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Employer Stock Funds Continue to Vex 401(k) Fiduciaries

Offering employees the opportunity to invest in the stock of their employer through a tax-favored vehicle like a Code Section 401(k) plan or employee stock ownership plan (“ESOP”) must have seemed like an innocuous idea at one time.  Indeed, Congress expressed its approval of such arrangements by creating special tax benefits for both the sponsors of such plans (in the form additional deductions) and participants in them (in the form of favorable tax treatment on unrealized appreciation in the value of employer stock).  Yet these “employer stock funds” are now the quickest path to the courthouse for employers that sponsor them and fiduciaries that administer them.

ERISA lawsuits involving employer stock funds — so-called “stock drop” cases — have not subsided over the past decade.  Unpublished information from one of the country’s largest fiduciary liability insurance carriers reveals that in 2009 alone plan sponsors, insurers, and fiduciaries paid over $330 million to settle litigation involving employer stock funds.  In light of the stock market’s massive volatility in recent weeks — which has reached nearly every corner of the economy — we expect to see another spike in such suits in the coming months.

Two federal court decisions handed down in the second quarter of 2011 reflect just what a dilemma employer stock funds can pose for plan fiduciaries.  In one case, fiduciaries were sued for continuing to offer the employer stock fund in the plan, when the price of that stock dropped.  In the other, fiduciaries were sued for eliminating the employer stock fund.  Thus, fiduciaries appear to be at risk whether the value of the sponsoring employer’s stock goes up or down.

The “Stock Drop” Theory

In most lawsuits over employer stock funds, plan participants contend that the plan’s fiduciaries violated their duties under ERISA by including the sponsor’s stock as an investment option in the plan when the fiduciaries knew, or should have known, that the stock was over-valued.  The individuals charged with administering the plan and selecting its investment options, and who are therefore plan fiduciaries under ERISA, are often corporate officers who have inside information about the company and its financial condition.  If the value of the employer’s stock drops, participants who invested in the employer stock fund lose money — frequently in large amounts. 

In an effort to recoup such losses, participants sue the plan’s fiduciaries, alleging that they should have foreseen the decline in stock value and taken action to avoid it.  This kind of claim is currently pending before the United States District Court for the District of Kansas, in a case called In re YRC Worldwide ERISA Litigation.

The challenge to employer stock funds can, however, be made in the converse situation; that is, when plan fiduciaries remove a company stock fund and the value of that stock subsequently increases.  In such cases, plan participants contend that the fiduciaries breached their duties under ERISA by imprudently deciding to eliminate an investment option that they knew, or should have known, would increase in value. 

In Tatum v. R.J. Reynolds Tobacco Company, participants made such a claim following the divestiture of R.J. Reynolds Tobacco from RJR Nabisco.  After the divestiture, the spun-off tobacco company’s 401(k) plan was amended to preclude future investment in Nabisco stock.  As one might predict, the value of that stock then soared, and participants sued because they were no longer allowed to invest in it.

YRC Worldwide — The Risk of Falling Stock Prices

The YRC Worldwide case represents the more typical scenario in stock drop cases.  Participants in YRC’s 401(k) plan alleged that the plan’s fiduciaries breached their fiduciary duties under ERISA when they continued to offer YRC stock as an investment option, even after the stock’s value declined precipitously.  According to the complaint, the stock dropped from $25.96 per share in October 2007 to a low of 45 cents per share in March 2010.

Although the YRC plan’s fiduciaries have asserted many defenses, the court has allowed the case to proceed.  The court acknowledged that employer stock funds enjoy a special status under the Tax Code and ERISA, and that a decision to include such a fund enjoys a “presumption of prudence.” 

This presumption imposes a high hurdle for plan participants to overcome.  Nevertheless, the court found that the participants had made factual allegations that, if proven, would overcome that presumption.  In so doing, this court became one of only a few that have accepted the presumption of prudence but allowed stock drop claims to proceed.

The court also rejected the fiduciaries’ argument that Section 404(c) of ERISA immunizes them from liability.  Section 404(c) provides a defense to investment loss claims if the loss can be attributed to a participant’s own investment decisions.  However, siding with an interpretation of Section 404(c) long advocated by the Department of Labor — and recently accepted by the Seventh Circuit Court of Appeals in Howell v. Motorola Inc. — the court concluded that Section 404(c) does not insulate fiduciaries from liability for assembling an imprudent investment menu.

The court recently certified the YRC case as a class action.  Thus, the YRC plan’s fiduciaries could end up responsible for investment losses incurred by nearly 17,000 participants who invested in the employer stock fund.

Tatum — The Risk of Rising Stock Prices

Unlike the plaintiffs in YRC, the participants in Tatum complained about their inability to continue investing in an employer stock fund that had once been available to them.  Like the YRC plaintiffs, however, the plaintiffs in the Tatum case survived many attempts to have their claims dismissed, and ultimately proceeded to trial.  A decision in that case is pending.

In a recent twist, however, the Tatum court ruled on June 1, 2011, that the plan participants could modify their theory of recovery — nearly 18 months after the trial (which concluded in February 2010).  Under this new theory, the participants contend that the plan amendment that closed the Nabisco stock fund to future investments was never properly authorized.  The court agreed, finding that the committee which had the authority to amend the plan never properly considered and approved the proposed amendment.  That finding could make it more difficult for the fiduciaries to establish that their decision to eliminate the employer stock fund was prudent.

What’s a Fiduciary to Do?

For years, the ERISA defense bar could boast that no court had ever found a fiduciary liable in a stock drop case.  Indeed, the case law was so fiduciary-friendly that most of those lawsuits were dismissed long before trial.  By and large, those boasts remain accurate.  But recent judicial trends, and a closer analysis of stock drop cases filed over the past decade, should make plan sponsors and fiduciaries think hard about employer stock funds.

Although courts in most jurisdictions still presume that the decision to include an employer stock fund is prudent, and although ERISA Section 404(c) still offers an effective defense in certain circumstances, a surprising number of stock drop lawsuits are now reaching the class certification stage or beyond.  Many such cases end in expensive settlements. 

At best, judicial decisions over the past year make the outcome of such litigation even more uncertain.  In addition to the YRC and Tatum cases, separate decisions from the Seventh Circuit Court of Appeals have cut back on the Section 404(c) defense (Howell v. Motorola) and rejected the notion that class certification is impossible in ERISA cases (Spano v. Boeing).  And, as noted in this issue’s Fiduciary Corner article, the United States Supreme Court’s Amara decision could create additional theories of recovery for ERISA plaintiffs.

In the end, we encourage plan sponsors and fiduciaries to conduct a careful cost-benefit analysis when considering whether to retain an existing employer stock fund, or whether to add a new one.  With the help of accountants, sponsors should attempt to quantify the tax value afforded by such an investment option.  With the assistance of legal counsel, sponsors should attempt to quantify the litigation risk associated with such funds.  That risk should include not only the likelihood of successfully defending a stock drop lawsuit, but also the cost of defense and any potential settlement.  And sponsors and fiduciaries must recognize that any decision to add, keep, or remove an employer stock fund will come with some risk.