Employers and ERISA fiduciaries are painfully aware of the litigation in the past few years asserting breach of fiduciary duty for not selling company stock held by a retirement plan soon enough to avoid losses. Now we have a case in which plan fiduciaries are taken to task for selling such stock too quickly, resulting in the plan’s missing out on windfall gains. Tatum v. RJR Pension Inv. Comm., 2014 U.S. App. LEXIS 14924 (4th Cir. Aug. 4, 2014), offers insights into making decisions about changes to investments in 401(k) plans. Tatum involved the decision-making process for the elimination of a company stock fund following a corporate spin-off but has broader implications for employers and fiduciaries who select investments for their retirement plans.
In Tatum, the U.S. Court of Appeals for the Fourth Circuit reversed a lower court judgment in favor of R.J. Reynolds Tobacco Company and R.J. Reynolds Tobacco Holdings, Inc. (collectively, RJR) and their 401(k) plan committees. The court of appeals found that the district court applied the wrong legal standard for determining whether the defendants’ breach of the ERISA fiduciary duty of procedural prudence resulted in losses to the RJR 401(k) plan and remanded the case to the district court for further proceedings.
In 1999, RJR Nabisco, Inc. (RJR Nabisco) decided to spin off its tobacco business (which became RJR) from its Nabisco food business. The primary stated purpose was to reduce the negative impact that tobacco litigation was having on RJR Nabisco’s stock price. Before the spin-off, RJR Nabisco sponsored a 401(k) plan. The RJR 401(k) plan at issue in Tatum (the New Plan) was created by a spin-off from the RJR Nabisco plan.
Immediately after the spin-off, the New Plan continued to offer most of the investment funds that were offered under the RJR Nabisco plan. The New Plan expressly provided for the retention of two Nabisco single-stock funds as “frozen” funds in the New Plan (the Nabisco Funds), meaning that participants could retain existing investments in the Nabisco Funds but could not make additional investments in those funds.
Following the spin-off, a “working group” of RJR employees (but not the New Plan committees responsible for investment selections) decided to eliminate the Nabisco Funds from the New Plan and selected a divestment timeline of six months. However, the working group (1) had no authority or responsibility under existing New Plan documents; (2) spent only 30 to 60 minutes discussing what to do with the Nabisco Funds; and (3) could not later explain how six months was determined as the appropriate divestment timeline.
Although one of the New Plan committees apparently adopted the working group’s recommendation to remove the Nabisco Funds, there was no evidence that the committee met, discussed or voted on the issue or otherwise signed a required consent in lieu of a meeting authorizing an amendment to eliminate the Nabisco Funds. The purported amendment that would have eliminated the Nabisco Funds was found to be invalid, as it was not properly adopted. If there had been a properly-adopted New Plan amendment directing the appropriate New Plan fiduciaries to eliminate the Nabisco Funds by a specified date:
- the amendment would have been a “settlor” act not subject to ERISA fiduciary duties; and
- the subsequent elimination of the Nabisco Funds in accordance with the amendment would have been a fiduciary act only to the extent that discretion was involved as to when and how the funds would be divested by the time specified in the amendment.
However, because the New Plan did not mandate divestment of the Nabisco Funds, the decision to eliminate those funds was a fiduciary decision.
The participants in the New Plan were informed of the decision to eliminate the Nabisco Funds. Thereafter, the working group met several months after its original meeting to discuss possible reconsideration of the decision to divest the New Plan of the Nabisco Funds. The working group decided to continue with implementing the divestment, primarily based on concerns that participants who had already divested their interests in the Nabisco Funds in reliance on prior communications about elimination of the funds might bring lawsuits. The working group apparently considered alternative actions, such as temporarily “un-freezing” the Nabisco Funds, but was concerned that such actions could be viewed as an investment recommendation to participants to remain invested in or to reinvest in the Nabisco Funds. As a result, the Nabisco Funds were fully liquidated in January 2000.
Nabisco shares were trading at all-time lows when the Nabisco Funds were divested from the plans. Despite the fall in value, analysts continued to maintain a favorable outlook on Nabisco stock post-spin-off. A few months after the funds were liquidated, a takeover offer for Nabisco by a substantial investor sparked a bidding war and by the end of the year, Nabisco stock was trading at all-time highs.
In May 2002, Richard Tatum, a New Plan participant (Tatum), filed a class action alleging RJR and New Plan fiduciaries breached their fiduciary duties under ERISA by eliminating the Nabisco Funds from the New Plan on an arbitrary timeline without conducting a thorough investigation. He further alleged that the fiduciary breach caused substantial loss to the New Plan by forcing the sale of Nabisco Funds at their all-time low, despite the strong likelihood that Nabisco’s stock prices would rebound.
District Court Decision
After years of litigation and a bench trial, the district court held that (1) there was no valid amendment requiring divestment of the Nabisco Funds on the six-month deadline; (2) the defendants breached their fiduciary duty of procedural prudence when it decided to remove and sell the Nabisco Funds without a proper investigation into the prudence of doing so; (3) the defendants bore the burden of proof as to whether, despite their breach, their ultimate investment decision was objectively prudent; and (4) the defendants’ ultimate investment decision was objectively prudent because a reasonable and prudent fiduciary could have made the same decision after performing a proper investigation. The last holding became the crucial issue on the appeal.
Fourth Circuit Decision
In a 2-1 decision, the Fourth Circuit affirmed the district court’s holding that the defendants breached their fiduciary duty of procedural prudence and thus bore the burden of proof as to whether the decision to eliminate the Nabisco Funds was objectively prudent. However, it held that the district court applied the wrong legal standard for determining objective prudence.
Fiduciary Duty of Procedural Prudence
The Fourth Circuit explained that the fiduciary duty of procedural prudence requires fiduciaries to (1) employ appropriate methods to investigate the merits of a particular investment; (2) engage in reasoned decision-making processes consistent with that of a prudent man acting in a like capacity; and (3) monitor the prudence of an investment decision to ensure that it remains in the best interest of plan participants. It emphasized that there is no uniform checklist for procedural prudence. Instead, the duty requires a totality-of-the-circumstances inquiry.
The Fourth Circuit had no trouble affirming the district court’s conclusion that the defendants violated this duty, pointing to the extensive factual findings at the district court level. For example:
- Because the purported amendment was invalid, there was no language in the New Plan documents eliminating the Nabisco Funds or limiting the duration in which the New Plan would hold the Nabisco Funds. Moreover, aside from testimony that the fiduciary committee agreed with the working group’s recommendation, there was no evidence that the fiduciary committee met, discussed, or voted on the issue of eliminating the Nabisco Funds.
- The working group’s discussion of whether and how to liquidate the Nabisco Funds lasted only 30 to 60 minutes.
- The working group’s decision to liquidate the Nabisco Funds was made with almost no discussion or analysis, was based on the assumptions of those present with no research or investigation and was made without input from any investment adviser.
- Before the divestment was complete, various RJR human resources managers, corporate executives, and in-house legal staff met to discuss possible reconsideration of the decision to sell the Nabisco Funds. However, the discussion had focused mainly on the potential liability in the event of a lawsuit by participants who had already divested themselves of holdings in the Nabisco Funds, rather than on what course of action would be in the best interests of Plan participants at that later time.
- RJR sent a letter to New Plan participants informing them that it would eliminate the Nabisco Funds from the New Plan. The letter erroneously stated that the law did not allow the New Plan to maintain the Nabisco Funds. The human resources manager who drafted the letter testified that she knew that the statement was incorrect. And even when responsible RJR officials were informed of the error, the statement was never corrected. In fact, a second letter was mailed that repeated the incorrect statement.
- Days before the final divestment, Tatum e-mailed members of the fiduciary committee asking them not to proceed with the divestment. Tatum stated that he wanted to wait until the stock price of Nabisco rebounded, and noted that company communications indicated that Nabisco was optimistic this would happen after the spin-off. In response, a committee member replied that nothing could be done to stop the divestment.
- There was no evidence that the working group ever considered an alternative to divestment of the Nabisco Funds within six months (e.g., maintaining the Nabisco Funds as frozen indefinitely or increasing the divestment timeline beyond six months).
- At the same time that the Nabisco Funds were eliminated from the New Plan, several RJR corporate officers retained their personal Nabisco stock or stock options, and several analysts were bullish about Nabisco because of removal of the tobacco “taint.”
Overall, the district court found no evidence – in documentation or testimony – of any process by which New Plan fiduciaries investigated, analyzed or considered circumstances regarding the Nabisco Funds and whether it was appropriate to divest.
“Would Have” Standard of Objective Prudence
The Fourth Circuit agreed with the district court that the defendants bore the burden of proof as to whether, despite their breach, their ultimate investment decision was objectively prudent. However, the majority disagreed as to the correct legal standard for determining objective prudence.
The majority noted that in a prior decision the Fourth Circuit had defined “objectively prudent” to mean whether a hypothetical prudent fiduciary would have made the same decision. See Plasterers’ Local Union No. 96 Pension Plan v. Pepper, 663 F.3d 210 (4th Cir. 0211). Conversely, the district court in Tatum had merely asked whether a hypothetical prudent fiduciary could have made the same decision. The court of appeals cited the U.S. Supreme Court’s decision in Knight v. Comm’r, 552 U.S. 181 (2008), to explain that “could have” describes what is merely a possibility, while “would have” describes what is probable.
The Fourth Circuit acknowledged that the “would have” standard is more difficult for defendant-fiduciaries to satisfy, but stated that this is the intended result. It noted that ERISA’s enforcement provision would be diminished to an “empty shell” if it were to use the “could have” standard, as breaching fiduciaries could easily avoid liability by pointing to the mere possibility that a prudent fiduciary “could have” made the same decision.
Judge J. Harvie Wilkinson III strongly dissented and argued that the majority’s standard of objective prudence was incorrect, stating that “[a]s for those who might contemplate future service as plan fiduciaries, all I can say is: Good luck.”
Judge Wilkinson described the majority’s decision as “semantics at its worst,” contending that the majority’s standard of review “would substitute for the fiduciary’s duty to make a prudent decision a duty to make the best possible decision, something ERISA never required.” [Emphasis added.] He noted that objection prudence does not necessarily dictate a single prudent decision, but rather “asks whether hypothetical prudent fiduciaries consider the path chosen to have been a reasonable one.” He cited the Supreme Court’s recent decision in Fifth Third Bancorp v. Dudenhoeffer, 134 S. Ct. 2459 (U.S. 2014) in support of his view of objective prudence.
Judge Wilkinson concluded his dissent as follows:
The majority has reversed the most substantiated of district court findings under the most stringent of hindsight tests. To impose personal monetary liability upon fiduciaries for prudent investment decisions made in the interest of asset diversification makes no sense. What this decision will lead to, despite all the words from the majority and Tatum, is litigation at every stage behind reasonable investment decisions by ERISA-plan fiduciaries. Who would want to serve as a fiduciary given this kind of sniping?
ERISA was “intended to ‘promote the interests of employees and their beneficiaries in employee benefit plans.’” * * * Yet far from safeguarding the assets of ERISA-plan participants, the litigation spawned by the majority will simply drive up plan-administration and insurance costs. It will discourage plan fiduciaries from fully diversifying plan assets. It will contribute to a climate of second-guessing prudent decisions at the point of market shift. It will disserve those whom ERISA was intended to serve when fiduciaries are hauled into court for seeking, sensibly, to safeguard retirement savings.
I had always entertained the quaint thought that law penalized people for doing the wrong thing. Now the majority proposes to penalize those whom the district court found after a month-long trial did indisputably the right thing — in professional parlance, the objectively prudent thing. [Citations omitted.]
In light of the strong dissent from a respected judge and the Supreme Court’s view in Dudenhoffer that ERISA fiduciaries are not required to out-guess the stock market, further litigation in this case is likely.
Lessons for Employers and Fiduciaries
Tatum offers two lines of lessons for employers and fiduciaries. The first line involves those situations where a plan amendment is appropriate for an investment decision, such as a corporate spin-off. The second line involves other situations where investment decisions are made by plan fiduciaries.
As to a corporate spin-off, the lessons include these:
- Companies whose stock is an investment option in a 401(k) plan need to consider the settlor and potential fiduciary decisions likely to arise when the company spins off a subsidiary and that other company’s shares will be held by the plan following the spin-off. To the extent possible, these issues should be considered well before the spin-off transaction occurs.
- A properly-adopted plan amendment is an important way to reduce the likelihood of ERISA litigation over a divestment decision or its timing. RJR’s failure to properly amend its plan led to the Tatum fiduciary claims that RJR has litigated for more than 12 years.
- The decision whether or not to divest and the timing of divestiture should be carefully made, based on consideration of the interests of plan participants and beneficiaries. The fiduciaries should seek objective expert financial and legal advice. Careful documentation of the reasoning for the decisions is necessary.
- The employer and fiduciaries should be able to identify — as a basis for their decisions — evidence of both their procedural prudence and objective prudence.
For other decisions on investments in a plan, the lessons include:
- It is important to maintain as clear a line as possible between settlor decisions and fiduciary decisions. While the same individuals may be involved in both types of decisions, it is essential to keep their roles and decisions made in those roles separate.
- Investment decisions are always subject to review in hindsight. In the absence of a crystal ball that really works, the only alternative is to exercise procedural prudence. This is especially important for decisions involving company stock, where the potential for allegations of fiduciary breach are magnified.
For further information, please contact any of the authors, Robert B. Wynne, James P. McElligott, Jr., Jeffrey R. Capwell and Steven D. Kittrell, or any other member of the McGuireWoods employee benefits team.