1. 0 ERISA Stock Drop Litigation: Recent Developments and a Look Forward Matthew G. Allison, Moderator Baker & McKenzie LLP
Gregory C. Braden Morgan, Lewis & Bockius LLP
2. 2007 Employment Practices & Fiduciary Liability Symposium
Los Angeles ~ May 7 & 8, 2007
3. 2 Consider this scenario A major drug store chain removes from store shelves merchandise that was scheduled to be marked down, delays accounting for the expense and treats the merchandise as if it has full value in its earnings reports.
The chain also delays disclosing that it plans to close 200 underperforming stores, and its CEO allegedly sells $5 million worth of his own stock but waits months to disclose that earnings would not meet projections. When disclosures are made, the chain’s stock drops 17 percent.
4. 3 Answer What does this have to do with ERISA?
An ERISA breach of fiduciary duty class-action suit by CVS 401(k) plan participants whose plan accounts held CVS stock between December 1, 2000 and October 30, 2001
5. 4 The Moral
6. 5 Understanding what makes these lawsuits attractive to the plaintiffs’ bar is critical for: Understanding which cases should be litigated to a conclusion or positioned for settlement; and
Having an intelligent basis for evaluating plan-related documents and fiduciary conduct regarding 401(k) plans that offer company stock as an investment, employee stock ownership plans (ESOPs), or combinations of both.
7. 6 Enron is perhaps the most notorious stock-drop case, but litigation dockets include many other well-known defendants Other Well-Known Defendants
AOL Time Warner
8. 7 How do these suits get started? Mining for Plaintiffs
9. 8 What do all of these stock-drop suits have in common? Some business event that causes the company’s stock price to drop, such as:
Restatement of corporate earnings
Downturn in an industry sector
Threatened or Actual Bankruptcy
What do the Plaintiffs allege and what proof is required to prevail on the claims?
10. 9 ERISA 101 ERISA: Comprehensive statute regulating employee benefit plans.
Section 404: Fiduciary duties:
11. 10 ERISA 101 (cont’d) Liability for breach of fiduciary duty:
Section 409: a fiduciary is personally liable to make good to the plan any losses resulting from the fiduciary’s breach
Section 502(a)(2): authorizes cause of action by participant, beneficiary, or DOL for appropriate relief under 409. Action is brought derivatively “on behalf of the plan as a whole.”
12. 11 Two basic claims in Stock Drop Cases: 1. Prudence – The company stock fund became an imprudent investment alternative and plan fiduciaries breached their fiduciary duty by continuing to allow investments in the fund in the face of adverse business conditions.
2. Misrepresentation/Omission (Fraud according to Plaintiffs) – The plan fiduciaries knew or should have known about the circumstances adversely affecting the company, and they breached their fiduciary duty by affirmatively misleading or failing to warn participants of the risks.
13. 12 Who gets sued? Named fiduciaries, including plan sponsors and plan administrators
Fiduciary committees and their members
Appointing fiduciaries – board members, officers, and committees
The not-so-innocent bystander as de facto fiduciary – Ken Lay touting the stock in the Enron cafeteria while quietly dumping his own shares
The recordkeeper and/or trustee (Fidelity, Schwab, etc.)
Other service providers (accountants, consultants)
14. 13 Eligible individual account plans (EIAPs) = ESOPs, 401(k) savings plans, are exempt from the diversification requirement under ERISA § 404(a)(2)
Congress wanted to encourage ownership by employees of the companies for which they work
To do that, it had to remove barriers that restricted a fiduciary’s ability to invest in company stock Congress decided to treat company stock in eligible individual account plans differently from other investments.
15. 14 Based on the employer stock exemption, some courts held that company stock is a “presumptively prudent” investment Moench (3d Cir.), Kuper (6th Cir.), Wright (9th Cir.) –investments in company stock are “presumptively prudent”
Some Courts do not think the presumption applies to EIAPs (vs. ESOPs) – Schering-Plough (3d Cir.)
16. 15 Rebutting the presumption of prudence What does a plaintiff have to show?
Significant drop in the stock price under circumstances that call into question the future viability of the company;
Continued investment in employer stock would defeat the purpose of the plan
Simply stated that the fiduciary abused its discretion by failing to get rid of the stock
17. 16 Even if the presumption does not apply . . . plaintiffs must still prove imprudence Prudence has a procedural and substantive component
“Prudence” must be determined in context of entire 401(k) portfolio-modern portfolio theory
Meaning that the participant must have had the opportunity to diversify
18. 17 …and causation Causation under ERISA 409: fiduciary liable for “losses to the plan resulting from” the fiduciary’s breach
Plaintiff must show a causal link between a fiduciary’s failure to investigate the continued prudence of the investment and the harm suffered by the plan
19. 18 Fiduciary Misrepresentations and Omissions
20. 19 Fiduciary Misrepresentations and Omissions Second broad category of fiduciary breach claims in stock-drop cases
Broadly stated, fiduciaries have an affirmative duty to warn plan participants of material adverse information about their investments in the employer stock and/or to tell them the stock is a risky investment if the fiduciaries know it to be true
21. 20 Problems with the theory Tension with the insider-trading prohibitions of the federal securities laws
Can ERISA be construed to require disclosure of material inside information only to plan participants (so they can avoid losses)?
DOL very active in this area; Enron amicus brief: (i) could have disclosed information to the market (“Look out below!”); (ii) eliminate employer stock as an investment option (“Look out below!”); (iii) alert the DOL and/or the SEC (“Look out below!”)
22. 21 Causation, causation, causation Individual participant must prove detrimental reliance on both the alleged misrepresentation and any omission
Plaintiffs may tie themselves in knots
Complaint alleges that many participants knew of wrongdoing and many were predisposed to invest in their employer’s stock
No court has ever held that reliance can be presumed under ERISA, unlike Rule 10b-5 cases
23. 22 The 404(c) Defense ERISA 404(c): “In the case of a pension plan which provides for individual accounts and permits a participant or beneficiary to exercise control over the assets in his account:. . .no person who is otherwise a fiduciary shall be liable . . . for any loss, or by reason of any breach, which results from such participant’s or beneficiary’s exercise of control.”
24. 23 Why does 404(c) matter? The 404(c) defense, if applied, relieves the plan fiduciaries – company, trustee, officers and directors – of liability if employees lose money in their 401(k) accounts because of their own poor investment decisions
Especially helpful in employer stock misrepresentation cases
25. 24 How broad is the 404(c) defense? By its terms, the 404(c) defense protects the fiduciary from “any loss” or “any breach” resulting from a participant’s exercise of control over assets in an individual account plan
The legislative history indicates that the 404(c) defense applies where the participant instructs the plan to invest “the full balance of his account in, e.g., a single stock”
26. 25 Unresolved issue Does the 404(c) defense apply to the selection and evaluation of funds in a defined contribution plan?
Department of Labor says no, but they made it up.
Unisys Savings Plan Litigation says yes.
DiFelice v. US Airways says no.
27. 26 Other Defenses Some individual defendants not fiduciaries
Company not a fiduciary
“Two hats” doctrine precludes breach of duty of loyalty claims/conflict of interest claims
Obligation to follow terms of the plan precludes breach of duty of loyalty claims/conflict of interest claims
Co-fiduciary liability claim automatically fails if primary breach claim is dismissed
28. 27 401(k) Litigation Update
29. 28 Stock Drop Litigation Update Lay of the land through early 2006:
In the Courts of Appeals:
Company stock is a presumptively prudent investment; to state a fiduciary breach claim, plaintiffs must plead and prove a precipitous decline in stock price coupled with evidence of serious mismanagement. Moench (CTA3 1995); Kuper (CTA6 1995); Wright (9th Cir 2004);
Fiduciary breach claims based upon drop in stock price are not suitable for resolution on motions to dismiss. Lalonde (CTA1 2004)
30. 29 Stock Drop Litigation Update Presumption of prudence is not applicable if decision to offer a company stock investment is left to the discretion of plan fiduciaries (as opposed to being mandated by the plan). Schering Plough (CTA3 2005)
Stock drop damage claims can be brought “on behalf of the plan,” even if the recovery goes to a subset of plan participants. Schering Plough (CTA3 2005); Milofsky (CA5 2007); issue on appeal in Baxter (CTA1).
31. 30 Stock Drop Litigation Update Lay of the land through early 2006:
In the District Courts:
Many district courts denied motions to dismiss, with a few notable exceptions.
As a result, many cases settled; only one case went to trial: U.S. Airways (E.D. Va. 2006) (defense verdict).
32. 31 Stock Drop Litigation Update Recent court of appeals authority is very helpful to plan fiduciaries:
Summers v. State Street Bank (CTA7 2006) (plaintiffs must plead and prove that stock fund participants were subjected to “excessive risk”
Langbecker v. Electronic Data Systems (CTA5 2007) (the death knell of stock drop) (opinion suggests that class certification may never be appropriate in a stock drop case because 404(c) contemplates individualized defenses)
33. 32 Stock Drop Litigation Update New district court opinions also offer “Rays of Hope” for plan fiduciaries:
Standing: Do former participants who cashed out have a “colorable claim to vested benefits”? Many district courts say no.
Standing cases now on appeal: Evans (CTA1); Dickerson (CTA2); Conextant (CTA3); Cameron & Barkley (CTA4); TXU (CTA5); AEP (CTA6); Guidant (CTA7); Bay Environmental (CTA9)
DOL and AARP have filed amicus briefs urging reversal in many of these cases.
34. 33 Stock Drop Litigation Update No 404(a)(2) duty to diversify:
ChoicePoint (N.D. Ga. 2007); Coca Cola (N.D. Ga. 2006); Delta Airlines (N.D. Ga. 2006); Syncor (C.D. Cal. 2006)
Plaintiffs can’t rebut the presumption of prudence:
ChoicePoint; Tribune Co. (N.D. Ill. 2006) (short term revenue drop did not have sufficient impact to overcome the presumption on favor of plan requirement to offer stock)
35. 34 Stock Drop Litigation Update Not fiduciary communications:
ChoicePoint (N.D. Ga. 2007); RCN (D.N.J. 2006) (statements made in press conferences were not fiduciary communications); Reliant (S.D. Tex. 2006) (statements incorporated in Form S-8 sent to participants were not made in a fiduciary capacity)
Conflict with securities laws:
Avaya (D.N.J. 2006) (requiring fiduciaries to divest company stock investment prior to any public disclosure would violate insider trading requirements)
36. 35 Stock Drop Litigation Update Still, in 2006, many district courts were reluctant to dismiss stock drop complaints:
Agway (N.D.N.Y. 2006) (allegations of “artificial inflation” sufficient to state a claim)
Merck (D.N.J. 2006) (even if Merck stock is presumptively prudent, Merck’s potential Vioxx liability is sufficient to call the plan fiduciaries’ actions or inaction into question)
37. 36 Stock Drop Litigation Update Goodyear (N.D. Ohio 2006) (rejecting defendant’s argument that plaintiffs must plead and prove that Goodyear was on the brink of “impending collapse” in order to state a fiduciary breach claim)
General Motors (E.D. Mich. 2006) (allegations of “artificial inflation,” dire financial straits and serious mismanagement sufficient to state a claim)
38. 37 ANATOMY OF A RECENT TRIALDiFelice v. US Airways, No. 1:04cv889 (E.D. Va. June 26, 2006) First post-Enron trial, certified class action
Not a misrepresentation case
Plaintiff claimed that fiduciaries were “imprudent” in offering company stock fund as an investment opportunity between Aug. 1, 2001 and company’s bankruptcy on Aug. 12, 2002
39. 38 Anatomy of a Recent TrialKey Characteristics of the US Airways 401 (k) Plan US Airways fiduciaries had discretionary authority to select or remove investment options
Neither the trust nor the plan document mandated the offering of US Airways stock as an investment
In addition to a US Airways stock fund, the plan provided 12 additional investment options
Company 401(k) match was in cash, not US Airways stock
40. 39 Anatomy of a Recent TrialUS Airways’ Business Challenges Significant losses in 2000 and 2001
Highest costs of any “legacy” carrier
Terrorist attacks of Sept. 11, 2001 change everything – all airlines, including US Airways, take drastic measures to survive
41. 40 Anatomy of a Recent TrialPlaintiff’s “Allegations” A prudent fiduciary would have taken these business developments into account
These developments meant that is was “imprudent” to permit voluntary investment in US Airways by September 2001 at the latest
A prudent fiduciary would have implemented an “orderly sale” of all US Airways stock, even if such a sale were against the wishes of the individual participants
Damages should be paid measured by the difference between the pre-Sept. 11 stock price and the stock price at the point of the “orderly sale”
42. 41 Anatomy of a Recent Trial“Substantive” Prudence Evidence Full disclosure of US Airways’ financial condition at all times
Plaintiff DiFelice testifies that he was fully informed of US Airways’ condition
Plan diversified across various classes of investment options – during class period only 4-8% of 401(k) assets in US Airways stock fund
US Airways stock held by numerous retirement plans of other companies
43. 42 Anatomy of a Recent Trial“Procedural” Prudence Evidence Combination of written records of plan committee and testimony of business knowledge of plan fiduciaries, demonstrated that fiduciaries took all relevant factors into account
Fiduciaries considered business prospects of US Airways, sought attorneys’ advice on continued offering of its stock, and engaged an independent fiduciary when it became unclear after mid-May 2002 whether US Airways could avoid bankruptcy
44. 43 Anatomy of a Recent TrialThe Court’s Holdings Though a riskier investment than others, ERISA favors inclusion of company stock in a diversified 401(k) plan
Modern Portfolio Theory supports inclusion of company stock in a diverse portfolio. Must judge “in light of its contribution to the entire portfolio, and not in light of its individual risk.”
Employer stock ok if 1) range of investment options; 2) true and accurate information disclosure regarding risks; 3) unfettered ability to trade in and out of investment options.
45. 44 Case Management and Settlement Issues Selection of counsel is, of course, key
Important to choose experienced ERISA litigators, these are not securities cases
Education of counsel wastes policy limits
Appropriate, not excessive staffing
46. 45 Case Management and Settlement Issues The right counsel translates into
Co-ordination with securities counsel
Consideration of joint defense agreements
Bottom Line: increased availability of Insurance policy limits to achieve settlements
47. 46 Case Management and Settlement Issues Counsel should prepare a litigation budget which serves as a road map during life of the litigation. Road map should optimally include high level view of expected critical events, i.e. 12(B)(6) Motion to Dismiss, Written and Oral Discovery, Motion(s) for Summary judgment, consideration of Mediation, etc.
Budget should also project anticipated staffing and retention of experts
48. 47 Case Management and Settlement Issues DiFelice shows, at least in the full disclosure context, that fiduciaries can demonstrate, based on contested “prudence” facts, that they acted appropriately after all, even when the plan sponsor eventually goes into bankruptcy
However, important to be receptive to settlement opportunities when they arise. Even if MTD not decided. i.e. road map has off ramps
Notwithstanding EDS, stipulate to class for settlement purposes
49. 48 Case Management and Settlement Issues Settlement considerations:
Red flags can provide bench marks in time line to calculate alternative loss calculations.
Efficient market theory can mitigate losses
Alternative methods to calculate loss
Plaintiffs preferred: best performing alternative
Closest available alternative
Hypothetical representative portfolio
Maximize potential coverage issues as settlement leverage with plaintiffs
50. 49 Case Management and Settlement Issues Plaintiffs’ Attorney Fees - Non cash enhancements for class; little cost
Hiring of Independent Fiduciary
Plan Modifications (i.e. removal of restrictions on company stock)
Employee investment education
Guaranteeing future match
51. 50 Underwriters’ Checklist: Plan Design and Risk Avoidance Basic truth: If a company has a 401(k) plan that provides for investment in employer stock, it’s a bull’s-eye for an ERISA breach of fiduciary duty lawsuit, likely a class-action lawsuit.
Each new wave of corporate issues triggers a response wave of shareholder and ERISA stock-drop suits (e.g., the current “option backdating” problems of, primarily, technology businesses). There’s no telling where the next problem will arise, or what type of company it will affect.
So: What can an underwriter do to minimize potential for big claim?
52. 51 Underwriters’ Checklist: Plan Design and Risk Avoidance Employer stock eliminated as an investment option
How many investment options are there?
Stock limited as an investment option
Limited allocation to, e.g., 20% of payroll contributions (generally not a recordkeeping issue)
Limited transfers into stock fund from other funds (may present significant recordkeeping problems)
Potential impact of limitations on availability of 404(c) protection is unclear
If company picks 20% as the limit, are they suggesting that having up to 20% of retirement funds in a single stock is advisable?
Must be combined with effective investment education (value of diversification, risk of single stock investment)
53. 52 Underwriters’ Checklist: Plan Design and Risk Avoidance Review rights to diversify out of company stock, even for matching contributions
PPA ’06 – In 2007, must permit immediate diversification of employee contributions; matching and other employer contributions after three years of participation (other than traditional ESOP); can be less restrictive – many stock-drop settlements include free diversification
Match in cash vs. stock – if permitting immediate diversification, consider matching in cash (using 404(c) protection, since even if participants can freely diversify out, stock was not their choice)
Issues re implementing new diversification right for previously “locked up” stock: Need to be prepared for spike in stock sales (cash demands within plan; impact on share price) (in practice, rarely becomes a real problem)
54. 53 Underwriters’ Checklist: Plan Design and Risk Avoidance Make sure plan is an “EIAP” (diversification N/A)
Make sure that employer stock (in fact, all investment funds) are “baked” into the plan document (settlor choice) instead of being selected by the plan’s investment committee (fiduciary choice)
ESOP may be even better option for companies:
May permit higher (“clearly imprudent”) Moench standard for prudence claim related to maintenance of employer stock fund
Requires relatively small changes in most public company plans that already offer employer stock as an option and permit free diversification (e.g., voting pass-through; right to receive distribution in kind)
May permit dividends on stock in plan to be deducted
55. 54 Underwriters’ Checklist: Plan Design and Risk Avoidance Review carefully plan’s fiduciary structure; know ways for companies to limit or avoid “imprudent monitoring/failure to disclose” claims
Leave board members and top-tier officers (those most likely to be exposed to material non-public information) off the committee
“Baking” the committee membership into the plan (e.g., by title or position) to avoid or limit “appointment/monitoring” claims; at the least, limiting the universe of appointing/monitoring fiduciaries
Retaining an outside fiduciary, especially when rough waters may be ahead
56. 55 “Wellness” Programs Review content and effectiveness of education program
Are employees “getting it”? Is your approach working, particularly for the rank and file? Increased focus on targeted communications.
PPA ’06 – beginning in 2007, requires quarterly participant statements that include diversification information (including risk of holding more than 20% in a single entity,e.g., the company’s stock)
Consider investment advice or investment management alternatives
PPA ’06 sets up safe harbor for investment advice by existing plan vendors – remains to be seen how widely these programs will be adopted (managed accounts not included; can lead the horse to water, but can’t make him drink)
May help with tension between legal/risk management (“don’t buy too much!”) and HR/shareholder relations (“Our company/stock is great!”)
57. 56 Underwriters’ Checklist: Plan Design and Risk Avoidance Review plan for 404(c) compliance
Review plan fiduciary practices (investment policy, committee charters, minutes, how often committee meets, monitoring practices, use of outside advisors where appropriate) – make sure that company stock as an investment is evaluated periodically and appropriately by the committee (at the least, to meet the Moench standard)
Make sure of compliance with blackout notice requirements (PPA ’06 will eventually provide 404(c) relief during blackouts if enhanced notice requirements met) and that blackout periods are as short as possible