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Fiduciary Duties of Directed Trustees in ERISA Stock Drop Litigation

The legacy of Enron’s highly publicized collapse includes a marked expansion of so-called stop drop litigation under ERISA’s fiduciary duty provisions. Such litigation occurs when a company’s stock loses value and, as a result, the company’s retirement funds, which are frequently invested in company stock, suffer significant losses. In such cases, employee plaintiffs typically assert that company officers, who also may play roles in administering the company’s benefit plans, had knowledge of the company’s financial instability, and were thus under a fiduciary duty to prevent the plans’ further investment in company stock, divest the plans of such holdings, and/or disclose certain material information about the company to plan participants. The targets of stock drop litigation have included fiduciaries who are named in plan documents, including plan administrators and trustees, senior executives who are members of the plan’s fiduciary committees, employers, officers, boards of directors and their compensation committees.  The targets also have included “directed trustees”—such as banks, trust companies and mutual fund companies—who execute transactions, such as making investments in certain investment options, according to instructions from a named fiduciary. 

A major issue that has emerged in stock drop litigation is the circumstances under which ERISA fiduciary liability may be imposed upon directed trustees for failing to stop allegedly imprudent investments by pension plans in employer stock.  Directed trustees have argued that they were retained to execute instructions from others, not to act as discretionary trustees or investment managers.  While ERISA § 403(a)(1) relieves directed trustees from fiduciary responsibility to the extent that they acted on the basis of a named fiduciary’s “proper” instructions, plaintiffs have attempted to argue that directed trustees should be subject to liability if they “knew or should have known” that the named fiduciary’s instructions were imprudent.

In this article, we discuss some important legal developments that have occurred over the last several years as to the existence and scope of fiduciary liability for directed trustees.  In sum, the duty of directed trustees to question the prudence of instructions from a named fiduciary appears to have been limited over the years to certain extraordinary circumstances, and courts are now more willing to dismiss claims against directed trustees at an earlier stage in the litigation.

The Enron Case

In In re Enron Corp. Securities, Derivative & ERISA Litig., 284 F. Supp. 2d 511, 601 (S.D. Tex. 2003),[1] the United States District Court for the Southern District of Texas held that a directed trustee is a fiduciary, but with limited fiduciary duties.  The court found that even though a directed trustee’s “authority and discretion to manage and control the assets of the plan” is “substantially constricted” by the directing named fiduciary, “[a]t least some fiduciary status and duties of a directed trustee are preserved.”  Id.  For instance, the court found that a directed trustee has a duty to investigate whether the directions from the named fiduciary are consistent with ERISA’s fiduciary duty of prudence.  Id. at 601-02.  In addition, the court held that a directed trustee may breach its fiduciary duties by proceeding with an administrative lockdown if exigent circumstances make the lockdown “clearly injurious to plan participants and beneficiaries.”  Id. at 602. 

The Enron case involved a 401(k) plan and an Employee Stock Ownership Plan (an “ESOP,” and collectively, the “Plans”), both of which were heavily invested in Enron stock.  Participants in the 401(k) plan could direct the investment of their elective deferrals among various investment options, which included a company stock fund.  The employer’s matching contributions were invested automatically in the company stock fund, where they remained until the participant reached age fifty.  Id. at 575, n.75.  Between October 17 and November 14, 2001, Enron imposed an administrative lockdown on the Plans while it switched to a new recordkeeper and trustee.  Id. at 535.  During this period, when participants could not move their investments between investment options, Enron stock lost over seventy percent of its value, falling from $33.84 to $10.00 per share.  Id.  Shortly after the lockdown, Enron stock was trading at $4.11 per share, and, on December 2, 2001, Enron filed for bankruptcy.  Id. at 535, n.10.

The plaintiffs argued that Northern Trust Company (“Northern Trust”) breached its fiduciary duties as a directed trustee by following the lockdown instructions because Northern Trust knew or should have known that the lockdown was imprudent, and the named fiduciary’s instructions were therefore contrary to ERISA.[2]  Id. at 582.  In ruling on this question in the context of a motion to dismiss, the court analyzed ERISA § 403(a)(1), which allows a “directed trustee to escape liability for his actions performed pursuant to the named fiduciary’s direction if the named fiduciary’s directions are ‘proper’ and ‘in accordance with the terms of the plan’ and ‘not contrary to’ ERISA.”  Id. at 583.  The court noted that it is difficult to determine “the scope of the directed trustee’s fiduciary obligations” because ERISA does not contain any definition of “‘proper’ with respect to the named fiduciary’s directions,” and does not provide any other “guidance about the nature and extent of a directed trustee’s duty to determine whether the named fiduciary’s directions are ‘in accordance with the terms of the plan’ and ‘not contrary’ to ERISA.  Id. at 583. The court rejected Northern Trust’s argument, based on the legislative history, that a directed trustee is not liable for following a named fiduciary’s directions “unless it is clear on their face that the actions to be taken under those directions would be prohibited by the fiduciary responsibility rules under the bill or would be contrary to the plan or the trust.”  Id. at 585 (quoting H.R. Conf. Rep. No. 93-1280 (1973) reprinted in 1974 U.S.C.C.A.N. 5038, 5079).  The court found that, like the undefined statutory term “proper directions,” Northern Trust’s proposed “facial compliance standard” was similarly “vague and ambiguous.”  Id. at 581, n. 86.  Moreover, the court found that a facial compliance standard would “impose only a minimal duty on the trustee and place the plan participants and beneficiaries and the assets in their pension plans at much greater risk.”  Id. at 592.  Rather, the court cited an Eighth Circuit Court of Appeals decision for the proposition that “[t]he trustee is ordinarily under a duty to make a reasonable inquiry and investigation in order to determine whether the holder of the power is violating his duty.”  Id. at 596 (quoting FirsTier Bank v. Zeller, 16 F.3d 907, 911-12 (8th Cir. 1994)).  Ultimately, the court concluded that a directed trustee has “something more than a duty to check [the] superficial compliance” of a named fiduciary’s instructions with ERISA, “[a]t least where the facts alleged (and ultimately the evidence) provide reason for the directed trustee to have known or should have known of a breach of fiduciary.”  Enron, 284 F. Supp. 2d at 599.  On the extraordinary facts before it, however, the court also concluded that even under a facial compliance standard, Northern Trust still should have known that the instruction to lock the Plans down was improper because of the “alleged exigent circumstances,” which made the timing of the lockdown “highly suspect and clearly injurious to plan participants and beneficiaries.”  Id. at 602.  Accordingly, the court denied Northern Trust’s motion to dismiss.  Id. at 601-02.

The Field Assistance Bulletin

Following Enron, commentators expressed concerns that directed trustees would either leave the business or substantially raise their fees.  On December 17, 2004, the United States Department of Labor (the “DOL”) issued Field Assistance Bulletin 2004-03 (the “FAB”), providing guidance on when a directed trustee may have a duty to question the prudence of instructions.  In the FAB, the DOL stated that directed trustees’ fiduciary responsibilities are limited by ERISA § 403(a) and are significantly less than those “generally ascribed to a discretionary trustee under common trust principles.”  Accordingly, the DOL concluded that a directed trustee’s duty to question the prudence of a named fiduciary’s directions is “significantly limited,” and varies based on whether the directed trustee possesses material non-public information about the company, or is privy to only public information that might raise red flags about the company’s wellbeing. 

Directed Trustee’s Duty to Act on Non-Public Information.  In the FAB, the DOL took the position that a directed trustee’s duty to question the prudence of transactions at market price involving publicly traded securities is “quite limited.”  The DOL explained that the primary circumstances where the obligation could arise is where the directed trustee has “actual knowledge” of “material non-public information that is necessary for a prudent decision.”  In such a case, before following the named fiduciary’s direction, the directed trustee has a duty to inquire about the named fiduciary’s knowledge and consideration of the information.  For example, if a directed trustee has material non-public information that a company’s financial statements contain material misrepresentations that significantly inflate the company’s earnings, the directed trustee may not simply follow a direction to purchase the stock at the artificially inflated price. 

Directed Trustee’s Duty to Act on Public Information.  According to the DOL, a directed trustee “will rarely have an obligation under ERISA to question the prudence of a direction to purchase publicly traded securities at the market price solely on the basis of publicly available information.”  The DOL based this conclusion on four considerations.  First, financial markets are assumed to be efficient, so that stock prices reflect publicly available information.  Second, with respect to employer stock, the securities laws impose substantial obligations on the company to ensure that its financial records are accurate.  Third, ERISA Section 404 requires the named fiduciary to “adhere to a stringent standard of care.”  Fourth, because stock prices fluctuate widely, a substantial drop in the value of a company’s stock does not, by itself, establish that a named fiduciary’s instruction to purchase or hold such stock was imprudent and therefore improper.

In “limited, extraordinary circumstances,” a directed trustee may have an obligation to refuse to follow a named fiduciary’s instructions “without further inquiry.”  Such circumstances could arise, accordingly to the DOL, where there are “clear and compelling public indicators,” such as an 8-K filing or bankruptcy filing, “that call into serious question a company’s viability as a going concern.”  The DOL explained, however, that the rule is different when an independent fiduciary, such as an investment manager, has been appointed to manage the plan’s investment in company stock.  In such instances, the directed trustee may follow the directions of such independent fiduciary without the need for conducting an independent assessment.

In re WorldCom

In In re WorldCom, Inc. ERISA Litig., 354 F. Supp. 2d 423 (S.D.N.Y 2005), the United States District Court for the Southern District of New York became the first court to consider the DOL’s position, articulated in the FAB, as to the scope of directed trustees’ fiduciary duties.  As in Enron, WorldCom’s financial collapse, following a series of accounting scandals, employees who owned WorldCom stock through WorldCom’s 401(k) plan sued multiple defendants. Merrill Lynch, the directed trustee of WorldCom’s 401(k), was one of the multiple defendants to be sued.  Id. at 426-27.  The plaintiffs argued that a directed trustee breaches its fiduciary duties when it fails to act when it “knows or ought to know,” based on publicly available information, “(1) that the directions it receives from a named fiduciary are imprudent, disloyal, or otherwise violate ERISA, or (2) that a co-fiduciary is breaching its own fiduciary duty to the plan.”  Id. at 444.  Specifically, the plaintiffs argued that Merrill Lynch breached its duty of prudence when it continued to execute orders to purchase WorldCom stock when it knew or should have known, based on publicly available information, that WorldCom stock was an imprudent investment option for the plan.  Id. at 427.  Because the plaintiffs did not allege that Merrill Lynch possessed non-public information about WorldCom’s financial condition, the court addressed only a directed trustee’s duty to act based on publicly available information.  Id. at 449, n.24.

In determining the scope of a directed trustee’s fiduciary duties, the court considered the DOL’s guidance in the FAB.  The court stated that the “opinions expressed in the Bulletin are well-reasoned and flow from a careful analysis of complex issues,” and found, therefore, that the FAB “reflects persuasive authority to which this Court should give at least substantial weight in articulating the standard that should be applied to a directed trustee’s responsibilities when receiving a direction to invest plan assets in particular securities.”  Id. at 447.  The court then adopted a standard of prudence for directed trustees based on the FAB, under which a directed trustee is required to inquire about the prudence of an instruction when it “knows or should know of reliable public information that calls into serious question the company’s short-term viability as a going concern.”  Id. at 449 (emphasis added).  This standard modifies the DOL’s standard announced in the FAB by requiring the public information to be “reliable,” as opposed to “clear and compelling,” and by limiting the timeframe for evaluating the company’s viability to the “short-term.”  Based on this standard, the court granted summary judgment to Merrill Lynch on the plaintiffs’ claim that it breached its fiduciary duties by failing to refuse to execute instructions to invest in WorldCom stock.  Id.

The court further elaborated on when a duty to inquire on the part of a directed trustee arises.  The court explained that a directed trustee’s knowledge that a company’s “stock price and profits were declining and that the company was undergoing a restructuring” does not give rise to a duty to inquire about the prudence of investing in company stock.  Id. at 449.  Similarly, the court stated that knowledge of a “government investigation of a company, including an investigation into the reliability of its financial statements, or the filing of a private lawsuit against the company,” does not impose a duty of inquiry.  Id.  The court stated, however, that a duty of inquiry may arise when formal civil or criminal charges have been filed by a government body, depending on the nature of the formal charges.  Id.

Conclusion

As the WorldCom court pointed out, the FAB “br[oke] new ground by giving concrete guidance to directed trustees about their duty to inquire into the prudence of investment decisions.”  WorldCom, 354 F. Supp. 2d at 446.  Whereas in the pre-FAB environment, many courts were reluctant to dismiss claims against directed trustees,[3] the “concrete guidance” from the Department of Labor may have made it easier for courts to dismiss claims against directed trustees at an earlier stage in the litigation.  Indeed, while only a handful of courts have considered the FAB to date, most of the courts that have considered it have cited it with approval.[4]  Moreover, based on WorldCom and a handful of other post-FAB cases, a number of other jurisdictions have dismissed claims against directed trustees since the DOL released the FAB.  See e.g., Summers v. State Street Bank & Trust Co., 453 F.3d 404 (7th Cir. 2006) (granting summary judgment to directed trustee); In re RCN Litig., 2006 U.S. Dist. LEXIS 12929, at *13-20 (D.N.J. Mar. 21, 2006) (granting motion to dismiss directed trustee on the basis of the FAB’s guidance); In re Cardinal Health ERISA Litig., 424 F. Supp. 2d 1002, 1039 (S.D. Ohio 2006) (granting motion to dismiss directed trustee, and finding that pre-FAB decisions refusing to dismiss directed trustees “less reliable” because they did not have the opportunity to “consider the [DOL]’s views as to directed trustees”); DiFelice v. US Airways, 397 F. Supp. 2d 735, 751, 755 (E.D. Va. 2005) (granting motion to dismiss directed trustee, distinguishing Enron and citing the FAB as support for the conclusion that a directed trustee’s duty “to make independent prudence determinations” is “‘significantly limited.’”).

Jeffrey S. Klein and Nicholas J. Pappas are partners at Weil, Gotshal & Manges, where they practice labor and employment law.  Millie Warner, an associate at the firm, assisted in the preparation of this article.

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Reprinted with permission from the October 8, 2007 edition of the New York Law Journal© 2007 ALM media Properties, LLC. All rights reserved. Further duplication without permission is prohibited.



[1]  The authors of this article are partners of the law firm of Weil, Gotshal & Manges LLP, which represented Enron Corp. in this matter.

[2] The plaintiffs also argued, in the alternative, that Northern Trust was a discretionary trustee, not a directed trustee, and that its fiduciary duties therefore were not limited by ERISA § 403(a).  The court held that whether Northern Trust was a discretionary or a directed trustee was an issue of fact, which could not be resolved on a motion to dismiss.  Id. at 581-82.

[3] See e.g., In re Amsted Industries, Inc. ERISA Litig., 263 F. Supp. 2d 1126 (N.D. Ill. 2003); In re Sprint Corp. ERISA Litig., 388 F. Supp. 2d 1207 (D. Kan. 2004).

[4] To date, the only criticism of the FAB has been in Summers v. State Street Bank & Trust Co., 453 F.3d 404 (7th Cir. 2006).  In Summers, Judge Posner accepts the reasoning behind the FAB, most notably the efficient market hypotheses and the idea that market price of a particular stock is “the best estimate” of its value such that it would be “hubris” for a trust company to attempt to second-guess the market’s judgment.  Id. at 408.  Judge Posner, however, criticizes the FAB’s statement that a directed trustee “may” have a duty to sell when “a bankruptcy filing . . . call[s] into serious question a company’s viability as a going concern,” on the grounds that “the hedge in ‘may’ and the fact that selling when bankruptcy is declared will almost certainly be too late” renders the standard “not . . . administerable.”  Id. at 411.

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