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Groom Law Group's Steve Saxon spoke on Employer Securities Issues After ENRON

By: Stephen M. Saxon
Date: 3/1/2002

Summary:

In the wake of the Enron collapse and in light of the ongoing congressional hearings, government investigations and proposed legislation, plan sponsors will need to address employee benefit plan holdings in employer stock. The purpose of this article is to help plan sponsors identify the key issues that need to be addressed.

We already know what some of the major questions are. The fundamental question is, When is a plan sponsor required to pull the plug on a plan's holdings in employer securities? While I am not going to answer this question now (I will let the courts do that), I will address a number of important related questions:

  • Are there any special rules under ERISA regarding employer securities?
  • Does it make a difference that my plan is designed for the purpose of holding employer securities?
  • Does 404(c) protect plan sponsors from liability for losses relating to employer securities?
  • How do the SEC's insider trading rules impact a plan sponsor's fiduciary obligations to participants?
  • How will Enron change the legal landscape?
  • How will Congress react to the Enron debacle?

Regrettably, given the level of litigation and legislative activity, it is simply not possible to give assurances about how these issues ultimately are resolved. Yet, even though the legal landscape is quite fluid, we think it is important to try to give plan sponsors as much information as possible so that when plan sponsors discuss their benefit programs with counsel, they will have some understanding about the risks and rewards, added fiduciary obligations and potential liability that could arise from plan holdings in employer securities.

1. ARE THERE ANY SPECIAL RULES UNDER ERISA REGARDING EMPLOYER SECURITIES?

During the time that Congress was considering the legislation that led to ERISA, Senator Russell Long of Louisiana was also promoting employee ownership of American companies -- particularly through "employee stock ownership plans" (ESOP"). As a consequence, special rules for employer securities and ESOPs were included in ERISA. In this sense, plans that hold employer securities are designed for a dual purpose. One purpose is to allow employees to share in the ownership and growth of their companies. The other purpose is to provide retirement benefits for employees. While these two purposes are usually coextensive, that is not always the case.

The special rules in ERISA relating to employer securities involve diversification. Exceptions to the diversification rules, allowing individual account plans, including 401(k) plans, to invest up to 100 percent of assets in employer securities, were made to accommodate holdings in employer securities.

2. IN APPLYING ERISA's PRUDENCE AND OTHER FIDUCIARY RESPONSIBILITY PROVISIONS, DOES IT MAKE ANY DIFFERENCE THAT THE PLAN IS DESIGNED FOR THE PURPOSE OF HOLDING EMPLOYER SECURITIES?

Congress did not enact special exceptions to ERISA's prudence and other fiduciary responsibility requirements regarding holdings of employer securities. However, several courts have created a "presumption" that where a plan is designed to hold employer securities and in fact does so, the prudence and other fiduciary responsibility requirements of ERISA are presumptively satisfied. This holding derives from section 404(a)(1)(D) that requires plan sponsors and other plan fiduciaries to follow the terms of the plan, as long as such provisions are consistent with ERISA. In other words, where a plan is designed to hold employer securities, a fiduciary must do so unless doing so will violate ERISA. We think the court-made "presumption" applies to ESOPs and individual account 401(k) plans where the employer match is made in the form of stock. We also think that this presumption may also apply to employer securities acquired through an employer stock investment option under a 404(c) plan.

3. DOES ERISA SECTION 404(c) PROTECT PLAN SPONSORS FROM LIABILITY FOR LOSSES RELATING TO EMPLOYER SECURITIES?

When the Labor Department first proposed regulations under section 404(c), transactions involving employer securities were not covered. However, based on certain conditions added to the final version, employer

Stock transactions are covered under the section 404(c) safe harbor. Thus, for plans qualifying under section 404(c), plan sponsors and other plan fiduciaries will not be held liable for losses directly resulting from a participant's allocation of his or her individual account balance to an investment option of employer stock.

However, where an investment option of employer securities constitutes a "designated investment alternative" under the regulations to section 404(c), plan sponsors are required to monitor whether the employer securities investment option complies with ERISA's prudence and other fiduciary responsibility requirements. As noted, it is at this point that plan sponsors must decide whether the court-made presumption, as described above, applies to this monitoring function.

In recent class action lawsuits, allegations have been made that the failure of fiduciaries to inform participants of needed information constituted a separate breach of fiduciary duty under section 404 of ERISA. These allegations suggest, as does the Labor Department's Request for Information on Fiduciary Disclosure, that even where plan sponsors provide the prospectus disclosures mandated by the regulation, liability may arise where sponsors fail to anticipate the informational needs of participants.

4. HOW DO THE SEC's INSIDER TRADING RULES IMPACT A PLAN SPONSOR'S FIDUCIARY OBLIGATION TO PARTICIPANTS?

Section 16(b) of the Securities Exchange Act of 1934 restricts employees, officers and directors of a plan sponsor from trading on inside information. Unfortunately, in many cases, members of a plan sponsor's benefits committee comprise the same management employees who possess confidential financial information.

In Enron and other class action lawsuits, the plaintiffs have alleged that the plan sponsor engaged in insider trading and securities fraud in addition to fiduciary violations under ERISA. Specifically, in Enron, the allegation is that management employees used inside information in trading their own holdings in employer securities while failing, in violation of ERISA, to use that same information to provide participants information they needed to make prudent decisions.

Given the current status of the law, it may be difficult to reconcile the application of the insider trading rules with ERISA's fiduciary responsibility provisions. Indeed, we have yet to see any authority that a plan sponsor is obligated to ignore the SEC insider trading restrictions and share insider information with participants of an individual account plan and at least one case holds to the contrary. Nevertheless, in situations where a company's financial condition is deteriorating, it may make sense for the plan sponsor to engage an independent fiduciary to take over responsibility for the operation of the Benefits Committee. In those cases, a "fire wall" should be erected separating members of the Benefits Committee possessing inside information from the independent fiduciary.

5. HOW WILL ENRON CHANGE THE LEGAL LANDSCAPE?

Even before Enron, it was evident that growing plaintiffs' bar believed that the pension system was fertile ground for class action lawsuits. While many recent suits like First Union have been high profile, we are not aware of any suit that has garnered the attention of the Enron suits.

There is an old adage; "Bad facts make bad law." If it turns out that the allegations in Enron are true, given the extent of the losses suffered by thousands of plan participants and retirees, the courts could render decisions that make it more difficult than ever for plan sponsors to maintain employee benefit plans holding employer securities. However, for the most part, the types of allegations made in Enron are not new. Even the allegations regarding fiduciary disclosure are not new. The real impact of Enron will not be in the courts. As we have already seen, the impact will be from Capitol Hill.

6. HOW WILL CONGRESS REACT TO THE ENRON DEBACLE?

Shortly after the Enron collapse, members of Congress in both houses began calling for hearings and investigations and introduced legislation to fix the Enron "problem." We anticipate that a very long line of witnesses will come to Capitol Hill, and detail heart-wrenching stories of the company's collapse and its effect on Enron employees' retirement prospects.

Congress will consider seriously proposals to rectify problems relating to plan holdings in employer securities. More than a dozen congressional hearings have been conducted and dozens of legislative proposals have been introduced, including the Administration's recent proposal, which has been incorporated into a bill, introduced by John Boehner (R-OH). In moving forward with this legislation, we think Congress will focus on a number of key areas: (1) percentage limits on employer securities holdings of 401(k) plans and individual account plans; (2) more liberal diversification for employer stock accounts, including matching stock contributions and ESOPS; (3) restrictions on blackout periods; (4) insider trading restrictions; and (5) more detailed disclosure about investments. Some in Congress have also proposed changes to ERISA's remedies' provisions allowing, among other things, participants to obtain relief outside of their plans. This could result in increased ERISA litigation.

While we are certain that these and other proposals will be seriously considered, the ultimate shape of new legislation is anybody's guess. In the meantime, plan sponsors should review their policies and practices in key areas -- such as monitoring employer stock accounts and diversification policies -- to identify areas where changes may be desirable.