Taking Stock

By Fred Reish

In recent years, company stock has become the primary source of 401(k) fiduciary litigation. Enron, Lucent, WorldCom and scores of other companies-—many of which are household names—-are the subjects of those lawsuits. Participants have lost hundreds of millions of dollars of retirement benefits and plaintiffs’ attorneys are trying to get that money back from the plan sponsors, their plan administrative committees, and the officers and directors who had oversight responsibilities for the 401(k) plans.

For example, in the Enron litigation, the participants are suing the members of the 401(k) administrative committee, the members of the Compensation Committee of the board of directors—-who had oversight responsibility for the plan committee, and officers who exercised control or influence over its investment in company stock.

Directors, officers and committee members who act as ERISA fiduciaries are personally liable for losses resulting from their imprudent conduct. Because of that, some plan sponsors buy fiduciary breach insurance to protect the committee members and other fiduciaries. However, where the losses are substantial, the insurance protection may not fully cover the fiduciaries. For example, in the Enron case there is a fiduciary breach policy with significant coverage. However, because of the amount of the losses, together with the attorney’s fees that will be paid from the policy, it is likely that the recovery will far exceed the policy limits; the responsible officers, directors and committee members will be personally liable for that excess amount.

That raises the obvious question: What can be done to protect fiduciaries where the 401(k) plan offers company stock as a match or as an investment option, or both?

Here are some ideas that will help:

• Remove all restrictions on the sale of diversification of company stock. Realistically, the right to diversify may be difficult to implement for closely-held and thinly-traded stock—-presenting a greater risk for fiduciaries of those plans.

• Offer employer stock either through a match or as an employee-directed investment, but not both. There is some evidence that, where plans provide for investment in both ways, participants tend to over-invest in company stock.

• Place a cap on the amount of company stock that participants can hold in their accounts. For example, the participants might be limited to 20% of their account balances in company stock. Plans that employ a cap tend to limit the concentration to 10% to 30% of a participant’s account balance.

• Educate employees on the risk of holding nondiversified investments, that is, company stock. At the very least, include a statement to that effect in the summary plan description and include a notice, in the participants’ quarterly statements. The DOL’s regulation on blackouts provides a notice that is helpful in drafting the warning.

• Consider a targeted communication/education program for participants who have invested large amounts in company stock. For example, target participants who hold over 20% of their benefits in company stock. Provide special communication and education programs that discuss the inherent risks.

• Provide investment advice to participants. Instruct the investment advisor to take into account the holdings in company stock in providing that advice-—so that the risk inherent in a single, nondiversified investment is minimized.

• If your plan is a 401(k) plan, consider converting it into a KSOP (which is an ESOP-—employer stock ownership plan-—that has a 401(k) component). While the law is not entirely clear, at least some courts have given additional deference to the fiduciaries for ESOPs.

• Offer a wide variety of other investment options, if you do not already do so. There is evidence that, if a robust line up of investment alternatives is offered, the participants will do a better job of diversifying.

• Consider a diversification process like the SMarT program designed by Professors Richard Thaler and Shlomo Benartzi (of the University of Chicago and UCLA, respectively). Their program involves both plain English education and a gradual process of diversifying company stock (to a targeted level) into other investments. (For a more detailed description, see www.anderson.ucla.edu/faculty/shlomo.benartzi/savemore.htm).

• Comply with the 404(c) requirements. While 404(c) won’t protect you from the failure to monitor the company stock, it does provide protection from participants who over-invest in company stock. Unfortunately, in my experience, most plans don’t comply with 404(c)’s 20 to 25 requirements. And, of those that offer company stock, few comply with the special provisions for that option (e.g., the procedures for preserving the confidentiality of participant investment decisions).

This article can serve as the starting point for a company stock “protection program.” Even more can be done. But, it takes expert advice. Committees should consult with their ERISA and securities counsel to properly structure a risk management program for the plan’s holdings in company stock.

© 2003 Article was reprinted, with permission, from Plan Sponsor magazine (June 2003). Copyright 2004. Asset International, Inc. All rights reserved.

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