Washington, D.C. ~ November 7-9, 2007

2007 International 2007 International ConferenceConference

Professionals on the Professionals on the ERISA Fiduciary ERISA Fiduciary

Firing LineFiring Line

ERISA Firing LineERISA Firing LinePanel MembersPanel Members

• MODERATOR: Carrie Brodzinski, Product Manager

Beazley Group plc

• Matthew Alison, PartnerBaker & McKenzie LLP

• Joan Goldberg, Senior Vice President Wells Fargo Insurance Services

• John Schultz,  PartnerMorgan Lewis & Bockius LLP

• Christopher Williams, Managing Director Travelers Bond & Financial Products

Pension FundingPension Funding

• A Brief and Exciting History of Pensions

• Management Incentives for Offering Pensions Tax Incentives Wage Freezes

• Workplace Demographics

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Pension FundingPension Funding (cont’d)(cont’d)

• Perfect Storm of 2005 and Funding Shortfalls

• Moral Hazards and the Pension Benefit Guaranty Corporation

• Dependency Ratios 1962: General Motors had 464,000 U.S.

Employees and paid benefits to 40,000 retirees. 2005: General Motors had 141,000 employees

and paid benefits to 453,000 retirees.

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Pension FundingPension Funding (cont’d)(cont’d)

• Pension Protection Act of 2006 Goal is to ensure pensions are fully funded Imposes additional funding obligations Implications for plans that are “at risk” Increases premiums due Pension Benefit

Guaranty Corporation Confirmed legitimacy of Cash Balance

Plans established after 6/29/05 under certain conditions.

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Pension FundingPension Funding (cont’d)(cont’d)

• Long Term Implications Pension Freezes

• Survey data reflect that approximately 25% of employers with ongoing pension plans are contemplating closing or freezing their plans

• 1980: 40% of employees had pensions• Today: Less than 20% of employees have

pensions

401(k) Plans6

Pension FundingPension Funding(cont’d)(cont’d)

• Long Term Implications Future Shortfalls

• Credit Crunch• Globalization

Cash Balance Plans• Cooper v. IBM, 457 F.3d 636 (7th Cir. 2006)

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ERISA Fee LitigationERISA Fee Litigation

• DOL and SEC Investigations

• Class Action Suits

• GAO Report

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• Major shift from employer-funded pension plans to employee-funded 401k plans

• GAO Statistics fewer than 30,000 401k plans in 1985, estimated

417,000 in 2005 10 million active 401k participants in 1985,

47 million in 2005 401k assets increased from $270 billion to $2.5

trillion in Current 2006 dollars

ERISA Fee LitigationERISA Fee Litigation(cont’d)(cont’d)

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• GAO Statistics (cont.)

In 1985 defined benefit plans covered 29 million participants and 401k plans 33 million

In 2005 defined benefit plans covered 21 million participants and 401k plans 55 million

ERISA Fee LitigationERISA Fee Litigation(cont’d)(cont’d)

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• Employees are funding their own retirement and also paying the fees associated with 401k plans

• Premise of government investigations and law suits is that the fees are both undisclosed and excessive

• Impact of excessive fees Decrease in net return of 25 basis points equates to

between 5 and 6% of an account balance over two years, or

$50,000 loss based on average assumptions

ERISA Fee LitigationERISA Fee Litigation(cont’d)(cont’d)

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• Fees typically charged

Investment and record keeping

Communication fees

Fee sharing arrangements

ERISA Fee LitigationERISA Fee Litigation(cont’d)(cont’d)

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• Allegations

Violations of ERISA duty to act as prudent expert

Inadequate disclosure

Violation of ERISA 404(c)

ERISA Fee LitigationERISA Fee Litigation(cont’d)(cont’d)

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ERISA Fee LitigationERISA Fee Litigation(cont’d)(cont’d)

• Avoid litigation, err on the side of greater disclosure

• DOL proposed changes to Form 5500

• Recent cases

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What do all of these stock-What do all of these stock-drop suits have in common?drop suits have in common?

• Some business event that causes the company’s stock price to drop, such as:

Corporate fraud Restatement of corporate earnings Downturn in an industry sector Threatened or Actual Bankruptcy

• What do the Plaintiffs allege and what proof is required to prevail on the claims?

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Two basic claims in Stock Two basic claims in Stock Drop Cases:Drop Cases:

1. Prudence – The company stock fund became an imprudent investment alternative and plan fiduciaries breached their fiduciary duty by continuing to allow investments in the fund in the face of adverse business conditions.

2. Misrepresentation/Omission (Fraud according to Plaintiffs) – The plan fiduciaries knew or should have known about the circumstances adversely affecting the company, and they breached their fiduciary duty by affirmatively misleading or failing to warn participants of the risks.

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• Eligible individual account plans (EIAPs) = ESOPs, 401(k) savings plans- exempt from the diversification requirement under ERISA § 404(a)(2)

• Moench (3d Cir.), Kuper (6th Cir.), Wright (9th Cir.) –investments in company stock are “presumptively prudent”

• Some Courts do not think the presumption applies to EIAPs (vs. ESOPs) – Schering-Plough (3d Cir.)

Congress decided to treat company stock in eligible individual account

plans differently from other investments

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Even if the presumption does not Even if the presumption does not apply . . . plaintiffs must still apply . . . plaintiffs must still

prove imprudenceprove imprudence

• When is investment in a publicly traded security “imprudent”? When the company is no longer viable When bankruptcy is imminent

• Prudence has a procedural and substantive component

• “Prudence” must be determined in context of entire 401(k) portfolio-modern portfolio theory

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Fiduciary Misrepresentations Fiduciary Misrepresentations and Omissionsand Omissions

• Second broad category of fiduciary breach claims in stock-drop cases

• Broadly stated, fiduciaries have an affirmative duty to warn plan participants of material adverse information about their investments in the employer stock and/or to tell them the stock is a risky investment if the fiduciaries know it to be true

• Tension with the insider-trading prohibitions of the federal securities laws

• Causation issues -- reliance not presumed

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Why Does 404(c) Matter?Why Does 404(c) Matter?

• The 404(c) defense, if applied, relieves the plan fiduciaries – company, trustee, officers and directors – of liability if employees lose money in their 401(k) accounts because of their own poor investment decisions

• Especially helpful in employer stock misrepresentation cases

• Does the 404(c) defense apply to the selection and evaluation of funds in a defined contribution plan? Unresolved

• Must (of course) meet 404(c) requirements; question of fact

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Stock Drop Litigation Stock Drop Litigation UpdateUpdate

• Recent court of appeals authority is helpful to plan fiduciaries: Summers v. State Street Bank (CTA7 2006)

(plaintiffs must plead and prove that stock fund participants were subjected to “excessive risk”

Langbecker v. Electronic Data Systems (CTA5 2007) (opinion suggests that class certification may never be appropriate in a stock drop case because 404(c) contemplates individualized defenses)

Di Felice v. U.S. Airways (CTA4 2007) (affirms first trial victory for defendants)

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Stock Drop Litigation UpdateStock Drop Litigation Update(cont’d)(cont’d)

• No 404(a)(2) duty to diversify: ChoicePoint (N.D. Ga. 2007); Coca Cola (N.D.

Ga. 2006); Delta Airlines (N.D. Ga. 2006); Syncor (C.D. Cal. 2006)

• Plaintiffs can’t rebut the presumption of prudence: ChoicePoint; Tribune Co. (N.D. Ill. 2006) (short

term revenue drop did not have sufficient impact to overcome the presumption on favor of plan requirement to offer stock)

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Stock Drop Litigation UpdateStock Drop Litigation Update(cont’d)(cont’d)

Not fiduciary communications:• ChoicePoint (N.D. Ga. 2007); RCN (D.N.J. 2006)

(statements made in press conferences were not fiduciary communications); Reliant (S.D. Tex. 2006) (statements incorporated in Form S-8 sent to participants were not made in a fiduciary capacity)

Conflict with securities laws:• Avaya (D.N.J. 2006) (requiring fiduciaries to

divest company stock investment prior to any public disclosure would violate insider trading requirements)

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Stock Drop Litigation UpdateStock Drop Litigation Update(cont’d)(cont’d)

• Still, many district courts remain reluctant to dismiss stock drop complaints:

Agway (N.D.N.Y. 2006) (allegations of “artificial inflation” sufficient to state a claim)

Merck (D.N.J. 2006) (even if Merck stock is presumptively prudent, Merck’s potential Vioxx liability is sufficient to call the plan fiduciaries’ actions or inaction into question)

Goodyear (N.D. Ohio 2006) (rejected defendant’s argument that plaintiffs must plead & prove that Goodyear was on the brink of “impending collapse” to state a fiduciary breach claim)

General Motors (E.D. Mich. 2006) (allegations of “artificial inflation,” dire financial straits and serious mismanagement sufficient to state a claim)

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ANATOMY OF A RECENT TRIALANATOMY OF A RECENT TRIALDiFelice v. US Airways, No. 1:04cv889 (E.D. DiFelice v. US Airways, No. 1:04cv889 (E.D.

Va. June 26, 2006)Va. June 26, 2006)

• Plaintiff claimed that fiduciaries were “imprudent” in offering company stock fund as an investment opportunity between Aug. 1, 2001 and company’s bankruptcy on Aug. 12, 2002

• US Airways fiduciaries had discretionary authority to select or remove investment options

• Neither the trust nor the plan document mandated the offering of US Airways stock as an investment

• In addition to a US Airways stock fund, the plan provided 12 additional investment options

• Company 401(k) match was in cash, not US Airways stock

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Anatomy of a Recent TrialAnatomy of a Recent TrialPlaintiff’s “Allegations”Plaintiff’s “Allegations”

• A prudent fiduciary would have taken business developments (highest industry costs, 9/11, recent losses) into account

• These developments meant that is was “imprudent” to permit voluntary investment in US Airways by September 2001 at the latest. A prudent fiduciary would have implemented an “orderly sale” of all US Airways stock

• Damages should be paid measured by the difference between the pre-Sept. 11 stock price and the stock price at the point of the “orderly sale”

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Anatomy of a Recent TrialAnatomy of a Recent TrialThe Court’s HoldingsThe Court’s Holdings

• Though a riskier investment than others, ERISA favors inclusion of company stock in a diversified 401(k) plan

• Modern Portfolio Theory supports inclusion of company stock in a diverse portfolio

• US Airways had a business plan for improving its prospects, and it was prudent for the plan fiduciaries to take this business plan into account even though that business plan failed

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Anatomy of a Recent TrialAnatomy of a Recent Trial“Substantive” Prudence Evidence“Substantive” Prudence Evidence

• Full disclosure of US Airways’ financial condition at all times

• Plaintiff DiFelice testifies that he was fully informed of US Airways’ condition

• Plan diversified across various classes of investment options – during class period only 4-8% of 401(k) assets in US Airways stock fund

• US Airways stock held by numerous retirement plans of other companies

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Anatomy of a Recent TrialAnatomy of a Recent Trial“Procedural” Prudence Evidence“Procedural” Prudence Evidence

• Combination of written records of plan committee and testimony of business knowledge of plan fiduciaries, demonstrated that fiduciaries took all relevant factors into account

• Fiduciaries considered business prospects of US Airways, sought attorneys’ advice on continued offering of its stock, and engaged an independent fiduciary when it became unclear after mid-May 2002 whether US Airways could avoid bankruptcy

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Underwriters’ Checklist: Plan Underwriters’ Checklist: Plan Design and Risk AvoidanceDesign and Risk Avoidance

• Basic truth: If a company has a 401(k) plan that provides for investment in employer stock, it’s a bull’s-eye for an ERISA breach of fiduciary duty lawsuit, likely a class-action lawsuit.

• Each new wave of corporate issues triggers a response wave of shareholder and ERISA stock-drop suits (e.g., the current “option backdating” problems of, primarily, technology businesses). There’s no telling where the next problem will arise, or what type of company it will affect.

• So: What can an underwriter do to minimize potential for big claim?

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Underwriters’ Checklist: Plan Underwriters’ Checklist: Plan Design and Risk AvoidanceDesign and Risk Avoidance

• Employer stock eliminated as an investment option• How many investment options are there?• Stock limited as an investment option

Limited allocation to, e.g., 20% of payroll contributions (generally not a recordkeeping issue)

Must be combined with effective investment education (value of diversification, risk of single stock investment)

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• Review rights to diversify out of company stock, even for matching contributions PPA ’06 – In 2007, must permit immediate diversification

of employee contributions; matching and other employer contributions after three years of participation (other than traditional ESOP); can be less restrictive – many stock-drop settlements include free diversification

Match in cash vs. stock – if permitting immediate diversification, consider matching in cash (using 404(c) protection, since even if participants can freely diversify out, stock was not their choice)

Issues re implementing new diversification right for previously “locked up” stock: Need to be prepared for spike in stock sales (cash demands within plan; impact on share price) (in practice, rarely becomes a real problem)

Underwriters’ Checklist: Plan Underwriters’ Checklist: Plan Design and Risk AvoidanceDesign and Risk Avoidance

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Underwriters’ Checklist: Plan Underwriters’ Checklist: Plan Design and Risk AvoidanceDesign and Risk Avoidance

• Make sure plan is an “EIAP” (diversification N/A)

• Make sure that employer stock (in fact, all investment funds) are “baked” into the plan document (settlor choice) instead of being selected by the plan’s investment committee (fiduciary choice)

• ESOP may be even better option for companies:

May permit higher (i.e. “clearly imprudent”) Moench standard for prudence claim related to maintenance of employer stock fund

Requires relatively small changes in most public company plans that already offer employer stock as an option and permit free diversification (e.g., voting pass-through; right to receive distribution in kind)

May permit dividends on stock in plan to be deducted33

Underwriters’ Checklist: Plan Underwriters’ Checklist: Plan Design and Risk AvoidanceDesign and Risk Avoidance

• Review carefully plan’s fiduciary structure; know ways to limit or avoid “imprudent monitoring/failure to disclose” claims

Leave board members & “top-tier” officers (those most likely to be exposed to material non-public information) off the committee

“Bake” the committee membership into the plan (e.g., by title or position) to avoid or limit “appointment/monitoring” claims; at the least, limits the universe of appointing/monitoring fiduciaries

Retaining an outside fiduciary, especially when rough waters may be ahead

• Review content and effectiveness of education program

• Consider investment advice or investment management alternatives

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Underwriters’ Checklist: Plan Underwriters’ Checklist: Plan Design and Risk AvoidanceDesign and Risk Avoidance

• Review plan for 404(c) compliance

• Review plan fiduciary practices (investment policy, committee charters, minutes, how often committee meets, monitoring practices, use of outside advisors where appropriate) – make sure that company stock as an investment is evaluated periodically and appropriately by the committee (at the least, to meet the Moench standard)

• Make sure of compliance with blackout notice requirements and that blackout periods are as short as possible

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Q & A

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Many Thanks To …Many Thanks To …

• Carrie Brodzinski

• Matthew Allison

• Joan Goldberg

• John Schultz

• Christopher Williams