From PLI’s Course Handbook

Class Action Litigation 2009

#18243

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Current topics in erisa class actions: “Stock Drops”and “Revenue Sharing”

Eric S. Mattson

Sidley Austin LLP


ERISA anecdotes are hard to come by, but here’s one. When I was in law school, there was a guy who had to write a comment for the Law Review. While most of his classmates searched for inherently interesting topics involving the First Amendment and such, this student was fascinated by a law that, to most students, seemed arcane at best: the Employee Retirement Income Security Act of 1974, more commonly known as ERISA. The student delved into ERISA, wrote his comment (complete with 331 footnotes), got it published, and saw his work cited with approval in an opinion of the Supreme Court of the United States.[1]

That ERISA-loving law student was . . . not me. Based on what little I knew of it, I wanted nothing to do with this statute, which seemed not only arcane and densely written but not especially relevant. I was right about the first two – ERISA is among the less lucid of Congress’s body of work – but irrelevant it is not. For the past 35 years, ERISA has set the standards that govern most pension plans in the United States, including 401(k) plans.

In recent years, the statute has become fertile ground for class actions, as plaintiffs seek to impose class-wide liability on plan fiduciaries and service providers for a wide variety of perceived misdeeds. And with the recent economic meltdown and concomitant declines in the balances of participants’ 401(k) plans, the pace of filings would seem more likely to speed up than slow down.

This paper provides an overview of two types of ERISA class actions. It begins with a description of ERISA basics, then discusses “stock drop” cases involving 401(k) plans and “revenue sharing” cases against both 401(k) plan fiduciaries and service providers. These two types of lawsuits are among the higher profile ERISA class actions, but other types have been filed – and more are assuredly on the way.


I. ERISA Basics

ERISA recognizes two kinds of pension plans: defined contribution plans and defined benefit plans.[2] Defined benefit plans once dominated the landscape of retirement plans, but as the Supreme Court recently observed, “That landscape has changed.”[3] Today, defined contribution plans such as 401(k) plans are the predominant form of employer-supported retirement plan.[4]

Defined contribution plans function like a retirement savings account. Employees or employers, sometimes both, contribute money to a plan participant’s account. Generally, the participant (the employee) chooses how to invest the money in the account, choosing from a menu of options that may include mutual funds, company stock (i.e., stock in the company that employs the participant), and a guaranteed interest option. Some plans include a brokerage window that enables the participant to invest in virtually any publicly traded security. Whether the account gains or loses money depends on the performance of the investments chosen by the participant.

Defined benefit plans, in contrast, place the investment risk on the “sponsor” of the plan – typically the employer. In defined benefit plans, participants accrue benefits calculated in accordance with a formula generally based on the participant’s salary and length of employment. For example, a plan may provide that a participant will receive an annual pension equal to 1.5 percent of the participant’s highest average salary, measured over a five-year period that yields the highest average, multiplied by the number of the participant’s years of employment. Such benefits generally are paid in the form of an annuity beginning at the participant’s “normal retirement age” under the plan and continuing for the rest of the participant’s life.

One type of defined benefit plan is known as a “cash balance plan.” Although from a legal perspective they are defined benefit plans, cash balance plans have some of the characteristics of defined contribution plans. For example, benefits in cash balance plans are expressed in the form of a hypothetical account balance, even though participants do not have individual accounts. Cash balance plans are thought to provide some of the benefits of defined contribution plans, such as portability when employees switch jobs, while retaining the features of defined benefit plans, such as lodging investment risks (and potential investment rewards) with the plan sponsor.[5]

Although many employers offer one or sometimes both kinds of pension plans, “Nothing in ERISA requires employers to establish employee benefits plans. Nor does ERISA mandate what kind of benefits employers must provide if they choose to have such a plan.”[6] Instead, ERISA endeavors to ensure that benefits, once promised and accrued, are paid,[7] and that ERISA fiduciaries act with loyalty and prudence when acting as such.[8]

More specifically, ERISA requires fiduciaries to “discharge [their] duties with respect to a plan solely in the interest of the participants and beneficiaries and . . . for the exclusive purpose of: (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan.”[9] It also requires fiduciaries to act “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 a like character and with like aims”; to diversify plan investments “so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so”; and to follow “the documents and instruments governing the plan.”[10]

While these general principles are easily stated, ERISA is “an enormously complex and detailed statute.”[11] It provides for nine types of civil actions,[12] three of which are most often invoked in class actions. The first authorizes participants and beneficiaries to sue for benefits they are entitled to, but did not receive, under the terms of the plan.[13] The second authorizes participants, beneficiaries and fiduciaries to pursue relief under a cross-referenced provision, 29 U.S.C. § 1109 – the basic remedy for breach of fiduciary duty, which permits courts to order fiduciaries to pay damages (“make good to such plan any losses to the plan resulting from each such breach”), disgorge profits (“restore to such plan any profits of such fiduciary which have been made through use of assets of the plan by the fiduciary”), and provide “other equitable and remedial relief,” including removal of the fiduciary.[14] The third form of remedy authorizes various forms of equitable relief to address violations of ERISA and violations of the terms of the plan.[15]

II. “Stock Drop” Cases

A. Background

In some 401(k) plans, participants are given the option of investing their 401(k) money in the stock of the company that employs them. ERISA encourages plans to offer this option by, among other things, exempting such offerings from the usual requirement of diversification.[16]

In good times, the stock price goes up and the 401(k) assets invested in the stock grow with the stock price. In bad times, the stock price drops and so does the account balance in participants’ accounts. Depending in part on how much money was lost, litigation may ensue.

The basic theory behind ERISA stock drop cases is that one or more fiduciaries of the plan should have pulled company stock from the plan’s menu of investment options before the stock price dropped – or even that company stock never should have been offered as an option at all. These cases are typically brought under 29 U.S.C. §§ 1109 and 1132(a)(2) (the second of the three remedies discussed above), and they are often filed as tag-alongs to securities fraud cases – often based on the same allegations of mismanagement and fraud that appear in the companion securities case.

The Seventh Circuit has explained why stock drop cases may be brought in addition to a securities case based on the same drop in stock price: “The burden of proving fraud [in a securities case] is heavier than that of proving a breach of fiduciary duty (provided, of course, that a fiduciary relation is established).”[17] In other words, “The duty of care, diligence, and loyalty imposed by the fiduciary principle is far more exacting than the duty imposed by tort law not to mislead a stranger.”[18]

As the Seventh Circuit noted, however, the plaintiff must show that the defendant was acting as a fiduciary when breaching any duty. As discussed in the next section, that is trickier than it may sound.


B. Fiduciary status

ERISA is rooted in the common law of trusts, but it is not a mirror image of it.[19] For one thing, “the trustee at common law characteristically wears only his fiduciary hat when he takes action to affect a beneficiary, whereas the trustee under ERISA may wear different hats.”[20]

Thus, while a common law trustee had to avoid conflicts of interest at virtually all costs, an ERISA fiduciary “may have financial interests adverse to beneficiaries.”[21] This is because ERISA provides that a person is a fiduciary only “to the extent” he does certain things.[22] “In every case charging breach of ERISA fiduciary duty, then, the threshold question is not whether the actions of some person employed to provide services under a plan adversely affected a plan beneficiary’s interest, but whether that person was acting as a fiduciary (that is, was performing a fiduciary function) when taking the action subject to complaint.”[23]

Deciding this threshold question is not always easy. Fiduciary status does not extend to “the decisions of a plan sponsor to modify, amend or terminate the plan,”[24] but other situations are less clear-cut. Given that a corporate executive or board member may properly wear two hats – one fiduciary, one for making business decisions – the question of whether a particular act was “fiduciary” in nature, and whether a particular defendant is a fiduciary at all, is regularly contested.[25]

C.  Liability standards

Assuming that a defendant is an ERISA fiduciary with respect to the selection of company stock, the next question is whether that defendant breached any duty under ERISA by allowing company stock to be offered. In many cases, this question is complicated by the fact that the plan document – a document that the fiduciary is generally obligated to follow – provides that company stock must be among the investment options.

One leading case, Moench v. Robertson, 62 F.3d 553, 556 (3d Cir. 1995), held that “in limited circumstances” fiduciaries can be liable for following directions in the plan document to invest in company stock. Much stock drop litigation has involved how “limited” those circumstances of potential liability will be.

Moench held that a fiduciary of an Employee Stock Ownership Plan “is entitled to a presumption that it acted consistently with ERISA” by investing in company stock.[26] “However, the plaintiff may overcome that presumption by establishing that the fiduciary abused its discretion by investing in employer securities.”[27] The touchstone under Moench is whether the fiduciary complied with “the settlor’s expectations of how a prudent trustee would operate.”[28]

Other circuits have questioned the analysis in Moench. The Ninth Circuit, for example, observed that the Moench standard is “difficult to reconcile with ERISA’s statutory text,”[29] which says nothing about a rebuttable presumption. Among other problems, the Ninth Circuit highlighted an issue that Moench acknowledged but did not resolve – namely, that requiring fiduciaries to remove company stock as an option when the company encounters financial difficulty might encourage corporate officials to “utilize inside information for the exclusive benefit of the corporation and its employees,” which would presumably violate the federal securities laws.[30]

The Seventh Circuit has likewise recognized that “the fiduciary’s duty of loyalty does not extend to violating the law.”[31] Nor does ERISA require plan fiduciaries to “continuously audit operational affairs.”[32] Instead, “a duty to investigate only arises when there is some reason to suspect that investing in company stock may be imprudent – that is, there must be something akin to a ‘red flag’ of misconduct.”[33]

D.  Class certification

Whether to certify a class is usually not the focus of the battleground in stock drop cases. The members of the putative class are typically all participants in a single defined contribution plan, and as a result courts have regularly found that it is appropriate for stock drop cases to be litigated on a classwide basis.[34]

Assuming that the prerequisites of Rule 23(a) are satisfied, stock drop cases are typically certified under what might be called the “Three Musketeers” provision of Rule 23 – the “one for all, all for one” standard of Rule 23(b)(1). Rule 23(b)(1)(A) may be invoked when separate actions could require defendants to follow incompatible judgments issued by different courts. In other words, Rule 23(b)(1)(A) “‘takes in cases where the party is obliged by law to treat the members of the class alike (a utility acting toward customers; a government imposing a tax), or where the party must treat all alike as a matter of practical necessity (a riparian owner using water as against downriver owners).’”[35] Some courts have held that this standard fits stock drop cases because a plan is generally required to treat participants alike, and cannot practicably offer company stock to some plan participants (those with a greater appetite for risk, perhaps) but not others.[36]