On September 11, 2018, a participant in the Frontier Communications 401(k) Savings Plan filed a class action suit against Frontier Communications (the plan’s sponsor) and plan fiduciaries, claiming that they breached their ERISA duties of loyalty and prudence and their duty to diversify plan investments by retaining stock in Verizon and AT&T (both former owners of Frontier assets).
The case is interesting in several respects: (1) Legacy stock is emerging as a significant litigation target following Fifth Third Bancorp et al. v. Dudenhoeffer. (2) The plaintiff (like the plaintiffs in the recently decided Schweitzer v. The Investment Committee Of The Phillips 66 Savings Plan) focuses on the ERISA fiduciary duty to diversify plan investments. And (3) the claim is based not on a drop in value but rather the alleged underperformance of Verizon stock “relative to prudently diversified alternatives such as an S&P 500 tracking ETF.”
In this article we begin by discussing the ERISA fiduciary issues presented by legacy stock generally. We then review the Reidt vs. Frontier complaint. We conclude with some takeaways for plan sponsors.
(We should note at the outset that this article is generally based on allegations in the complaint, some or all of which may be refuted by subsequent filings by defendants.)
“Legacy stock” is (generally) stock in a company that formerly was part of the same controlled group as the current employer/plan sponsor but is no longer. This typically happens in connection with a spinoff of a controlled group member. As part of this sort of transaction, a parent retirement plan that holds company stock may wind up with legacy stock in the spun off company, and the spun off company’s retirement plan may wind up with legacy stock in the former parent.
One challenge presented by legacy stock is that there is litigation risk no matter what the sponsor does. Thus, in Tatum v. R.J. Reynolds Tobacco Company, plaintiffs in the plan of the former parent (RJR) of the spun off company (Nabisco) sued plan fiduciaries claiming that they imprudently divested (sold off) legacy Nabisco stock shortly before a tender offer for it dramatically increased its market price. (This is called a “reverse stock drop” suit.) In Schweitzer v. Phillips, in contrast, plaintiffs in the spun off company sued plan fiduciaries for failing to divest stock in the former corporate parent (in a classic stock drop suit).
In other words, there is no “safe” solution, which puts plan fiduciaries in a challenging position.
Facts in Reidt v. Frontier
Reidt v. Frontier (according to the complaint) involves the acquisition by the Frontier plan of Verizon stock in connection with the (2010) corporate spinoff (to Frontier) of “the local exchange business and related landline activities of Verizon in predominantly rural areas in 14 states.” Subsequently (in 2014) Frontier acquired certain additional “wireline proprieties” from AT&T in connection with which the plan acquired AT&T stock. And it appears that in 2016 the plan acquired additional Verizon stock in connection with a similar transaction with Verizon.
As a result of these transactions, at the end of 2016, 13.15% of plan assets were invested in Verizon stock and 4.55% in AT&T stock. The AT&T stock investment appears to be only relevant to the diversification issue: plaintiff alleges that “the stock price of AT&T and Verizon were highly correlated.”
Issues presented by legacy stock cases
Post-Dudenhoeffer, legacy stock litigation has raised (at least) five fundamental issues:
- Does legacy stock constitute “employer securities” for purposes of ERISA? ERISA section 404(a)(2) generally provides that, in a DC plan, employer securities are not subject to the requirement that ERISA fiduciaries diversify plan investments. Schweitzer v. Phillips addressed this issue, concluding in a fairly fact-specific analysis that the legacy stock in that case was not employer securities under ERISA.
- If the legacy stock is not ERISA employer securities, to what extent do the principles articulated by the Supreme Court in Fifth Third Bancorp et al. v. Dudenhoeffer apply? In Dudenhoeffer, the Supreme Court rejected the “presumption of prudence” rule for plan investments in employer securities, replacing it with, in effect, a presumption that acquisition of, or failure to dispose of, a company’s publicly traded stock at a market price is prudent. The decision in Dudenhoeffer by its terms only applied to the acquisition, holding and disposition of employer securities, to which (as we noted) no diversification requirement applies.
- How, in a plan (e.g., the typical 401(k) plan) in which participants may choose from a fund menu of diversified investment options, is ERISA’s diversification requirement to be applied? The court in Schweitzer v. Phillips concluded that, because participants – at the individual account level – had the option to adequately diversify their individual plan portfolio by selecting from a diverse range of available investments, ERISA’s diversification standard was satisfied. We do not know, based solely on the complaint, whether Frontier plan participants had this sort of option.
- Regardless of a diversification obligation, in what circumstances do plan fiduciaries have a prudence obligation to divest legacy stock? With respect to this issue, the Schweitzer v. Phillips court applied a Fifth Third (market price = prudence) standard.
- Does ERISA authorize a complaint based on an obligation to diversify where the only damages are from “underperformance?” The complaint in Reidt vs. Frontier is based on the alleged underperformance of Verizon stock. The ERISA obligation, however, is that (quoting the statute) “a fiduciary shall discharge his duties with respect to a plan … by diversifying the investments of the plan so as to minimize the risk of large losses.” Plaintiff in this case do not allege that there were any “large losses” – just that Verizon stock underperformed the S&P 500. (We note that the issue of damages based on underperformance is also an issue in ERISAprudence litigation not involving employer securities or legacy stock.)
Takeaways for sponsors
The (increased) risk of litigation with respect to legacy stock is in many ways similar to the risk with respect to company stock: because the performance of a single stock is generally more volatile than the performance of, e.g., a diversified mutual fund, there is a greater risk that investor-participants will lose significant amounts of money. And those losses often trigger lawsuits.
With respect to legacy stock there is sometimes another risk (not present in employer securities stock drop litigation): if plan fiduciaries elect to divest the legacy stock (as in Tatum), participants may miss out on significant post-divestment gains.
This is the third major legacy stock case since Dudenhoeffer. It’s conceivable that, as Dudenhoeffer has made employer securities-based stock drop cases more difficult to bring, plaintiffs lawyers view legacy stock litigation as a growth area.
Thus far, in legacy stock litigation, the courts have sided with the defendants (although, in Tatum, only after some back-and-forth between the district court and the Fourth Circuit). But it is not inconceivable that a sympathetic court may allow a legacy stock complaint to proceed, even where the participant had the ability to transfer a legacy stock investment to another available option under the plan.
Given these risks, employer officials will want to consider making the issue of “what to do about legacy stock” an element of planning for the spinoff itself. And, in that regard, they will want to begin by consulting with counsel.
Both pre- and post-spinoff, plan fiduciaries should review options, consider all relevant factors, and document their deliberations and decisions.
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We will continue to follow this issue.