On August 11, 2020, the United States Court of Appeals for the Fourth Circuit handed down its decision in Stegemann v. Gannett, ruling (in a 2-1 holding) that plaintiffs could proceed with their claim that a legacy stock fund in the Gannett 401(k) plan violated ERISA’s fiduciary prudence and diversification requirements.
Broadly, Gannett is a stock drop case – an ERISA fiduciary claim brought in connection with losses participants sustained when stock held in the plan lost significant value – involving stock that is not employer securities. The stock at issue in this case was stock in Gannett’s former corporate parent, TEGNA, Inc.
Subject to certain conditions, DC plans are, with respect to employer securities, exempt from ERISA’s fiduciary diversification requirements. We say “requirements” (plural) because the ERISA fiduciary rules have a general diversification requirement, that fiduciaries are responsible for “diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.” But an obligation to diversify is also understood to be implicit in fiduciaries’ (separate) duty of prudence.
Non-employer securities, such as the legacy TEGNA stock held by the (post-spinoff) Gannett plan, are not exempt from these requirements.
Sponsors of plans holding what once were employer securities will often find themselves holding a significant percentage of non-employer securities after a corporate spinoff/split-up. In this case, at the time of Gannett’s 2015 spinoff, 21.7% of the continuing Gannett plan’s assets were in legacy stock that was, after the spinoff, no longer employer securities. The plan continued to hold that stock, and over time it lost considerable value, causing (plaintiffs allege) losses of between $43 million and $57 million.
These sorts of corporate transactions often confront sponsor fiduciaries with a challenge: should the plan continue to maintain a legacy single stock fund or liquidate it as soon as possible?
Ironically, while Gannett, involves a lawsuit by participants claiming that plan fiduciaries should have liquidated the legacy stock fund, an earlier Fourth Circuit case, Tatum v. RJR Pension Inv. Comm, involved a lawsuit by participants claiming that plan fiduciaries should not have liquidated the legacy stock fund – because the legacy stock went up significantly in price after that liquidation. Tatum involved considerable litigation (and three separate rulings by the Fourth Circuit) before defendant fiduciaries finally won.
This sort of whipsaw highlights the heads-I-win-tails-you-lose risk that legacy stock funds present for sponsor fiduciaries. The best answer to the question of what to do in these situations is for the plan fiduciaries to engage in a deliberate, well-documented process of evaluating different courses of action, and then choose the one that seems most prudent, seeking advice from outside experts where necessary.
Indeed, the alleged failure of Gannett plan fiduciaries to “monitor” the prudence of the TEGNA legacy stock fund was a necessary element of plaintiffs’ case. And, as a practical matter, the mere allegation of such a failure may be sufficient to survive a motion to dismiss, at least on this issue.
Now, let’s review the court’s decision in greater detail.
Fourth Circuit holding
The Fourth Circuit reversed a district court ruling in favor of defendant-plan fiduciaries. According to the Fourth Circuit, the district court’s key holdings were:
(1) Plaintiffs’ duty-of-prudence claims were barred under Fifth Third Bancorp v. Dudenhoeffer, … which raised the bar for pleading a breach of the duty of prudence related to the retention of publicly traded stock by requiring a plaintiff to allege “special circumstances” related to mistakes in market valuation not alleged here, and (2) the duty to diversify requires diversity among the full set of funds offered in the menu of plan offerings but does not compel every individual fund in a plan to be diversified.
The Fourth Circuit rejected both of these holdings.
Oversimplifying somewhat, defendants’ Dudenhoeffer argument was that there cannot be “imprudence” with respect to a single-stock investment, where that stock is publicly traded, absent “special circumstances.” In effect, the stock is only “worth” what the market at any given time says it is worth, and the only prudence issue is price.
To repeat what we said above: DC plan holdings of employer securities are exempted from ERISA’s diversification requirements; non-employer securities generally do not have the benefit of that exemption. The Fourth Circuit rejected defendants’ “Dudenhoeffer argument,” finding that plaintiffs’ claim was not based on a “price” theory of prudence but on a modern portfolio theory of the inherent value of diversification.
[T]he essence of diversification is that a diversified portfolio is superior to a non-diversified portfolio because a diversified portfolio can achieve the same expected return as an un-diversified portfolio, but the diversified portfolio will be less risky. … Plaintiffs do not contend that fiduciaries should have outsmarted an efficient market. A claim that a fund was imprudent due to lack of diversification does not turn on reading tea leaves to predict the performance of a stock – what Dudenhoeffer forecloses as a basis for liability. Instead, Plaintiffs allege that their fiduciaries should have recognized the imprudence of a fund based on the fund’s composition.
This is an interesting, if somewhat abstract, argument. Taken to its logical conclusion, it would (as the dissent argued) establish something like a per se rule that ERISA prohibits non-employer securities single-stock funds. The majority rejected, as “premature” at the motion to dismiss stage, such a conclusion.
The duty to diversify applies at the fund level
Quoting the court: “Defendants contend that in a defined contribution plan a fiduciary is not obligated to ensure individual funds are diversified so long as the plan’s menu allows participants to choose between a mix of options; diversification must be judged at the plan level rather than the fund level.”
The Fourth Circuit rejected this argument, finding that it was bound by its 2007 decision in DiFelice v. U.S. Airways, Inc., which held that “’each available [f]und considered on its own’ must be prudent.” The court acknowledged that this holding is at odds with the Fifth Circuit’s holding in Schweitzer v. Inv. Comm. of the Phillips 66 Sav. Plan.
404(c) and the broader implications of the court’s holding
The court did not dismiss the concerns about basic 401(k) plan fund menu design that this sort of rule – that there must be diversification at the fund level – might raise. In considering an “appropriate way to account for participant choice,” the court found that, given the “over twenty-five requirements that a fiduciary must meet before invoking the § 404(c) safe harbor,” an argument based on 404(c) (and more broadly on participant choice generally) should be treated as an “affirmative defense,” and therefore may not be raised in a motion to dismiss.
Quoting the court: “the fiduciary of a defined contribution plan should not have the benefit of safe harbor on account of participant choice without proving the § 404(c) defense first.” In effect, that proof would involve some sort of evidential proceeding (conceivably in a motion for summary judgment) not suitable to a motion to dismiss, which is based only on pleadings, not evidence.
For what it is worth, while the court’s analysis may logically hang together, it will strike most people involved with 401(k) plans as somewhat strange. That is, this approach is generally at odds with how most think about diversification where participants are allowed to choose plan investments from a fund menu.
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The Fourth Circuit’s decision in Gannett raises several issues for sponsor fiduciaries considering “what to do about” legacy stock. Fiduciaries facing the prospect of plan investment in legacy stock (e.g., in connection with an anticipated spinoff) will want to consult with counsel early in the planning process, if possible.
We will continue to follow this issue.