Employee Relations. Palmason v. Weyerhaeuser Company, et al.: Allegations of Imprudent Investment Strategy in the Defined Benefit Context

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1 VOL. 37, NO. 3 WINTER 2011 Employee Relations L A W J O U R N A L ERISA Litigation Palmason v. Weyerhaeuser Company, et al.: Allegations of Imprudent Investment Strategy in the Defined Benefit Context Craig C. Martin and William L. Scogland On April 25, 2011, a participant in an ERISA plan filed a four-count complaint in the Western District of Washington on behalf of a putative class against Weyerhaeuser Company, Weyerhaeuser Asset Management LLC, Morgan Stanley, Northwater Capital Management, Inc., and the individuals who served on Weyerhaeuser Company s investment committee alleging that Weyerhaeuser adopted a very risky investment strategy for its pensions assets, heavily weighted to hedge funds, that directly resulted in the Weyerhaeuser Retirement Plan for Salaried Employees (the salaried plan) and the Weyerhaeuser Retirement Plan for Hourly Employees (the hourly plan) (together the plans) going from being overfunded by $2 billion to being underfunded by $450 million. The basic theory of the complaint was that the defendants, in their various roles, breached their fiduciary duties by causing or permitting plan assets to be invested in an unduly risky manner that relied on a heavy mix of alternative investments. 1 The Plans According to the complaint, the purpose of the plans was to provide retirement benefits to eligible employees and their beneficiaries. 2 Craig C. Martin, a partner in Jenner & Block LLP s Chicago office, is co-chair of the Firm s National Litigation Department and a long-time member of the firm s governing committee. William L. Scogland, who also is a partner in the firm s Chicago office, is chair of the firm s Employee Benefits and Executive Compensation Practice. The authors can be reached at cmartin@ jenner.com and wscogland@jenner.com, respectively. The authors wish to thank Michaelene R. Martin for her help in preparing this column.

2 Both the salaried plan and the hourly plan are defined benefit, noncontributory plans under which Weyerhaeuser makes all the contributions to the plan. 3 The plaintiffs allege that as of December 31, 2009, the salaried plan and the hourly plan had net assets available for plan benefits of approximately $1.5 billion and $2.2 billion, respectively. 4 Causes of Action The complaint purports to state four causes of action: 1. Breach of the ERISA fiduciary duties of loyalty, prudence, and diversification on the part of Weyerhaeuser Company as the plans sponsor/administrator and Weyerhaeuser s investment committee by failing to establish and maintain a prudent investment policy for the assets of the Master Trust; 2. Breach of the ERISA fiduciary duty of loyalty and breach of ERISA s obligation to act in accordance with plan documents, on the part of Morgan Stanley, Northwater, and Weyerhaeuser Asset Management, all of which allegedly served as investment managers to the plans, by failing to properly implement the Investment Policy and prudently invest the assets of the Master Trust; 3. Breach of the duty to monitor the other fiduciaries, on the part of Weyerhaeuser and the investment committee members, by failing to properly monitor the performance of fiduciary appointees and remove and replace those whose performance was inadequate; and 4. Cofiduciary liability for failing to prevent breaches by other fiduciaries of their duties to the plan, asserted against all defendants. 5 Portable Alpha Strategy The plaintiffs allege that the defendants permitted or caused plan assets to be invested in an unduly risky manner. At the heart of this theory is the allegation that plan assets were invested in a portable alpha strategy, where the goal was to make investments with portfolio managers that would outperform a predicted return (the alpha) and be balanced by investments that would help the entire portfolio meet a set level of risk (the beta). 6 According to the complaint, the success of the portable alpha strategy required achieving two goals. 7 The first goal is alpha generation, or excess return on each alpha generating manager s portfolio relative to the expected return of a Vol. 37, No. 3, Winter Employee Relations Law Journal

3 hypothetical portfolio with the same beta (level of risk). The plaintiffs assert that an alpha of zero provides no excess return, a positive alpha of 1.0 means the fund has outperformed its benchmark by one percent, and an alpha of -1.0 would indicate an underperformance of one percent. 8 The second goal is proper evaluation and management of the portfolio s beta, which is the extent to which the portfolio moves with a targeted benchmark. 9 Beta measures the risk and return conferred on a portfolio by virtue of its correlation with the targeted benchmark portfolio as a whole. 10 In the absence of alpha, according to the complaint, if the targeted benchmark portfolio rises by 10 percent, a portfolio with a beta of 1.2 is expected to rise 12 percent. If the targeted benchmark declines by 10 percent, the portfolio with a beta of 1.2 is expected to decline by 12 percent. 11 More Than 330 Alternative Investments The plaintiffs also allege that, in the course of implementing the portable alpha strategy, more than 81 percent of plan assets were invested in 330 different alternative investments (including 53 percent in hedge funds and 24 percent in private equity) that were allegedly unduly risky and nearly impossible to properly monitor and evaluate. 12 According to the complaint, the magnitude of the number of investments prevented the defendants from properly ascertaining the degree of correlation each investment had with the targeted benchmark and prevented them from doing adequate due diligence. 13 The plaintiffs allege that it was nearly impossible for the defendants to properly manage the risk of 330 alternative investments. 14 Further, the plaintiffs asserted that hedge funds and private equity pose significant risks and challenges that demand greater expertise and efforts on the part of fiduciaries than more traditional investments. 15 According to the plaintiffs, these include: Lack of transparency because fiduciaries have limited information about the underlying investments or the valuation of the underlying investments; Limited liquidity due to the absence of a public market; Greater exposure to operational risks including trading errors; Fraud by any of the multitude of managers utilized by the Master Trust; and The risk that comes with greater reliance upon the skill and strategies of individual investment managers as compared to the market as a whole. 16 Employee Relations Law Journal 3 Vol. 37, No. 3, Winter 2011

4 The plaintiffs further allege that hedge funds are risky because investors cannot get their money out easily because of an imposed lock-up period that requires investors to commit their money for periods of one to two years or more. 17 Moreover, the plaintiffs asserted that even after the lock-up period has ended, investors may not be able to redeem their investments at will, but rather are limited to specified window periods with a prenotification requirement. 18 The complaint alleges that, as with hedge funds, investments in private equity face risks beyond the risks of traditional investments because private equity funds are prone to concentration risk in the underlying holdings, private equity funds typically use leverage, and they often require commitments of ten or more years. 19 Further, according to the plaintiffs, private equity funds are difficult to value making it challenging to assess how the fund has performed until the underlying investments are sold. 20 Excessive Risk Further, the complaint asserts that the investment managers miscalculated the alpha relative to the beta, thereby exposing plan assets to excessive risk and causing the Master Trust (which held assets of the two plans) to lose 41 percent of its value $2.4 billion in According to the plaintiffs, by their actions Defendants failed to adopt and implement an investment policy that properly minimized the risk of loss. 22 As a consequence, by implementing the investment strategy, Weyerhaeuser and the investment committee members allegedly breached their duty of loyalty to the plans. 23 The plaintiffs allege that rather than outperforming its benchmark, the Master Trust underperformed its benchmark by 27 percent in 2008, and did not yield any material outperformance of the benchmark in 2009 or 2010 despite the excess risk taken on by the defendants. 24 According to the complaint, the Master Trust s portfolio between 2000 and 2010 had almost twice as much risk as it was supposed to, which allegedly indicates that the Defendants have systematically underestimated the amount of risk in the portfolio contrary to the plans investment policy and suggests that any returns received over the years were the result of excess risk rather than investments that were outperforming expectations. 25 More specifically, the plaintiffs allege that in the Master Trust, the alpha-generating portion of the portfolio is the 81 to 88 percent allocation to hedge funds, private equity, and real estate funds. 26 The complaint alleges that the inherently risky investment strategy magnified that risk with the purchase of derivatives which allowed [Weyerhaeuser] to gamble with retirement assets, all while conferring no actual or potential benefit to the plans participants and beneficiaries, because if the strategy failed, plan participants paid the price in the increased risk to their pensions, and if it succeeded, Weyerhaeuser would be able to report additional income arising from net gains in the value of pension plan assets. 27 Vol. 37, No. 3, Winter Employee Relations Law Journal

5 Potential Damages The complaint asserts that Weyerhaeuser s pension plan assets were overfunded by $2.1 billion at the end of 2007 but were underfunded by $450 million by the end of 2008, prompting Weyerhaeuser to avert [d]isaster by making no-interest, short-term loans of $285 million to allow the plans to continue to pay benefits. 28 The complaint asserts that the plans would not have lost $2.4 billion in 2008 except for the unduly risky investment strategy, and it asserts that the defendants are liable for plan losses as well as the amount needed to cause the Plans to again be fully funded to satisfy their accumulated benefit obligations. 29 However, the complaint does not allege that any benefits have not been paid to the plaintiffs. It is unclear, as of yet, how the plaintiffs will prove damages. More to Follow? The legal theories asserted in Palmason v. Weyerhaeuser Company, et al. are novel theories, especially as applied to defined benefit plans. Time will tell if these theories will ultimately be successful. Every company, however, should be aware that these theories are out there. Notes 1. Complaint Id Id Id Id Id. 4, Id Id. 9. Id. at Id. 11. Id. 12. Id. 4, 79 94, Id Id. 15. Id Id. Employee Relations Law Journal 5 Vol. 37, No. 3, Winter 2011

6 17. Id Id. 19. Id Id Id Id Id Id. 25. Id Id Id. 5, Id. 5, Id. 5, 116, 118, 138, 145. Copyright 2011 CCH Incorporated. All Rights Reserved. Reprinted from Employee Relations Law Journal Winter 2011, Volume 37, Number 3, pages 86-91, with permission from Aspen Publishers, Inc., Wolters Kluwer Law & Business, New York, NY, , Vol. 37, No. 3, Winter Employee Relations Law Journal