides specific issues on which the Departments would like additional comments as a follow-up to the public comments received in response to IRS Notice 2010-63.

© 2011 Dykema Gossett PLLC.