United States: The Quandary Of Publicly-Traded Employer Stock In A 401(K) Plan

Offering employer stock in a 401(k) plan investment line-up can seem like a win-win situation. It can enable employees to become company owners—real, skin-in- the-game, participants in their employer's economic future—through a simple deferral election. The U.S. Su- preme Court has even recognized the value of employer stock funds, confirming that Congress sought to en- courage their creation through provisions and stan- dards contained in the Employee Retirement Income Security Act of 1974 (''ERISA'').

However, in the wake of a series of high-profile em- ployee lawsuits seeking recovery against Enron, Leh- man Brothers, and other employers for losses from 401(k) investments in employer stock, such funds can— almost as easily—seem a recipe for disaster. This article examines the quandary that employer stock funds pose for plan sponsors, who must navigate ERISA's careful balance of (1) ensuring fair and prompt enforcement of employee rights under employer-provided retirement plans while (2) encouraging employer creation of these plans.

Regulatory Background

Enacted in the wake of a series of mid-20th century corporate bankruptcies, ERISA provides plan partici- pants with clearly-defined rights and certain assurances that retirement dollars will be there when needed. Ac- cordingly, ERISA contains rigorous standards for those tasked with plan administration, and specifically man- dates that certain actions must be carried out prudently, and for the benefit of plan participants. These standards (''Fiduciary Duties'') require a plan's fiduciaries—a cat- egory which often includes its trustee(s), plan commit- tee members, and its sponsor—to ensure that the nest eggs of workers are protected. ERISA also specifically prohibits certain actions (''Prohibited Transactions'') by a fiduciary that involve self-dealing, kickbacks, and conflicts of interest.

Derived from the common law of trusts, the Fiduciary Duties provide that a trustee has a continuing duty— separate from the duty to exercise prudence in selecting investments at the outset—to monitor 401(k) invest- ments and to remove imprudent ones. With limited ex- ceptions, the Fiduciary Duties require that the assets of a plan never inure to the benefit of its sponsor, and that an appointed trustee control the assets of the plan ex- cept to the extent that (1) the plan document expressly reserves fiduciary responsibility to an otherwise named entity or individual, or (2) the trustee delegates the au- thority to manage, dispose of, or acquire assets to one or more investment managers.

ERISA demands that fiduciaries keep abreast of risk factors and act with the type of ''care, skill, prudence, and diligence under the circumstances'' of a person ex- perienced with and knowledgeable about investments, financial products, legal and regulatory requirements, and the individual retirement needs of plan participants and beneficiaries. To enforce this requirement, federal courts and the Department of Labor (''DOL'') consider both the merits of the fiduciary's actions and the thor- oughness of the fiduciary's investigation before it takes its actions. An ERISA fiduciary that breaches his or her Fiduciary Duties or causes a plan to engage in a Prohib- ited Transaction can be (1) held personally liable for all losses suffered by the plan, (2) required to return prof- its obtained through the improper use of plan assets, and (3) held liable for other remedial and equitable re- lief deemed appropriate by a court.

It is permissible for plan fiduciaries to allow invest- ment in employer stock through an ERISA plan, but the acquisition or sale of employer stock to a plan will only not result in a Prohibited Transaction under ERISA if (1) the acquisition or sale is for ''adequate consideration''—defined differently depending on whether stock is publicly- or privately-traded—and (2) no commission is charged on the acquisition or sale. Fi- duciaries must be careful to adhere closely to ERISA's Fiduciary Duties when making any decisions that relate to employer stock offered as an investment alternative to plan participants, as described below.

Participant-Directed Investing Issues

A 401(k) plan is a type of defined contribution plan that contains an individual account for every participant to which participants may make—and invest—pre-tax deferrals of compensation. In a defined contribution plan, a participant's retirement benefits are based upon amounts specifically contributed to his or her account, and any income, expenses, gains, or losses attributable to the way in which those amounts are invested.

Most 401(k) plans allow plan participants to select their own investments. A specific section of ERISA (Section 404(c)) provides protection for plan fiduciaries from liability for investment losses suffered by plan par- ticipants, as long as certain requirements are met. To satisfy ERISA Section 404(c), a defined contribution plan must (1) provide a menu of at least three ''core'' investment alternatives with materially different risk and return characteristics, (2) provide participants with sufficient disclosure regarding the investment alterna- tives, and (3) provide participants with effective control of the investment of their accounts, all as detailed in the ERISA Section 404(c) regulations.

Under a plan designed to comply with ERISA Section 404(c), the plan fiduciary is responsible for the selection of a menu of plan investment alternatives, but each plan participant is responsible for losses and gains attribut- able to his or her specific selections within those invest- ment alternatives. As mentioned above, while it is per- missible for a plan fiduciary to allow investment in em- ployer stock as an investment alternative, ERISA Section 404(c) requires that participants receive quar- terly statements that include ''a statement of the risk that holding more than 20 percent of a portfolio in the security of one entity (such as employer securities) may not be adequately diversified.''

ERISA Section 404(c) can provide protection for plan fiduciaries from liability for participant losses on invest- ments in an employer stock fund if the following addi- tional requirements are satisfied:

  1. The plan establishes procedures that provide for the confidentiality of information relating to partici- pants' purchase, holding, and sale of employer stock;
  2. Participants are informed of these procedures;
  3. Participants are informed of the name and address of the plan fiduciary responsible for monitoring these procedures; and
  4. Participants are allowed to transfer their invest- ments out of employer stock into an income-producing, low-risk, liquid option at least as often as they are al- lowed to otherwise transfer assets.

Protection under ERISA Section 404(c) for employer stock funds generally extends to losses attributable to a participant's decision to invest in an employer stock fund that is already offered under a plan.

However, increasing numbers of cases filed in federal courts have alleged Fiduciary Duty and Prohibited Transaction violations when (1) a plan fiduciary makes the initial decision to include an employer stock fund in a 401(k) plan investment line-up, (2) a plan fiduciary re- moves an employer stock fund from a 401(k) plan in- vestment lineup, or (3) a plan fiduciary fails to regularly analyze—and disclose to participants—the propriety of maintaining an employer stock fund in a 401(k) plan in- vestment line-up. These cases—known colloquially as ''stock-drop'' cases—generally arise when the value of an employer stock fund experiences a sharp decline, and focus on a fiduciary's responsibilities to assess and monitor the value of employer stock funds.

Valuation Issues

No matter what the specific theory of the stock-drop case may be, the basic allegation remains the same: the selection, termination, or maintenance of employer stock as an investment option caused a violation of ERISA, and the ERISA violation presented an action- able loss for participants. Most stock-drop cases focus on problems with the valuation of publicly-traded stock as the cause of a breach of Fiduciary Duties or Prohib- ited Transaction violations.

Stock that is issued by an employer and is readily tradeable on an established securities market is consid- ered ''publicly-traded.'' A stock is readily tradeable on an established securities market if it is traded on a na- tional securities exchange that is registered under the Securities Exchange Act of 1934. Most courts have con- cluded that publicly traded stock contained in a 401(k) plan is valued under the ''efficient market theory.'' The efficient market theory assumes that a stock's market price reflects an accurate estimate of the value of that stock's risk and return profile. In an efficient market, no one may profit from publicly-available information— i.e., beat the market— because all publicly-available in- formation is presumed included in the stock's price.

Under a pleading standard recently adopted by the U.S. Supreme Court in 2014's Fifth Third Bancorp v. Dudenhoeffer, federal courts are instructed to dismiss

any allegations that it is imprudent for a fiduciary to as- sume a stock's market price is the best available esti- mate of its value, unless there is evidence that the mar- ket price is inaccurate due to concealed corporate fraud or other ''special circumstances.''

Though judges have used this ''special circum- stances'' requirement to dismiss lawsuits involving the company stock of J.C. Penney, General Motors and Ra- dioShack Corp., the Supreme Court has not provided much guidance as to what kind of ''special circum- stances'' could render the market price unreliable. Some stock-drop cases have advanced the idea that a fi- duciary has a duty to liquidate an employer stock fund when it becomes clear that a business is no longer vi- able as a going concern. It remains unclear whether the Supreme Court would agree that a fiduciary is required to divest of a publicly-traded employer stock investment option based solely on the inherent riskiness of a com- pany's business or financial condition.

For any action related to plan assets, ERISA requires plan fiduciaries to review relevant data, assess its sig- nificance, and supplement data where necessary. Given that the same Fiduciary Duties apply to employer stock as apply for all other ERISA-governed investments, plan fiduciaries would be well-advised to consider cre- ating and implementing a process for tracking and evaluating facts—other than market price—about a plan sponsor's stock as well as documenting the work done and the results obtained.

Documentation is key under ERISA for demonstrating that a plan fiduciary took care to reasonably dis- charge his or her Fiduciary Duties with respect to the plan. In the absence of documentation of the process engaged in with respect to any particular decision and the reasons for embarking on any action or inaction, the plan fiduciary is unable to ''prove'' its satisfaction of the prudent fiduciary process requirement.

Possible Solutions

Following Dudenhoeffer, many 401(k) plan sponsors (and/or the committee to which the plan document or plan sponsor delegates plan management) have turned to their documents, and taken action to amend their plans to limit the overall amount any individual partici- pant can invest in employer stock or to eliminate the employer stock fund as an investment alternative alto- gether.

If a plan sponsor chooses to limit the overall amount a participant can invest in employer stock or eliminate the employer stock fund altogether, such actions should be phased in over time, to give participants sufficient opportunity to rebalance their accounts and allow plan fiduciaries time to implement the change in a prudent manner. We generally see plan fiduciaries establishing a timeline of between 6 and 24 months to implement the change, the thinking being that this time window pro- vides participants with sufficient notice of the limitation on or elimination of the employer stock fund so that they can gradually divest out of employer stock and are not unduly or adversely impacted by a ''single point in time'' valuation of the employer stock. A 6-to-24-month timeline will also provide enough time for the plan sponsor to satisfy all notice requirements and help avoid a claim that the limitation on or elimination of the employer stock fund itself was a breach of ERISA's Fi- duciary Duties.

The decision to limit or eliminate the employer stock fund from the plan, and the accompanying plan amend- ment, is—strictly speaking—not a fiduciary act. How- ever the implementation of such decisions is a fiduciary act. Therefore, the sheer level of disruption and partici- pant confusion that can result from the limitation or elimination of the employer stock fund as a 401(k) in- vestment option must be thoroughly discussed and documented in order to satisfy ERISA's Fiduciary Du- ties.

If a plan sponsor instead chooses to retain the em- ployer stock fund within the 401(k) plan's line-up (ei- ther limited or unrestricted), it is important that ERISA's Fiduciary Duties continue to be satisfied. Plan fiduciaries are no longer able to ''ignore'' the employer stock fund when selecting, monitoring, and evaluating the investment line-up offered to participants in a par- ticipant directed account.

Plan fiduciaries should review their plan's investment policy statement (''IPS'') to ensure it adequately ad- dresses the employer stock fund and provides guidance to the plan fiduciaries—and their investment advisors— with respect to the factors that will be considered in monitoring the employer stock fund. These factors gen- erally include review of criteria such as: (1) stability/ management, (2) diversification, (3) performance rela- tive to benchmarks, (4) expense ratio relative to the peer group, and (5) the accessibility of public informa- tion on the employer stock fund. The IPS can provide documentation of the process through which facts about employer stock are tracked and evaluated by the plan fiduciaries, and should contain written provisions, like those reproduced below, which instruct how the employer stock fund should be benchmarked and moni- tored as a 401(k) investment alternative:

Employer Stock Guidelines

A plan fiduciary will use the following information to evaluate the reasonableness of the plan fiduciary's reli- ance on the value set by the market upon which the em- ployer stock is traded and to confirm that no special cir- cumstances make reliance on this market value impru- dent. On a quarterly basis, an investment advisor will provide the plan fiduciary with a report setting forth the following information:

  1. Average weekly trading volume for the em- ployer stock for each week of the most recently closed quarter;
  2. Number of analysts following the employer stock as of most recently closed quarter;
  3. Number of market makers/arbitrageurs in em- ployer stock as of most recently closed quarter;
  4. Confirmation of the company's eligibility to do an S-3 filing;
  5. Market capitalization for the employer stock as of most recently closed quarter;
  6. Bid and ask spread for the employer stock as of most recently closed quarter;
  7. Percentage of employer stock held by insiders; and
  8. Confirmation that the employer stock trades on an established market.

The investment advisor will also communicate with the committee concerning any material changes to the above listed information, on an ad hoc basis. One item not addressed by the example of IPS language above is the treatment of non-public information. Cur- rent case law and DOL regulations regarding Fiduciary Duties require that ERISA plan fiduciaries consider all information available when making plan investment de- cisions. When a corporate officer who also serves as an ERISA plan fiduciary acquires inside information, he or she might violate ERISA if he or she does not act on that information before it becomes publicly known. How- ever, that same fiduciary might violate federal securities laws by acting upon the same information before it be- comes publicly known.

Dudenhoeffer acknowledged that plan fiduciaries confront unique challenges given this potential for con- flict. To address this, Dudenhoeffer instructs that, to state a claim for a breach of the Fiduciary Duties on the basis of inside information, a plaintiff must plausibly al- lege an alternative action that (1) the fiduciary could have taken, that (2) would have been consistent with federal securities laws and, that (3) a prudent fiduciary would not have viewed as more likely to harm the fund than to help it.

Many recent cases have attempted to impose more expansive obligations, suggesting that an insider must either disclose the material non-public information, or suspend stock purchases. With respect to disclosure, the Securities Exchange Commission (''SEC'') and DOL have taken the position that any insider responsible for misstatements or omissions that constitute material non-public information must make a disclosure that renders previous statements or omissions not mislead- ing. An insider not responsible for disseminating mate- rial non-public information, but with knowledge of it, may elect to disclose the information. With respect to trading, the SEC has stated that a fiduciary must avoid both buying and selling employer stock in order to avoid violating securities laws, and must promptly and accurately disclose suspension of trading and the rea- sons for it by filing an 8-K.

Note that an IPS that includes standards for appoint- ing an outside, independent fiduciary—such as a fidu- ciary investment advisor or an independent trustee— specifically to track an employer stock fund can help address the aforementioned securities laws concerns. Appointing a fiduciary independent of the company as- sures that the fiduciary will not be exposed to material non-public information in the performance of corporate management responsibilities. And independent fiducia- ries have no personal interests that could be seen as creating an appearance or the reality of loyalty to inter- ests other than those of the plan's participants. An inde- pendent fiduciary can be limited in its ability to receive non-public information so that it can truly make an ob- jective evaluation of the fund's propriety.

Similarly, it is worth considering whether it is advis- able to create and, if appropriate, to implement alterna- tive courses of action, such as halting purchases of the stock or making disclosures independent of the ordi- nary corporate disclosure processes if a fiduciary be- comes aware of material non-public information. Such courses of action should be evaluated both for consis- tency with the securities laws and to determine whether they would in fact be protective of the participants or just ''do more harm than good.''


While the law is still developing in regard to what ex- actly the process and documentation should look like, process and documentation are extremely important in the face of challenges to Fiduciary Duties and Prohib- ited Transactions. Fiduciaries should make honest and objective efforts to understand the quandary posed by employer stock. Fiduciaries should hire outside advi- sors when necessary to bring about true understanding, consider advice provided by advisors, and question any methods or assumptions that do not make sense. These efforts should be thoroughly documented in minutes and contemporaneous memoranda.

Prudence may require periodic evaluations of data relevant to the reliability of the stock price as an indica- tor of value. Though it is not clear whether ERISA im- poses fiduciary liability with respect to publicly-traded employer stock based on issues other than over- or under-valuation—such as the inherent riskiness of the company's business and financial condition—a plan fi- duciary should weigh the pros and cons of introducing a limit on participant investments in the undiversified employer stock fund to limit participant exposure to loss. A limit, regardless of the precise level, could apply to allocations of current contributions, overall plan bal- ances, or both.

Just like any decision related to plan assets governed by ERISA, the propriety of including employer stock in a plan's investment menu ultimately can depend on the unique character of that plan's population, as well as the dilig on of that plan's decision- makers.

Originally published in Bloomberg Law, May 25, 2017

The Quandary Of Publicly-Traded Employer Stock In A 401(K) Plan

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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