Attorneys May Be Liable if They Knowingly Participated in an Insurer's Fiduciary Duty Breach

In a case of first impression, a federal district court ruled that the attorneys for an insolvent health fund that breached its fiduciary duty could be held liable for that breach if they knew that their legal fees came out of the fund's unspent reserve fund. The court indicated that the language in ERISA's fiduciary liability provision makes such a lawsuit possible, but it further noted that, ultimately, proving such a breach may be very difficult. However, the attorney's liability for the breach hinges on other factors as well. The case is L.I. Head Start Child Development Services Inc. v. Frank, 165 F. Supp. 2d 367 (E.D.N.Y., Sept. 26, 2001).

The ruling puts in issue the extent of attorneys' -- and certain other parties in interest -- protection under ERISA from liability for a fiduciary's breach of duty. The court only ruled on the attorneys' motion to dismiss the claim, not on the merit of whether they aided in a fiduciary breach.

Facts of the Case

L.I. Head Start Child Development Services Inc. maintained a health and welfare benefit fund with Community Action Agencies Insurance Group (CAAIG), which used contributions from L.I. Head Start to either purchase or self-fund insurance coverage for L.I. Head Start's employees. By 1992, CAAIG had built a significant reserve of unspent L.I. Head Start contributions, and in 1993, L.I. Head Start informed CAAIG that it was terminating coverage and asked for the reserve to be returned. When CAAIG refused, L.I. Head Start sued.

The court held that since CAAIG was acting as a fiduciary for L.I. Head Start, ERISA's "exclusive benefit" rule required that all of the unspent funds be returned to L.I. Head Start once it terminated its contract. As such, the court entered a judgment of more than $802,331 against CAAIG. This amount included, in addition to the reserve, interest and attorney's fees and costs. However, when CAAIG became insolvent -- and could not pay the judgment -- L.I. Head Start sued CAAIG's former attorneys, Frank & Breslow, P.C., in federal district court, alleging that the attorneys:

The attorneys argued that ERISA did not recognize such a claim, and sought dismissal.

Non-Fiduciary Could Be Liable For Fiduciary Duty Breach

The court held that L.I. Head Start's claim was premised on the argument that a non-fiduciary, such as a plan's attorney, could be held liable for knowingly participating in the plan's breach of fiduciary duties under ERISA. Citing the 2nd U.S. Circuit Court of Appeals' ruling in Diduck v. Kaszycki & Sons Contractors Inc., 974 F.2d 270 (2nd Cir., 1992), the court held that ERISA allows non-fiduciaries to be sued under such circumstances. And since no contrary authority existed, the court added, the courts within the 2nd Circuit (in which this case is being heard) continue to follow the Diduck ruling. The U.S. Supreme Court had earlier questioned this reasoning in Mertens v. Hewitt Associates, 508 U.S. 248 (S. Ct., 1993). However, in Harris Trust and Savings Bank v. Salomon Smith Barney Inc., 530 U.S. 238 (S. Ct., 2000), the Court ruled that ERISA allows lawsuits against non-fiduciaries under a provision that prohibits "parties in interest" from engaging in prohibited transactions with a fiduciary. The L.I. Head Start court said that this retreat from a narrow reading of ERISA's enforcement mechanisms suggests that the Diduck reasoning still applies.

The attorneys argued that they were exempt from ERISA liability because they merely provided legal services to CAAIG, adding that they were protected under a safe harbor that allows plans to avoid violating ERISA's prohibited transaction provision while contracting for legal or accounting advice or office space. However, the court held that the attorneys could not use the prohibited transaction safe harbor as a defense to L.I. Head Start's claim that they participated in a breach of fiduciary duty. (The safe harbor provision specifically protects parties in interest from claims under ERISA's prohibited transaction provision. However, the issue in L.I. Head Start was whether the safe harbor also protects against claims that an attorney knowingly participated in a fiduciary duty breach.)

The court then noted that, while it could not find a case in which a plaintiff could sue an insolvent ERISA fund's former attorneys over a trust from which the attorneys were paid, such a lawsuit is possible under ERISA. While the court agreed with the attorneys that such a lawsuit would effectively turn an ERISA plan's attorney into a guarantor of a potential judgment against the plan, it said that such a lawsuit would be consistent with ERISA's goals.

The court also said that, since the essential element to such a lawsuit would be whether the attorneys knowingly participated in a fiduciary duty breach -- attorneys who simply provide legal services to ERISA plan could not be held liable. However, if the attorneys -- hypothetically speaking -- knowingly participated in their client's breach of its fiduciary duties, the court indicated that it would be "fitting and proper" to require the attorneys to restore the proceeds of the fiduciary duty breach to the fund. Therefore, the court, citing Diduck, said that L.I. Head Start must sufficiently allege that: (1) the fiduciary (in this case, CAAIG) breached its duty to act exclusively in the plan participants' best interests; and (2) the attorneys knowingly participated in the breach.

L.I. Head Start alleged that the payment of the attorneys' legal fees and disbursements from the reserve was a breach of fiduciary duty. Since CAAIG did not challenge this allegation, the court said that it assumed that CAAIG's payment of its legal fees from the reserve was a breach of fiduciary duty.

The court found that L.I. Head Start claimed that the attorneys "knew or should have known" that CAAIG's payment of their fees was coming from the reserve. The court said that, although L.I. Head Start did not allege in their lawsuit that the fund was insolvent, it would assume that its argument that CAAIG's inability to pay the judgment is the result of CAAIG's insolvency. Therefore, the motion to dismiss was denied.

Questions Raised About Attorneys' Knowledge of the Breach

However, the court said that L.I. Head Start must not only prove that CAAIG was tapping into the reserve to pay the attorneys, but that the attorneys should have known of the reserve's existence, and that being paid from it was a fiduciary duty breach. While it is unlikely that an outside attorney would have such knowledge about a client's accounting practices, the court said that it must give L.I. Head Start the opportunity to show that the attorneys knew about the reserve. However, the court noted, L.I. Head Start's ability to prove this will be affected by the fact that most of the communications between CAAIG and the attorneys are protected by attorney-client privilege.

The court further noted that, even if L.I. Head Start could prove that the attorneys knew about CAAIG's fiduciary duty breach, its lawsuit may be barred by the statute of limitations for fiduciary duty breach claims, depending on when the breach was discovered.

Excerpted from the December 2001 supplement to Employer's Guide to Self-Insuring Health Benefits,, ©Thompson Publishing Group, Inc., 2001. All rights reserved.

BenefitsLink is an independent national employee benefits information provider, not formally affiliated with the firms and companies who kindly provide much of the content and advertisements published on this Web site, including the article shown above.