By Lawrence J. Hass and Joshua H. Sternoff
In the recent wave of employer stock litigation, directed trustees of corporate pension plans have been marked by the plaintiffs' bar as targets with invitingly deep pockets. This litigation trend has resulted in the filing of more than 100 company-stock-related breach of fiduciary duty lawsuits in the past four years. The cases have involved not only bankrupt concerns like Enron Corp., WorldCom Inc. and Global Crossing Holding Ltd., but also solvent, successful companies such as BellSouth Corp., Xerox Corp. and Sears, Roebuck & Co. (filed in November 2002 before its acquisition by Kmart Holding Co.).
The litigation has raised many important issues for fiduciaries of participant-directed 401(k) and similar plans. For financial institutions that provide directed-trustee services, the litigation has raised questions that go to the core of these institutions' responsibilities as trustee.
In the recent cases, the claim against the directed trustee is generally that it breached its fiduciary duty under the Employee Retirement Income Security Act by permitting the plan and its participants to continue to invest in employer stock, i.e., by failing to override fiduciary or participant directions with respect to the acquisition or continued holding of employer stock.
As a general rule, ERISA requires that pension plan assets be held in trust by one or more trustees. In the case of corporate pension plans, the trustee that is used for this purpose is typically a bank or trust company. Most corporate pension plans and 401(k) plans give their trustees no discretion in the management of plan assets, reserving that discretion for either the employer's investment committee, investment managers or plan participants; the directed trustee's primary responsibilities involve maintaining custody of plan assets, record keeping and carrying out investment directions.
A trustee that is expressly required to carry out the investment directions of a named fiduciary has the limited responsibility under ERISA to duly carry out those directions, subject only to ascertaining that the directions are proper and in accordance with the terms of the plan and not contrary to ERISA.
However, ERISA does not define what a "proper" direction is, nor does the statute provide further guidance on the scope of a directed trustee's obligation to determine whether a particular direction is contrary to ERISA.
Many institutional trustees have historically operated under the principle that directed trustees take on neither the responsibility nor the potential liability for the prudence of a potential investment course of action. Lawsuits involving directed trustees and plan investments over the three decades since ERISA's enactment have resulted in a decidedly mixed bag of legal rulings. Some courts have held that a directed trustee, lacking investment discretion, is not a fiduciary at all, and thus could not be held liable for breaches of fiduciary duty relating to plan investments.
This, however, is a minority view. In the Enron decision, Judge Melinda Harmon of U.S. District Court for the Southern District of Texas, Houston, imposed a "know or should know" fiduciary standard on the directed trustee in that case, Northern Trust Co. In effect, the Enron court held that a directed trustee may be exposed to liability if it should have known from "significant waving red flags" relevant to the company's outlook that an investment direction was imprudent. Under the circumstances, a directed trustee may be liable under ERISA for failing to override the directions it received; including in this case, the direction to implement a blackout period during which employees could not change their investments. The Enron case against Northern Trust continues. Discovery is scheduled to be a lengthy process and trial is not expected until the end of 2006.
Last December, the Department of Labor issued a "field assistance bulletin" to provide guidance on its view of the scope of the responsibilities of a directed trustee. This guidance generally recognizes that the directed trustee's responsibility is "significantly narrower" than that of primary fiduciaries, and while it adopts the "should have known" standard enunciated in the Enron decision, it also provides its views on the relatively limited contours of that obligation in the employer stock context.
The DOL's guidance states that a directed trustee does not have an independent obligation to determine the prudence of every plan transaction or second-guess the work of the discretionary fiduciary. Unsurprisingly, where a directed trustee has material non-public information regarding a company's stock, the DOL indicates the trustee would have an obligation to question plan transactions in the stock. For large institutional trustees, the DOL indicates the possession of material non-public information by one part of an organization will not be automatically imputed to the directed trustee personnel of the organization so long as the organization maintains procedures designed to prevent the illegal disclosure of such information under the securities, banking or other laws.
In addition, the DOL indicates that while in its view a directed trustee generally does not have a duty to question market transactions involving publicly traded securities based solely on publicly available information, there may exist "limited, extraordinary circumstances, where there are clear and compelling indicators" (e.g., a company's bankruptcy filing or formal charges by regulators relating to a company's financial irregularities) that "call into serious question a company's viability as a going concern." In these rare instances, the DOL indicates the directed trustee may have a duty to decline to follow the directions of the named fiduciary without further inquiry.
In the first major decision in this area following the DOL field assistance bulletin, Judge Denise L. Cote, for the Southern District of New York, in the WorldCom case, adhered closely to the DOL guidance. The ruling generally concurred with the more limited standard of responsibility on directed trustees. Significantly, the WorldCom ruling held that, absent non-public information, a directed trustee's responsibility is limited to extreme circumstances where the directed trustee knows or should know that a company faces imminent collapse. Merrill Lynch, the directed trustee, was granted summary judgment in the case. The ruling noted that knowledge that a government body has filed formal civil or criminal charges against a company might trigger a directed trustee's responsibility depending upon the nature of the formal charges. On the other hand, the ruling also noted that a directed trustee's knowledge that a company undergoing a restructuring is experiencing a decline in stock value and profits or knowledge of a government investigation (including an investigation into the reliability of the company's financial statements) or private lawsuit against a company would generally not impose a duty upon a directed trustee.
It will remain interesting to see whether the DOL bulletin and WorldCom decision will bring more certainty for directed trustees. Given the range of standards imposed by differing courts, no clear legal standard of conduct has yet developed for directed trustees. This forces them (or their insurance providers) to maintain costly defenses, even though in the typical case the directed trustee is in no better position than plan participants or the public at large to know whether some undisclosed activity or fact about the company looms as a threat to its stock price and, therefore, its employees' retirement accounts. By the time the news becomes public, the damage has typically been done. It is far from clear that, even if a directed trustee had the power or authority at that point to unilaterally halt the company stock investments (or sell the shares), such a course of action would have significantly protected the plan's assets.
Lawrence J. Hass is a partner and head of the pension practice at Paul, Hastings, Janofsky & Walker LLP, New York, where Joshua H. Sternoff is also a partner.