February 2008

Limitation on Liability in Service Provider Agreements

Service providers sometimes try to limit their liability for mistakes through provisions in their service contracts. These provisions raise a number of questions that plan sponsors need to consider.

1. Is such a provision in the best interests of the participants in the plan? In addressing this issue, the Department of Labor has said that it is not a breach of fiduciary duty for a plan sponsor to enter into a contract with a provision that limits the liability of a service provider. It went on to say, however, that the plan sponsor must take into account whether the plan could engage a different service provider who could provide the same level and quality of service at a similar cost without such a limitation on liability. In other words, the plan fiduciaries must carefully consider the prudence of agreeing to such a limitation.

2. Is the service provider a fiduciary under ERISA? If so, ERISA Section 410(a) specifically prohibits a fiduciary from obtaining a release from prospective liability (such a provision is “void as against public policy.”). In other words, a provision that seeks to limit fiduciary’s liability is unenforceable under the law.

3. If the service provider is not a fiduciary, is the limitation reasonable? Assuming the plan sponsor determines that it is appropriate to agree to a limitation, the next issue is whether, if the service provider makes a mistake and incurs liability, would the plan be adequately compensated for any reasonably likely loss or damage under the limitation? If not, the limit should be eliminated or increased. Consider three examples:

a. The agreement may provide that the service provider will indemnify the plan and plan sponsor for its gross negligence or willful misconduct. Without getting into the technicalities of the law, “gross” negligence requires a more significant disregard for proper standards of conduct than “simple” negligence. To better protect the plan and plan sponsor, the word “gross” should be eliminated.

b. The agreement may provide a limit on the service provider’s liability equal to the amount of its annual fees (or perhaps a multiple, such as two times). Suppose the annual fee is $10,000. Under such a provision, the service provider’s liability for damages caused by its negligence or bad acts could be as little as $10,000 (or $20,000 if the limit is two times the fee). The plan sponsor must consider whether this amount is likely to compensate the plan adequately for a mistake made by the service provider.

c. The agreement may provide that, if information is provided by the service provider – e.g., a trust account or participant statements, it will be deemed accepted and the service provider will have no liability for mistakes made in the information after a period of time. This is a kind of contractual “statute of limitations.” Often, the service provider seeks to limit the time period to 60 or 90 days. This would mean that the plan sponsor must not only review the information, but essentially re-do the service provider’s work to verify the information – and must do so promptly after receipt of the information. In representing plan sponsors, we generally reject this type of proposed limitation, though sometimes it is agreed to if the time period is long enough to permit a realistic review of the information by another party, such as a plan auditor.

While there is nothing inherently wrong with a liability limitation provision, it is one which the plan sponsor should carefully consider and negotiate in an attempt to either eliminate it or to increase the limit if the provision is otherwise deemed acceptable.

Services and Industries

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