Limitation of Liability Provisions In Service Provider Contracts
If your company provides services for employee benefit plans, and you have been in business for any appreciable length of time, you may have experienced that gut wrenching feeling that comes when you open your errors and omissions insurance renewal notice. You find out that your annual premium has gone up 50%, or find the even more depressing realization that “defendant” has been added to your list of titles when the process server shows up with a malpractice complaint.
A recent Department of Labor (DOL) advisory opinion addresses one of the ways in which service businesses may seek to reduce their exposure to claims and lawsuits – including a “limitation of liability” provision in the service agreement.
Limitation of liability clauses are apparently in increasingly wide use among service providers, especially large, national employee benefit consulting firms. (This article refers collectively to service providers, including third party administrators, actuaries, and consultants, as “Consultants.”) Most often, these provisions put a cap, or limit, on the amount of damages that a plan or plan sponsor may recover in connection with the Consultant’s services. Typical provisions limit the damages that may be recovered in a lawsuit or arbitration to one year’s fees, or to the greater of one year’s fees or a specific sum, for instance, $10,000.
For those Consultants who have never been sued, or had a liability claim asserted against them by one of their clients, this may seem like a mundane, “boilerplate” provision that has little relevance in the real world. To those who have been sued, and to the litigation attorneys who sue and defend them, these kind of provisions are often more important to the outcome than to the question of whether the Consultant did anything wrong in the first place. Why?
Consider This Example:
A Consultant prepares an amended and restated defined benefit plan. (The Consultant did not draft the original plan document.) The old plan includes a provision excluding those employees who are covered by a plan through a collective bargaining agreement from participating in the company plan. The company owner – who responds to the Consultant’s information requests -- has always responded by indicating that the company has only one employee. In fact, the company has numerous employees, but all but one (the owner) are covered by a separate plan through a collective bargaining agreement. When the Consultant prepares the amended and restated plan document, he neglects to review the prior plan document, and omits any provision excluding union employees from the plan. The client looks to the Consultant to make the contributions to the plan for the benefit of the participants who would have been excluded from participating but for the Consultant’s oversight. The damages are claimed to be more than $300,000. (These were the facts of an actual lawsuit.)
If the Consultant used an engagement agreement, and if the engagement agreement included an enforceable limitation of liability clause, the damages that the plan sponsor might recover from the Consultant could be limited to the amount of the Consultant’s fees. In the example above, that could mean that despite the fact that the client has a funding obligation of $300,000, the Consultant’s liability could be limited to less than $10,000 (depending upon the exact terms of the limitation of liability provision).
Consultants who are considering using a limitation of liability provision have several issues to address. The first question, and the one that the DOL addressed, is whether a plan fiduciary violates his fiduciary duty to the plan by agreeing to a limitation of liability provision in favor of a Consultant. In DOL Advisory Opinion 2002-08A, the DOL noted that “...limitation of liability and indemnification provisions may be becoming increasingly popular with actuarial firms according to press and other reports.” Consequently, the DOL was responding to a request for an Advisory Opinion regarding “...whether inclusion of certain indemnification and hold-harmless provisions in a plan’s service provider contract would violate the fiduciary provisions of ERISA.”
The DOL first noted that ERISA §404(a)(1) requires fiduciaries to discharge their duties solely in the interest of participants and beneficiaries, and with the care, skill, prudence and diligence that a prudent person acting in a like capacity would use under the same circumstances. The DOL also referred to ERISA’s prohibited transaction provisions, noting that a plan fiduciary shall not cause the plan to engage in a transaction if he or she knows that the transaction constitutes a direct or indirect furnishing of services between the plan and a party in interest, or transfer of any plan assets to a party in interest. [ERISA §406(a)(1)(C) and (D).] ERISA provides a statutory exemption to these prohibited transactions for contracting or making reasonable arrangements with a party in interest for services related to the establishment or operation of the plan, provided that no more than reasonable compensation is paid. [ERISA §408(b)(2).]
The DOL instructed that “...the responsible plan fiduciary must engage in an objective process designed to elicit information necessary to assess the qualifications of the provider, the quality of services offered, and the reasonableness of the fees charged in light of the services provided. In addition, such process should be designed to avoid self-dealing, conflicts of interest or other improper influence.”
The DOL concluded “[t]he Department does not believe that, in and of themselves, most limitation of liability and indemnification provisions in a service provider contract are either per se imprudent under ERISA §404(a)(1)(B) or per se unreasonable under ERISA §408(b)(2). The Department believes, however, that provisions that purport to apply to fraud or willful misconduct by the service provider are against public policy and void. It would not be prudent or reasonable to agree to such provisions. Other limitations of liability and indemnification provisions, applying to negligence and unintentional malpractice, may be consistent with §§404(a)(1) and 408(b)(2) of ERISA when considered in connection with the reasonableness of the arrangement as a whole and the potential risks to participants and beneficiaries. At a minimum, compliance with these standards would require that a fiduciary assess the plan’s ability to obtain comparable services at comparable costs either from service providers without having to agree to such provisions, or from service providers who have provisions that provide greater protection to the plan.”
In addition, the DOL stated that compliance with ERISA’s fiduciary provisions would also require that the fiduciary assess the following: (1) the potential risk of loss that might result from a service provider’s act or omission subject to a proposed limitation of liability provision, (2) the outside limits of potential loss, and (3) other actions that may be available to the plan to minimize such a loss.
Therefore, the only “sure thing,” according to the DOL Advisory Opinion is that a fiduciary will breach his or her duties to the plan by agreeing to a limitation of liability provision that purports to limit liability arising out of the Consultant’s “fraud or willful misconduct.” Whether a fiduciary violates his fiduciary duty in agreeing to other limitations of liability will be decided on a case-by-case basis.
Presumably, this DOL opinion could result in more widespread use of limitation of liability provisions in Consultant service agreements. If the courts follow the DOL analysis, plan fiduciaries will not automatically be found to have breached their fiduciary duties in agreeing to such provisions, as long as they engage in “procedural prudence” in deciding whether to execute agreements with these provisions.
So, should Consultants routinely require these provisions as part of their agreements with their clients? That is a more complicated question, the answer to which depends on a complex weave of risk management, insurance strategies and marketing considerations.
Given the DOL’s opinion, if the number of Consultants that require these agreements increases dramatically, it may very well decrease the chances that a plan fiduciary will be found to have breached his or her fiduciary duty by agreeing to limit the Consultant’s liability. After all, to overcome a fiduciary breach claim, according to the DOL, a fiduciary should “…assess the plan’s ability to obtain comparable services at comparable costs either from service providers without having to agree to such provisions.” If every Consultant required a limitation of liability provision, it would be impossible for a plan fiduciary to obtain professional services for the plan without agreeing to a limitation of liability provision. In that circumstance, it may also be impossible to successfully argue that the fiduciary breached his or her duty by agreeing to the provision.
On the other hand, if only relatively few Consultants require these provisions as a condition of performing services, plan fiduciaries could presumably secure similar services without having to agree to limit their Consultants’ liability. That could prompt some Consultants to simply obtain insurance against large malpractice claims, and to attempt to set themselves apart from other Consultants by emphasizing their willingness to work without requiring limitation of liability provisions.
While the DOL has indicated that use of limitation of liability provisions does not per se give rise to a breach of fiduciary duty, another issue is whether these provisions are enforceable under the laws of the state in which the Consultant practices – or more precisely, the state in which a Consultant gets sued. This issue may be the most significant that a Consultant considers in deciding whether to use a limitation of liability clause in its contracts. After all, most courts that have considered the question have decided that state negligence and malpractice laws apply to claims against Consultants who are alleged to have committed negligence in providing their regular, non-fiduciary professional services. {See, e.g., Berlin City Ford, Inc. v. Roberts Planning Group, 864 F.Supp. 292, 295 (D.NH 1994); Coyne & Delany Co. v. Selman, 98 F.3d 1457 (4th Cir. 1996): [holding that “garden-variety” state law professional malpractice claims are not preempted by ERISA].}
In California, for instance, the courts will consider a host of factors in deciding whether a limitation of liability provision violates public policy, or is otherwise unenforceable. Among other things, the courts consider whether the services being performed are a practical necessity for some consumers, whether the party seeking the limitation possesses a “decisive advantage of bargaining strength” over those who seek their services, and whether the party seeking the limitation uses a standardized contract that doesn’t allow a customer to pay additional reasonable fees and obtain protection against negligence.
A thorough analysis (and comparison) of the various state laws regarding limitation of liability provisions is beyond the scope of this article. However, consider this: if it is questionable whether a limitation of liability provision is enforceable under the state law that governs, it may make little business sense to use them. Discriminating clients may question the provisions, negotiate their limits, or in the worst case, hire another Consultant altogether if they feel the proposed provision is overreaching.
Meanwhile, Consultants should be able to insure against claims that arise due to simple negligence or malpractice. While errors and omissions insurance premiums for benefit plan Consultants have seen significant increases, Consultants may be able to soften the blow by relatively modest increases in their fees. Assuming that you are able to obtain errors and omissions insurance, and thus, your insurance carrier bears most of the risk of a lawsuit, you should ask yourself whether you are really receiving any benefit from a limitation of liability provision that trumps the potential loss of goodwill that may follow.
© 2002
Article was reprinted, with permission, from The ASPA Journal, Vol. 32, No. 6 (Nov-Dec 2002). Copyright 2002 ASPA. All rights reserved.
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