United States: Company Stock Fund Litigation - The SPD And Prospectus

Last Updated: May 14 2013
Article by James B. Bristol

401(k) Plans Not Exempt. Normally, retirement and 401(k) plans are exempt from the rules governing the sale of securities. But when the plan allows participants to direct contributions into a company stock fund, the company must comply with ERISA as well as the laws governing the sale of securities. SEC rules require the employer to "register" the securities offered through the plan unless an exemption is available. SEC Rule 701 is available for companies with privately held stock. Employers with publicly traded stock can usually register the stock sold through the plan on SEC Form S-8. In either event, the company is obligated to provide a "prospectus" to plan participants describing the investment opportunity.

Conveniently, much of the information that must be included in the prospectus is already provided by employers through the summary plan description, or SPD, under ERISA. Historically, many companies have combined these into a single document due to the overlapping information. Both the SPD and prospectus must describe how an employee becomes eligible to participate, contributions that can be made to the plan, distribution rights and information on vesting and general administration. In addition, a prospectus must provide current and historical financial information of the company, risk factors for investing in company stock and a description of investment funds that are available other than company stock. Rules for eligibility, distribution and the like seldom change. Current financial information of course changes constantly. Mercifully, a company can "incorporate by reference" the financial information that is disclosed to the public through the normal SEC disclosure process.

Dual Legal Standards. The issue that courts have tackled is whether the employer in acting as the plan administrator – a fiduciary – has separate ERISA obligations when providing the financial disclosures required by federal securities law. When a company offers its stock for sale, it is normally engaged in an arms-length relationship with investors. It must provide all information that an investor would deem "material" to the investment decision. The prospectus that includes this information is subject to SEC standards for accuracy. A company may be liable to investors if it knew or "should have known" that the financial information reported was inaccurate or incomplete. In contrast, an ERISA fiduciary cannot act towards plan participants in such an arms-length manner. There are many other distinctions between SEC and ERISA duties. For example, if the company becomes aware of information that could be material but is not public, under SEC rules the company may not and, at times, should not disclose that information to the public. Corporate issuers develop "insider trading policies" to avoid misuse of material, non-public information. An ERISA fiduciary may be obligated to handle such "inside" information differently.

The Conflict. A recent decision in the Sixth Circuit Court of Appeals shows how this conflict in duties can lead to surprising results. The company's stock value had dropped precipitously and the 401(k) retirement plan lost significant value in the stock fund. Participants had received a combined SPD/prospectus with financial information as well as normal information about plan administration. This meant the prospectus information was a fiduciary communication. The company as plan administrator might then be responsible as a fiduciary if the financial information in the combined SPD/prospectus proved to be inaccurate. The court would not allow the fiduciary to simply pass along in the SPD the information that was furnished to all other investors under SEC rules. This standard could lead to absurd results.

Financial information about a company that is scrutinized in "stock drop" litigation is almost never included in the physical SPD delivered to participants. Instead, there is usually little more than a reference to a website where SEC filings are available to the public. The plan administrator cannot control the content of the financial disclosures. Other courts have reached a different result, although all seem to agree that the combined document is a fiduciary communication. The Second Circuit Court of Appeals, for example, has ruled that the plan administrator could pass along the SEC disclosures as long the fiduciary believed in good faith that the information was accurate.

A Tale of Two Hats. Employers need a practical solution that is more reliable than hoping that lawsuits will all be filed in the Second Circuit. Keep in mind that ERISA does not itself require the financial disclosures. The problem is that the plan administrator is wearing the "fiduciary hat" when it delivers financial information in a combined SPD/prospectus. Rather than gratuitously convert financial disclosures into a fiduciary communication, companies should be able to separate the prospectus information into a second document that is delivered while wearing only the non-fiduciary "company hat." Informal surveys suggest that most companies that offer a company stock fund in the retirement plan either have adopted or will adopt a two-instead-of-one approach to the delivery of SPD and prospectus information.

Careful coordination between securities and ERISA counsel is needed so that the company truly wears only its "company hat" when issuing the separate prospectus. A best practice that is related is to exclude executive officers and directors from participation on the retirement committee when a plan has a company stock fund. These individuals are frequently in possession of material, nonpublic information. Their duties to shareholders in general can, in those instances, come into conflict with their ERISA duties. Providing a prospectus that is separate from the SPD will not cure this type of conflict.

For further information visit Waller's ERISA Exchange blog

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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