“A pure heart and an empty head are not enough.” This is a quote from an early case defining the scope of ERISA fiduciary liability. However, ERISA has always made fiduciaries responsible only for losses caused by their breaches of fiduciary responsibility. It doesn’t make fiduciaries insurers of plan assets.

A recent Fourth Circuit Court of Appeals case has established its own gloss on the ERISA rules to determine when fiduciaries who follow imprudent procedures will have to make up plan losses. The Fourth Circuit rule is based on what a hypothetical prudent fiduciary, who I will call the “prudent shadow”, would have done in the same situation.

Like the recent “Teflon Fiduciary” decision of the Fifth Circuit Court of Appeals, discussed in a prior blog post , the lower court decision seemed to exonerate fiduciaries in situations that may not have been intended by the drafters of ERISA. We will have to see how the new rule is applied in order to determine whether the Fourth Circuit rule does so and whether it is workable.

What Happened?

After the spinoff of Nabisco businesses from RJR Nabisco, the RJR 401(k) plan held blocks of Nabisco stock in two frozen funds. A working group that was not authorized under the plan documents decided after a short discussion to divest the stock in these frozen funds within six months. It did so at a time when the stock price had declined, because it was concerned about fiduciary liability for violating the rule that employee plan investments must be diversified and thought continuing the Nabisco funds was illegal.

The group didn’t consult an outside investment adviser or hire an independent fiduciary to determine the best time to divest. Nor did it seek the advice of an outside ERISA attorney about what the ERISA diversification rule, which actually provides that investments be diversified “unless it is prudent not to do so,” required.

The plan ended up selling its stock at a time when outsiders rated the stock a “buy” due to forecasts of improving company prospects, and the stock did, in fact, rebound. However, the appellate court decided that even though the decision-making process wasn’t prudent, there might not be any damages – it all depended on whether the prudent shadow would have sold the stock in the fund at that time.

What Did the Lower Court Decide?

The district court had ruled in favor of RJR, even though it concluded that an imprudent process had been followed, on the ground that the breach of using an imprudent process didn’t cause plan losses if the prudent shadow COULD have divested the stock at the same time that the imprudent fiduciaries decided to do so.

Note the difference between the “could have” standard and the “would have” standard applied by the Court of Appeals. The smallest probability may satisfy the “could have” standard, whereas the “would have” standard seems to require that it be more likely than not that the prudent shadow would have divested at the same time.

Where Do We Go From Here?

The case was remanded to the district court to determine whether there were losses under the “would have” sold standard. Presumably, the district court will find liability if it determines, for example, that the prudent shadow would have sold the stock later. However, the implications of this rule seem to be that if a bumbling fiduciary somehow stumbled on an appropriate sale date, or blundered into a good investment, there may be no way in the Fourth Circuit for participants to hold the fiduciary accountable for failing to act prudently. In this case, the court might instead, for example, have determined that damages would be based on the most favorable sale date or an average of the most favorable sale dates over a defined period.

What Fiduciaries Should Do?

The lesson for fiduciaries is clear. Fiduciaries can be sued for not selling stock as well as for selling at what plaintiffs allege is the wrong time. And now that the Supreme Court has eliminated the so-called “Moensch presumption” that decisions involving employer stock are presumptively prudent, fiduciaries of plans with employer stock funds need to be particularly diligent.

However, courts do not apply 20-20 hindsight in reviewing whether investment decisions were prudent. Had the correct RJR fiduciaries followed a prudent process, the issue of damages might never have been reached. Written documentation of a prudent process by the correct plan decision makers is essential, and that prudent process often involves consulting the right expert advisers.