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ERISA Tagalong Claims: Loss Prevention Strategies

By Dan Bailey, Esq.

Directors and officers of many corporations, particularly those organizations that allow employees to invest in company stock or other sponsored benefit plans, are subjected to the uncertainty of whether ERISA tagalong class action claims, if filed, are viable. As a consequence, these individuals face real financial risk and should take appropriate steps to minimize their exposure and to assure they are adequately protected financially in the event they do incur significant liability in these claims.

The following summarizes a number of proactive loss prevention concepts that can both reduce the likelihood that an ERISA tagalong claim will be filed and also enhance the defendants’ ability to successfully defend such actions.

1. Maximize Protection from Plan Terms

Benefit plan documents should be reviewed annually to assure compliance with the most recent case law and regulatory developments. Most importantly, if the plan allows participant-directed investments, it should have an express provision which relieves fiduciaries of fiduciary responsibility for losses incurred as a result of a participant’s investment instruction. Such a provision is authorized by Section 404(c) of ERISA.

Department of Labor regulations impose numerous conditions that must be satisfied in order for a fiduciary to escape liability based on such a provision. Those regulations generally require that the plan provide (1) diversified investment options; (2) opportunities to transfer assets in the plan account; (3) sufficient information to allow participants to make sound investment decisions; and (4) notice to participants of the Section 404(c) provision. Although these requirements may appear reasonably easy to satisfy, recent ERISA tagalong claims demonstrate that fiduciaries frequently have difficulty proving that all of these requirements were met.

This difficulty results from the fact that plaintiffs frequently raise two issues when arguing that the Section 404(c) protection does not apply to fiduciaries. First, they allege that plan fiduciaries either misrepresented or failed to provide plan participants with material information about the true value of the company’s stock. Because this is largely a fact issue, plaintiffs usually are able to defeat the defendants’ motion to dismiss based on 404(c). Second, some plans restrict the sale of the employer’s matching stock contribution until the participant reaches a certain age. Such a restriction likely eliminates the protection under Section 404(c), and therefore should be eliminated if possible.

In any event, the plan should clearly and expressly provide diversified investment options for plan participants, and participants should receive notice that the plan documents relieve fiduciaries of their responsibilities with respect to participant-directed investments pursuant to Section 404(c).

2. Offer Company Stock Pursuant to Plan Design

Even if Section 404(c) applies, the selection by plan fiduciaries of investment options for a participant-directed plan is a fiduciary act subject to ERISA fiduciary duties. Therefore, there is a fiduciary duty to monitor the prudence of continuing to offer company stock as an investment option in the plan. However, if the option to invest in company stock is expressly required by the plan documents, the plan fiduciaries arguably have no discretion over the decision to include company stock as an investment option and therefore arguably have no fiduciary duty with regard to whether company stock should remain an investment option for plan participants.

Although this defense has received mixed results from the courts, such a plan provision can be quite beneficial to plan fiduciaries and therefore should be included in the plan documents if the company intends to permit plan accounts to own company stock.

3. Don’t Blindly Follow Plan Provisions

Even if the plan requires company stock as investment option or otherwise expressly requires certain actions, fiduciaries are not necessarily protected by following those plan requirements. Fiduciaries are generally required to administer the plans as written and are not permitted to vary from plan design. However, if a plan provision or its enforcement is inconsistent with the provisions of ERISA, some courts have required the fiduciaries to ignore that provision and substitute their judgment for the decision of the plan sponsor. This duty to override the plan’s terms most frequently arises where the plaintiff proves that the fiduciary could not have reasonably believed that continued adherence to the plan’s terms was in keeping with the plan sponsor’s expectations of how a prudent fiduciary would behave.

Fiduciaries should therefore question whether, under the circumstances, a particular plan provision seems reasonable and should seek a legal opinion from qualified counsel regarding their fiduciary duty if there is concern about the provision. Assuming the fiduciaries disclose all relevant facts to qualified counsel and the legal advice appears on its face to be reasonable, fiduciaries should be able to avoid personal liability by acting in reliance upon the legal advice.

4. Appoint Independent Fiduciaries

One of the most problematic allegations in ERISA tagalong claims is that the plan fiduciaries had an inherent conflict of interest by serving as both a plan fiduciary and as an officer or director of the sponsor company. Because of this dual capacity, plaintiffs argue that the plan fiduciaries took actions primarily for the benefit of the company rather than plan participants, and that plan fiduciaries knew but failed to disclose material non-public information which injured plan participants.

To avoid or minimize the effect of such conflict-of-interest allegations, companies should consider appointing independent fiduciaries to manage and monitor the plan’s investment in company stock. These independent fiduciaries should have no actual or perceived relationship with the company or its directors and officers, and should have exclusive control over all investment-related decisions for the plan. Because the liability exposure for plan administration is much less than the liability exposure for plan investments, independent fiduciaries could be appointed solely with respect to plan investments, thereby allowing the plan sponsor and its officers to control various non-investment administrative tasks.

Alternatively, company officials who typically do not have access to the company’s non-public information could be designated investment fiduciaries, although such a practice invites arguments that the fiduciary in fact knew or should have discovered the non-public information by reason of his position with the company.

5. Avoid Inadvertent Fiduciary Status

The test for determining whether an individual or entity is a fiduciary under ERISA requires a “functional” analysis. A person who is not named as a fiduciary in the plan documents can still be liable as a fiduciary under ERISA if the person’s actions were the functional equivalent of a fiduciary’s actions. As a result, anyone who performs services or communicates on behalf of a plan is potentially liable for breach of ERISA fiduciary duties.

Frequently, ERISA tagalong claims name not only the plan’s named fiduciaries, but also other directors, officers and human resources personnel of the plan sponsor, as well as investment and administrative committee members as defendants. To avoid individuals being inadvertently subjected to ERISA fiduciary duties, the company and the plan should tightly control the number of people who become involved in plan matters, and the responsibilities for each such person should be well defined and understood. In addition, the plan sponsor should not be a named fiduciary, or if it is a named fiduciary, the board of directors should expressly delegate the company’s fiduciary responsibility to an individual or group of individuals. Otherwise, the directors may be liable for improperly discharging the company’s ERISA fiduciary duties.

6. Communicate Promptly and Accurately

Federal securities laws require a company to disclose material information to investors only at certain designated times, such as when an SEC filing is due or when the company is purchasing or selling its own securities. In contrast, ERISA may require plan fiduciaries (including company officers) to disclose material information regarding the company on a more current basis if the information could reasonably be viewed as important to plan participants in making plan investment decisions. These conflicting disclosure obligations under the securities laws and ERISA place company officers who are plan fiduciaries in a classic “Catch-22.” If they disclose the non-public information to plan participants, they are likely violating the insider trading rules under the securities laws. If they do not disclose the information to plan participants, they may violate their ERISA fiduciary duties.

Some courts have concluded that plan fiduciaries can remove themselves from this Catch-22 situation by (1) disclosing the non-public information to all investors and plan participants as soon as possible, (2) eliminating company stock from the plan, or (3) notifying the regulators of the specific dilemma. In addition, if the plan utilizes only independent fiduciaries and not company officers with respect to plan investments, those independent fiduciaries will likely not learn of the non-public information and therefore not be placed in the conflict situation.

In any event, all communications by plan fiduciaries to participants should be prompt, accurate, clear and consistent with disclosures to other company constituents. Clever “spin” or other vague or confusing communications should not be tolerated. Instead, the communications should be easy to understand and convey the whole truth. Even unsophisticated participants should be able to readily understand the disclosed information. Bad news should not be understated and good news should not be overstated.

7. Encourage Diversification of Investments

Consistent with sound investment concepts, company management and plan fiduciaries should encourage participants to diversify their investments and not include within their investment portfolio an unreasonably large percentage of company stock. An excessive concentration of an employee’s investment portfolio in company stock can not only create unnecessary investment risk and create the potential for tagalong claims, but may motivate employees to act inappropriately in order to artificially maintain or increase the company’s stock price.

8. Eliminate Company Stock in Plan

There are clearly benefits to employees owning stock in the company, thereby aligning their interests with outside investors. However, as demonstrated by the recent waive of ERISA tagalong claims, such a practice creates inherent and potentially large litigation risks. As a result, some companies are eliminating company stock altogether as an authorized investment option and as the employer’s matching contribution under plans. This is unquestionably the safest strategy from a risk management perspective.

ABOUT THE AUTHOR

Dan A. Bailey, Esq. is a Partner in the Columbus, Ohio, law firm of Bailey Cavalieri, LLC. Mr. Bailey specializes in D&O liability insurance, corporate and securities law. He is a frequent lecturer and has authored and co-authored several books and articles dealing with D&O liability issues.

riskVue | The webzine for risk management professionals
August 2006