The Enron bankruptcy has provoked a flurry of activity by employers, legislators, and class action lawyers. Current and former Enron employees have filed class action suits, the first of which is scheduled to begin trial in December 2003, alleging that Enron and other plan fiduciaries breached their fiduciary responsibilities to Enron's 401(k) plan. The suits name Enron, the members of the plan's administrative committee, and Northern Trust, the plan's directed trustee, as the primary defendants.
Among other claims, the suits allege that plan fiduciaries breached their fiduciary duties by providing misleading information about Enron's prospects to encourage plan investments in Enron stock; by declining to postpone an excessively long "lockdown" period during which participants could not sell Enron stock as the company approached bankruptcy; and by continuing to offer Enron stock as an investment option even as the price continued its downward spiral. In addition, the suits allege that the plan provision blocking participants from selling Enron stock received as "matching" contributions was inconsistent with ERISA and should not have been enforced.
The phenomenon is not limited to Enron: similar suits have been filed against Global Crossing, which filed for bankruptcy in late January, as well as Lucent Technologies and Nortel Networks. Indeed, any company that sponsors a 401(k) plan or other defined contribution plan that includes company stock has reason to fear ERISA litigation if the stock price plummets. About half of the large companies surveyed by the Committee on Investment of Employee Benefit Assets (CIEBA) in October 2001 required matching contributions to be invested in company stock, and 20% of those companies expected to liberalize some or all of the restrictions on selling the stock this year. It is almost certain that even more companies are planning to reduce plan holdings in company stock or to allow greater flexibility to sell company stock in the post-Enron era.
Current Regulation of Plan Investments in Company Stock
ERISA imposes no limit on the amount of employer securities that can be held by a "defined contribution" retirement plan such as a 401(k) plan. In contrast, traditional defined benefit pension plans are permitted to invest no more than ten percent of their assets in employer securities.
ERISA's legislative history indicates that Congress believed that investments in employer securities should be limited in defined benefit pension plans because participants in such plans are promised specific pension benefits, and that promise should not depend on the employer's financial condition. Employees covered by defined contribution plans were expected to understand that the funds available for retirement would depend on the investment performance of the plan's assets. As long as the plan clearly states that the plan may invest up to 100% of its assets in company stock, employee expectations would not be defeated even if the stock becomes worthless.
At the time ERISA was enacted, however, defined contribution plans were more likely to supplement a traditional defined benefit plan than to serve as the sole retirement plan, as is now common. The original rationale for permitting unlimited investment in company stock by defined contribution plans is now being questioned.
Today, most defined contribution plans are participant-directed. Many employers structure their plans to take advantage of the limited relief from fiduciary liability for participant-directed plans that is provided by section 404(c) of ERISA. Although section 404(c) does not relieve employers of fiduciary liability for the selection of investment options to be offered under the plan, it does relieve employers of fiduciary liability for the participants' asset allocation decisions - including voluntary decisions to invest in company stock, if certain conditions are satisfied. However, since employers always retain fiduciary responsibility for the selection of the plan's investment options, they may be subject to liability under ERISA for continuing to offer company stock as a plan investment option if the company's prospects are cloudy.
Legislative Proposals
Many legislative proposals addressing these issues have already been introduced in the House of Representatives, and President Bush has outlined his own reform proposal. Several of the proposals include caps on the total amount of company stock that may be held in a defined contribution plan, although some would exempt true ESOPs (employee stock ownership plans) from these caps.
President Bush opposes any fixed cap on defined contribution plan investments in company stock. However, his proposal would require plans to permit participants to trade out of company stock received as employer matching contributions after three years. This approach would permit publicly-traded companies to retain favorable tax treatment for their matching contributions without draining their cash reserves. Unless privately-held companies are exempted, however, these companies would be forced to choose between making cash contributions, maintaining cash reserves to buy their stock back from the plan after three years, or foregoing employer contributions altogether.
President Bush's proposal was introduced by Sen. Hutchinson on February 26. The following day, Sen. Grassley introduced legislation that would provide new diversification rules for company stock, require advance notice of a "lockdown," require the Labor Department to issue regulations providing clear guidance on employer liability during a "lockdown," prohibit executives from trading personal stock during a "lockdown," and require employers to provide more frequent benefit statements.
More recently, Sen. Kennedy announced that he will introduce legislation this week that would require employers to choose between making their matching contributions in company stock and offering company stock as an investment option for elective salary deferrals. In this regard, studies have demonstrated that participants are more likely to make voluntary investments in company stock in those plans in which the employer matches their contributions in company stock, apparently because the employer's contribution is viewed as an endorsement of company stock as a prudent investment choice. Sen. Kennedy has also indicated that his bill would require companies to inform workers about executive stock sales.
Some proposals focus on improving the information available to employees by, e.g., requiring more frequent benefit statements, or requiring periodic statements describing the financial condition of the employer. However, a controversial part of President Bush's proposal would remove an existing prohibition against fiduciary conflicts of interest by permitting financial institutions and other investment advisers who have a financial interest in one or more of the plan's investment options to provide investment advice to plan participants. Other legislators, including Sen. Grassley, have questioned the wisdom of removing ERISA's existing protections against conflicts of interests in the wake of the Enron disaster.
Employer Liability During "Lockdown" Periods
Every transition to a new recordkeeper requires a "lockdown" period to permit the new recordkeeper to reconcile the account balances to the old recordkeeper. The length of the "lockdown" depends largely on the compatibility of the systems used by the old and new recordkeepers, but the three or four-week "lockdown" in the Enron plan represents the industry average, according to a recent survey conducted by ASPA.
The media attention that has been focused on the "lockdown" in the Enron plan is perhaps undue, given that most of the decline in the value of Enron stock occurred before the lockdown took effect. Enron enhanced the appearance of impropriety, however, by negotiating a one-week delay of the "lockdown" in response to employee complaints but neglecting to tell its employees of the delay until fifteen hours before the extended trading period expired. Interestingly, Global Crossing's bankruptcy filing also closely followed a five-week "lockdown" in its 401(k) plan.
President Bush's proposal would require employers to give workers at least 30 days' notice of an impending "lockdown" and would bar executives from trading personal holdings of company stock during a "lockdown." An alternative bill would apply a special tax on gains by corporate insiders for company stock transactions occurring during a "lockdown."
President Bush would also make executives responsible for performance of the employees' investments in the plan during the "lockdown." This proposal seems somewhat at odds with the Labor Department's regulations under section 404(c) of ERISA, which generally permit employers to limit investment directions to once per calendar quarter without losing 404(c) protection. More importantly, expanding employer liability during unavoidable "lockdown" periods may have the unwanted effect of forcing plans to continue relationships with under-performing recordkeepers.
Employers Can Reduce Litigation Risk
What can employers who offer company stock as an investment option under the 401(k) plan do to minimize fiduciary liability? Several strategies for reducing risk are worth considering even without a legislative mandate. For example, companies may consider adopting some or all of the following modifications:
- Avoid recommending plan investments in company stock.
- Inform plan participants that concentrated investment in any single security may be imprudent.
- Negotiate a penalty or incentive provision in recordkeeping agreements to facilitate transitions to a new recordkeeper within a reasonable timeframe.
- Provide employees with at least 30 days' advance notice of any "lockdown."
- Make independent investment education and advice available to plan participants.
- Consider appointing an independent fiduciary on behalf of the plan to determine whether to continue to offer company stock (or whether to sell company stock already held by the plan), particularly if corporate insiders are aware of nonpublic information that might have a substantial impact on the value of the stock.
Plan amendments to restrict employee investments in employer securities or to provide greater freedom to diversify stock contributed by the employer may also be considered. However, employers may choose to await the results of the current legislative initiatives.
We will keep you informed of important developments in this area.