Loading article...
On August 4, 2014, the 4th Circuit handed down its decision in Tatum v. R.J. Reynolds Tobacco Company. The court reversed the district court’s decision in favor of defendant-fiduciaries and remanded the case for further proceedings. (We discussed the district court decision in our article Tatum v. R. J. Reynolds Tobacco Company: Plan Fiduciary Issues.)
This case is interesting in several respects:
It involves the treatment of a ‘non-employer stock’ fund in a defined contribution plan where participants choose investments from a fund menu. Typically, plans wind up holding non-employer stock where (as in this case) there is a corporate transaction (e.g., a spinoff of a subsidiary).
It’s a ‘reverse stock drop’ case. The usual stock drop case (e.g., Fifth Third Bancorp et al. v. Dudenhoeffer decided by Supreme Court) involves stock that has lost significant value (hence, ‘drop’), and the plaintiff is arguing that stock in the plan should have been sold (or not bought). In a reverse stock drop case, the plaintiff is suing because the stock was sold, before a significant increase in share price.
The case involves (and the 4th Circuit decision turns on) the ‘objective prudence’ defense – the argument that a defendant-fiduciary is not liable even though it failed in its fiduciary duty (here, to appropriately consider the decision to sell stock), because a prudent fiduciary could or would have reached the same decision.
Briefly: the 4th Circuit agreed with the lower court’s finding that RJR fiduciaries were ‘procedurally imprudent’ in selling Nabisco stock – that they took that decision without appropriate review and deliberation. It disagreed with the lower court’s holding that, notwithstanding that procedural imprudence, the defendant-fiduciaries were not liable because a hypothetical prudent fiduciary ‘could have’ reached the same decision. The 4th Circuit said the issue was not ‘could have’ but ‘would have.’ That is, the issue was not ‘was it possible’ that a prudent fiduciary could have reached this decision, but, ‘was it probable’ that she would have done so.
In what follows, we review the decision in detail.
Oversimplifying, in June 1999 RJR Nabisco, Inc. (‘RJR’) spun-off its Nabisco subsidiary (there were two types of Nabisco shares – common and holding company stock). RJR (post-spinoff, primarily a tobacco company) continued to sponsor the ‘old’ RJR Nabisco plan, and a new plan was created for Nabisco employees. This litigation involves the tobacco company plan (the ‘Plan’).
After the spinoff, the Plan had an RJR stock fund and a Nabisco stock fund. Stock in the RJR stock was deemed ‘employer securities’ within the meaning of ERISA section 404(a)(2) and therefore not subject to ERISA’s diversification requirement. The Nabisco stock was not deemed ‘employer securities’ and therefore was subject to that requirement.
In November 1999, the Secretary of the Plan’s Employee Benefits Committee (EBC) drafted and signed a document that included language which would have eliminated the Nabisco stock fund, but in a 2011 decision the court found that that ‘amendment’ was not validly executed or voted upon by the EBC. As a result, the court found that the plan document required “that the Nabisco Funds remain as frozen funds in the Plan” and, in effect, required continued investment in Nabisco stock.
The Nabisco stock in the Plan was sold on January 31, 2000. Between June 15, 1999 and January 31, 2000, the market price of Nabisco common fell 28% (and Nabisco holding company stock fell 60%). Participants investing in the Plan’s Nabisco stock fund sustained significant losses when the Nabisco stock was sold.
On March 30, 2000, Carl Icahn made an unsolicited offer for Nabisco. A takeover battle ensued, and Nabisco was ultimately sold, on December 11, 2000, to Philip Morris. On that day, Nabisco common stock had increased 82% over its January 31, 2000 share price (and the holding company stock had increased 247%).
The lower court held that: (1) the decision to sell Nabisco stock was a fiduciary act; (2) RJR plan fiduciaries did not adequately investigate and analyze that decision and therefore violated ERISA’s procedural prudence standard; but (3) the decision was ‘objectively prudent’ because “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) and therefore plaintiff was not entitled to ERISA relief.
In our article on the lower court’s decision, we discuss in detail its finding that RJR fiduciaries were ‘procedurally imprudent’ – that is, that they did not follow adequate procedures in their decision to sell Nabisco stock. The 4th Circuit upheld this finding:
[T]he district court’s well-supported factual findings establish that RJR … made a divestment decision that cost its employees millions of dollars with ‘virtually no discussion or analysis’ without consideration of any alternative strategy or consultation with any experts, and without considering ‘the purpose of the Plan, which was for long term retirement savings,’ or ‘the purpose of the spin-off, which was, in large part, to allow the Nabisco stock a chance to recover from the tobacco taint and hopefully rise in value.’ … RJR carried out this decision by adhering to a timeline that was ‘chosen arbitrarily and with no research.’ … And in doing so, RJR failed to act ‘solely in the interests of participants and beneficiaries’ and instead ‘improperly considered its own potential liability.’ … Indeed, the extent of procedural imprudence shown here appears to be unprecedented in a reported ERISA case.
In reaching this decision, the 4th Circuit rejected defendants’ assertion that RJR “did not breach its duty of procedural prudence because certain types of investment decisions assertedly trigger a lesser standard of procedural prudence.” RJR had argued that “‘[n]on-employer, single stock funds are imprudent per se’ due to their inherent risk.”
The court held that “this per se approach is directly at odds with our case law and federal regulations interpreting ERISA’s duty of prudence.” Those (the law and regulations) require “a totality-of-the-circumstances inquiry that takes into account ‘the character and aim of the particular plan and decision at issue and the circumstances prevailing at the time.'” The court also cited Department of Labor regulations that “expressly rejected the suggestion that a particular investment can be deemed per se prudent or per se imprudent based on its level of risk.”
The court found that once procedural imprudence and loss are established, the burden of proof shifts to the defendant fiduciary to establish that the procedural imprudence did not cause the loss. Perhaps the key element of the 4th Circuit’s decision is its holding that this requires that the defendant fiduciary show that “a hypothetical prudent fiduciary would have made the same decision anyway” (emphasis added). Thus, the lower court’s decision, which was based on what a hypothetical fiduciary ‘could have’ done, was in error.
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.
The court further held that, in determining what a hypothetical prudent fiduciary “would have done,” the lower court should consider RJR’s lack of compliance with the governing Plan document.”
In reaching this conclusion, the court rejected the dissent’s assertion (see below) that diversification (selling Nabisco shares and diversifying the investment of the proceeds) is generally prudent under ERISA:
Under the dissent’s reading of the statute, any decision assertedly “made in the interest of diversifying plan assets” would be automatically deemed “objectively prudent.” This approach would put numerous investment decisions beyond the reach of ERISA’s fiduciary liability provision. As a result, in any case in which a fiduciary could claim that it acted in pursuit of diversification, ERISA would neither deter a fiduciary’s imprudent decision-making, nor provide a make-whole remedy for injured beneficiaries. Congress certainly did not intend this result when it expressly provided that a fiduciary who breaches “any” of its ERISA duties “shall be personally liable” for “any losses to the Plan resulting from [the] breach.”
The 4th Circuit decision was split 2-1. Judge Wilkinson wrote a vigorous dissent, arguing that “parsings of the differences between ‘would have’ and ‘could have’ obfuscate rather than illuminate. It is semantics at its worst.” In his view, ‘objective prudence’ describes a range of reasonable decisions that are not appropriately divided into the ‘more likely than not’ and ‘less likely than not.’
He found that the RJR’s decision to sell Nabisco stock was objectively prudent because:
[M]onetary liability … should almost never lie where the decision was made, as this one was, in the interest of diversifying plan assets.
[T]here was a substantial threat to the Nabisco stocks’ share prices from the “tobacco taint.”
Nabisco’s stock prices had been steadily falling since the two companies split. … And even had RJR chosen to keep the Nabisco stocks, there was, as the district court noted, no reason to think that the stocks would have provided above-market returns, given the public nature of the relevant financial information and the general efficiency of the stock market. … 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 Fifth Third Bank case.)
[T]he ultimate cause of the dramatic appreciation in Nabisco stock prices in 2000 – the bidding war sparked by investor Carl Icahn’s takeover bid – was totally unexpected by RJR, analysts, and the broader market.
Company stock in DC plans has for decades been a litigation target. The most significant reason for this is that, as a single-stock investment, it is volatile. Participants investing in company stock can lose a lot of money quickly, and those losses produce potential plaintiffs. There is even more litigation risk with respect to non-company single stock funds, because those funds generally do not have the exemption from ERISA diversification requirements available to company stock funds.
But there is no easy way out of this risk: If the stock goes down in value, and the fiduciary has not sold it, the likelihood of litigation increases (this was the case in Fifth Third). If the fiduciary sells, and the stock goes up in value, the likelihood of litigation increases (this was the case in RJR). A classic Catch-22.
Clearly one way to increase the likelihood that you will win any such litigation is to engage in a prudent process. In this case (and accepting the court’s findings of fact), RJR would have been helped if it had properly amended its plan and adequately reviewed the decision to sell Nabisco stock. And the court’s decision clearly indicates that RJR would have been better off if a lawyer (and, probably, a financial advisor) had been more involved in the consideration of the decision to sell.
On the facts as given, that is, in the context of procedural _im_prudence, the 4th Circuit decision is disturbing. There is no question that perfectly prudent investors were selling (and buying) Nabisco stock in January 2000. At that time, the market price that emerged from that prudent activity reflected the views of all investors as to Nabisco’s value. How that judgment might be unpacked into a more probable (majority) view as to Nabisco’s ‘true value’ (e.g., that Nabisco was undervalued) and a less probable (minority) view (that it was overvalued) is a mystery.
The notion that selling a widely held, publicly traded security at a market price might be imprudent seems to import subjective (as opposed to market-determined) notions of what a stock’s “true value” is. Thus, the 4th Circuit’s decision would seem to be another case of misunderstanding what prices and markets are, as pointed out by the Supreme Court in Fifth Third:
In our view, where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances. … The [Sixth Circuit]’s decision to deny dismissal therefore appears to have been based on an erroneous understanding of the prudence of relying on market prices. (Emphasis added.)
Thus, RJR appears to be a step back from Fifth Third. Away from reliance on the market to determine prudence and back to (non-objective) notions of ‘fundamental value’ – “Nabisco’s strong fundamentals and positive market outlook” and “analyst reports” that “rated Nabisco stock positively, ‘overwhelmingly recommending [to] “hold” or “buy,” particularly after the spin-off.’”
Even after 40 years, it would seem, a fiduciary’s obligations with respect to company stock and other single-stock funds is still evolving. We will continue to follow this issue.