On August 1, 2007, the Court of Appeals for the Fourth Circuit upheld a defense judgment in a 401(k) employer stock case following a bench trial on breach of fiduciary claims. The appellate court’s analysis of the Eastern District of Virginia’s 58-page opinion presents a roadmap for how plan sponsors and fiduciaries should deal with employer stock in defined contribution plans.
US Airways, Inc. 401(k) Savings Plan
Like many 401(k) plans sponsored by employers across the country, particularly in the late 1990s and early 2000s, the menu of investment options for participants in the US Airways defined contribution plan encompassed 12 diversified investment funds and a Company Stock Fund. The Company Stock Fund held only stock in US Airways’ parent company and enough cash to satisfy transfers and payments, usually about 10 percent of fund assets. Participants were barred from investing employer matching contributions in the Company Stock Fund, and after withdrawing assets from the Company Stock Fund, participants had to wait 30 days to reinvest in the fund. Moreover, plan literature, including the summary plan description, cautioned participants about the volatility and risk of investing in a single-security option.
US Airways, the named plan administrator, delegated authority to make decisions about plan investment options to the Pension Investment Committee (“PIC”), whose members included US Airways’ chief financial officer. The PIC met regularly to review investment options and to consult with financial advisers and investment professionals and reported to the board of directors.
The Company Stock Fund was authorized, but not mandated, by the governing plan documents. Indeed, the plan documents specified that if the plan’s investment options included a fund for company stock, then US Airways (or its delegate, the PIC) had the obligation to monitor the continued suitability of company stock.
Difficult Times at US Airways and the PIC’s Response
US Airways’ financial condition began a serious decline in the wake of the September 11 attacks. Its stock price had already declined from $11.62 to $4.48 from September 10 to October 1, the first day of the class period certified by the district court (October 1, 2001 to June 27, 2002). The value of the Company Stock Fund declined concomitantly. The share price increased to $6.34 by the end of 2001, and stayed at approximately the same level into April 2002.
US Airways took various steps to attempt to gain control over spiraling costs and diminishing liquidity, such as cutting its workforce, expanding its use of regional jets and turbo-prop aircraft and borrowing against its fleet. By April 2002, US Airways recognized that these efforts were inadequate and thus turned to a federal government agency, the Air Transportation Stabilization Board (“ATSB”), for assistance. Its stock price remained largely unchanged despite these endeavors.
During this time, the mixed feelings of concern and cautious optimism inspired by US Airways’ financial problems and efforts to forge solutions caused the PIC to explore whether to retain the Company Stock Fund as a plan investment option. Between September 2001 and April 2002, the PIC consulted with in-house and outside counsel, and all (the PIC as well as its inside and outside lawyers) agreed that divesting the plan of the Company Stock Fund was not necessary at the time. The human resources committee of the board of directors and the full board evaluated and assented to the PIC’s decision not to terminate the Company Stock Fund.
May 2002 brought a turn in the tide. On May 5, US Airways raised the specter of bankruptcy in a public filing with the Securities and Exchange Commission. Although the airline stated in this Form 10-Q that it believed it could recover with financial assistance from the ATSB, it noted that “alternative restructuring scenarios in the context of a judicial reorganization also must be considered.” At approximately the same time, the PIC recommended that US Airways’ board appoint an independent fiduciary to exercise the company’s authority with regard to the Company Stock Fund. The board accepted the PIC’s recommendation. By June 27, the last day of the class period, Fiduciary Counselors Inc. was in place as the fiduciary for the Company Stock Fund. US Airways stock had declined to $3.72 per share.
Fiduciary Counselors took prompt action as independent fiduciary. First, it sold enough US Airways stock to increase the cash percentage of the Company Stock Fund from 10 percent to 20 percent. Next, on July 3, Fiduciary Counselors ceased additional purchases of US Airways stock for the Company Stock Fund, but allowed participants to continue moving in and out of the Company Stock Fund.
Within the next few days, US Airways learned that the ATSB had granted its request for financial assistance, provided US Airways could secure significant concessions from its creditors and employees. Because the airline could not obtain the concessions despite its concerted efforts to do so, on August 11, 2002, it filed for Chapter 11 bankruptcy protection. The next day, Fiduciary Counselors closed the Company Stock Fund. Fiduciary Counselors then transferred the cash component of the Company Stock Fund to a money market fund, and allowed participants to direct the assets in their accounts to any other investment option. On December 30, Fiduciary Counselors advised plan participants that existing US Airways stock would be cancelled and participants whose assets were still invested in the Company Stock Fund would not receive any distribution for those investments.
District Court Proceedings and Judgment for US Airways
A plan participant, Vincent DiFelice, subsequently sued US Airways, directed trustee Fidelity Trust Management Company and Fiduciary Counselors in the United States District Court for the Eastern District of Virginia. Although dismissing the claims against Fidelity and Fiduciary Counselors and granting summary judgment in favor of US Airways on a fiduciary misrepresentation/disclosure duty claim, the district court declined to dismiss the plaintiff’s imprudent investment and duty of loyalty claims and certified the case as a class action. The court then held a six-day bench trial, hearing live or videotaped deposition testimony from 18 witnesses, including five experts for the plaintiff and two experts for US Airways, and receiving over 200 documents into evidence.
On June 26, 2006, Judge T.S. Ellis III of the Eastern District of Virginia issued lengthy findings of fact and conclusions of law. DiFelice v. US Airways, Inc., 436 F. Supp. 2d 756 (E.D. Va. 2006). The court defined the “essential question for decision” as “whether U.S. Airways violated its duty as the Plan fiduciary when, during the class period, it retained the Company Stock Fund as an investment option for Plan participants despite the Company’s precarious financial position.” Id. at 781-82. The court concluded that “[n]either the factual record nor ERISA support[ed] the plaintiffs’ contention” that a prudent fiduciary would have removed the Company Stock Fund as an imprudent investment because of the likelihood of US Airways’ seeking bankruptcy protection. Id.
Applying what it described as “modern portfolio theory,” the district court refocused its inquiry on whether:
U.S. Airways provided Plan participants with the investment options and the information necessary to allow the participants to construct a diversified portfolio. If these requirements are met, and the record clearly so reflects, U.S. Airways has satisfied its fiduciary duty to act prudently under ERISA when selecting and monitoring the Plan’s investment options. In this regard, it is not disputed that at all times during the class period, U.S. Airways continued to offer Plan participants thirteen different investment options that spanned the range of risk and return characteristics. At one end of this range was the relatively low risk and low expected return money market fund. At the opposite end of this range was the relatively high risk, high expected return Company Stock Fund. In between these two poles were investment options that offered Plan participants investment choices with intermediate risk/return characteristics.
Id. at 786. The court also noted that plan literature informed participants of the risks of investing in the Company Stock Fund. Therefore, the district court concluded,
because the investment options offered by the Plan allowed participants to construct a prudent, diversified portfolio, and because participants had the information necessary to construct a prudent portfolio of investments, the inclusion of a high risk investment option during the class period, in this case the Company Stock Fund, was not a breach of U.S. Airways’ fiduciary duty.
Id. at 787.
Bolstering the district court’s conclusion was “ERISA’s recognition of the unique status of company stock in an employee pension plan.” Id. After surveying the statutory provisions favoring employee investments in employer stock – particularly the exemption in ERISA § 404(a)(2), 29 U.S.C. § 1104(a)(2), of eligible individual account plans (such as 401(k) plans) from the duty of diversification and the duty of prudence to the extent it requires diversification – the district court held, “ERISA is especially solicitous of decisions to hold employer securities, or indeed, to permit participants to choose to invest in employer securities.” Id. Accordingly, the court reasoned:
if, as in this case, a 401(k) plan offers participants a broad array of investment choices, one of which is a relatively risky option to invest in employer securities, the fiduciary should not be deemed to have violated any fiduciary duty for offering this option provided the investment in company stock remains viable, and the company has fully disclosed to participants the risks attendant in that investment.
Id. at 787-88. Applying these principles, the district court concluded:
In the instant case, there is no question the Company Stock Fund was a viable investment option throughout the class period. While U.S. Airways faced significant and well-publicized risks, the opportunity for significant gain in the event the Company were to succeed in its voluntary restructuring efforts made the Company Stock Fund a legitimate option for Plan participants who included it as part of a well-diversified portfolio. The uncontested testimony of the members of the PIC was that the Company Stock Fund was regarded as such throughout the class period, and that the PIC members continued to believe that the Company’s efforts to restructure outside of bankruptcy proceedings would prove successful. And, the [Air Transportation Stabilization Board’s] contingent approval of the Company’s loan application confirms that U.S. Airways would have been a viable ongoing entity had it been able to obtain the remaining necessary labor concessions. Furthermore, as soon as U.S. Airways publicly announced the possibility of a bankruptcy filing it took appropriate action by hiring an independent fiduciary to make decisions regarding the Company Stock Fund. In sum, the fact that U.S. Airways was not able to avoid a bankruptcy filing, thereby greatly diminishing the value of units of the Company Stock Fund is not evidence of U.S. Airways’ breach of its fiduciary duties, but simply evidence of why investors are compensated for risk.
Id. at 788.
The district court also rejected the plaintiffs’ contentions that US Airways had not monitored adequately the performance of company stock and had not given sufficiently serious consideration to the elimination of the Company Stock Fund from the plan. The court gave three reasons for rejecting the plaintiffs’ claims: (1) the PIC and US Airways’ board of directors had on three occasions “formally considered” whether to retain the Company Stock Fund as an investment option; (2) the PIC included high-level US Airways management personnel, who were well aware of the performance of the airline’s stock and the risks and potential returns of investments in the Company Stock Fund; and (3) the PIC retained outside counsel to advise it regarding retention of the Company Stock Fund, an action the court described as “evidence of thorough consideration.” Id. “In sum,” the district court concluded, “the PIC gave reasonable and appropriate consideration to whether or not to retain the Company Stock Fund as an investment option throughout the class period, and therefore U.S. Airways did not breach its fiduciary duties under ERISA in this respect.” Id.
Finally, the district court rejected the plaintiffs’ claim that US Airways breached the fiduciary of loyalty by not eliminating the Company Stock Fund, allegedly “for fear of impacting the price of Group stock or sending negative signals to potential creditors.” Id. at 789. The court’s primary reason for rejecting this claim was its earlier conclusion that the PIC did not have a duty to remove the Company Stock Fund from the plan. Additionally,
as soon as the Company publicly announced the possibility of a judicial restructuring, it took the unprecedented step of appointing an independent fiduciary to exercise the Company’s fiduciary responsibilities with respect to the Company Stock Fund. And, the fact that the independent fiduciary considered whether to close the Company Stock Fund to participant investments, and elected not to do so until the actual bankruptcy filing, belies the contention that the PIC’s retention of the Company Stock Fund was somehow attributable to the PIC’s divided loyalties US Airways.
The Fourth Circuit’s Decision
The plaintiff appealed the district court’s judgment to the Fourth Circuit. Early in its August 1, 2007, opinion affirming the judgment for US Airways, the appellate court summarized the inquiry as follows:
A fiduciary like U.S. Airways – that is, a fiduciary of a defined contribution, participant-driven, 401(k) plan created to provide retirement income for employees who is given discretion to select and maintain specific investment options for participants – must exercise prudence in selecting and retaining available investment options. In determining whether U.S. Airways has done so here we examine the totality of the circumstances, including, but not limited to: the plan structure and aims, the disclosures made to participants regarding the general and specific risks associated with investment in company stock, and the nature and extent of challenges facing the company that would have an effect on stock price and viability.
DiFelice v. U.S. Airways, Inc., ___ F.3d ___, 2007 WL 2192896, at *6 (4th Cir. 2007). The court further opined that all of the grounds the plaintiff advanced for challenging the district court’s judgment were “meritless, and many, given the thoroughness of the district court opinion, require no discussion.” Id.
The Fourth Circuit divided its analysis into three sections: first, the plaintiff’s general criticism of the district court’s findings and conclusions with regard to the duty of prudence and duty of loyalty claims; second, the plaintiff’s more targeted challenges to the district court’s summary of findings and application of “modern portfolio theory”; and third, elucidating (albeit in fairly generalized terms) the critical parameters of the duty of prudence in the context of employer stock in a 401(k) plan. The second-to-last sentence of the opinion summarizes the Fourth Circuit’s overall view of the plaintiff’s contentions: “Accordingly, the Employees cannot succeed in this lawsuit simply by demonstrating that U.S. Airways offered the Company Fund during a time of grave uncertainty for the company, no matter how significant the Employees’ ultimate financial losses.” Id. at *12.
Affirmation of the District Court’s Findings Regarding Prudence and Loyalty
Addressing the plaintiff’s general criticism of the district court’s findings (that US Airways had not breached a duty of prudence or loyalty), the Fourth Circuit explained that the inquiry must focus on the fiduciaries’ decision-making process, examining whether the fiduciaries used appropriate methods to investigate removal of the Company Stock Fund from the plan. Concluding that US Airways and the PIC had employed “a reasoned, ‘prudent,’ decisionmaking process, using ‘appropriate methods to investigate the merits’ of retaining the Company Fund as an investment option,” the Fourth Circuit highlighted several facts about the plan and the PIC’s and US Airways’ monitoring of plan investment options during the class period. Id. at *8. The court pointed out that the plan offered 12 diversified investment options in addition to the Company Stock Fund, allowed participants to transfer assets freely among the options, forbade investment of employer matching funds in the Company Stock Fund and notified participants in plan literature of “risks associated with a non-diversified retirement portfolio in general, and the Company Fund in particular . . . .” Id. at *7. With regard to the fiduciaries’ conduct, the court noted that the PIC considered continued retention of the Company Stock Fund on four occasions during the class period and obtained opinions from outside counsel on whether to eliminate the Company Stock Fund. Further,
when the company publicly announced that it was considering judicial reorganization as a contingency plan, U.S. Airways appointed an independent fiduciary to ensure that a non-company fiduciary would determine the future of the Company Fund in the Plan. Additionally, U.S. Airways’ PIC continued reasonably to believe, throughout the class period, that U.S. Airways had a “credible and viable voluntary restructuring plan with a reasonable chance of success,” and that it “would be able to avoid bankruptcy.”
Id. (quoting DiFelice, 436 F. Supp. 2d at 779). Declaring the district court’s findings “unassailable,” the Fourth Circuit upheld the conclusion that the fiduciaries acted prudently, adding:
We stress that U.S. Airways twice engaged independent advisors once – during the class period, and once marking its end. . . . Although plainly independent advice is not a “whitewash,” . . . it does provide “evidence of a thorough investigation” . . . . Similarly, although appointment of an independent fiduciary does not “whitewash” a prior fiduciary’s actions, timely appointment of an independent fiduciary, prompted by concerns about the continued prudence of holding company stock under an ERISA plan, does provide some evidence of “procedural” prudence and proper monitoring during the relevant period.
Id. at *8 (citations omitted).
The appellate court next turned to the district court’s findings with regard to the plaintiff’s duty of loyalty claim, noting that the presence of corporate officers on a fiduciary committee such as the PIC does not, in and of itself, create a conflict of interest, and that the plaintiff had failed to offer any other evidence of a conflict. In this regard, the court explained:
The district court found no evidence of other indicators of a breach of a duty of loyalty, e.g., that high-ranking company officials sold company stock while using the Company Fund to purchase more shares, or that the Company Fund was being used for the purpose of propping up the stock price in the market. Indeed, the court found that, throughout the class period, the PIC had a “well-founded” belief that the company would avoid bankruptcy. If the PIC had been correct, holding Group stock could have been a very profitable venture and one that would have been in the best interest of participants. Furthermore, if U.S. Airways had closed the Company Fund prematurely, and Group stock had rebounded further, the PIC would have succeeded only in locking in participant losses and precluding Plan participants from benefitting from the increase in stock price.
Id. For these reasons, the Fourth Circuit upheld the district court’s rejection of the duty of loyalty claim.
Specific Challenges to the District Court’s Reasoning
The Fourth Circuit then turned to two specific challenges to the district court’s reasoning. The appellate court concluded first that a summary sentence toward the end of the district court’s opinion, while incomplete in its description of the duty of prudence, did not present any basis for reversal.
Second, the Fourth Circuit opined that the district court may have placed too much reliance on modern portfolio theory “because a fiduciary cannot free himself from his duty to act as a prudent man simply by arguing that other funds, which individuals may or may not elect to combine with a company stock fund, could theoretically, in combination, create a prudent portfolio.” Id. at *10. The Fourth Circuit concluded, however, that the district court’s emphasis on the modern portfolio theory did not in any way affect the validity of its conclusions, remarking that “even considered individually the Company Fund was a viable and prudent option for investment over the class period.” Id.
Rejection of the Overall Thrust of the Plaintiff’s Case
The Fourth Circuit concluded its opinion by taking on what it called “the heart” of the plaintiff’s case: “the view that, given their losses and U.S. Airways’ undisputed knowledge of its uncertain financial condition over the class period, U.S. Airways must have violated ERISA’s ‘prudent man’ duty when it continued to offer the Company Fund as a Plan option.” Id. “Although we are not unsympathetic to the Employees’ losses,” the court went on, “such a contention is not tenable.” Id. The Fourth Circuit gave two reasons for rejecting the plaintiff’s view. First, the prudence of a fiduciary’s conduct cannot be evaluated in hindsight. “Put another way, an investment’s diminution in value is neither necessary, nor sufficient, to demonstrate a violation of a fiduciary’s ERISA duties.” Id.
Second, the Fourth Circuit emphasized Congress’ preference for employee investments in employer stock in 401(k) plans and the exemption from the duty of prudence (to the extent it requires diversification) of investments in employer stock. See 29 U.S.C. § 1104(a)(2). Although noting “that the risks of concentration [in employer stock] are especially great when the employer stock is volatile or the company’s prospects in peril,” the Fourth Circuit reasoned that “Congress considered the possible benefits to employees and employers from undiversified investments in employer stock and found them to out-weigh the risks inuring from such strategy.” Id. at *11.
As a concluding note, the appellate court suggested that Congress may wish to revisit its favorable treatment of employer stock in “participant-driven, non-ESOP, defined contribution plans”, but “this policy decision is one for Congress and not for the courts.” Id. at *12.
Applications to Similar Pending Cases
The Fourth Circuit’s affirmance of the judgment in favor of US Airways embraces many of the arguments put forth by defendants in seeking dismissal of similar 401(k) “stock-drop” cases: Congress’ preference for employee investments in employer stock in defined contribution plans; the exemption of employer stock funds from the duty of prudence to the extent it requires diversification; evaluation of the prudence of fiduciary conduct without regard to hindsight or results; and that a mere decline in the price of a plan investment – even a big drop – does not implicate a breach of fiduciary duty.
The Fourth Circuit’s affirmance also provides guidance to plan sponsors and fiduciaries of 401(k) plans containing employer stock: evaluate regularly whether to retain employer stock (and, indeed, all investment options) in the plan; inform plan participants of the risks of investing in an undiversified option such as an employer stock fund; retain and consult often with outside counsel knowledgeable about employer stock as an investment option; and, particularly when the employer finds itself facing difficult circumstances, consider employing an independent fiduciary to exercise fiduciary authority over the company stock in the plan – granting the fiduciary the authority to remove the stock if deemed the prudent course.