In August 2020, the SEC issued two orders against VALIC Financial Advisors Inc. (VFA) related to VFA’s management of 403(b) and 457(b) plans. These matters arise out of two of the SEC’s enforcement initiatives, the Teachers and Military Service Members’ Initiative and the Share Class Selection Disclosure Initiative. VFA is a registered investment adviser and broker-dealer with approximately $21.1 billion in assets under management and services defined contribution retirement plans for Florida public school teachers, among other plans. These two orders follow a sweep of letters sent by the SEC in fall of 2019 to several third-party administrators and affiliates, including broker-dealers and registered investment advisers that work with 403(b) and 457(b) plans. While these actions are the first to come out of the SEC’s Teachers’ Initiative, they are unlikely to be the last.
The DOL recently provided retirement plans with a new method to comply electronically with certain participant disclosure and notice requirements. See our blog post outlining the new DOL rule. This new method adds to the previously issued DOL safe harbor and the IRS rules. Below is a side-by-side general comparison to help plan administrators keep track of when each method may be used, and what requirements must be met. Plan administrators should consult with counsel on the details of any electronic disclosure procedures to verify compliance with all applicable rules.
A few caveats to this framework:
- This chart could evolve in the future. The preamble to the new DOL pension rule noted the agency’s ongoing study of the future application of these rules to welfare plans. It also gave a nod to the IRS’s stated intent to issue more guidance regarding electronic delivery.
- There is additional flexibility during the COVID-19 national emergency. DOL guidance provides some leniencies in applying various ERISA deadlines and requirements during the national emergency if a plan administrator takes good faith action to furnish notices, disclosures or documents as soon as administratively practicable under the circumstances. Electronic communications (e.g., websites, e-mails and text messages) with people who have effective access can be considered good faith acts. For more information, see our blog post outlining EBSA Disaster Relief Notice 2020-01.
Employers that are tax-exempt or have tax-exempt affiliates (for example, a foundation) should pay close attention to a 21% excise tax under Section 4960 of the Internal Revenue Code on certain executive compensation. Proposed Regulations under Section 4960 are described here. The discussion includes traps for the unwary. Please reach out to your Proskauer contact to discuss how these rules affect your organization.
The U.S. Department of Labor’s (the “DOL”) new “fiduciary rule” package, issued on June 29, 2020, and published in the Federal Register on July 7, 2020, has three important components:
- The DOL has formally reinstated its “five-part test” initially set forth in its 1975 regulation for determining whether a person is a “fiduciary” by reason of providing “investment advice” for a fee. This reinstatement is effective immediately, and generally reflects the status quo after the Obama administration’s 2016 fiduciary rule was vacated by the Fifth Circuit in 2018.
- The DOL has provided commentary on its interpretation of the “five-part test”. Most notably, the DOL states that advice on whether to take a distribution from a retirement plan and roll it over to an IRA could be considered fiduciary “investment advice” after considering the facts and circumstances surrounding the advice. In describing this interpretation, the DOL stated that it will no longer follow its “incorrect” contrary analysis set forth in Advisory Opinion 2005-23A (the “Deseret Letter”).
- The DOL has proposed a new prohibited transaction exemption (the “Proposed Exemption”) that would give “investment advice” fiduciaries more flexibility to provide advice (including with respect to IRA rollovers) that affects their compensation. The Proposed Exemption would also permit “investment advice” fiduciaries to enter into and receive compensation from “riskless” and certain other “principal transactions” where the fiduciary is purchasing a security for its own account or selling a security from its own inventory. Comments on this proposal are due by August 6, 2020. If granted, the Proposed Exemption would become effective 60 days after the final exemption is published in the Federal Register.
Below we describe in more detail the rules for determining whether a person is a “fiduciary” (including by way of providing “investment advice” under the “five-part test”), the DOL’s views on the “five-part test” and rollover advice, the consequences of being a “fiduciary”, and the Proposed Exemption.
Who is a Fiduciary? The “Five-Part Test”
Under each of Section 3(21) of the U.S. Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and Section 4975(e)(3) of the U.S. Internal Revenue Code of 1986, as amended (the “Code”), there are three ways for a person to be considered a “fiduciary” with respect to a retirement plan or IRA:
- The person exercises any discretionary authority or control respecting management of the plan or IRA or with respect to the management or disposition of its assets;
- The person renders “investment advice” for a fee or other compensation, direct or indirect, or has any authority or responsibility to do so; or
- The person has any discretionary authority or responsibility in the administration of the plan or IRA.
The “fiduciary rule” package (like the Obama administration’s vacated rule) relates only to the second prong – rendering “investment advice” for a fee. The guidance has no bearing on becoming a fiduciary by reason of having discretionary authority or responsibility over the management, administration, or investment of the assets of a plan or IRA.
Under the “five-part test”, a person is considered to be providing “investment advice” only if the person: (i) renders advice as to the value of securities or other property, or makes recommendations as to investing in, purchasing or selling securities or other property, (ii) on a regular basis, (iii) pursuant to a mutual agreement, arrangement, or understanding with the plan, the plan fiduciary or IRA owner that, (iv) the advice will serve as a primary basis for investment decisions with respect to plan or IRA assets, and (v) the advice will be individualized based on the particular needs of the plan or IRA. A person who meets all five prongs of the test and receives direct or indirect compensation will be considered an “investment advice” fiduciary with respect to the applicable plan or IRA.
On April 8, 2016, the DOL replaced the “five-part test” with a new fiduciary regulation that significantly expanded the scope of “investment advice.” However, that rule was vacated by the U.S. Court of Appeals for the Fifth Circuit on March 15, 2018. Following that decision, on May 7, 2018, the DOL issued Field Assistance Bulletin 2018-02 (“FAB 2018-02”), which provided (among other things) that the DOL would not enforce the 2016 fiduciary rule and instead would go back to the “five-part test.” The latest regulation implements that decision.
DOL’s Commentary on the Five-Part Test
Historically, service providers have often taken the position that advice on whether to leave money in a plan or to roll over to an IRA was not provided on a “regular basis” and/or was not provided pursuant to a “mutual” agreement, arrangement or understanding that the advice would serve as a “primary basis” for the decision. Further, in the Deseret Letter, the DOL suggested that advice to roll assets out of a plan to an IRA did not constitute “investment advice,” because it was not advice with respect to moneys or property of a plan.
In the commentary to the Proposed Exemption, the DOL disclaimed its guidance in the Deseret Letter as an “incorrect analysis.” The DOL now says that the “better view” is that IRA rollover advice is a recommendation to liquidate or transfer the plan’s property to effectuate the rollover. This means that advice on whether to take a distribution from a retirement plan and roll it over to an IRA (or to roll over from one plan to another plan, or one IRA to another IRA) may be covered by the “five-part test,” if the advice is either part of an ongoing relationship or the start of an ongoing relationship.
In this regard, the DOL notably stated the following:
- The full “five-part test” applies for determining whether a service provider is an “investment advice” fiduciary. Whether or not the prongs of the test are satisfied “will be informed by all the surrounding facts and circumstances”;
- IRA rollover advice may be an isolated and independent transaction that would fail to meet the “regular basis” prong, but the analysis will depend on the surrounding facts and circumstances:
- In circumstances where an advice provider has been giving financial advice to an individual about investing in, purchasing, or selling securities or other financial instruments, any rollover advice provided to the individual would be considered part of an ongoing advice relationship that would satisfy the “regular basis” requirement;
- Similarly, where a rollover advice provider will be regularly giving financial advice with respect to the IRA following the rollover (even if it has not otherwise provided any advice before the rollover), the rollover advice would be the start of an advice relationship that could satisfy the “regular basis” requirement;
- The determination of whether there is a “mutual” agreement, arrangement, or understanding that the investment advice will serve as a “primary basis” for investment decisions will be based on the reasonable understanding of each of the parties:
- Written statements disclaiming a mutual understanding are not determinative, but may be considered as part of the analysis;
- The advice does not need to serve as “the” primary basis of investment decisions, but rather it only need to serve as “a” primary basis; and
- When a financial service professional makes recommendations that are based on the individualized needs of the recipient or made in accordance with a best interest standard such as the Securities and Exchange Commission’s (“SEC”) best interest standard, the parties “typically should reasonably understand that the advice will serve as at least a primary basis for the investment decision.”
Consequences of Being a “Fiduciary”
If a person is considered to be a “fiduciary” of a plan or IRA under ERISA and/or the Code, it will be subject to the prohibited transaction rules under Section 406 of ERISA and/or Section 4975 of the Code. These rules generally prohibit a fiduciary from causing the plan or IRA to engage in many different types of transactions with a potentially broad universe of counterparties unless the transaction qualifies for an exemption. The prohibited transaction rules also prohibit a fiduciary from engaging in certain “self-dealing” transactions whereby it deals with the assets of the plan or IRA for its own account or receives a “kick-back” in connection with a transaction involving the assets of the plan or IRA. In particular, a fiduciary would be prohibited from providing investment advice to the applicable plan or IRA that results in the fiduciary or its affiliate receiving additional compensation; and the fiduciary also would not be able to engage in principal transactions with the plan or IRA, unless an exemption is available.
Further, even if the requirements for an exemption are satisfied, fiduciaries of ERISA-covered plans are also subject to ERISA’s fiduciary duties, including prudence and loyalty, which are among the highest known to the law. ERISA gives plan participants and beneficiaries a private right of action to challenge the prudence and loyalty of advice, even if the requirements of an exemption have been satisfied.
The Proposed Exemption
The Proposed Exemption would provide relief for certain “investment advice” fiduciaries (but not for parties with discretion) that is broader and more flexible than existing exemptions, provided that the fiduciary is willing and able to comply with the “impartial conduct” standards. The “impartial conduct” standards are intended to be aligned with the standards of conduct for investment advice professionals established and considered by other U.S. Federal and State regulators – in particular, the SEC and its Regulation Best Interest.
More specifically, the Proposed Exemption would permit “investment advice” fiduciaries to receive compensation as a result of providing what would otherwise be considered “conflicted” fiduciary investment advice (including IRA rollover advice) to a Retirement Investor (i.e., an ERISA plan participant or beneficiary, IRA owner, and a fiduciary of an ERISA plan or IRA) if the “investment advice” fiduciary is a registered investment adviser, broker-dealer, bank, or insurance company (or an employee, agent, or representative of an eligible entity). The compensation could include, for example, including 12b-1 fees, trailing commissions, sales loads, mark-ups and mark-downs, and revenue sharing payments from investment providers or third parties.
The Proposed Exemption would also permit qualifying “investment advice” fiduciaries to enter into and receive compensation with respect to “riskless” and certain other “principal transactions” with a Retirement Investor where the fiduciary either purchases certain investments from a Retirement Investor for its own account or sells certain investments out of its own inventory to the Retirement Investor.
The critical protective condition set forth in the Proposed Exemption is that the investment advice must be provided in accordance with “impartial conduct” standards – namely, a best interest standard (which includes duties of prudence and loyalty specifically requiring the “investment advice” fiduciary not to place its financial or other interests ahead of the interests of the Retirement Investor or to subordinate the Retirement Investor’s interests to interests of the financial institution or the investment professional; duties that would not otherwise apply to advice provided to an IRA not subject to ERISA); a reasonable compensation standard; and a requirement to make no materially misleading statements. The Proposed Exemption also requires that the “investment advice” fiduciary:
- Disclose both the financial institution’s and the investment professional’s status as an “investment advice” fiduciary and material conflicts of interest;
- Establish, maintain and enforce policies and procedures designed to ensure compliance with the “impartial conduct standards”; and
- Conduct an annual review to ensure compliance with the conditions of the Proposed Exemption.
In contrast to the DOL’s vacated class exemptions, the Proposed Exemption would not provide a separate right of action to Retirement Investors, nor would it require a separate written contract or otherwise create any new legal claims beyond what is already provided under ERISA.
An “investment advice” fiduciary could lose the ability to rely on the Proposed Exemption for a period of 10 years for certain criminal convictions, providing misleading statements to the DOL in connection with relying on the exemption, or engaging in an intentional violation or systematic pattern of violating the conditions of the exemption.
The Proposed Exemption would not cover advice arrangements that rely solely on “robo-advice” without interaction with an investment professional. Those advice arrangements are covered by the statutory exemption in Sections 408(b)(14) and 408(g) of ERISA and Sections 4975(d)(17) and 4975(f)(8) of the Code and the regulations thereunder.
As part of the 2016 fiduciary rule package, the DOL granted two new prohibited transaction class exemptions (i.e., the Best Interest Contract Exemption and a Class Exemption for Principal Transactions) and amended several pre-existing exemptions. FAB 2018-02 (described above) allowed “investment advice” fiduciaries to continue to rely on the new Best Interest Contract Exemption and Class Exemption for Principal Transactions if they worked diligently and in good faith to comply with the impartial conduct standards required by those exemptions.
The Proposed Exemption is consistent with the DOL’s temporary enforcement policy under FAB 2018-02, in that investment advice professionals that established processes and procedures to comply with the “impartial conduct” standards under the vacated exemptions would be able to use the same processes and procedures under the Proposed Exemption. For the time being, the DOL’s temporary enforcement policy in FAB 2018-02 remains in place.
In connection with the issuance of the Proposed Exemption, the DOL removed from its website the vacated exemptions (i.e., the Best Interest Contract Exemption and the Class Exemption for Principal Transactions), and the DOL has confirmed that the pre-existing class exemptions that were amended in 2016 (i.e., PTEs 75-1, 77-4, 80-83, 83-1, 84-24 and 86-128) have reverted to their pre-amendment form.
Although the ERISA world has been operating under the “five-part test,” we now have confirmation from the DOL that it applies. The DOL’s commentary that IRA rollover advice could be fiduciary “investment advice” is a formal departure from the Deseret Letter, but it is consistent with prior comments from DOL officials. The Proposed Exemption would formally implement the temporary guidance from FAB 2018-02, but will not go into effect unless and until it is finalized. The latest guidance undoubtedly will not be the last word on this topic.
The Fifth Circuit concluded that an individual plaintiff was not entitled to attorneys’ fees, even though she persuaded the Fifth Circuit to vacate and remand a summary judgment decision in favor of the Humana Health Plan, because her victory was “purely procedural.” While ERISA section 502(g)(1) provides that a court “in its discretion may allow a reasonable attorney’s fee and costs of action to either party,” the Supreme Court has made it clear that an ERISA fee claimant must show “some degree of success on the merits.” Hardt v. Reliance Standard Life Ins. Co., 560 U.S. 242, 255 (2010). The Supreme Court also ruled many years ago, in a non-ERISA case, that a claimant whose only “victory” is an interlocutory ruling by a court of appeals has not received any relief on the merits. Hewitt v. Helms, 482 U.S. 755, 760 (1987).
In the case before the Fifth Circuit, the plaintiff had spent time in an eating disorder treatment center and sought reimbursement of fees incurred from the plan. The plan declined to provide her with coverage because it determined that her hospitalization was not “medically necessary.” On appeal, the Fifth Circuit concluded that there were disputed issues of fact about whether the treatments were medically necessary and remanded to the district court for additional proceedings. While the Fifth Circuit’s decision allowed the plaintiff to proceed with her claim, it did not alter the parties’ legal relationship or require that the defendant do something. Accordingly, she had not achieved some degree of success on the merits and was not entitled to a fee award.
The case is Katherine P. v. Humana Health Plan, Inc., No. 19-50276 (5th Cir. June 29, 2020).
A federal district court in Illinois recently dismissed “excessive fee” and “imprudent investment” claims against the plan fiduciaries of the CareerBuilder 401(k) plan fiduciaries, relying largely on the Seventh Circuit’s decision in Divane v. Northwestern University, 953 F.3d 980 (7th Cir. 2020). (Our blog on the Divane decision is available here.) In the case against the Careerbuilder plan fiduciaries, the plaintiff alleged that defendants breached their duties of prudence and loyalty under ERISA by:
- Paying excessive recordkeeping fees;
- Failing to invest in cheaper institutional shares as opposed to retail shares; and
- Failing to include more passively managed as opposed to actively managed funds.
The court first addressed the recordkeeping fee claim. The court observed that the fund at issue in Divane charged recordkeeping fees that averaged between $153 and $213 per person and the fees here similarly averaged between $131 and $222 per person. Because Divane had held that a similar range of fees did not give rise to an inference of imprudence, plaintiff’s allegations here also could not either. The court further explained that an inference of imprudence was even less plausible here than in Divane because CareerBuilder’s plan had fewer participants and thus less leverage to negotiate lower fees.
The court next quickly disposed of plaintiff’s claim that the plan should have invested in institutional share classes rather than more expensive retail share classes because Divane had held that a fund’s failure to invest in institutional as opposed to retail funds does not give rise to an inference of imprudence.
Turning to plaintiff’s claim that the plans should have included more passively managed funds, the court concluded that defendants’ failure to offer “every index fund under the sun” was not, in and of itself, imprudent as long as the plan offered a mix of investments and there are no other indicia of a flawed process. The court found that the plan offered an acceptable mix of options with expense ratios ranging from .04% to 1.06%—within the range found to be reasonable as a matter of law by other courts. The court also found that plaintiff’s allegations that defendants removed or modified a majority of the funds in the plan over a five-year period actually supported an inference that defendants had a prudent process in place for monitoring the plan’s funds.
Finally, the court dismissed plaintiff’s duty of loyalty claims because plaintiff failed to raise an inference of self-dealing and relied largely on facts supporting his duty of prudence claims.
The case is Martin v. CareerBuilder, LLC, No. 19-cv-6463, 2020 WL 3578022 (N.D. Ill. July 1, 2020).
On June 29, 2020, the Internal Revenue Service (the “IRS”) issued Notice 2020-52 that provides temporarily relief to plan sponsors that amend their safe harbor Section 401(k) or 401(m) plans (“Safe Harbor Plans”) mid-year to reduce or suspend employer safe harbor matching or nonelective contributions due to the COVID-19 pandemic. To qualify for the relief, a Safe Harbor Plan would need to be amended between March 13, 2020 and August 31, 2020.
Under current IRS regulations and related guidance, a Safe Harbor Plan may be amended mid-year to reduce or suspend the employer’s safe harbor matching or nonelective contributions only if all of the following requirements are met:
- The employer either (i) is operating under an economic loss for the year (which is generally a facts and circumstances test), or (ii) included a statement in the original safe harbor notice given to participants before the start of the plan year (“Original Notice”) that the employer may reduce or suspend contributions mid-year and that the reduction or suspension will not apply until at least 30 days after participants are provided notice of the reduction or suspension (“Required Reservation”).
- All eligible participants are provided with a supplemental notice that explains (i) the consequences of the amendment that reduces or suspends the future safe harbor contributions, (ii) the procedures for participants to change their cash or deferred elections, and (iii) the effective date of the amendment (“Supplemental Notice”);
- The reduction or suspension of safe harbor contributions is effective no earlier than the later of the date the amendment is adopted or 30 days after eligible employees are provided the Supplemental Notice;
- Participants must be given a reasonable opportunity (including a reasonable period after receipt of the Supplemental Notice) prior to the reduction or suspension of safe harbor contributions to change their 401(k) elections;
- The plan must be amended to provide that the ADP test and the ACP test (if applicable) will be satisfied for the entire plan year using the “current year testing method” (i.e., the plan can no longer use the safe harbor to satisfy such testing for the year); and
- The plan must make the pre-amendment safe harbor contributions through the effective date of the amendment.
Temporary Relief and Other Guidance Provided Under Notice 2020-52
Due to unprecedented circumstances resulting from the COVID-19 pandemic, Notice 2020-52 provides the following additional temporary relief from the general prohibition on mid-year reductions or suspensions of safe harbor contributions:
- For a plan amendment adopted between March 13, 2020 and August 31, 2020, a plan will not be treated as failing to satisfy the requirement that the employer either is operating under an economic loss for the year or included the Required Reservation in the Original Notice given to participants.
- For a plan amendment that reduces or suspends safe harbor nonelective contributions adopted between March 13, 2020 and August 31, 2020, the plan will not be treated as failing to satisfy the requirement that participants be provided the Supplemental Notice at least 30 days prior to the effective date of the reduction or suspension, so long as (i) the Supplemental Notice is provided to participants no later than August 31, 2020, and (ii) the plan amendment is adopted no later than the effective date of the reduction or suspension of safe harbor nonelective contributions. This relief does not apply to mid-year reductions or suspensions of safe harbor matching contributions.
- The temporary relief described above also will apply on similar terms to Section 403(b) plans that apply the Section 401(m) safe harbor rules to satisfy the nondiscrimination rules applicable to such plans.
Separately, Notice 2020-52 clarifies that, because contributions made on behalf of highly compensated employees (“HCEs”) are not included in the definition of safe harbor contributions, a mid-year change that reduces only the contributions of HCEs is not considered a suspension or reduction of safe harbor contributions that requires an employer to satisfy the rules described above. However, such a mid-year change would be a change to the content of plan’s Original Notice, and pursuant to prior guidance issued in IRS Notice 2016-16 an updated safe harbor notice and an election opportunity must be provided to HCEs to whom the mid-year change applies.
Many employers have implemented or are considering changes to their 401(k) plan matching and nonelective contributions in light of the economic situation related to the COVID-19 pandemic. There are a number of considerations with any of these changes and employers should consider them carefully with counsel. IRS Notice 2020-52 provides welcome guidance in this regard for employers considering changes to Safe Harbor Plans.
On June 23, 2020, the U.S. Department of Labor (the “DOL”) issued a proposed rule (which was published in the Federal Register on June 30, 2020) that would amend its “investment duties” regulation set forth at 29 C.F.R. § 2550.404a-1. The DOL states that the proposed rule is intended to “eliminate confusion” and limit when and how ERISA plan fiduciaries may (i) consider non-pecuniary factors, such as environmental, social and corporate governance (“ESG”) factors (also referred to as “socially responsible investments” or “economically targeted investments”), when making plan investment decisions for a defined benefit plan, or (ii) offer an ESG-themed investment option under an individual account defined contribution plan (e.g., a 401(k) plan). In particular, the proposed rule would:
- codify what the DOL describes as its longstanding position that ERISA plan fiduciaries of both defined benefit and defined contribution plans must make investment decisions based solely on the risk-adjusted value to plan participants and beneficiaries and may not subordinate the interests of the plan to unrelated goals or objectives;
- provide specifically that ERISA’s exclusive purpose rule and duty of loyalty prohibit fiduciaries from considering any non-pecuniary factors over the financial and retirement income interests of plan participants and beneficiaries;
- provide that ESG factors can be pecuniary factors only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories;
- require ERISA plan fiduciaries to consider how an investment or investment course of action compares to available alternatives;
- require specific documentation in the “rare circumstances” where, after appropriate investment analysis, fiduciaries consider ESG factors as a “tie-breaker” in choosing between economically “indistinguishable” investments; and
- without limiting ERISA’s general rules, confirm that an ESG fund may be added to a 401(k)-type plan only if (i) the fund is well managed and adequately diversified, (ii) the fund is selected and monitored through a prudent process, based only on objective risk-return criteria, (iii) the relevant factors are documented, and (iv) the fund is not used as the plan’s qualified default investment alternative (or a component of the QDIA).
In its commentary, the DOL noted the confusion that persists for ERISA plan fiduciaries in regards to its ESG-investing rules, which the DOL acknowledged may be a result of varied statements it has made over the years in past guidance. In short, the proposed rule would codify the DOL’s view that the sole focus of ERISA plan fiduciaries must be the financial returns and risk to participants and beneficiaries. ERISA plan fiduciaries must not sacrifice investment returns, take on additional investment risk, or pay higher fees to promote non-pecuniary benefits or goals.
The DOL invited comments from the public on all facets of the proposal (which are due by July 30, 2020, 30 days after the date of publication in the Federal Register). If finalized, these rules would become effective 60 days after publication of the final rule.
Several retired employees of Dominion Energy Transmission, Inc. sued their former employer alleging that they were entitled to lifetime healthcare benefits, and the unilateral changes made by Dominion to their post-retirement medical benefits violated ERISA. The Third Circuit concluded that the retirees failed to state a claim. Applying ordinary principles of contract interpretation, the Court concluded that the CBA did not “clearly and expressly” vest the retirees with lifetime benefits. In so ruling, the Court rejected the retirees’ argument that because the Plan required union consent before altering medical benefits and also did not include a general durational clause, it could be inferred that “the parties clearly expressed their intent to vest post-retirement medical benefits.” The “absence of a termination clause combined with a consent clause does not clearly and expressly vest retirees” with lifetime benefits, said the Third Circuit. The case is Blankenship v. Dominion Energy Transmission, Inc., No. 19-3374, 2020 WL 3397740 (3d Cir. 2020).
The Fifth Circuit in Schweitzer v. Inv. Comm. of Phillips 66 Sav. Plan dismissed claims against 401(k) plan fiduciaries related to allowing plan participants to hold a single stock that was not an employer security as a plan investment alternative. No. 18-cv-20379, 2020 WL 2611542 (5th Cir. May 22, 2020). The Court held that: (i) 401(k) plan fiduciaries had a duty to ensure that the plan’s investment line-up was diversified, but no duty to ensure that participants actually diversified their portfolios; (ii) the Supreme Court’s decision in Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. 409 (2014), effectively foreclosed claims that the plan fiduciaries should have taken action on the basis of public information that suggested risk from holding the stock; and (iii) ERISA does not prohibit an individual account plan, like a 401(k) plan, from offering a single-stock fund.
As discussed below, the Court’s decision offers meaningful guidance to fiduciaries of participant-directed plans and, more specifically, to those evaluating what to do with a company stock fund after a spinoff or divestiture.
ConocoPhillips maintained a 401(k) plan with two employer stock funds that invested in ConocoPhillips stock. ConocoPhillips spun off certain operations to Phillips 66, which was not affiliated with ConocoPhillips. The spinoff resulted in the transfer of over 10,000 ConocoPhillips employees to Phillips 66, and their 401(k) accounts were transferred to a separate plan sponsored by Phillips 66.
Many of the transferred employees had invested in the ConocoPhillips stock funds. Those investments transferred in-kind to the Phillips 66 plan. As a result, the Phillips 66 Plan held two funds with a single stock that was not an employer security. The Phillips 66 plan’s fiduciaries closed the funds to new investments, and participants were allowed to sell at any time, but those who did not want to sell were allowed to hold their investments in the funds. During the five-year period that followed the spinoff, ConocoPhillips’s share price increased significantly and then decreased just as significantly.
Participants in the Phillips 66 Plan filed a putative class action complaint alleging two ERISA breach of fiduciary duty claims: breach of the duty of diversification by offering the ConocoPhillips stock funds; and breach of the duty of prudence for failing to remove the ConocoPhillips stock funds. The participants pointed to the inherent risk of investing in a single stock and publicly available “red flags” that purportedly signaled additional risk.
The district court dismissed the complaint for failure to state a claim. The district court first found that the diversification claim failed because participants could no longer invest in the ConocoPhillips stock funds and participants could remove their assets from the funds at any time. The district court concluded that the claim was really an issue of prudence and whether the plan fiduciaries should have forced participants to divest their holdings from the funds. The district court then evaluated the participants’ breach of the duty of prudence claim and concluded that it was foreclosed by the Supreme Court’s ruling in Dudenhoeffer.
The Fifth Circuit’s Opinion
The Fifth Circuit affirmed the district court’s dismissal of all claims. To begin with, the Court concluded that the diversification claim failed because the complaint lacked any allegation that the fiduciaries failed to offer a diverse menu of investment options or otherwise warn the participants of the risk of assembling a non-diversified portfolio. In so ruling, the Court rejected the participants’ reliance on authority addressing diversification requirements for defined benefit plans. The court explained that, for a defined contribution plan, a fiduciary’s responsibility is to create a diverse menu of available investment options. Individual options on the menu do not necessarily have to be diverse, and allocation of assets among the available options is the responsibility of each participant.
The Court next turned to the participants’ claim that the fiduciaries breached the duty of prudence by allowing participants to hold their investments in the ConocoPhillips stock funds after the spinoff. First, the Court concluded that the Supreme Court’s decision in Dudenhoeffer precluded plaintiffs’ claim that the plan fiduciaries should have known from publicly available information that ConocoPhillips’ share price did not adequately reflect the stock’s risk.
Nevertheless, the Court noted that, under some circumstances, it could be imprudent to keep a single-stock fund on the investment menu. The Court determined that Dudenhoeffer did not control here because this was not a claim about whether the plan fiduciaries should have taken action based on publicly available information and did not involve employer securities. The Court concluded that the fiduciaries were not imprudent because they had closed the ConocoPhillips stock funds to new investments and adequately warned participants of the risks of not diversifying in the summary plan description.
The Fifth Circuit’s ruling approves a common approach for handling company stock funds after a spinoff or similar divestiture. Nevertheless, plan fiduciaries should continue to monitor all investment options, and to keep investment disclosures up to date, to ensure that participants have the information necessary to make sound investment decisions.