Company Stock And The ERISA Fiduciary: The Aftermath Of Enron
By William A. Schmidt Kirkpatrick & Lockhart LLP, Washington, DC
Neither regulators nor courts have provided fiduciaries sufficient guidance to navigate the maze of administering ERISA accounts.
It has been impossible to pick up a newspaper recently without reading about the Enron collapse and the catastrophic losses that Enron employees and retirees have suffered as a result of their investments in Enron stock, either directly or through Enron’s 401(k) plan. These headlines are not easy reading for executives of plan sponsors and institutional fiduciaries who must actually implement the somewhat schizophrenic regulatory requirements encouraging plan investments in plan sponsor stock, on the one hand, and attempting to protect worker retirement savings, on the other.
Like Claude Rains in "Casablanca," politicians and pundits have been "shocked! shocked!" that 401(k) plans and similar retirement arrangements are permitted to invest substantially all of their assets in stock issued by the plan sponsor. But that has been permitted ever since ERISA was enacted in 1974. Indeed, ERISA explicitly recognizes the role of employee stock ownership plans as vehicles that are intended to encourage worker investments in employer securities. In ERISA, however, Congress did not resolve the conflict between enhancing opportunities for workers to participate in their employers’ financial success and protecting worker retirement savings. Instead, ERISA employers and other plan fiduciaries face the responsibility of complying with an array of ill-defined requirements with very significant downside consequences. Although it is impossible to say exactly how these fiduciary principles will be applied in cases like Enron, it is worthwhile to review the basic legal principles and to try to explain how they interact.
Any person who manages the assets of an ERISA-covered employee benefit plan or who provides advice about the investment of a plan’s assets is a "fiduciary" subject to the ERISA standards governing decisions about plan investments. Many of these requirements are adapted from traditional trust law principles – including the requirements that fiduciaries act prudently and that they invest plan assets solely in the interests of plan participants and beneficiaries and for the exclusive purpose of providing benefits and defraying reasonable expenses of plan administration. In addition, ERISA includes stringent transaction restrictions that bar any dealings between a plan and the plan sponsor (as well as others who may be in a position to improperly influence the operation of the plan), unless a statutory or administrative exemption applies.
Certain of the ERISA fiduciary requirements are particularly relevant to plan investments in employer stock:
Diversification and "Eligible Individual Account Plans." Generally, ERISA requires plan fiduciaries to diversify plan investments to minimize the risk of large losses. Moreover, ERISA generally prohibits traditional defined benefit pension plans from investing more than 10 percent of their assets in securities issued by the plan sponsor (or any affiliate). "Eligible individual account plans" are subject to more lenient requirements. Virtually all defined contribution pension plans except money purchase plans may qualify as eligible individual account plans.
An eligible individual account plan is not subject to the 10 percent limitation on investment in employer securities. In addition, although defined benefit plans may only invest in stock that is "marketable," eligible individual account plans may invest in any kind of employer stock. Eligible individual account plans also enjoy an exemption from the ERISA diversification requirements (and from the prudence requirement to the extent it is construed to require diversification).
The Plan Document
The extent to which an eligible individual account plan may invest in employer stock depends on the terms of the plan document. Thus, an eligible individual account plan may invest up to 100 percent of its assets in employer stock, but only if the plan so provides.
Many eligible individual account plans not only permit investments in employer stock, but require that some or all of the plan’s assets must be invested in such stock. An employee stock ownership plan, for example, must be designed to invest "primarily" in employer securities.
The "ERISA Override" Plan fiduciaries must also discharge their duties in accordance with the "documents and instruments" governing a plan, unless it would be inconsistent with the requirements of ERISA to do so. Thus, a fiduciary is theoretically legally obligated to adhere to plan provisions relating to investments so long as such investments may be made consistently with the ERISA prudence requirement, but the fiduciary is obligated to disregard such plan provisions the moment the investment becomes imprudent.
The responsible fiduciaries. As noted above, anyone with authority to manage or dispose of plan assets is an ERISA fiduciary. The scope of each fiduciary’s responsibilities, however, is generally determined with reference to the plan document. Thus, for example, many eligible individual account plans provide that the plan sponsor or a committee of officers and employees of the plan sponsor are ultimately responsible for supervising plan investments in employer stock. In these cases, the plan sponsor or committee acts as a "named" fiduciary and directs the plan’s trustee regarding such investments. In such circumstances, the trustee generally is not responsible for losses resulting from implementing directions that are regular on their face and consistent with the terms of the plan. In other cases, plan documents are not clear about who is ultimately responsible for determining whether to adhere to a plan direction to invest in employer securities.
Participant directions. Many 401(k) plans allow plan participants to direct how all or some of their individual account assets will be invested. In this connection, Sec. 404 (c) of ERISA provides that plan fiduciaries generally are not liable for investment losses that result from a participant’s exercise of control over his or her plan account. The relief for "Sec. 404 (c) plans", however, is available only if the plan complies with the requirements of regulations issued by the U.S. Department of Labor. Those regulations indicate that the Sec. 404 (c) relief is available for participant decisions to invest in employer stock only if the stock is readily marketable and only if voting and similar rights are passed through to plan participants (with appropriate safeguards to preserve the confidentiality of participant voting decisions).
Although an ERISA plan may allow plan participants to decide the extent to which they wish to invest their individual account assets in employer stock, ERISA generally does not require the plan to provide participants with that choice. A provision of the Internal Revenue Code, however, does require that participants in employee stock ownership plans must be given the opportunity to diversify their individual account investments after they reach age 55.
What Does It All Mean?
Plan sponsors and other fiduciaries face a daunting task in parsing through the ERISA requirements outlined above. This is particularly so in light of the somewhat surprising lack of real guidance on the issues from either the regulators or the courts. Although it is impossible to predict at this point how all the ERISA issues relating to employer stock will be resolved, it is possible to identify some of the more significant issues and describe the current state of play:
The effect of investment directions in the plan document. Perhaps the most difficult decision for any fiduciary who is trying to administer a plan that directs investments in employer securities is determining when it is necessary to disregard the investment direction in the plan in order to avoid acting in a way that is inconsistent with ERISA – put more simply, how bad do things have to get before a fiduciary must stop investing in, or even sell, employer stock held by a plan?
There is no easy answer to this question. Using various formulations, courts appear to have recognized that fiduciaries are presumed to have acted properly in following a plan direction to invest in employer stock. Most courts also take the view, however, that there is a point at which continued investment in employer stock becomes so imprudent that a fiduciary must disregard plan terms mandating such investments. The difficulty, of course, is determining when that point is reached. This point is likely to be clarified in current litigation surrounding employer bankruptcies.
In the meantime, employers and other plan fiduciaries can obtain some degree of protection by focusing on the process they use to determine whether to follow plan terms mandating investments in employer stock. A plan sponsor that blindly follows plan directions, without considering whether ERISA requires some other course of action will be a much more attractive defendant that a plan sponsor that has periodically reviewed the propriety of following the plan and that has documented the reasons for continuing employer stock investments.
Identifying the responsible fiduciary. As we have seen, even where a plan expressly requires investments in employer stock, some degree of fiduciary responsibility remains. Usually plan sponsors want and have this residual responsibility. Ambiguously drafted plan documents can create uncertainty about allocation of responsibilities, however.
Opportunities to Diversify. Many plans lock workers into investments in employer stock for some period of time. This is permitted under ERISA (and in the case of ESOPs can be required), and there can be sound business reasons for including such a feature as a matter of plan design. In the current environment, however, plan sponsors may want to consider whether the advantages of assuring substantial plan investments in employer stock outweigh the risks. Depending on the circumstances, providing employees with more flexibility to invest "away" from employer stock may be in order.u
William A. Schmidt works in the areas of institutional investing and employee benefits, with particular emphasis on fiduciary responsibility matters under the Employee Retirement Income Security Act of 1974 ("ERISA"). Mr. Schmidt advises major financial institutions, including banks, insurance companies, registered investment advisers and large employee benefit plans about ERISA restrictions relating to plan investments and to fee arrangements for investment management and plan administrative services.