The United States Department of Labor (“the DOL”) has challenged the dismissal of a 401(k) plan fiduciary breach claim on two grounds, in an amicus brief filed with the Sixth Circuit Court of Appeals, See Pfeil v. State Street Bank & Trust Co., E. D. Mich. No. 09CV12229; (Brief available here). One argument the DOL is rejecting is a position that affords fiduciaries of 401(k) plans and ESOPs a presumption of reasonableness in stock drop cases. The DOL’s second argument is that under the ERISA Section 404(c) safe harbor, fiduciaries may still be liable for the imprudent selection and monitoring of investment options even when participants have the ability to invest their deferrals in a variety of options besides employer stock.

As background, employers that sponsor ESOPs and 401(k) plans with employer stock as an investment option risk facing a class action suit under ERISA when the value of the employer stock falls. Many federal courts, however, dismiss these lawsuits early in the litigation. The reason for these dismissals is application of the “Moench presumption” of prudence (named after a Third Circuit Court of Appeals decision). Under Moench, employers who offer employer stock in a plan are presumed to have acted consistent with the ERISA duty of prudence, unless a plaintiff can show that an impending corporate collapse or other extreme situation existed at a relevant time. Plaintiffs often fail to plead such facts, leading to dismissal of their claims. The Third, Fifth, and Sixth Circuits previously have expressly adopted the Moench presumption. In contrast, the Seventh and Ninth Circuits have affirmed dismissals of stock drop suits without specifically adopting the Moench presumption.

Additionally, ERISA Section 404(c) shields fiduciaries from liability for losses that result from the participant’s exercise of control over investments. As mentioned in a prior blog [404(c)], in recent years the DOL has been arguing for limitation of the availability of this important safe harbor. Many courts have dismissed claims in stock drop cases because plaintiffs had the ability to invest in a variety of other investment options with different risk and return characteristics. See, In re Citigroup ERISA Litigation, No. 07 Civ. 9790, 2009 WL 2762708 (S.D.N.Y. Aug. 31, 2009 (available here). As such, the decision to invest in employer stock was more the result of participant control than a fiduciary decision. This protection does not apply, however, to claims that the selection of a fund as an investment option was prudent. Fiduciaries still must select and monitor investment funds prudently. The preamble to the DOL regulations under ERISA Section 404(c) that the 404(c) protection does not extend to “the act of designating investment alternatives.” Because of that, the protection under ERISA Section 404(c) often is considered limited or illusory.

In essence, these standards allow plans to be designed to require fiduciaries to make employer stock an investment option under a plan, unless that would be an imprudent investment or otherwise violate a fiduciary duty. Because Congress adopted statutes to encourage both ESOPs and employer stock in 401(k) plans, one might conclude that Congress intended fiduciaries to be biased in favor of holding employer stock. Yet, the DOL is attacking this reasoning. In Pfeil, State Street Bank & Trust Co. was the trustee and independent fiduciary of General Motors’ 401(k) plans. Under its trust agreement with G.M., State Street was required to offer G.M. stock as a plan investment unless (1) there was a serious question as to G.M.’s ability to continue as a going concern without resorting to bankruptcy or (2) there was no possibility in the short-term of recouping any substantial proceeds of the sale of stock in a bankruptcy proceeding. The District Court actually held that the plaintiffs plead sufficient facts showing that these conditions existed, but it ultimately threw out the case because the plaintiffs did not show that State Street was the proximate cause of the loss. The District Court found that the plans offered several diverse investment options, and that the participants had the ability to allocate their investments however they saw fit. The court held that State Street could not be held liable for losses that resulted from the participants’ decisions to continue to allocate their investments to G.M. stock.

This case is being appealed to the Sixth Circuit. In its amicus brief, the DOL is urging the Sixth Circuit to reject the “impending collapse” standard that the District Court used in applying Moench. The DOL fears that this standard will allow fiduciaries to contract out of their duties, making it difficult for participants to file suits against them. Instead, if a plaintiff shows that a prudent fiduciary would not invest in the stock in like circumstances, the fiduciaries should lose the presumption of reasonableness. It appears that DOL believes that the application of Moench has favored fiduciaries at too large of a degree, and imposing a higher fiduciary standard in these types of cases is necessary to restore balance with respect to participants. In addition, the DOL is challenging the application of ERISA Section 404(c) to shield fiduciaries from liability when the employer stock price falls, even when participants have a variety of investment options to choose from. The DOL fears that such an application of ERISA Section 404(c) would allow fiduciaries to escape liability even when they acted imprudently in keeping employer stock as an investment option.

The DOL’s positions on these issues raise concerns for employers and other plan fiduciaries whose plans and trust agreements require that company stock be offered as an investment option. The DOL’s position would increase uncertainty as to when fiduciaries would need to follow plan terms or disregard those terms because of a fiduciary duty to do so. Further, encouraging fiduciaries to sell employer stock could expose fiduciaries to litigation anyway. If a fiduciary sells employer stock that has been declining, and the price rebounds, participants may claim that fiduciaries were not prudent in selling the stock at a low point. Additionally, selling employer stock could create other issues. Participants who wanted to continue to hold the stock in their plan accounts until the price rebounded would be deprived of the opportunity to do so. Also, selling employer stock from a plan probably would drive the price down even more, which would worsen the situation and perhaps create issues with corporate fiduciary duties and federal securities laws. This uncertainty easily could lead to an increase in ERISA litigation and the costs to defend such litigation. It also may require plans and trust agreements to be revised to provide greater flexibility in removing employer stock as an investment option.

Essentially, employers would be placed in a Catch-22 because regardless of whether the stock price went up or down, a Monday morning quarterback would have the ability to challenge the employer’s decision. All of these issues show that Ohio and other Sixth Circuit employers that sponsor ESOPs or 401(k) plans that offer employer stock as an investment option, as well as trustees of such plans, should watch closely for a decision in Pfeil. Regardless of the outcome, it could be a game-changer.