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Why do employees file lawsuits over their 401(k) plans? Extended blackout periods, perceived conflicts of interest -- or maybe they're just mad at the markets. Here's how to keep your company in the clear.
David M. Katz, CFO.com | US
April 1, 2003
For at least another few weeks, Ellen Vinck will be worrying.
The vice president of risk management and benefits for United States Marine Repair blames the 22-day blackout of the company's 401(k) plan. Until April 17, when plan participants are scheduled to regain access to their accounts, worst-case scenarios are likely to trouble Vinck's days — and nights.
What if, for instance, a flu epidemic sidelines the two people assigned to move the plan's data from its existing recordkeeper to The Vanguard Group, its new full-service provider?
That could throw a monkey wrench into the schedule. If the company doesn't meet its deadline, frets Vinck, "all those people couldn't transfer funds." Employee investments and corporate credibility could suffer — and United States Marine just might find itself on the receiving end of a lawsuit.
Like many other executives involved in managing 401(k)s, Vinck is still haunted by the specter of Enron. The fear is that a misstep involving retirement plan policies or procedures — especially those concerned with investment — will spawn a lawsuit by angry employees. Remember that the ill-fated energy trading company invoked a blackout period for its 401(k) plan in October and November of 2001, just as the company's accounting problems were starting to emerge.
Recall also that Enron 401(k) portfolios were stuffed with company stock when the company locked down its plan to change recordkeepers. The prospect of thousands of pensioners unable to manage their accounts — just as Enron stock was poised for a dive — helped fuel a congressional inquiry and a whopping class-action suit filed under the Employee Retirement Income Security Act of 1974 (ERISA).
The most prominent 401(k) lawsuits have involved public companies. Typically, participants charge executives with holding back information — such as an expected drop in the share price — that could have made a difference in plan investments. But the sense of peril seems to have spread to smaller, nonpublic employers, too. Even businesses like United States Marine Repair, which doesn't offer company stock as a 401(k) investment option, could be shouldering fiduciary liabilities, some risk managers feel. With the economy in a sustained tailspin, any curb on the ability of employees to cut their losses might become grounds for a complaint.
United States Marine has done its best to lay the groundwork for a smooth change of providers. The company, a defense contracting subsidiary of publicly held United Defense Industries, delivered notice of the plan's lockdown to all its 401(k) beneficiaries two months in advance — a month earlier than required under the blackout provisions of the Sarbanes-Oxley Act.
Giving people that extra lead time was a challenge, notes Vinck. Since many of the company's employees work aboard U.S. Navy ships and installations at the company's six domestic facilities, they weren't all that easy to reach. To make sure that employees got the blackout notices, plan administrators conveyed the message via E-mail and in-person meetings as well as on paper. They also made sure that it was translated for the company's many Hispanic employees.
But well-laid plans have been known to go astray. That's why Vinck's so anxious for her company to meet its deadline and lift its 401(k) blackout period. "I will worry up until that time," she says.
The Tipping Point
More vexing than the possibility of a botched blackout, however, are the conflicts that can crop up when 401(k) administrators do offer employer stock as an investment alternative or use it to match employee contributions. Although Enron is the most well-known case linking a 401(k) class-action suit to an accounting scandal via company stock, it wasn't the first. Big lawsuits brought by plan members against Ikon Office Products (2000) and Lucent Technologies (2001) alleged that fiduciaries invested employer stock in the plans even though they were aware of problems at the companies.
Following the fall of Enron, similar class actions were filed in the wake of the WorldCom, Tyco, and Global Crossing fiascoes. The result? Benefits managers and finance executives perceive an increased risk of liability lurking in their 401(k) plans — and CFOs are looking especially vulnerable.
There's more here than simply a conflict between corporate finance and the company retirement plan. When a plan buys company stock on behalf of participants, fiduciaries can be trapped between the competing dictates of employment law and securities law, says Linda Shore, a benefits attorney and adjunct law professor at Georgetown University.
The clash stems from the potential collision between the corporate-insider role of CFOs (and other executives) and their 401(k) role. Under ERISA, "fiduciary" is defined as, among other things, someone who makes decisions about the administration of a plan and the management of its assets. Since many finance chiefs and their bosses either have a hand in running their 401(k) or in appointing someone who does — often it's the treasurer — they're fiduciaries of the plan and must act solely in its best interest, say benefits attorneys.
The problem arises when an executive-fiduciary has inside information that could affect the employer's share price. If that executive tips off plan beneficiaries to material, nonpublic facts about the company — even in a well-intentioned effort to act in the best interests of the plan — he or she could be charged with insider trading. (That may (or may not) have on Ken Lay's mind when he allegedly failed to tell Enron 401(k) participants that trouble might be afoot.)
Thorny though the dilemma is, a few new brambles may be emerging. Until now, the only requirement under ERISA that applied to employers in possession of material, nonpublic information was not to lie about it to plan participants, says Shore, citing the 1996 Supreme Court decision in Varity v. Howe. But if a Department of Labor friend-of-the-court brief holds sway, employers will be asked to do more than simply hold their peace.
The DoL brief, filed last August on behalf of the plaintiffs in the Enron case, asserts that fiduciaries have a greater duty than not to speak with forked tongue — they must protect plan participants from misleading information. In practical terms, the DoL maintains, Enron's fiduciaries should not only have come clean about Enron's dire straits, they should have eliminated Enron stock as a 401(k) investment option and as an employer match. After all, argues the DoL, insider-trading laws bar only the buying and selling of stock on the basis of inside knowledge — they don't prohibit directors and officers simply from stopping share transactions. So senior executives and board members who are fiduciaries should act to stanch the bleeding, maintains the DoL.
When a plan stops buying company stock, counters Linda Shore, the Securities and Exchange Commission might then be able to argue that the action "implicitly conveys material information." Adds Shore: "The only reason the company has put a brake on this is that there's a problem. A reasonably smart participant would sell, and sell now, based on the implicit [information], wouldn't he?"
A fiduciary who does the right thing in the eyes of the DoL, by curbing plan losses, could thus be charged by the SEC with being an inside tipster. The implications are "very scary" for employers in such situations, says Shore, who represents employers for Silverstein and Mullens, a division of Buchanan Ingersoll. "You've got to think twice about offering company stock."
Another reason to reconsider is that overabundant 401(k) holdings in company shares might knock the balance of total employee compensation packages off-kilter. If you add salary and bonus into the calculation, "you're investing a lot in a company just by working for it," says Ed Goldfinger, CFO of Empirix, a Waltham, Massachusetts-based Web applications provider. It's better to diversify, he adds, and to not let your 401(k) ride on company stock.
These dangers haven't been lost on fiduciary liability insurers. Alarmed by what he calls "fiduciary claims dressed up as securities claims," John Coonan, Chubb & Son's fiduciary liability product manager, has directed his field underwriters to lessen the carrier's risk exposure. "We're asking more and tougher questions" of corporate clients, he says. "Do you have company stock in your plan?" is at the top of the list.
If the answer to that question is yes, there are likely to be consequences. Just a few months ago, Chubb slashed the fiduciary liability coverage that it will make available to some Fortune 500 companies. If they have more than 10 percent of their total benefit-plan assets (including 401(k)s as well as other plans) in company stock, at their next renewal their available protection would be reduced from $25 million to a maximum of $10 million.
These companies can also expect elephantine premium boosts. While some of Chubb's clients in the billion-dollar-asset range have been hit with relatively moderate increases — where "moderate" means a 40 percent to 50 percent hike — Chubb is likely to extract multiples of that amount if the client is a Fortune 500 company, says Coonan.
Despite the tightening insurance market and the legal risks, however, company stock continues to be a mainstay of 401(k) plans. In a study of about 50,000 plans with 15 million 401(k) participants, as of year-end 2001, 45 percent of the participants were in plans that offered company stock as an investment option. The study, conducted by the Employee Benefits Research Institute and the Investment Company Institute, added that of the participants in plans offering stock, more than half held a portfolio that included 20 percent company stock or less — but 16 percent held a portfolio including more than 80 percent company stock.
Indeed, the much-vaunted advantages of providing company shares are still being vaunted. The positives, of course, include the alignment of employee and shareholder interests and the feeling of ownership that employees can enjoy.
Furthermore, when an employer like Charles Schwab puts a hold on its 401(k) cash contributions — as Schwab recently did, though a company representative maintains that this is a temporary measure — equity matches might make even more sense. "When cash flow is tight, you can continue to make matching contributions," says David Wray, president of the Profit Sharing/401(k) Council of America. "It's better to have a company-stock match than no match at all."
Tell It to the Judge
While company stock is widely regarded as the most fearsome fiduciary risk facing 401(k) plans, it's apparently not the only one. In the past two years there's been a boom in retirement-related lawsuits. In 2002 the number of civil cases filed under ERISA rose 9 percent, to more than 11,000, according to the Administrative Office of the U.S. Courts, following a 13 percent increase in 2001.
Why so litigious? Employees who are mad at the markets are simply taking their anger out in court, says Alden Bianchi, a partner in Mirick, O'Connell, DeMallie, and Lougee in Worcester, Massachusetts. "The company-stock issue is a symptom, but it's not the whole problem," says Bianchi "The problem is that all investments are down."
That fact has led both plan participants and plan sponsors into a sometimes frantic quest for diversification. Employees working for some of Bianchi's client firms are asking their employers to offer such exotic investment choices — exotic, at least, for 401(k)s — as real estate investment trusts, negative-volume index funds (which focus on days when trading volume is down), and gold. These days, says Bianchi, "not everyone investing in gold is some millennialist nut case."
Supplying tons of funds might also help shield plan sponsors from lawsuits claiming that employees had no way to cut their losses. True, plan menus with too many funds could cause administrative headaches, says Mark Larsen, a risk management consultant with Tillinghast-Towers Perrin. (Offering too many options, say some observers, also tends to overwhelm less sophisticated investors.) But offering too few funds might enable participants "to claim they didn't find an investment they were really comfortable with."
Under ERISA, 401(k) sponsors must furnish participants with at least three materially different investment alternatives. But providing an adequate array of funds doesn't guarantee that the portfolio will forever represent the required diversity. Mutual fund investment styles tend to drift, according to David Mair, a principal with Risk Excellence, a Colorado Springs, Colorado, consulting firm. "You think you're holding a balanced mutual fund, and you look up and it's holding 90 percent stock."
Even the increasing sophistication of fund managers can nudge funds into different categories. In 1998, when Mair was risk manager for the U.S. Olympic Committee, he discovered that the services provider for the U.S.O.C.'s 403(b) plan — a defined-contribution plan for employees of nonprofits that's similar to a 401(k) — had inadvertently spawned unfairness in the plan. In 1990, the provider had agreed to work under a single investment contract. But as the fund manager's operations grew more elaborate, that single contract mysteriously morphed into four. One of them included a guaranteed-income provision that the plan sponsors hadn't counted on.
Oops. As a result of the blooper, "some of the parties would have gained [an advantage] over other participants," explains Mair. In the midst of the boom, with all portfolios blooming, it didn't amount to a problem; the U.S.O.C. simply had the provider supply guaranteed-income provisions to all participants. But had the mistake occurred in today's hard times, muses the risk manager, "it might have been a liability."