Sponsors take steps to reduce company-stock litigation risk

As the U.S. Supreme Court reviews another ERISA-based challenge to company-stock management in 401(k) plans, many sponsors have acted to reduce their litigation risk in stock-drop cases.

ERISA attorneys and defined contribution consultants say sponsors that outsource management of company stock to independent fiduciaries or who keep high-ranking insiders off oversight committees have a better chance of avoiding — or at least prevailing in — stock-drop lawsuits.

"Litigation risk is the No. 1 factor for companies selecting an independent fiduciary for company stock," said Nancy Ross, a Chicago-based partner and co-chair of the ERISA litigation practice of Mayer Brown LLP.

"Companies that are bitten once are inclined to hire independent fiduciaries," said Ms. Ross, adding that hiring an independent fiduciary can be a condition of an ERISA lawsuit settlement.

The case now before the Supreme Court, Retirement Plans Committee of IBM et al. vs. Larry Jander et al., highlights the dilemma faced by corporate executives who also serve as fiduciaries for their 401(k) plans.

In their DC plan roles, they must follow ERISA rules governing prudence of management and loyalty to participants. These rules were interpreted by the Supreme Court's unanimous decision in 2014 that established guidelines for lower courts to determine if a stock-drop complaint should be dismissed or allowed to go to trial.

But in their corporate roles, executives must follow the rules of the Securities and Exchange Commission regarding insider informa- tion. The Supreme Court said a fiduciary cannot violate securities laws in managing a company-stock fund in a DC plan. It also said that fiduciaries' inaction, "based on negative inside information," must be weighed by lower courts in balancing an "ERISA-based obligation" vs. potential conflict "with the complex insider trading and corporate disclosure requirements" in federal securities laws.

The intersection of the SEC rules and ERISA has led to clashes of legal interpretations. In June, the Supreme Court agreed to hear the case. Oral arguments were held Nov. 6. A decision is expected next year.

Annual research by Callan LLC shows that the hiring of independent fiduciaries by DC plans with company stock has grown during this decade. Despite yearly variations in the Callan surveys, the overall trend reveals greater use of independent fiduciaries over time — from a low of 12.5% in 2011 to a record 37.5% in 2019. (Callan's annual surveys cover clients and non-clients. The numbers and names of the respondents vary from year to year.)

When considering an independent fiduciary or a change in committee membership, "a key factor is clients' perception of litigation risk," said Marla Kreindler, a Chicago-based partner at Morgan Lewis & Bockius LLP. "Also, there is a question of corporate culture." Companies that prefer the status quo "have a strong culture of (company) stock investment," said Ms. Kreindler, adding that top executives want to be involved in committee decisions.

Other clients view the hiring of an independent fiduciary as providing both legal protection and administrative services for the company-stock fund, Ms. Kreindler said. "Our clients have strong views one way or the other," she said.

Sponsors' strategies can depend on how their attorneys interpret legal trends.

Among Callan clients and its annual surveys, "we've seen the number of independent fiduciaries fluctuate due to legal standards," said Jana Steele, a Chicago-based senior vice president and defined contribution consultant.

For many years, sponsors benefited from a legal principle called the Moench presumption, based on a 1995 decision by a federal appeals court in Philadelphia, Moench vs. Robertson. The court said that because Congress encourages employees to own company stock, sponsors were presumed to have acted prudently in offering it.

The U.S. Supreme Court struck down the Moench presumption in the 2014 case Fifth Third Bancorp vs. Dudenhoeffer et al., which set the guidelines for lower courts. Initially, some members of the DC industry feared this would lead to more effective challenges. However, "Dudenhoeffer set a high bar" for plaintiffs, Ms. Steele said.

This 2014 decision and the Supreme Court's reaffirming Dudenhoeffer in the 2016 ruling Harris vs. Amgen erected a solid wall against stock-drop complaints as lower courts said plan participants failed to show that sponsors had violated the guidelines.

The IBM-Jander case represents the first crack in the wall because a federal appeals court supported arguments by plan participants, saying they met the Dudenhoeffer case guidelines.

"It is creating some concern and consternation" in the DC industry, Ms. Steele said.

In a 2015 lawsuit, IBM's plan managers were accused of violating ERISA by failing to protect company-stock investors when IBM wrote down $2.4 billion for a troubled microelectronics unit and then paid $1.5 billion to another company to take the unit.

A U.S. District Court judge in New York dismissed the complaint in September 2016 and September 2017. The judge said the plaintiff failed to demonstrate that a prudent fiduciary could have taken actions without causing more harm than good, referencing the Dudenhoeffer guidelines.

In December 2018, the 2nd U.S. Circuit Court of Appeals in New York reversed the decision and sent the case back to the District Court. A three-judge panel said participants "plausibly allege" that plan managers "had the requisite knowledge" that IBM's stock was overvalued due to the microelectronics unit's problems. These allegations "tip the scales toward plausibility," the court wrote. IBM appealed the decision to the Supreme Court.

During the oral argument before the Supreme Court, much of the discussion focused on how to reconcile the SEC rules and the ERISA rules regarding DC plan management.

"Do you think that it is workable, practical, to require an insider fiduciary to determine whether the disclosure of information — inside information to the public at a particular point in time will do more harm than good?" said Justice Samuel Alito, according to the transcript of the oral argument.

"Is that inherently a workable standard, or is it your argument that it is not and that's why you reached the position that you reached?" Mr. Alito asked Jonathan Ellis, assistant to Solicitor General Noel J. Francisco.

The solicitor general had filed a brief arguing that both courts and both parties incorrectly interpreted the Supreme Court's stock-drop guidance. Mr. Francisco recommended that the Supreme Court vacate the appeals court ruling and send it back "to allow the court of appeals to apply the correct standard."

Justice Neil Gorsuch wondered why a DC sponsor would want to have corporate insiders making decisions about company stock.

"I guess I'm not clear exactly what employees gain from having insiders as trustees if, at the end of the day, they wind up being know-nothings because they can't do anything," he said, according to the transcript.

"An outsider might, in these circumstances, be able to make a reasoned judgment of some kind about whether to sell or buy or act differently in a way that an insider is … disabled from doing," he said.

Rather than hire independent fiduciaries, some DC plans have sought to reduce their risks by keeping high-ranking corporate insiders off committees responsible for managing company stock.

Callan's annual research shows 21.9% of plans with company stock didn't have insiders on their oversight committee in 2019 — a record result over the last decade.

Callan's surveys don't specifically identify insiders, but Ms. Steele said the firm is suggesting that they include CEOs, chief financial officers and those who have inside information about issues likely to affect a company's stock.

"In general, I recommend that lawyers not serve on the committees because it can blur the role of the lawyer giving advice and being a decision-maker," said Jeremy Blumenfeld, a Philadelphia-based partner for Morgan Lewis & Bockius LLP.

"In my experience, I think it's generally a good idea not to have a CEO or CFO on the committee," he added.

Consultant Robyn Credico agrees. "We say keep the insiders off the committee — no CEO and no CFO," said Ms. Credico, the Arlington, Va.-based defined contribution consulting leader for Willis Towers Watson PLC.

Some clients resist taking action, saying, for example, that hiring an independent fiduciary would add to the plan's cost or would take action that company executives might find unpalatable.

"If you hire an independent fiduciary, you have to live with what they want to do," Ms. Credico said. Some company executives are concerned that "very cautious" independent fiduciaries could liquidate the company stock in a 401(k) plan, Ms. Credico added. "That could send the wrong message to employees and the public," she said.