The Enron and Lucent Cases: Responsibilities for Employer Stock

By Fred Reish and Joe Faucher

The massive losses suffered by participants in the Enron and Lucent 401(k) plans raise questions regarding fiduciaries' responsibilities with respect to employer stock as an investment in 401(k) plans. How Congress or the courts answer those questions will affect all companies offering company stock in their 401(k) plans.

The media coverage of the fiduciary breach lawsuits against Lucent Technologies (Lucent) and Enron Corporation (Enron) -— and their committee members and directors -— has focused attention on employer stock as an investment in 401(k) plans and on the responsibilities of fiduciaries for the management of that investment.

The Lucent and Enron lawsuits involve tens of thousands of participants, hundreds of millions of dollars in lost benefits, and claims that range from a conspiracy to hide offshore debt instruments (in the Enron lawsuit) to misrepresentations regarding “business problems” that would inevitably result in stock value declines (in the Lucent lawsuit). Any law, good or bad, legislated by Congress or decided by the courts, that results from those lawsuits will apply to every company that offers employer stock as an option in its 401(k) plan.

The purpose of this column is to examine those lawsuits and the ERISA provisions that govern them and to provide some guidance to 401(k) plan sponsors who offer employer stock in their 401(k) plans.

LUCENT AND ENRON
In Reinhart v. Lucent Technologies, Inc., (D. NJ. No. 01-3491) the plaintiffs -— participants in the Lucent 401(k) plan -— allege that Lucent and the plan fiduciaries were aware of business problems that would diminish the value of Lucent stock, which was one of the options in Lucent's 401(k) plan. The plaintiffs allege that the fiduciaries breached their duty to disclose those problems. The complaint against Lucent states:

Any investment in employer stock in the Plans was an un-diversified investment in a single company's stock whose public price was based on expectations of continued rapid growth. As a result, any such investment carried with it an inherently high degree of risk. These inherent risks made the Defendants' duty to provide complete and accurate information about investing in Company stock in the Plans even more important than would otherwise be the case. Rather than providing complete and accurate information to the Plans' participants and beneficiaries regarding the risks of investing in the Company stock fund in the Plans, Defendants withheld and concealed material information ... and instead actively misled the participants and beneficiaries of the Plans about the Company's earnings prospects and business condition, thereby encouraging participants and beneficiaries of the Plans to continue to make and to maintain substantial investments in Company stock in the Plans.

The complaint goes on to allege that Lucent's board of directors was aware of facts that warranted a downward revision of earnings estimates, and that the board was aware that if earnings estimates were lowered, Lucent's stock price would drop. The plaintiffs claim that the company nevertheless continued to publish unrealistically optimistic projections. The impact on Lucent's 401(k) plan participants was staggering —- 42 percent of the plan assets were in company stock, which dropped 92 percent in value from its high to its low.

At least four lawsuits have been filed for the employer stock losses in the Enron 401(k) plan. The allegations in one of those class action cases, Kemper v. Enron Corp., (S.D. TX. No. H-01-4089) are as follows:

In recent weeks, the value of Enron stock has plummeted in the wake of revelations that, for years ...Enron, aided and abetted by [Arthur Andersen LLP, its accountant,] materially misled investors concerning the Company's profitability and concealed billions of dollars of debt through secret, off -— shore partnerships set up to borrow and covertly funnel money to the Company. When the Company was forced to report a large third -— quarter 2001 loss in mid-October, 2001, surprising the market, the scheme unraveled and the price of Enron stock collapsed.

In Enron's 401(k) plan, employer-matching contributions were made in the form of company stock, and participants under age 50 were prohibited by the plan's terms from liquidating and diversifying the employer stock match. In addition, during the midst of revelations of its financial problems, Enron switched plan recordkeepers and imposed a “blackout period” during which no plan participant -— including participants over age 50 -— could sell the company stock. (Benefits professionals have traditionally used the term blackout for the transition period for the transfer by a 401(k) plan from one investment provider to another, or from one recordkeeper to another, but the media and politicians have begun referring to this period by the more dramatic phrases lockout period and lockdown period.)

About 60 percent of the 401(k) assets were invested in Enron stock, which fell from a high of $90 per share to less than $1 per share.

It is hard to overstate the impact on the Enron and Lucent plan participants. Because of the large numbers of affected participants, and the devastating losses of the participants' retirement benefits, the courts are being called on to define how ERISA's general fiduciary rules apply to employer stock and to explain how those rules regulate fiduciaries in the selection and monitoring of employer stock in 401(k) plans. Plan sponsors that allow their participants to purchase employer stock as a 401(k) plan investment option, or that contribute employer stock to the plans (e.g., as matching contributions), will be subject to the decisions of the courts in the Lucent and Enron cases. In addition, several legislative proposals have been made to limit or regulate employer stock in 401(k) plans.

THE LUCENT AND ENRON ALLEGATIONS
The complaints against Lucent and Enron make a number of assertions about ERISA's requirements and how they apply to 401(k) plan holdings of employer stock. For example, the complaints assert that fiduciaries have duties to provide complete and accurate information about the company's business if it is material to participants' decisions to buy, hold, or sell the employer stock. However, this column focuses on the duties of fiduciaries to monitor the holding of employer stock, and if they are so required, to stop additional investments in the stock or to sell the stock.

The complaint against Lucent alleges:

ERISA Section 404(a)(1)(A) imposes on a plan fiduciary a duty of loyalty -— that is, a duty to “discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries ... for the exclusive purpose of ...providing benefits to participants and their beneficiaries...” Section 404(a)(1)(B) also imposes on a plan fiduciary a duty of prudence -— that is, a duty to “discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and ... with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man, acting in a like capacity and familiar with such matters, would use in the conduct of an enterprise of alike character and with like aims....”

A fiduciary's duties of loyalty and prudence also entail a duty to conduct an independent investigation into, and continually to monitor, the merits of the investment alternative in the Plans, including employer securities, to ensure that each investment is a suitable option for the plan. From the inception of the Class Period, Defendants breached this duty of investigation and monitoring with respect to the Company stock fund. During the Class Period, none of the Defendants could have reasonably made a determination that the Company stock fund was a suitable investment for the Plans. During the Class Period, the Company stock was an unsuitable investment option for the Plans.

However, notwithstanding the terms of the Plan, Enron and the other Defendants remained responsible at all times for ensuring that Enron stock was a suitable and prudent investment. They were obliged, among other things: (1) to discontinue offering Enron stock to employees for purchase with employee contributions as soon as it appeared not to be a suitable or prudent investment; (2) to discontinue Enron stock as the form in which employer contributions would be made as soon as it appeared not to be a suitable or prudent investment; and (3) to permit participants under age 50 holding Enron stock previously -— received as employer contributions to sell some or all of it and move to other options under the Plan as soon as Enron stock appeared not to be a suitable or prudent investment. ERISA 404(a)(1)(D), 29 U.S.C. § 1104(a)(1)(D).

The Enron Defendants, however, had no strict and objective process for actively monitoring the prudence of Enron stock as an investment option for the Plan. Nor did the Defendants have any protocol for discontinuing the use of Company stock upon it becoming no longer prudent as an investment for Plan assets. Once the initial, “plan design” decision was made to offer Company stock as an investment option for voluntary contributions and as the form the Company's matching contribution would take, the Enron Defendants essentially never looked back -— or forward, believing either that the terms of the Plan tied their hands and/or that Company stock was inherently or necessarily a prudent and suitable investment for the Plan, when neither is true.

Moreover, Defendant Enron knew or should have known that the senior Enron officials (Defendant Prentice and Defendants John Does Nos. 1 through 10) it appointed to the Committee lacked the incentive and the necessary investment expertise to monitor the prudence of Enron stock as an investment, and further knew that the Committee had not retained any outside expert to advise it in that respect. On information and belief, Enron made clear to the Committee, directly and indirectly, that they were not to even consider discontinuing use of Company stock as the form the Company match would take and as an option for employee contributions and in fact the Committee never once did.

By contrast, the Committee did take steps to investigate and monitor on an ongoing basis the Plans' other investments options, in which the Company had no self-interest. During the Misrepresentation Period, the Committee employed consultants and used other personnel to monitor the prudence and performance of the Vanguard and Fidelity —- brand mutual funds offered in the Plan. While this was both prudent and necessary, there was far less need to monitor those investments than there was to closely and continuously monitor Enron stock because those mutual fund options were by their very nature inherently diversified and far less volatile and risky than the single security that was Enron stock. They also were managed by professional money managers, overseen by an independent Board of Directors. No such safeguards were in place with respect to investments in Enron stock.

THE LAW AS IT STANDS NOW
There is only limited statutory law that specifically addresses the fiduciary duties for employer stock as an investment alternative for 401(k) plans, and that guidance is of little help on the issue of monitoring.

There are the familiar standards that apply to investment fiduciaries of all ERISA plans. These are the general fiduciary provisions known as the prudent man rule, the exclusive benefit rule, and the duty of loyalty. One court explained:

ERISA imposes high standards of fiduciary duty upon those responsible for administering an ERISA plan and investing and disposing of its assets. [29 U.S.C. §1104(a)(1)] This court has explained that the fiduciary duties under ERISA encompass three components. The first is a “duty of loyalty” pursuant to which “all decisions regarding an ERISA plan `must be made with an eye single to the interest of the participants and beneficiaries.”' [Berlin v. Michigan Bell Tele. Co., 858 F.2d 1154, 1162 (6th Cir. 1988) (quoting Donovan v. Bierwirth, 680 F.2d 263, 271 (2d Cir.), cert. denied, 459 U.S. 1069, 103 S. Ct. 488, 74 L.Ed.2d 631 (1982))] The second obligation imposed under ERISA, the “prudent man” obligation, imposes “an unwavering duty” to act both “as a prudent person would act in a similar situation” and “with single-minded devotion” to those same plan participants and beneficiaries. [Id.] Finally, an ERISA fiduciary must “`act for the exclusive purpose”' of providing benefits to plan beneficiaries. [Id. quoting Donovan, 680 F.2d at 271] If a fiduciary fails to meet these high standards, he may be held personally liable for any losses to the plan that result from his breach of duty. [29 U.S.C. § 1109(a)]
[Kuper v. Iovenko, 66 F.3d 1447, 1458 (6th Cir. 1995)]

“A trustee's lack of familiarity with investments is no excuse.” [Katsaros v. Cody, 744 F.2d at 279] As noted in Donovan v. Cunningham, 716 F.2d at 1467, a “pure heart and an empty head are not enough.” A trustee must make [a] reasonable investigation into the representations of interested parties and where that investigation would have revealed evidence that the investment was unsound, the trustee can be held liable. [Katsaros v. Cody, 744 F.2d at 279.]
[Reich v. Valley Nat'l Bank of Arizona, 837 F. Supp. 1259, 1273 (S.D. N.Y. 1993)]

The Department emphasizes, however, that the act of designating investment alternatives (including look-through investment vehicles and investment managers) in an ERISA Section 404(c) plan is a fiduciary function to which the limitation on liability provided by Section 404(c) is not applicable. All of the fiduciary provisions of ERISA remain applicable to both the initial designation of investment alternatives and investment managers and the ongoing determination that such alternatives and managers remain suitable and prudent investment alternatives for the plan. Therefore, the particular plan fiduciaries responsible for performing these functions must do so in accordance with ERISA.

The limited statutory guidance for employer stock is found in ERISA Sections 404(a)(2) and 407(d)(3). Those sections provide that 401(k) plans (and certain other types of plans) that offer employer stock are not subject to ERISA's diversification requirement -— as it would otherwise apply to the employer stock; however, there is no statutory relief from the other fiduciary rules.

There is also little case law concerning 401(k) plan investments in employer stock. However, there have been a number of court decisions about the responsibilities of fiduciaries for employer stock in employer stock ownership plans (ESOPs). Although those decisions are instructive, they will not dictate the outcome in the Lucent and Enron cases because of the unique dual purposes of ESOPs. That is, while ERISA requires that fiduciaries of retirement plans fulfill their duties for the exclusive purpose of providing retirement benefits, ESOPs also have a statutorily endorsed purpose of investing primarily in employer stock.

An ESOP is an ERISA plan whose purpose is to invest primarily in “qualifying employer securities” -— shares of stock in the employer sponsoring the plan. [See generally, ERISA § 407(d)(6)(A)] ESOPs are unlike other ERISA-governed retirement plans. While the typical retirement plan (e.g., a 401(k) plan) is designed exclusively to provide benefits for the sponsor's employees, ESOPs have been described as having a dual purpose of providing retirement benefits and as a “technique of corporate finance” that would encourage employee ownership. [Martin v. Feilen, 965 F.2d 660, 664 (8th Cir. 1992), cert. denied, 506 U.S. 1054, 113 S. Ct. 979, 122 L. Ed. 2d 133 (1993)] Because of their dual nature, the courts recognize that ESOPs place retirement assets at much greater risk than other ERISA retirement plans. [Moench v. Robertson, 62 F.3d 553, 568 (3rd Cir. 1995)] As a result, some courts hold the fiduciaries of ESOPs to a modified standard of review for their investment in employer stock. That modified standard is lower than the duty for fiduciaries of other retirement plans. [See Buckley, “Eligible Individual Account Plans and ERISA's Fiduciary Duties,” J. Pension Benefits (Autumn 2001) at, 27] As the court in Moench stated,

Thus, “ESOP fiduciaries must, then, wear two hats, and are `expected to administer ESOP investments consistent with the provisions of both a specific employee benefits plan and ERISA.’” [Moench, 62 F.3d 569 (quoting Kuper v. Qauntum Chem. Corp., 852 F. Supp. 1389, 1395 (S.D. Ohio 1994))]

These competing concerns make it more difficult to delineate the responsibilities of ESOP trustees. In Donovan v. Cunningham, 716 F.2d 1455 (5th Cir. 1983), the Fifth Circuit elaborated on this conflict:

On the one hand, Congress has repeatedly expressed its intent to encourage the formation of ESOPs by passing legislation granting such plans favorable treatment, and has warned against judicial and administrative action that would thwart that goal. Competing with Congress' expressed policy to foster the formation of ESOPs is the policy expressed in equally forceful terms in ERISA: that of safeguarding the interests of participants in employee benefit plans by vigorously enforcing standards of fiduciary responsibility. [Id. at 1466 (footnotes omitted)]

In Moench, the Third Circuit attempted to find “a way for the competing concerns [of ERISA fiduciaries and ESOPs] to coexist.” [Moench, 62 F.3d at 570] In determining that subjecting an ESOP fiduciary's investment decisions to a strict standard of review was inappropriate, the Third Circuit noted that such scrutiny “would render meaningless the ERISA provision excepting ESOPs from the duty to diversify.” [Id.] This, in turn, would risk transforming ESOPs into ordinary pension plans, thus frustrating Congress's desire to encourage employee ownership and contravening the intent of the parties.

The Third Circuit found that the better balance between these concerns was achieved by measuring a fiduciary's decision to continue investing in employer securities for an abuse of discretion. [Moench, 62 F.3d at 571] Thus, it held that “keeping in mind the purpose behind ERISA and the nature of ESOPs themselves,... an ESOP fiduciary who invests the assets in employer stock is entitled to a presumption that it acted consistently with ERISA by virtue of that decision. However, the plaintiff may overcome that presumption by establishing that the fiduciary abused its discretion ....” [Moench, 62 F.3d at 571]
[Kuper v. Iovenko, 66 F.3d 1447, 1458, 1459 (6th Cir. 1995)]

Because 401(k) plans do not have the “dual purposes” of ESOPs, and have as their sole statutory purpose providing benefits to participants and beneficiaries, fiduciaries for 401(k) plans presumably are not entitled to the lower standard of review given to ESOP fiduciaries in evaluating their investments in employer stock. As a result, the 401(k) fiduciaries likely have a higher duty to prudently determine whether employer stock is an appropriate investment for their plans' participants.

In addition, some commentators disagree with the Moench and Kuper decisions and argue that even ESOP fiduciaries are not entitled to a differential standard of review. [See, e.g., Hayes, “Moench v. Robertson: When Must an ESOP Fiduciary Abandon a Sinking Ship?” Rutgers L. Rev. 1231 (Spring 1997)]

The Third Circuit subsequently pointed out that its decision in Moench should not be applied to plans other than ESOPs:

In Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995), cert. denied, 516 U.S. 1115 (1996), we did apply a deferent arbitrary and capricious standard of review to a claim by a plan's participants that the fiduciary was imprudent. We were careful to point out in Moench, however, that our holding was limited to the specific type of plan involved in that case, an Employee Stock Ownership Plan (ESOP). Here, of course, the Unisys [401(k)] Plan was not an Employee Stock Ownership Plan.
[In re: Unisys Sav. Plan Litig., 173 F.3d 145, 155 (3d Cir. 1999)]

In our next column, we will look at the effect of a plan provision or administrative decision that limits the ability of participants to direct the sale of employer stock, for example, the Enron prohibition on participants under age 50 liquidating the employer stock in their matching accounts and the Enron blackout, or lockdown, period that limited the ability of the participants who were age 50 or older to sell their stock.

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Employee Benefits
ERISA Litigation