A common theme in many of our blogs is that of respecting boundaries. ERISA contains many examples of boundaries and compromises that are designed to balance on one hand the goal of encouraging employers to adopt employee benefit plans while on the other hand protecting the benefits of employees who participate in those plans. A common example of a boundary is the distinction between “settlor,” or general business decisions, and “fiduciary” decisions related to plan administration. Sometimes it is difficult to know which side of the boundary line a particular decision falls upon. When employers sponsor an ESOP, the boundary lines often become even more blurry. A recent decision from the District Court of Indiana provides an example of this issue. Malcolm v. Trilithic, Inc., 2014 WL 1324082; No. 1:13-cv-00073-SEB-DKL (S.D. Ind. Mar. 31, 2014). Trilithic does not raise any novel issue of law, but it provides a great example of how what otherwise would seem to be general corporate decisions risk becoming ERISA fiduciary decisions. That discussion will be the focus of this blog.
Settlor vs. Fiduciary Functions
Before describing the Trilithic example, we should provide a brief primer on the difference between settlor and fiduciary functions. General corporate decisions, such as whether to offer a plan or what level of benefits to provide under a plan, are considered settlor decisions. Decisions that relate to the administration of the plan, such as the investment options to offer participants, are fiduciary decisions. Boundaries are healthy, and essential. Decision makers need to know when they are wearing a corporate hat, acting in the best interests of the shareholders, versus when they are wearing an ERISA fiduciary hat, acting in the best interests of the plan participants and beneficiaries.
It is not always easy to determine whether a decision relates to a settlor or fiduciary function, and the difficulty often increases with respect to decisions that impact an ESOP. In addition to providing retirement benefits, a key purpose of the ESOP is to invest primarily in employer securities, thereby encouraging employee ownership. In fact, ESOP plan documents often require the investment of plan assets to be primarily in employer securities, a process typically called “hardwiring.” That would seem to be a general corporate decision, similar to the decision as to whether to sponsor any type of plan, rather than fiduciary decision.
Some participants have argued, however, that an ESOP invests in employer stock via fiduciary discretion, and that the fiduciary must continuously consider whether the employer stock remains a prudent investment. This argument has been made so often that the Supreme Court will issue a decision on the issue soon. This argument (along with several other arguments beyond the scope of this blog) also was a key argument that the plaintiff made in Trilithic.
Applications to ESOPs, as Explained in Trilithic
Bruce Malcolm, the former CEO and Chairman of the Board of Directors of Trilithic, Inc. (“Trilithic”) learned during Trilithic’s annual audit about a false sale that was recorded on Trilithic’s books. Malcolm shared this information with the other Board members, many of whom were also members of the ESOP’s Benefits Committee, which administered the ESOP. These other Board members either had participated in the recording of the false sale, or they did not investigate the false sale allegations. Soon after that, the Board removed Malcolm as CEO and as a director. Malcolm sued the company and Board members, alleging several complaints, and the Board members filed several counter claims.
The focus of this blog is Malcolm’s breach of fiduciary claim. Similar to many other breach of fiduciary claims related to ESOPs, Malcolm’s claim related to allegations of fraud and business judgment. Specifically, Malcolm alleged that the false sale would violate Trilithic’s loan agreements, thereby impairing the value of the company and thus the value of the benefits under the ESOP. The defendants countered that recording a false sale related to duties as corporate officers and directors, not administrators of the ESOP. In other words, it was a settlor function, not a fiduciary one.
The court rejected this argument, saying the basis of Malcolm’s claim was not the recovery of amounts related to fraudulent accounting, but rather to determine what he was entitled to under the ESOP. In other words, upon learning about the accounting fraud, the Board members had a decision to make about whether the fraud would impair the value of the company, and thus whether it was prudent to continue to have the ESOP invest in company stock. The decision not investigate the fraud was therefore a fiduciary decision, not a corporate one.
Had the court stopped there, the boundaries between settlor and fiduciary functions could have become extremely blurry. Fortunately, the court explained the limits of the fiduciary duty of prudence. The court, citing Seventh Circuit precedent, explained that the duty to investigate arises only when a “red flag of misconduct” is present and suggests that investing in company stock may be imprudent. The court added that Malcom failed to allege that the fraudulent sale had any negative impact on the plan’s investment in Trilithic stock such that it would amount to a red flag signaling imprudence.
The end result may have been a good one for the plan sponsor, but the blurring of the boundaries between settlor and fiduciary functions is still troubling. After all, isn’t it rational to believe that the investigation of accounting fraud is a settlor function, subject to corporate fiduciary duties, rather than a plan an administrative function subject to ERISA fiduciary duties? The good news at least is that the duty of prudence does not require constant monitoring of a company’s accounting practices.
Still, Trilithic shows that investing in employer stock creates risks that what otherwise would be settlor or corporate decisions could become fiduciary decisions. There are a couple of fairly easy steps that ESOP plan sponsors can take to help mitigate these risks. One is that when questions arise as to the viability of the company, anyone who serves in a corporate fiduciary role, such as a director or officer, should not make decisions as part of an ESOP committee in an ERISA fiduciary role as well. Another step is that the ESOP’s fiduciaries should meet periodically and document the decisions they made and the reasons for making those decisions.