Diversification question for participant directed DC plan

[mal]

We have a multiemployer plan that uses a large bank as its "directed trustee." The bank maintains custody of the assets and provides the daily valuation software. This is a participant directed DC plan (with a negotiated hourly contribution rate). Although participant directed, the plan is not 404© compliant, nor does the SPD claim compliance.

When this plan was established in the mid-1990's the trustees opted to include the bank's stock as one of the eight or nine investment alternatives. Due to the relatively stable performance of the stock over the last few years, approximately 50% of

all plan assets are in that single security.

My (conservative) view is that this creates a serious diversification problem. Moreover, as the plan is not 404© compliant it seems the trustees would be "on the hook" if this

stock were to pull an Enron, WorldCom, etc.

We met with one of the bank's ERISA attorneys to address this issue. He indicated that this would not be a diversification problem since the stock has a long history of stable performance versus the S&P 500. He also argued that by making the actual decision to allocate their assets the stock, the participants would have great difficulty in stating a claim against the fiduciaries.

While this explanation made the administrator feel better, I know that the bank is not fiduciarily responsible for investing the participant contributions. I am also concerned about the inherent conflict in relying on a bank's attorney to provide advice about his employer's stock. I would appreciate knowing where others stand on this situation.

[KJohnson]

1) Performance and diversification are two separate issues. Your performance can be out of this world and still have a breach of fiduciary duty for diversification. However, what the relief for such a breach would be (other than possible removal of fiduciaries) is a question.

2) Even if the Plan were 404© compliant the trustees of the multiemployer plan, in the DOL's view, would still be liable if the bank stock "pulled an Enron" See the following from DOL's amicus brief in the Enron case:

Even if the Savings Plan were a 404© plan, the Defendants could not escape liability if the allegations of the Complaint are true. By its terms, ERISA § 404© provides relief from ERISA's fiduciary responsibility provisions that is both conditional and limited in scope. The scope of ERISA § 404© relief is limited to losses or breaches "which resulted from" the participant's exercise of control. Section 404© plan fiduciaries are still obligated by ERISA's fiduciary responsibility provisions to prudently select the investment options under the Plan and to monitor their ongoing performance. See Advisory Opinion No. 98-04(A) ("In connection with the publication of the final rule regarding participant directed individual account plans, the Department emphasized that the act of designating investment alternatives in an ERISA section 404© plan is a fiduciary function to which the limitation on liability provided by section 404© is not applicable."); Letter from the Pension and Welfare Benefits Administration, U.S. Department of Labor to Douglas O. Kant, 1997 WL 1824017, at *2 (Nov. 26, 1997)("The responsible plan fiduciaries are also subject to ERISA's general fiduciary standards in initially choosing or continuing to designate investment alternatives offered by a 404© plan.").(9) Consequently, if, as alleged, the Defendants violated their fiduciary duties when they continued to offer Enron stock as an investment option, they are personally liable for the losses.

3) 404© compliance would give you relief from participant asset allocation decisions and, I think, may well provide you with relief if a "diversification problem" arises because of participant direction of investments. However, DOL's view is that without 404© compliance you have no such protection. If 50% of the assets of the plan are invested in one stock you surely might have a diversification issue.

4) The bank is a party in interest by serving as a directed trustee. There may very well be a prohiibited transaction exemption for the continuing purchase of bank stock, but you may want to verify this.

[Kirk Maldonado]

KJohnson:

What would be the rationale supporting a conclusion that there is a prohibited transaction?

[KJohnson]

Kirk,

I guess you are right absent the stock being puchased directly from the bank or its officers, employees, directors, or 10% shareholders.

[Kirk Maldonado]

Isn't there an exemption that would apply even here, provided certain conditions are met?

[KJohnson]

There very well may be. I just glanced through 408 and nothing jumped out at me as a statutory exemption. However, there could well be a DOL class exemption. I haven't gone back and looked.

[mbozek]

KJ: With due respect to the DOL position - What is the alleged breach of fid duty in ENRON? According to published reports the only investment information that was available to the Fids was material non public information which could not be used by a Fid without violating the insider trading laws.

[MGB]

In Enron, the DOL is claiming fiduciary standards are not preempted by insider trading rules.

[KJohnson]

Just using the language of the original poster. DOL's position (and I believe the law) is clear in that you have a duty to monitor investment options offered. If those options are unsuitable, you have the duty to take action. 404© does not get you around this requirement. As to the "insider trading" argument--here is what DOL had to say:

. The Administrative Committee Members Could Have Taken a Number of Steps, Consistent With Their Duties Under Federal Securities Laws, That May Have Protected Participants in Accordance With the Fiduciary Provisions of ERISA

In their motions to dismiss, the Administrative Committee Defendants and Olson have responded to the Plaintiffs' allegations by arguing, among other things, that they could not have taken action to protect participants without engaging in insider trading in violation of securities laws because the information was not public. See Olson Mot. to Dismiss at 12; AC Mot. to Dismiss at 28-29. While they allegedly sold millions of dollars worth of their own Enron stock during this time period, Complaint at ¶¶ 64-92, 272, 681, they (Olson in particular) contend that because the information they had or could have obtained about accounting irregularities was not public, disclosing the information to the participants would have made the Administrative Committee Member Defendants criminally liable for insider trading, and would have rendered the participants who traded on the information "tippees" subject to disgorgement of profits. Olson Mot. to Dismiss at 12-13. Thus, Olson contends, the Plaintiffs' claim that she "breached her fiduciary duties by failing to do something that was illegal and utterly impractical, also should be dismissed." Olson Reply, at 7.

Liability for insider trading is based on § 17(a) of the Securities Act of 1933, 15 U.S.C. 77q(a), § 10(B) of the Securities Exchange Act of 1934, 15 U.S.C. 78j(B), and SEC Rule 10b-5, 17 C.F.R. 240.10b-5. Section 17(a) provides that "it shall be unlawful for any person in the offer or sale of securities . . . to employ any device, scheme, or artifice to defraud, or . . . to engage in any transaction, practice or course of business which operates or would operate as a fraud or deceit upon the purchaser." Section 10(B) similarly provides that it shall be unlawful for any person "to use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive devise or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors." Likewise, SEC Rule 10b-5 makes it unlawful "[t]o engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." 17 C.F.R. 240.10b-5.

Although these provisions do not mention or specifically forbid "insider trading," in the seminal case of In the Matter of Cady, Roberts & Co., Exchange Act Release No. 34-6668, 40 S.E.C. 907, 1961 WL 60638 (Nov. 8, 1961), the Securities and Exchange Commission recognized that Rule 10b-5 incorporates the affirmative duty imposed by the common law of some jurisdictions on "corporate 'insiders,' particularly officers, directors, or controlling stockholders" to either disclose material nonpublic information before trading or to abstain from trading altogether. Id. at *3. The SEC set forth two elements for establishing a 10b-5 violation: "first, the existence of a relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone, and second, the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing." Id. at *4. The fraud necessary for establishing a Rule 10b-5 violation arises only where the insider fails to disclose material nonpublic information before trading on it and thus makes "secret profits" at the expense of those to whom he owes a fiduciary duty of loyalty. Id. at *6 n.31.(7) The Supreme Court endorsed this basic approach in subsequent cases. Chiarelli v. United States, 445 U.S. 222 (1980); Dirks v. SEC, 463 U.S. 646 (1983).

Defendants' duty to "disclose or abstain" under the securities laws does not immunize them from a claim that they failed in their conduct as ERISA fiduciaries. To the contrary, while their Securities Act and ERISA duties may conflict in some respects, they are congruent in others, and there are certain steps they could have taken that would have satisfied both duties to the benefit of the plans. First and foremost, nothing in the securities laws would have prohibited them from disclosing the information to other shareholders and the public at large, or from forcing Enron to do so. See Cady, Roberts, 1961 WL 60638, at *3. The duty to disclose the relevant information to the plan participants and beneficiaries, which the Plaintiffs assert these Defendants owed as ERISA fiduciaries, is entirely consistent with the premise of the insider trading rules: that corporate insiders owe a fiduciary duty to disclose material nonpublic information to the shareholders and trading public. See id. (incorporating common law rule that insiders should reveal material inside information before trading); see also Plaintiffs' ERISA Opposition at 39 n.18 (arguing that these Defendants could have publicly disclosed or forced Enron to disclose before selling the stock).

Second, it would have been consistent with the securities law for the Committee to have eliminated Enron stock as a participant option and as the employer match under the Savings Plan. Indeed, the Complaint alleges that "had Olson and the Committee immediately discontinue Enron stock as an investment option for new contributions," once Olson had learned of Watkins' allegations, the "employees would have been prevented from throwing another $100million into Enron stock, as they did between August and December 2, 2001, in large measure because of the continued encouragement" to do so by Lay and the continued investment of the employer match in Enron stock. Complaint at ¶ 689. The securities rules do not require an individual never to make any decision based on insider information. To the contrary, the insider trading rules require corporate insiders to refrain from buying (or selling) stock if they have material, nonpublic information about the stock. Thus, the "disclose or abstain" securities law rule is entirely consistent with, and indeed contemplates, a decision not to purchase a particular stock. See Condus v. Howard Sav. Bank, 781 F. Supp. 1052, 1056 (D.N.J. 1992) (it is perfectly legal to retain stock based on inside information; violation of insider trading requires buying or selling of stock). It would have been entirely consistent with the securities laws for the fiduciaries to have eliminated Enron stock as a participant option and the employer match. The Administrative Committee had no affirmative duty to injure the plan by continuing to purchase stock that they allegedly knew or should have known was artificially inflated. Finally, another option would have been to alert the appropriate regulatory agencies, such as the SEC and the Department of Labor, to the misstatements.

Defendant Olson's assertion that a general disclosure (which she decries as "utterly impractical") would have caused more harm to the plans, see Olson Reply, at 7 & n.7, is clearly a factual issue not amenable to disposition on a motion to dismiss. Indeed, her argument makes the counter-factual assumption that the stock would not ultimately have plummeted in value without regard to the fiduciaries' conduct. In actual fact, the stock's market high was not permanently sustainable and the plans' stockholdings lost essentially all their value even without disclosure by the fiduciaries. Moreover, if the improprieties had been disclosed earlier, it is possible that Enron would not have engaged in further corporate malfeasance. But even if disclosure was not an option, the fiduciaries may have significantly reduced the harm to the plan by eliminating Enron stock as an investment option for participants and by investing the matching employer contributions in something other than Enron stock. Assuming the truth of the Plaintiffs' allegations, the Savings Plan was purchasing stock at inflated prices as a result of Enron's fraud on the market. Merely by putting a stop to the plan's purchases, the fiduciaries would have avoided much of the losses that resulted when the bottom fell out of the market for Enron stock because the Plan would not have purchased the inflated stock in the first place. According to the Complaint, plan participants expended over $100 million on Enron stock from August to December 2001 alone (the period after Lay and Olson had received the Watkins memo). Complaint at ¶ 689.

Defendants can point to only one ERISA case, Hull v. Policy Mgmt. Sys. Corp., No. CIV.A.3:00-778-17, 2001 WL 1836286, at *2 (D.S.C. Feb. 9, 2001), to support their argument that any action they could have taken would have violated the insider trading laws. The court in Hull, however, noted that the plaintiffs did not allege that the fiduciaries responsible for investments had any knowledge of any misinformation concerning the company stock or that they participated in the dissemination of information they knew or should have known was misleading. Moreover, to the extent that the court suggested that fiduciaries of employee benefit plans holding employer stock might be in violation of securities laws if they refrained from additional purchases, the decision is simply wrong. Compare Dirks, 463 U.S. at 661 (1983)(viewing the Cady, Roberts rule as requiring insiders to disclose the insider information or refrain from trading the stock).

In sum, Plaintiffs have alleged that, instead of taking some action to protect the plan participants, the fiduciaries continued to purchase stock at inflated prices, which proved unsustainable and ultimately resulted in millions of dollars in additional losses – losses that would not have occurred if the plan had simply not continued to purchase the stock. While the Administrative Committee arguably could not have sold the plan's Enron stock without full market disclosure, they were neither allowed under ERISA nor required under securities law to do nothing.

[Kirk Maldonado]

KJohnson:

As for the location of the exemption from the prohibited transaction rules, look at ERISA Section 408(e).

[KJohnson]

Kirk,

How is the purchase of bank stock by a multiemployer fund the purchase of an employer security exempt under 408(e)?

[Kirk Maldonado]

KJohnson:

You bring up a very valid point; literally, Section 408(e) would not apply (because the stock would not be "employer stock").

Curiously enough, I think that means that you get to the same conclusion. Namely, you don't need an exemption because there isn't an prohibited transaction.

This assumes, of course, that the stock is being purchased in "blind transactions" (i.e., where neither the buyer nor the seller know the identity of the other party) in the open market. Stated in a different fashion, if the shares were purchased directly from the bank, you might have a prohibited transaction.

[mbozek]

While ENRON may yet prove to be another example of how bad facts make bad law, the issue of imprudence based upon the fids failure to halt investing in the co. stock based upon Watkins' allegations of accounting impropriteties may be difficult to prove because ENRON retained counsel to review the allegations and the Law firm issued a report indicating that was no basis to support Watkins' allegations of improprieties by ENRON executives and Arthur Anderson. The real issue is what is the required level of due dilligence for a plan fid when the plan sponsor retains oustide counsel to investigate charges of violations of the securities law and the report turns up no violations. Does the Fid have a duty to conduct its own investigaton which would require that it obtain/report on material non public information from the sponsor? Since Enron engaged in a pattern and practice of deceiving all investors, not just the plan particpants, it would be fair to treat the employees' claims on the same basis of other investors.

[four01kman]

It seems to me the purchase of the bank stock by the plan participants is not the issue. Rather, is the offering of that stock by the Trustees as an investment option a "prudent" decision?

There also is the issue raised earlier of "diversification". Isn't this again a prudency issue? That is, the trustees have selected a variety of investment options available to the plan participants. To the extent those selections represent an appropriate diversification, aren't they okay, even if a 404© election hasn't been made. I seem to recall the original line of cases on diversification (pre-ERISA) dealt with the entire portfolio available, not a particular investment.

[KJohnson]

Prudence and diversification are two separate ERISA requirements under 404. You could invest the entire plan in a single asset and, perhaps, in certain situations this might be prudent but it would violate the separate diversification requirement.

Without 404© protection (in DOL's view) it is the trustee (or in the case of a directed trustee typically the "named fiduciary") who is responsible for making asset allocation decisions even if the applicable fiduicary is only following participant instructions. Therefore, I believe that DOL would analyze the fact situation presented by the original poster as a fiduciary electing to put 50% of all of the plan's assets in one security. You raise an interesting point on whether the issue of "diversification" is on a plan level or on an individual account level, however the original post indicated that 50% of the entire plan is now invested in the bank securities.

[Jon Chambers]

The DOL's position on this issue is clear. The following quote is from their booklet "A look at 401(k) fees... for employees". Note the third bullet point:

"Employers are held to a high standard of care and diligence and must discharge their duties solely in the interest of the plan participants and their beneficiaries. Among other things, this means that employers must:

Establish a prudent process for selecting investment alternatives and service providers

Ensure that fees paid to service providers and other expenses of the plan are reasonable in light of the level and quality of services provided

Select investment alternatives that are prudent and adequately diversified

Monitor investment alternatives and service providers once selected to see that they continue to be appropriate choices"

I don't see how any single stock could be "prudent and adequately diversified".

[mbozek]

401(k) plans of many large publicy held companies (Coke, Philip Morris, P & G, etc.) have over 80% of the assets invested in employer stock. Is it imprudent for the fids to allow such concentration? Should the fids of the Philip Morris plan restrict purchases or dump the stock because the Company may have to file in bankruptcy even though this is publicly available information to all stock holders? What if the company stock increases in value after the stock is removed as an investment? Also the curtailment of investment by the fids or the dumping of the stock by the plan would cause a steep decline in the stock value which would be an imprudent act for which there would be fid liability. There is a real problem in curtailing the investment in company stock.

[Jon Chambers]

Plans offering employer stock have a natural defense--they were following the terms of the plan, that provide for investement in employer stock. No such defense is available to the plan that offers stock that is NOT employer stock--the fact pattern here.

Additionally, Employer stock is exempt from the diversification rules under ERISA, but not from the prudence rules. Hence, you see prudent fiduciary conduct that changes the terms under which employer stock is offered when there is a substantive question regarding the prudence of retaining employer stock as an investment option, such as United Airlines' decision to retain an independent fiduciary for employer stock held through its retirement plans (the independent fiduciary decided to sell), or Federal Mogul's decision to discontinue matching with employer stock when asbestos litigation threatened bankruptcy.

Employer stock doesn't get a free pass from fiduciary concerns. Stock that is not employer stock, that is offered as a designated investment alternative, comes perilously close to a per se violation of ERISA's fiduciary rules.

[Kirk Maldonado]

Jon:

I think that you conclusion about "perilously close" is a bit of an overstatement.

If a plan offers 10 investment funds, all of which have materially different investment opportunites and are well-diversified, I find it hard to believe that a court would find including a single stock investment option (as the 11th investment choice) would be a breach of fiduciary duty.

[mal]

As a follow-up to my original post...

We had a meeting last night and the Trustees were

urged to eliminate the bank stock as an available investment

option. Due to the relatively strong performance over the

last 5 years and the popularity of the investment, the

Trustees do not want to exercise that option. Instead, they

will be freezing any further purchases of the stock

through new contributions or reallocations. The idea

is to begin to reduce the overall allocation over the

next 2-3 years. Our best estimate is that the percentage

would move from 50% to 20% in 3 years. Not great, but

on the right path. Meanwhile, we are moving forward with

404© compliance efforts and papering the participants

with information about the need to diversify.