U.S. Supreme Court Considering Fiduciary Responsibility For 401(k) Plan Company Stock Funds and Other Employee Stock Ownership Plans (ESOP)

Transcription

1 Fiduciary Responsibility For Funds and Other Employee Andrew Irving Area Senior Vice President and Area Counsel

2 The Supreme Court of the United States is poised to enter the debate over the standards of prudence and loyalty that an ERISA plan fiduciary must satisfy when a defined contribution plan offers participants a fund dedicated to company stock as one of the plan s investment options. The Court heard oral argument on April 2, 2014 in a case brought by participants in Fifth Third Bank s 401(k) plan alleging that the bank and its officials who were the plan s fiduciaries breached their fiduciary duties under ERISA by maintaining the plan s company stock fund even as the Bank s stock declined by 74% in the aftermath of poor financial results stemming from the Bank s expansion of its subprime lending and other high-risk businesses. The plan s company stock fund lost tens of millions of dollars as a result, according to the plaintiffs. The name of the case is Fifth Third Bank v. Dudenhoeffer and a decision is expected by the end of June. Summary and Overview Company stock funds pose unique challenges and risks to plan fiduciaries who must decide what, if anything, to do when the company and its stock face serious challenges, putting participant investments in the stock fund in jeopardy. The Supreme Court is expected to provide at least some clarification as to the nature of those fiduciary responsibilities and the fiduciary breach claims that stock fund participants can bring when plans lose millions of dollars on company stock. The Supreme Court may address how appointing an independent fiduciary can alleviate some of the inherent conflicts, and resulting risks, associated with putting company insiders with access to material nonpublic information in fiduciary positions. What s at Stake According to the briefs filed with the Supreme Court, thousands of companies offer some kind of employer stock investment opportunity to their employees. Company stock funds can take the form of standalone Employee Stock Ownership Plans (ESOPs) that exist side by side with an ordinary 401(k) plan, or as one of the several investment options offered within the 401(k) plan (so-called KSOPs ). AARP, citing a study by Vanguard, reports that nearly 60% of participants enrolled in plans covering at least 5,000 participants were offered employer stock as an investment option, and that retirement plans held $240 billion in employer stock as of Congress has indicated its support for the concept of employee ownership, and has facilitated the offering of employer stock funds in 401(k) plans by explicitly providing that such funds are exempt from the diversification element of ERISA s demanding fiduciary standards. Because employer stock funds are, by definition, undiversified, plan participants who choose to invest in the stock fund can suffer significant losses if the stock price drops dramatically. Perhaps not surprisingly in our litigious society, those losses have given rise to lawsuits. A nonparty friend INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 2

3 of the court brief filed by Delta Airlines listed 235 so-called stock drop litigation cases under ERISA filed between July 1997 and August While plaintiffs have yet to win a case that has gone to trial, the friend of court brief filed by the Chamber of Commerce and other employer organizations reported that such lawsuits often settle for tens of millions of dollars. Gallagher s institutional investment and fiduciary services practice has reviewed and approved ERISA stock-drop settlements for as much as $57 million. The Issues The U.S. Department of Labor and attorneys representing plan participants have very different views from attorneys representing plan fiduciaries on how a fiduciary should manage an employer stock fund. ERISA and the fiduciary dilemma created by employer stock funds ERISA imposes a fiduciary duty on fiduciaries managing ESOP and KSOP company stock funds consisting of three components: Loyalty: A duty to act solely in the interests of the participants and beneficiaries and for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying the plan s reasonable administrative expenses; Prudence: A duty to act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, but without the duty to diversify investments that applies to other ERISA plan assets; and Conformity with plan documents: A duty to act in accordance with the plan s governing documents to the extent consistent with specified provisions of ERISA, including the provisions outlining the other elements of fiduciary duty. In contrast to other fund investment options, company stock funds invest in only a single security. Despite the risk associated with such an undiversified investment, Congress has expressed its support for giving employees an opportunity to become owners of a stake in their employers by exempting ESOPs and KSOPs from the investment diversification element of fiduciary duties that applies to all other plan investments. Another distinguishing feature of company stock funds is that the plan s governing documents, typically drafted by the employer establishing the plan (a function trust law refers to as a settlor function ), often mandate that the employer stock fund be offered and do not authorize the fiduciaries to eliminate the fund the way they can eliminate or replace the plan s other investment options. In addition, the company officials assigned to provide fiduciary oversight of the plan s investments often have access to negative nonpublic information about the company but (1) are barred by the securities laws from relying on that information to sell the plan s holdings of company stock before the INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 3

4 news becomes public and drives down the stock price, and (2) would be defying the plan document if they were to sell the plan s stock holdings or bar participants from investing in it. The question facing not only the Supreme Court but also the fiduciaries responsible for making decisions about employer stock funds is how, if at all, ERISA s fiduciary s duties of loyalty, prudence and plan document conformity are different when a company stock fund is involved, as compared to the plan s other investments. A fiduciary needs to know what circumstances give rise to a duty to override the plan s direction and either limit or bar new investments into the stock fund, or even to sell the fund s holdings of the employer stock. And fiduciaries and their insurers need to know how expensive litigation will be and how likely they are to be held liable if, on the one hand, the fiduciaries maintain the stock fund and the company s stock declines or even becomes worthless in a bankruptcy, or they decide to sell the stock when it is under pressure and a declining company recovers and the stock price rallies. The Moench Presumption of Prudence Most courts have adopted what has come to be known as the Moench presumption, named for a participant in an ESOP sponsored by a New Jersey bank that went bankrupt. Mr. Moench sued the ESOP fiduciaries for breach of fiduciary duty for continuing to purchase the bank s stock for the ESOP even as they became aware of the bank s deteriorating condition. The United States Court of Appeals for the Third Circuit decided in that 1995 case that when it comes to employer stock, as opposed to other investments, fiduciaries are entitled to a presumption of prudence in light of the special nature of employer stock funds described above. According to the Moench presumption, plaintiffs who suffer losses on their employer stock investments must meet a higher burden of proof to establish that fiduciaries breached their duties, versus the burden of proof required to establish breaches of fiduciary duties pertaining to other investments. Since then, virtually all of the Courts of Appeal around the country have agreed that such a presumption is appropriate and applies to ESOPs and KSOPs alike. However, the courts have been unable to agree on a formulation of exactly what circumstances overcome the presumption and give rise to a fiduciary duty to respond to negative developments about the company by taking action to close or liquidate a stock fund or make disclosures to participants outside the requirements of the securities laws. In the Moench case itself, the court said that employer stock fiduciary decisions are presumed prudent unless they amount to an abuse of discretion in that the fiduciary could not have believed reasonably that continued adherence to the [plan provisions calling for an employer stock fund] was in keeping with the settlor s expectations of how a prudent trustee would operate. While agreeing that a decline in the stock s price was not by itself enough to require fiduciary action, courts have used phrases like extreme risk, dire situation, [doubts as to] viability as a going concern, serious INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 4

5 mismanagement and impending collapse to attempt to characterize the additional circumstances that must be present to render a fiduciary dutybound to stop investing the plan s assets in the employer s stock. Fiduciary defendants support a strong statement of the presumption, arguing that without it employers will become reluctant to establish employer stock funds notwithstanding public policy encouraging them, and that plan participants can use the securities laws to recover if their losses result from fraud-like conduct. Meanwhile, attorneys for plan participants continue to argue that, aside from the exemption from diversification, ERISA does not provide for a separate fiduciary standard applicable to employer stock. The Department of Labor has consistently taken that same position, asserting that employer stock fiduciaries are not entitled to the special deference or protection a presumption of prudence creates. Under this view, plan participants who suffer losses on employer stock investments need only show that a trustee adhering to ERISA s prudence and loyalty standards should have taken action to close or eliminate the stock fund, or taken other steps such as making disclosures to participants or limiting investments in the fund. Further, the inside information dilemma can be addressed by appointing an independent fiduciary untainted by such information to make decisions about the fund. A separate but related issue concerns the stage of the proceedings at which plan participants must present specific facts other than the decline in the price of the stock sufficient to overcome a presumption of prudence (however it is formulated). Most courts have agreed with fiduciary defendants that the complaint filed at the beginning of the case must meet that standard or the case will be dismissed. Dismissal of a case at that early stage prevents lengthy, expensive litigation involving extensive document production, depositions, motions and the associated legal fees. And the prospect of dismissal can discourage attorneys from pursuing stock drop claims. Plan participants, on the other hand, again supported by the Department of Labor, urge that if there is to be a presumption of prudence it should only apply after a full record has been developed through pre-trial discovery, since participants do not have access to all the facts concerning the company and the fiduciaries conduct when a case begins. They say that requiring participants to allege facts needed to overcome a prudence presumption places an effectively insurmountable barrier to recovery of employer stock losses. What Will the Supreme Court Do? The Supreme Court received a total of 12 briefs in the case. Delta Airlines and Key Bank, who are facing similar stock drop litigation, filed friend of the court briefs supporting Fifth Third Bank s arguments in favor of a strong presumption of prudence. Similar briefs were filed by the ESOP Association, a coalition of organizations representing plan sponsors such as the Chamber of Commerce and the National Association of Manufacturers, INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 5

6 and the Securities Industry and Financial Markets Association. On the other side, the Solicitor General of the United States (on behalf of the Department of Labor), the AFL-CIO, AARP and a group of law professors supported the plan participants in arguing that ERISA does not permit a presumption of prudence and if it does, it should not apply at the outset of the case. The briefs appeared to agree on one point only: that a stock price drop by itself is insufficient proof of a breach of fiduciary duty. Otherwise, the briefs presented disagreements even among those arguing on the same side as to what renders continued maintenance of an employer stock fund imprudent and a violation of the duty of loyalty, both with and without a presumption of prudence. At oral argument an engaged Court pressed all the lawyers on the practical issues facing employer stock fund fiduciaries, but the focus was limited almost exclusively on the situation in which fiduciaries are insiders who come to possess materially adverse information about the company. There was acknowledgment that fiduciary action to liquidate the company stock fund, before the adverse information was disclosed, would not only violate the securities laws but itself drive down the price of the stock to the detriment of the participants. The Justices also asked the lawyers how a fiduciary could be expected to outguess the market as to whether the company stock was overvalued other than by reference to inside information. But several Justices asked whether insider fiduciaries with negative nonpublic information need the protection of the Moench presumption if compliance with the securities laws means they cannot sell stock before the public disclosure of the information drives down the stock price. The back and forth on those issues led some Justices to seem to suggest that if ordinary standards of prudence did not require fiduciaries to violate the securities laws by selling on non-public information or to outguess the market, then no special prudence rule for employer stock funds was even necessary. Justices also observed that replacing insiders with an independent fiduciary to assume responsibility for the company stock fund would resolve the inside information dilemma. With the focus on the inside information problem, little was said during the argument about the dilemma of fiduciaries at risk for dismantling a company stock fund too early rather than too late. And the Justices gave scant attention to the question of whether a presumption of prudence, if sustained, applies at the beginning of a case or should only be considered after a full record has been developed. This omission was surprising since it was the different views in the lower courts on this particular point that was central to the Court s decision to hear the case in the first place. The ebb and flow of oral argument does not always provide a reliable indicator as to how the Court will rule in a particular case. It may be that the Justices avoidance of discussion about when the presumption should apply indicates an inclination to reject the presumption itself. The Court may accept the suggestion of the United States Solicitor General to limit its opinion to situations where a failure to disclose material inside information known to the responsible fiduciaries has artificially inflated the stock s value. INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 6

7 Such an outcome would leave unaddressed the fiduciary obligations in other situations such as a company facing serious but fully disclosed financial or business problems driving down its stock price. The Court likewise could focus on the availability of independent fiduciaries to resolve some elements of the dilemma corporate insiders face when they choose to serve also as plan fiduciaries. And the Court may not address at all whether it matters how definitively plan language mandates that an employer stock fund be offered. One thing is clear after 20 years of debate in the lower courts, the companies who create employer stock funds, the in-house and independent fiduciaries who manage them and the plan participants who invest in them are hoping for clarification of the fiduciary rules of the road. We will know by the end of June if the Court will deliver that clarification. Arthur J. Gallagher & Co. s Institutional Investment and Fiduciary Services Practice has served as independent fiduciary for numerous employer stock funds in a variety of industries. INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 7

8 Andrew Irving About the Author Andrew Irving, Area Senior Vice President and Area Counsel of the Institutional Investment & Fiduciary Services group of Arthur J. Gallagher & Co., leads the fiduciary decision-making practice, which focuses on providing independent, conflict-free, discretionary decisions regarding particular transactions or plan assets. As Area Counsel, he also provides guidance on legal issues that arise in the course of client engagements and manages the services of outside legal counsel when particular assignments require their assistance. Andrew Irving Area Senior Vice President and Area Counsel Institutional Investment & Fiduciary Services Investment advisory services and named and independent fiduciary services are offered through Gallagher Fiduciary Advisors, LLC, an SEC Registered Investment Adviser. This document contains proprietary information that belongs to Gallagher Fiduciary Advisors, LLC and is protected by copyright, trade secret and other State and Federal laws. Any copying, redistribution, or retransmission of any of the contents without the written consent of Gallagher Fiduciary Advisors, LLC is expressly prohibited. Gallagher Fiduciary Advisors, LLC is a single-member, limited-liability company, with Gallagher Benefit Services, Inc. as its single member. Neither Arthur J. Gallagher & Co., Gallagher Fiduciary Advisors, LLC nor their affiliates provide accounting, legal or tax advice 2014 Gallagher Fiduciary Advisors, LLC INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES ARTHUR J. GALLAGHER & CO. MAY 2014 :: 8 14GBS25521A