When Your Two Hats are Both Fiduciary Caps – A Fiduciary Fable

April 20th, 2018|By Amy Klein

Donovan v. Mazzola, 716 F.2d 1226 (9th Cir. 1983)

Once Upon A Time, a long, long time ago, a Northern California labor union and its participating employers established a “Pension Fund” to provide retirement benefits to union members and their beneficiaries. The Pension Fund was an employee benefit plan subject to ERISA.

A few years later (and still a long, long, time ago), the union established a “Convalescent Fund”. The Convalescent Fund owned and operated a hotel that provided rooms at discounted prices (the Konocti Harbor Inn), a summer camp, and a low-cost retirement housing project for participants of the Convalescent Fund and their families.

The trustees of the Pension Fund and the Convalescent Fund were the same. The participants and the contributing employers were not, although there was substantial overlap.

ERISA became effective on January 1, 1975. We don’t know how the Pension Fund and Convalescent Fund trustees ran those funds before the effective date of ERISA, but some of their actions between 1975 and 1979 startled the Secretary of Labor into action. In December 1975, the loaned $1.5 million from the Pension Fund to the Convalescent Fund. Before granting the loan, the trustees failed to determine the value of the property deeded as security for the loan. Although the Convalescent Fund’s total property holding was appraised at $16 million, the loan collateral did not include the resort facilities. AND a portion of the property given as security was subject to prior rights of a bank and already was security for the Pension Fund’s $5.5 million loan to the Convalescent Fund! AND the interest rate on the loan was below market rate! The following year, they granted a moratorium on payment of that loan as well as all other loans that the Pension Fund had made to the Convalescent Fund! The trustees did not negotiate amendments to the loan terms in consideration for the moratorium, and they did not request additional collateral. In 1978 and 1979, the trustees also granted the Convalescent Fund two extensions to repay a $500,000 loan originally granted in December 1974 and due November 1, 1978. With these extensions, the total final payment was more than $400,000. Again, there was no change in the terms of the loan, and no additional security.

I know, right? SMH. Did anyone read the ERISA fiduciary rules? The Department of Labor did more than shake their heads. They sued for breach of the fiduciary duty to act in the best interest of the Pension Fund participants, and for engaging in a transaction on behalf of a party whose interests are adverse to the interests of the plan or the interests of its participants or beneficiaries….

But wait! There’s more!

Obviously the Convalescent Fund’s financial status was somewhat dicey. So, in March 1977, the Trustees engaged a friend of one of the trustees (a physician named Dr. Davis) and paid him $250,000 for a feasibility study to determine the most profitable use of the Convalescent Fund’s Konocti Harbor Inn. The DOL thought that a comparable study of equal or superior quality could have been obtained for substantially less money, so it added another charge of breach of the fiduciary duty.

But wait! There’s more!

In addition to the loans made to the Convalescent Fund, in 1975 the trustees made a $650,000 loan of Pension Fund assets to a limited partnership known as S & F Spas for the conversion of a hotel to a health spa. Guess who one of the principals of the limited partnership was? Why, our friend Dr. Schwartz! Prior to making this loan the Pension Fund trustees had approved a $2 1/4 million construction loan secured by the property on which the spa was to be constructed. Put another arrow in the breach of fiduciary duty quiver!

What did the DOL want? It wanted the trustees to be removed from as Pension Fund trustees and to be forbidden from serving as fiduciaries to any employee benefit plan covered by ERISA. In addition, all transactions between the Pension Fund and the Convalescent Fund would be reversed, and the Pension Fund made whole for any losses incurred in connection with the prohibited transaction at the trustees expense. The DOL also wanted the fiduciaries to reimburse the costs of the lawsuit. And finally, because these are individuals after all, the DOL thought it was a good idea for the trustees to post a $1 million bond to secure these obligations (which the trustees did not do, at least not right away, which kind of ticked the court off – it held the individual appellants in contempt and imposed a fine of $100 per day per trustee).

The Court of Appeals completely and totally agreed. As Jean Luc Picard would say, “Make it so.”

The Moral of the Story

First of all, know your responsibilities. Act prudently. Check out the credentials of your service providers. Benchmark their fees. Make sure loans from plan assets are made on commercially reasonable terms. And never, never loan funds between plans.


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