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In February 2016, the United States District Court for the Middle District Of North Carolina handed down its (second) decision in Tatum v. R.J. Reynolds Tobacco Company, holding (again) that even though the plan fiduciaries violated “procedural prudence” in selling Nabisco stock held by the R. J. Reynolds defined contribution plan, their decision to do so was “substantively prudent” and therefore did not violate ERISA.
This is a “reverse stock drop” case – plaintiffs are suing plan fiduciaries for disposing of stock in a legacy single-stock fund shortly before that stock significantly increased in value. The court’s decision provides insight into the issues sponsor-fiduciaries should consider when disposing of single stock funds (including both legacy stock funds (as in this case) and company stock funds).
Briefly (and oversimplifying): The case arises out of RJR’s spinoff of Nabisco. After that spinoff, the RJR plan continued to hold Nabisco stock (the “legacy single stock fund”). About nine months after the spinoff, the RJR plan sold the Nabisco shares held by the plan. Shortly thereafter, an unsolicited tender offer was made for Nabisco, a takeover battle ensued, and the Nabisco stock significantly increased in value over what the plan sold it for.
The case is complicated by the way the sale of the RJR plan’s Nabisco stock was handled. The court found that the RJR plan amendment authorizing the sale was not validly executed, hence the court’s finding that the plan’s fiduciaries had violated ERISA’s “procedural prudence” requirement. As a result, the plan’s fiduciaries “bore the burden of … proving by a preponderance of the evidence that a prudent fiduciary would have made the same decision” (the “substantive prudence” standard).
Finally, the litigation itself has had a complicated history. In its first decision, the lower court found for defendant fiduciaries, holding that: “A hypothetical prudent fiduciary could have decided not to add or maintain the Nabisco Funds as either frozen or active funds on January 31, 2000.” [Emphasis added.] On appeal, the Fourth Circuit (in a divided decision) agreed with the lower court that the fiduciaries had violated ERISA’s procedural prudence, but reversed on the issue of “substantive prudence,” holding that the issue was not what a prudent fiduciary “could have” have done but rather what such a fiduciary “would have” done.
In remanding the case for a review of this issue, the court described what was required:
The district court’s task on remand will be to review the evidence to determine whether RJR has met its burden of proving by a preponderance of the evidence that a prudent fiduciary would have made the same decision.
In doing so, the court must consider all relevant evidence, including the timing of the divestment, as part of a totality-of-the-circumstances inquiry. … Perhaps, after weighing all of the evidence, the district court will conclude that a prudent fiduciary would have sold employees’ existing investments at the time and in the manner RJR did because of the Funds’ high-risk nature, recent decline in value, and RJR’s interest in diversification. Or perhaps the court will instead conclude that a prudent fiduciary would not have done so, because freezing the Funds had already mitigated the risk and because divesting shares after they declined in value would amount to “selling low” despite Nabisco’s strong fundamentals and positive market outlook.
In a vigorous dissent, Judge Wilkinson criticized this decision as at odds with the Supreme Court’s decision in Fifth Third Bancorp et al. v. Dudenhoeffer.
The lower court, in its (second) February 2016 decision, found:
That single stock funds are generally more risky than diversified funds (“approximately four times as risky as a diversified portfolio of mutual funds”) and that the Nabisco stock also had additional, “idiosyncratic” litigation and bankruptcy risks.
That “[t]here was no reason in [the relevant period] to expect extraordinary returns from [the Nabisco stocks]. … In other words, ‘the markets for [the Nabisco stocks] were generally efficient … and in an efficient market, there is no ability for investors to predictably make extraordinary returns based on publicly available information.”
That “[t]he persuasive evidence does not suggest analyst recommendations provided meaningful investment direction.”
That the post-disposition appreciation in the Nabisco stock’s value “was not foreseeable.”
That the nine-month period between the spinoff and the plan’s disposition of the Nabisco stocks was reasonable.
As a result, the court held for the defendant-fiduciaries, concluding that: “Defendants have proven by a preponderance of the evidence that a prudent fiduciary would have decided to divest the Nabisco Funds and held to the determination that divestiture was a benefit to Plan participants and retained the same time line for divestment.”
These cases almost always arise in the context of a spinoff (or spinoff-like) transaction of some sort. Single stock funds always present a higher risk of litigation, simply because the risk of large losses is greater, and large losses create plaintiffs. When the stock involved is not company stock, the argument for disposing of the stock is pretty compelling.
But the litigation risk with respect to the disposition itself is also high. Obviously, it’s all about timing: if, as in Tatum v. RJR, the stock goes up significantly in value after the plan sells it, disappointed participants will want to sue.
Thus, with respect to a legacy stock, fiduciaries are between a rock and hard place: they are faced with a heightened risk of litigation (1) if the plan continues to hold it and the stock price goes down or (2) the plan sells it and the stock price goes up.
In this situation, as Tatum bears out, process is the fiduciary’s friend. The complicated “substantive prudence” analysis applied by the court was the result of the failure of the plan’s fiduciaries to engage is a proper procedure. So, the most important takeaway from this case for fiduciaries is: make sure your process is thorough, conforms to ERISA and the plan documents, and is well documented. A major corporate transaction (like the spinoff in this case) can be a chaotic time for company officials doubling as plan fiduciaries. It is critical that, as fiduciaries, they not take their eye off the ball: stick to the process.
In Fifth Third the Supreme Court held that:
Where a stock is publicly traded, allegations that a fiduciary should have recognized on the basis of publicly available information that the market was overvaluing or undervaluing the stock are generally implausible and thus insufficient to state a claim.
In his dissent in the Fourth Circuit decision, Judge Wilkinson stated: “As the Supreme Court has recognized, ‘a fiduciary usually “is not imprudent to assume that a major stock market . . . provides the best estimate of the value of the stocks traded on it that is available to him.”’” (Citing the Supreme Court’s decision in Fifth Third Bank.)
The Supreme Court did not take up Tatum. And so, in re-considering its original decision for defendants, the lower court produced a fact-based analysis that came to more or less the same conclusion as the Supreme Court in Fifth Third: absent “special circumstances,” the idea that a market price for a large, publicly traded stock is “wrong” (and that, therefore, selling or buying at that price is imprudent) is implausible.
Lower courts are continuing to develop the “law of company (and legacy) stock funds.” It remains to be seen whether the market-based analysis, explicit in the above-quoted passage from Fifth Third, will in practice be adopted. We note, in that regard, that Fifth Third was a unanimous decision – so, presumably, the Supreme Court is strongly committed to its approach.
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We will continue to follow these issues.