In Peabody v. Davis, Nos. 09-3428, 09-3452, 09-3497, 10-1851, 10-2079, 10-2091, 2011 WL 1364427 (7th Cir. April 12, 2011),[11] the Seventh Circuit ruled that the fiduciaries of an Eligible Individual Account Plan (EIAP) plan breached their duty of prudence under ERISA by allowing the plan to remain heavily invested in stock of a closely held corporation when they knew the value of the company’s profit margin had substantially decreased due to regulatory changes. The Court acknowledged that EIAP’s are exempt from the duty to diversify, but nevertheless concluded that the fiduciaries had a duty to reduce exposure to company stock in an orderly way, as company profitability abruptly and openly dropped. Although the facts of the case are unique, the ruling may expose potential risks for the fiduciaries of EIAPs.

Background[12]

Peabody was employed at The Rock Island Company of Chicago (RIC) from 1998 until 2004. Peabody’s claims arose from his participation in the Rock Island Securities (RIS) Salary Savings Plan (Plan). RIS, a subsidiary of RIC, was the Plan sponsor. Defendants Davis and Kole were co-founders of RIC, corporate officers, trustees and fiduciaries of the Plan. According to Peabody, he resisted pressure by Davis to buy RIC stock until December 1999 when RIC was no longer contractually bound to give him a bonus. At that time, Davis informed Peabody that RIC was going to give him a bonus in cash and stock. Peabody, not wanting to use the bonus to buy RIC stock, suggested that in exchange for receiving his bonus entirely in cash, he would agree to roll over his external IRA into the Plan and then use those proceeds to buy stock in the Plan. Davis agreed. Peabody eventually rolled over $167,819, of which $166,000 was used to purchase RIC stock. This left Peabody 98% invested in RIC stock. The three other Plan participants each had fewer than 5% of their Plan assets invested in the stock.

Since RIC was a closely-held corporation, the value of RIC could not be determined by the market. Instead the valuation of RIC stock required an analysis of the company’s financial data. In 1999 when Peabody purchased his stock in the Plan, the stock was valued at $2,000 per share. In April 2001, after Kole told Peabody that Davis wanted all employees to purchase more RIC stock, Peabody purchased five additional shares which were valued at $500 per share. In 2004, the stock was valued at $550 per share.

The Restricted Stock Agreement provided that upon an employee’s termination RIC was granted the option to repurchase an employee’s stock at book value; however, employees had no corresponding right to sell the stock back to RIC. When Peabody’s employment ended in January 2004, RIC offered to purchase his shares under one of three terms: (1) immediately redeem the 835 RIC shares that he held in the Plan for $215 per share; (2) redeem the shares in 2005 for $300 per share; or (3) redeem the shares in 2007 for $400 per share. Peabody rejected those options and agreed instead to enter into a loan agreement with RIC, pursuant to which RIC agreed to purchase all of Peabody’s stock for $350 per share within one year. This transaction transformed Peabody’s equity interest in RIC into a creditor’s interest. According to the terms of the loan, it was to be repaid in a single payment due on February 1, 2005.

The payment due under the terms of the loan was not made on time, and on or about March 18, 2005, along with other RIC creditors, Peabody was informed that RIC was not creditworthy. That same day, Peabody formally demanded the distribution and was told that the loan could not be repaid. RIC went out of business sometime in 2005.

RIC was a securities firm and its income was derived from commissions. In 2000 the SEC implemented a rule that required all U.S. public exchanges to allow stocks to be traded at values measured in terms of pennies instead of fractional dollars. This change, termed “decimalization,” diminished the profit margins yielded by commissions on trades. According to Davis, this decimalization rule “crushed” RIC’s profit margins such that by 2003 or 2004 profit margins had declined by 70–80%.

In his complaint, Peabody alleged multiple theories of fiduciary breach against the Plan defendants pursuant to ERISA § 502, and asserted a claim to recover damages against two insurance companies that provided commercial crime policies that insured the Plan against employee dishonesty.

The Ruling By The District Court

After conducting a bench trial, the district court issued a memorandum that found defendants Davis, Kole, and RIS liable for breach of fiduciary duty. The court acknowledged that those defendants did not violate their duty to diversify because Peabody “knowingly and voluntarily” waived this claim at the time of the rollover transaction. However, the district court held that defendants breached their fiduciary duty of prudence when they maintained the investment in RIC stock throughout RIC’s decline and when they failed to distribute Peabody’s Plan benefit. The district court also determined that the loan-for-stock exchange was a prohibited transaction and that defendant Davis breached his fiduciary duty by offering only a loan in payment for RIC stock.

Although Peabody’s expert testimony was struck for failure to comply with discovery rules and Peabody did not offer evidence of damages as to each theory of liability, the district court awarded him damages on his breach of duty of prudence claim based on the rapid decline in profitability of RIC between 2001 and 2003. The district court awarded Peabody $506,601.82 in damages.

The court did not permit recovery, however, via a claim for distribution of benefits. Even though it acknowledged that this form of relief, as opposed to damages relief, might be more favorable to Peabody from a tax standpoint, the court concluded that it would be a duplication of the recovery to which Peabody was entitled under ERISA § 502(a)(3).

The district court dismissed the claims against the insurance companies, finding that the insurance companies were not proper defendants to claims under ERISA §§ 502(a)(1)(B) or 502(a)(2), and that damages were not recoverable against them under ERISA § 502(a)(3).

The Seventh Circuit’s Opinion[13]

Duty of Prudence. The Seventh Circuit first recognized that the Plan was an EIAP and, as such, exempt from ERISA’s duty to diversify. Specifically, the Court found that ERISA “unambiguously exempts all EIAPs from the duty to diversify, including savings plans like that one at issue.” Nevertheless, the Court found that, while the duty to diversify was inapplicable to the fiduciaries of this Plan, the duty of prudence under ERISA still applied to them. The Court noted that the Third Circuit in Moench v. Robertson, 62 F. 3d 553 (3d Cir. 1995) and the Ninth Circuit in Quan v. Computer Sciences Corp., 623 F.3d 870, 881 (9th Cir. 2010), in reconciling the duty of prudence with the absence of an express duty to diversify, determined that for an EIAP or Employee Stock Ownership Plan (ESOP) that required investment in company stock, there was a presumption that an investment in employer stock was prudent. The Court observed that the Plan here, unlike in the cases applying the presumption, did not affirmatively require or encourage investment in employer securities, and thus divestment from company stock would not have required any deviation from the Plan terms. In any event, the Court decided not to “grapple” with the extent to which the Moench presumption of prudence applied to EIAPs, and stated that even if the Moench presumption applied, the district court correctly concluded that defendants breached their duty of prudence.

In making this determination, the Court agreed with the district court that “a prudent investor would not have remained so heavily invested in RIC’s stock as the company’s fortunes declined precipitously over a five-year period for reasons that foretold further and continuing declines.” The Court noted that defendants Davis and Kole knew that RIC’s profit margins decreased by 70 to 80% because of “a widely-known and permanent change in the regulatory environment that undermined RIC’s core business model.” The Court noted that even though those developments were public, “no one was better positioned to know of RIC’s prospects and the future of its stock values than Davis and Kole, who co-founded the company and set the share value.” The Court stated that those facts were consistent with the circumstances under which its sister courts would have found it imprudent to continue an investment in company stock. The Court concluded that when the SEC changed the regulatory environment, RIC’s business model was impacted and as a result, RIC’s stock became an imprudent investment.

The Court emphasized the narrowness of its ruling, in that most business failures were not foreseeable and that a severe decline in the value of company stock did not, without considerably more, create a duty to divest from company stock.

In finding that defendants breached their fiduciary duty, the Court rejected the argument that Peabody’s fiduciary breach claim was waived when he agreed to the stock investment and never requested that the fiduciaries reduce his investment. The Court found that although Peabody consented to the non-diversified investment of RIC stock at the time of the rollover transaction, defendants were not relieved of their fiduciary duties with regard to carrying out the rollover transaction and subsequently allowing Peabody to remain invested exclusively in company stock during the company’s decline.

In so ruling, the Court found that the defense of waiver was the same as a defense available under ERISA § 404(c), which “frees fiduciaries from responsibility for plan losses attributable to the participant’s investment decision” for certain types of accounts. The Court noted that when a plan does not comply with ERISA § 404(c), fiduciaries are not entitled to the safe harbor protection it provides. Here, defendants never argued that the Plan complied with ERISA § 404(c). Applying this standard, the Court affirmed that defendants could be liable for allowing Peabody to select company stock as an investment if it was “manifestly imprudent to allow [him] to do so.” Concluding that defendants did not justify their failure to divest the Plan of company stock, the Court affirmed the district court’s finding that defendants breached their duty of prudence under ERISA.

Prohibited Transaction Claim. The Court found that Peabody was “technically correct” that the loan-for-stock transaction constituted a prohibited transaction under ERISA § 406(a)(1)(B) because the fiduciaries loaned Plan money to RIC, a party-in-interest. However, the Court also found that the transaction consisted of the exchange of worthless stock for a worthless loan. Accordingly, even though a prohibited transaction occurred, there were no losses directly attributable to that transaction. And, because there was no injury to the Plan, there were no damages to Peabody as a result of the substitution of debt for equity.

Damages. The remedy in an action for breach of fiduciary duty under § 502(a)(2) is for the fiduciary to make good the loss to the Plan. Here, the Seventh Circuit found the district court’s method of calculating damages erroneous because the figures used were not solidly tied to the breach of fiduciary duty. In determining damages, the Court stated that “[t]he key questions are when did the fiduciary breach occur, and what was the resultant loss.” The Court advised the district court to proceed, on remand, on the theory that defendants were required to divest from RIC as the profitability of the company sharply declined. For purposes of calculating damages, the Court stated that “because of the uncertainties involved, prudence did not require that the account be totally drained of the arguably imprudent stock investment immediately, even though it eventually became worthless.” Rather, it would be reasonable for at least a quarter to a third of the original RIC stock to be left in the account when it was converted to a loan, without an imprudence violation. The Court pointed out that it did not mean to suggest there was a general duty to “diversify” Peabody’s stock holding, but rather that defendants had “a prudential duty to reduce exposure to company stock in an orderly way, as the company’s profitably abruptly and openly dropped.”

The Seventh Circuit did not disturb the district court’s ruling denying Peabody’s claim for distribution of benefits under ERISA § 502(a)(1)(B) as duplicative of the court’s award under ERISA § 502(a)(2), even though this would have enabled Peabody to maintain the benefits of a tax rollover. The Seventh Circuit observed that after the Supreme Court’s decision in LaRue v. DeWolff, Boberg & Assocs., Inc., 552 U.S. 248 (2008), the relationship between ERISA § 502(a)(2) and the traditional mechanism of individual relief under ERISA § 502(a)(1)(B) has been muddied. The Court stated that Peabody’s tax-related concerns could be addressed when defendants complied with the district court’s order.

Liability of Insurance Defendants. With respect to the liability of the insurance defendants under their dishonesty bonds issued to the Plan, the Court held that Peabody’s argument under ERISA § 502(a)(3) failed because the relief he sought was money damages under the plan’s insurance policy, not equitable relief.

Proskauer’s Perspective

The Seventh Circuit’s opinion in Peabody, while recognizing that ERISA unambiguously exempts all EIAPs invested in employer securities from the duty to diversify, nevertheless defines a fiduciary’s “prudential duty” to include reducing an EIAP’s exposure to company stock when the company’s fortunes precipitously decline. In creating this duty, the Court failed to give any instruction to fiduciaries as to how to implement this duty when there is a steady decline in the company’s stock and there is no market for the shares because the company is a closely-held corporation. Should the company be forced to buy back the shares or should they be required to find a private investor who is willing to buy the shares? Unfortunately, there is no concrete answer. At a minimum, though, before a fiduciary decides to divest the company stock from the plan in these circumstances, he/she should read the plan document, investigate alternative actions, and consider obtaining advice from an outside consultant.