"A pure heart and an empty head are not enough." This
is a quote from an early case defining the scope of ERISA fiduciary
liability. However, ERISA has always made fiduciaries responsible
only for losses caused by their breaches of fiduciary
responsibility. It doesn't make fiduciaries insurers of plan
A recent Fourth Circuit Court of Appeals case has
established its own gloss on the ERISA rules to determine when
fiduciaries who follow imprudent procedures will have to make up
plan losses. The Fourth Circuit rule is based on what a
hypothetical prudent fiduciary, who I will call the "prudent
shadow", would have done in the same situation.
Like the recent "Teflon Fiduciary" decision of the
Fifth Circuit Court of Appeals, discussed in a prior blog post , the lower court decision
seemed to exonerate fiduciaries in situations that may not have
been intended by the drafters of ERISA. We will have to see how the
new rule is applied in order to determine whether the Fourth
Circuit rule does so and whether it is workable.
After the spinoff of Nabisco businesses from RJR Nabisco, the
RJR 401(k) plan held blocks of Nabisco stock in two frozen funds. A
working group that was not authorized under the plan documents
decided after a short discussion to divest the stock in these
frozen funds within six months. It did so at a time when the stock
price had declined, because it was concerned about fiduciary
liability for violating the rule that employee plan investments
must be diversified and thought continuing the Nabisco funds was
The group didn't consult an outside investment adviser or
hire an independent fiduciary to determine the best time to divest.
Nor did it seek the advice of an outside ERISA attorney about what
the ERISA diversification rule, which actually provides that
investments be diversified "unless it is prudent not to do
The plan ended up selling its stock at a time when outsiders
rated the stock a "buy" due to forecasts of improving
company prospects, and the stock did, in fact, rebound. However,
the appellate court decided that even though the decision-making
process wasn't prudent, there might not be any damages –
it all depended on whether the prudent shadow would have sold the
stock in the fund at that time.
What Did the Lower Court Decide?
The district court had ruled in favor of RJR, even though it
concluded that an imprudent process had been followed, on the
ground that the breach of using an imprudent process didn't
cause plan losses if the prudent shadow COULD have divested the
stock at the same time that the imprudent fiduciaries decided to do
Note the difference between the "could have" standard
and the "would have" standard applied by the Court of
Appeals. The smallest probability may satisfy the "could
have" standard, whereas the "would have" standard
seems to require that it be more likely than not that the prudent
shadow would have divested at the same time.
Where Do We Go From Here?
The case was remanded to the district court to determine whether
there were losses under the "would have" sold standard.
Presumably, the district court will find liability if it
determines, for example, that the prudent shadow would have sold
the stock later. However, the implications of this rule seem to be
that if a bumbling fiduciary somehow stumbled on an appropriate
sale date, or blundered into a good investment, there may be no way
in the Fourth Circuit for participants to hold the fiduciary
accountable for failing to act prudently. In this case, the court
might instead, for example, have determined that damages would be
based on the most favorable sale date or an average of the most
favorable sale dates over a defined period.
What Fiduciaries Should Do?
The lesson for fiduciaries is clear. Fiduciaries can be sued for
not selling stock as well as for selling at what plaintiffs allege
is the wrong time. And now that the Supreme Court has eliminated
the so-called "Moensch presumption" that decisions
involving employer stock are presumptively prudent, fiduciaries of
plans with employer stock funds need to be particularly
However, courts do not apply 20-20 hindsight in reviewing
whether investment decisions were prudent. Had the correct RJR
fiduciaries followed a prudent process, the issue of damages might
never have been reached. Written documentation of a prudent process
by the correct plan decision makers is essential, and that prudent
process often involves consulting the right expert advisers.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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