WASHINGTON - Section 404(c) might not be the safe harbor most defined contribution plan sponsors think it is, a federal appeals court decision suggests.
The decision - involving Unisys Corp. - also suggests the entrance to the safe harbor is far more difficult to navigate than most employers understand. In fact, employers cannot rely solely on the guidance of a consultant to pilot them into the safe harbor, but had better review the consultant's data and supplement it where necessary, the court's decision says.
In particular, employers will need to scrutinize investment options for defined contribution plans and the information given the employee about the investments.
In the first court case to consider the application of the Labor Department's Section 404(c) regulation, the court questioned whether tougher standards in selecting investments and disclosure to participants were needed to protect participants of Unisys' defined contribution plan.
Interestingly, Unisys attorneys used 404(c) as part of their defense, yet the investments in question were made before the regulations had been issued.
The appeals court reversed a U.S. District Court's January 1995 summary judgment on the case and sent it back to the district court for trial.
In Meinhardt vs. Unisys Corp., the U.S. Court of Appeals for the 3rd Circuit, Philadelphia, questioned whether fiduciaries to Unisys' defined contribution plan of Blue Bell, Pa., breached their duties of prudence, disclosure and diversification when they purchased more than $200 million in guaranteed investment contracts from Executive Life Insurance Co., Los Angeles. Executive Life's investments went sour, and the company went into receivership in 1991.
In its defense, Unisys lawyers said even if the company failed to comply with pension law by purchasing Executive Life GICs, Section 404(c) protected it from any liabilities because the participants had control over their investment choices, and therefore were responsible for their losses.
But the appeals court said there was enough evidence to show the district court was wrong in granting a summary judgment in favor of Unisys. The appeals court also said there were genuine issues concerning whether Unisys breached its fiduciary duties and whether Unisys could use 404(c)'s protections. Because of the summary judgment, those issues hadn't been addressed in the lower court.
Meanwhile, industry experts predict the appellate decision would send defined contribution plan sponsors scurrying to look at their own plan descriptions.
404(c) is 'slippery'
This case is "indicative of how slippery 404(c) really is. You may think you are under 404(c)'s protections, but with 20/20 hindsight, you really aren't," said Dennis Coleman, principal at Kwasha Lipton, Fort Lee, N.J.
"Companies need to look at this case closely and see how they can protect themselves so they don't get into the same position that Unisys is in."
The 404(c) regulation, issued by the Department of Labor in 1992, is not mandatory. To voluntarily comply, however, many plan sponsors would have to add investment options and information to participants to avoid certain liability issues.
Mr. Coleman added plan sponsors should be looking at all the issues involved in the case and to compare them to the facts in their own plans. Plan sponsors need to know whether they could answer the same questions in this case and win, Mr. Coleman said.
"You are probably going to find companies are going to have to scramble to protect themselves," Mr. Coleman said. "They're going to need to make a paper trail that describes all the things that they should be doing" to comply with the 404(c) regulation.
What's key is the process plan sponsors use to select and monitor investments, and the procedures used in communicating to participants, said David Wray, president of the Profit Sharing/401(k) Council of America, Chicago.
"It's critical that the (plan) sponsor goes through a thorough process of choosing managers and crafting investment options," Mr. Wray said. "Then if they go into a court of law, the prudence protection will be there for them."
Labor Department Associate Solicitor Marc Machiz said sponsors should be fine if they comply with what is in the 404(c) regulation.
"I don't think there is anything in the (appeals court) opinion that changes or calls into question the legal framework set out in the DOL's regulation," he said.
"This case is going to be a benchmark for where courts in the future are going to come down on 404(c)," the Profit Sharing Council's Mr. Wray said.
What the appeals court said
The appeals court said Unisys could use 404(c) as its defense, but must show where 404(c) applies in the case. The appeals court said it didn't have enough evidence to decide whether participants actually had control of their investments, a key element that would trigger the 404(c) defense.
"In our view, if the plans did not offer an acceptable alternative to GIC investments, a participant did not have the freedom, and in turn, the control to decide how his or her assets were ultimately invested," said Judge Carol Los Mansmann, writing for the court.
In questioning Unisys' degree of prudence, the appeals court said Unisys did not act prudently when it invested in five-year contracts with Executive Life.
According to the decision, Unisys relied on its consultant, Johnson & Higgins, to analyze Executive Life's creditworthiness. But, Murray Becker of Johnson & Higgins said in his deposition that it was not a credit-rating agency and had a standard of recommending companies that had a AAA rating, as measured by Standard & Poor's Corp. What's more, Johnson & Higgins only recommended purchasing three-year contracts; Unisys purchased its first of three five-year contracts on June 9, 1987, and shortly after, terminated Johnson & Higgins.
Writing for the appeals court, Judge Mansmann said Unisys failed to analyze the how J&H made its recommendation, and that "a reasonable fact finder could also conclude that Unisys passively accepted its consultant's positive appraisal of Executive Life without conducting the independent investigation that ERISA requires."
In addressing the diversification issue, the appeals court said because the risk of loss was only among the GIC contracts, it was appropriate to decide whether the fixed-income and insurance contract funds - which held the Executive Life GICs - were adequately diversified. But, that decision would be left to the district court trial because there was not enough information for the appeals court to understand the reasoning in making the investments.
In the disclosure issue, the court said that in previous cases it has held fiduciaries cannot mislead participants, and while 404(c) protects fiduciaries from investment decisions participants make, it doesn't relieve them from disclosing information to participants. While the appeals court said it could not decide whether Unisys was obligated under 404(c) to tell participants about the risks involved and Executive Life's financial condition, it did say there were a number of disclosure issues that needed sorting out.
The court said "while Unisys was not obligated to share with participants everything it knew about GICs and Executive Life, it was obligated to impart to participants material information of which it had knowledge that was sufficient to apprise the average plan participant of the risks associated with investing in the fixed income and insurance contract funds" that held Executive Life investments.
No court date has been set for the district court trial.