July 7, 2006
Two recent court decisions make important contributions to the developing caselaw on the obligation that ERISA fiduciaries may have to remove company stock from employee benefits plans when the stock is declining in value.
In Summers v. State Street Bank & Trust Co., Nos. 05-4005, 05-4317 (7th Cir. June 28, 2006), the Seventh Circuit affirmed a district court ruling that a “directed trustee” to United Air Lines’s employee stock ownership plan (“ESOP”) did not violate its fiduciary duty by failing to divest company stock from the plan before United’s bankruptcy in late 2002. Although United’s CEO had stated in a letter that the company was “in a struggle just to survive” and that unless the “bleeding [was] stopped . . . United will perish sometime next year,” Judge Posner, writing for the court, observed that the markets were aware of the letter and United’s other struggles and yet the price for the company stock still implied a market capitalization of more than $800 million. “A trustee is not imprudent to assume that a major stock market . . . provides the best estimate of the value of the stocks traded on it that is available to him,” Judge Posner stated. Indeed, “it would be hubris for a trust company like State Street to think it could predict United’s future more accurately than the market could, and preposterous for a committee of union officials (the named fiduciary) to challenge the market’s valuation.”
The court’s decision went on to suggest that a company’s debt-equity ratio may be a better measure of the riskiness of investment, but conceded that determining the “right” point or range of points “for an ESOP fiduciary to break the plan and start diversifying” – that is, start selling company stock – “may be beyond the practical capacity of the courts to determine.” Among other things, the court explained, whether an investment risk is unacceptable to plan participants depends on the participants’ other investments as well as their individual risk tolerance. Neither of these is a matter that would be known to a plan fiduciary.
Judge Posner’s opinion for the Seventh Circuit is an important addition to the cases that have sharply questioned the circumstances in which even a substantial drop in a company stock price should cause plan fiduciaries to second-guess the market and override plan participants’ decision to invest in company stock.
In DeFelice v. US Airways, Inc., No. 1:04cv889 (June 26, 2006), Judge Ellis of the Eastern District of Virginia rejected plaintiffs’ arguments that US Airways breached its fiduciary duty under ERISA by allowing the stock of its parent corporation to remain as a 401(k) plan investment option despite its perilous financial condition. The case is the first of the 401(k) “stock drop” cases to proceed to trial and decision.
In his opinion, Judge Ellis accepted the modern portfolio theory of investment, noting that “an investment in a risky security as part of a diversified portfolio is, in fact, an appropriate means to increase return while minimizing risk.” He also correctly observed that “investment vehicles containing company stock are favored by ERISA.” He accordingly held that a fiduciary may continue to offer employer stock as a 401(k) investment option as long as the plan also provides “(1) a range of investment options; (2) true and accurate information regarding the risk/return characteristics of those investment options; and (3) the unfettered ability to trade in and out of the various investment options.” Thus, “the fiduciary should not be deemed to have violated any fiduciary duty for offering this option provided the investment in company stock remains viable, and the company has fully disclosed to participants the risks attendant to that investment.”
In an earlier decision Judge Ellis had rejected the application of ERISA § 404(c) to the US Airways fiduciaries’ selection of investment options for the plan, see DiFelice v. US Airways, Inc., 397 F. Supp. 2d 758, 777 (E.D. Va. 2005), but the substantial latitude given fiduciaries in this more recent decision may provide a § 404(c)-type safe harbor for fiduciaries who maintain employer stock as an investment option while also providing plan participants a diversified portfolio of investment options and adequate information regarding investment risks and returns. Such an understanding may prove useful to courts when considering Judge Posner’s difficult questions about courts’ capability to determine when a particular stock becomes an imprudent benefit plan investment.
Gibson, Dunn & Crutcher has extensive experience with employee benefits litigation and counseling nationwide, including handling a number of recent 401(k) "stock drop" cases and several Supreme Court ERISA cases. To learn more about the firm’s ERISA litigation, contact the Gibson Dunn attorney with whom you work or William J. Kilberg (202-955-8573; firstname.lastname@example.org) or Eugene Scalia (202-955-8206; email@example.com) in Washington, D.C., or Labor and Employment Practice Group Co-Chair Deborah J. Clarke in Los Angeles (213-229-7903; firstname.lastname@example.org). To learn more about the firm’s employee benefits counseling, contact Employee Benefits Practice Group Co-Chairs Stephen W. Fackler (650-849-5385; email@example.com) in Palo Alto.
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