Plan Fiduciary: Fiduciaries Need Not Violate Insider Trading Rules to Avoid a Breach

Introduction

Litigation against Enron and other companies alleging that plan fiduciaries violated the Employee Retirement Income Security Act of 1974 (ERISA) when the value of company stock plummeted after disclosures of accounting irregularities are disclosed has served to highlight the tension between ERISA and federal securities laws prohibiting insider trading. [See, e.g., Tittle v Enron Corp., Civil Action. No. H-01-3913 (S.D. Tex.)] Although Enron has been the object of public attention, a number of other lawsuits have been filed against corporations whose stock was allegedly overvalued because of accounting irregularities. In re McKesson HBOC Inc. (ERISA Litigation, N.D. Calif., No. COO-20030RMW) is one such lawsuit.

On September 30, 2002, the district court in McKesson issued rulings on five motions to dismiss. [See In re McKesson HBOC Inc. ERISA Litig., 2002 WL 31431588 (N.D. Cal. Sept. 30, 2002)].

As a general rule, the standards used to decide a motion to dismiss are designed to err in favor of plaintiffs, which is why, when in doubt or annoyed at the "bare bones" complaint plaintiffs filed, the McKesson court dismissed the claim but gave plaintiffs leave to file an amended complaint. The court repeatedly complained that plaintiffs' complaint was insufficient even under Rule 8 of the Federal Rules of Civil Procedure, which provides that a complaint include a "short and plain statement of the claim showing that the pleader is entitled to relief." The court stated that "plaintiffs have taken the 'short and plain statement' language too literally for the complaint contains little factual detail and is replete with overly general allegations." [Id. at 3 (quoting Fed. R. Civ. E 8)].

The opinion is striking for this reason because it is unusual for a court to complain that a complaint insufficiently pleads facts. It appears that either the complaint was scantier on facts than the average complaint filed in federal court, this judge likes to see more facts than the average judge, or the complaint was very poorly written and the judge was totally annoyed.

It is too early to review the court's ruling in depth because motions to dismiss are brought before any discovery is done and are not typically decisions on the merits of the issue. Notwithstanding the procedural posture of the case, the court's railings on the claim alleging a violation of ERISA's diversification provision and the claim alleging imprudence for failure to divest the plan of the company stock are worth discussing even at this early point. This column therefore discusses both holdings and comments on the extent to which these holdings may have implications for other lawsuits raising similar Enron-type claims.

The McKesson Facts

In 1999, the McKesson Corporation merged with HBO Corporation (HBOC). The merged company was named McKesson HBOC, Inc. (McKesson), and HBOC became a McKesson subsidiary, known as McKesson Information Solutions, Inc. (HBOC). Prior to the merger both companies had separate pension plans. The McKesson Profit Sharing Investment Plan was a 401(k) plan with an employee stock ownership plan (ESOP) feature. Under the terms of the McKesson plan, all company contributions, at the company's election, were to be made either in employer stock or cash. The plan required that any cash contributions be converted to employer stock as soon as practicable. HBOC also sponsored a 401(k) plan to which it made various contributions on behalf of the employees. The HBOC plan was a participant-directed plan with seven investment alternatives, one of which was an HBOC company stock fund. Following the company mergers, the plans were merged and all plan participants received 37 shares of McKesson HBOC stock for each HBOC share held in their accounts. According to the court's opinion, after the merger the majority of the plan's assets consisted of company stock. [Id. at 2].

After the merger, in what has now become an all too familiar confession, McKesson disclosed that HBOC had engaged in "improper and illegal accounting practices, had materially misrepresented the financial condition of the company and that [the company's] financial results would be restated downward." [Id.] As a result of the company's restated value, the plan allegedly experienced losses of $800 million.

The Allegations of the McKesson Plaintiffs

The Diversification Claim

ERISA Section 40(a)(1)(C) requires that a fiduciary diversify plan investments so as to minimize the risk of large losses, unless it is clearly prudent not to do so. ESOPs are exempt from ERISA's diversification requirements. [ERISA § 404(a)(2)] ERISA also requires that fiduciaries operate plans in accordance with the governing plan documents, unless the plan provisions are inconsistent with ERISA's fiduciary obligations. [ERISA § 404(a)(1)(D)]

Plaintiffs apparently claimed that the plan fiduciaries violated ERISA by making employer contributions in company stock and thereby overweighting the plan with company stock. This, plaintiffs appear to have alleged, violated ERISA's diversification provisions. In rebuttal, defendants argued that the plan did not give them investment discretion. Under the terms of the plan document, defendants claimed they were obligated to invest in employer stock or cash, but, if cash was used, the plan required that the cash be converted to company stock as soon as practicable. The term practicable was not defined. Defendants reasoned, however, that, since McKesson was a publicly traded company, as soon as practicable meant immediately.

The court dismissed plaintiffs' claim because they failed to allege sufficient facts to support their claim, but gave them leave to file an amended complaint correcting the insufficiency. The court reasoned that, since the McKesson plan allowed the company to make the employer match either in company stock or in cash, the plan appeared to give the company investment discretion, and accordingly, "with that discretion comes potential fiduciary liability." (See McKesson, 2002 WL 31431588, at 4] For this reason, the court was unwilling to dismiss the claim with prejudice. In dismissing the claim, however, the court provided plaintiffs with a detailed view on what they needed to allege to state a claim.

The court made it plain that plaintiffs had to show, in the first instance, that, the plan language notwithstanding, the company had investment discretion. The court also stated that plaintiffs would need to state facts in the complaint demonstrating that circumstances leading up to the merger "were such that it was an abuse of discretion" for the plan fiduciaries to follow the terms of the Plan document." [Id. at 5]

Relying on Kuper v. Iovenko [66 F 3d 1447 (6th Cir. 1995)] and Moench v. Robertson [62 F 3d 553 (3d Cir. 1995)], two cases decided in the ESOP context where the plan documents provided that investments were to be made primarily, if not entirely, in employer stock, the court ruled that when a fiduciary operates the plan according to the terms of the plan, there is a presumption that a fiduciary has acted reasonably. [See McKesson, 2002 WL 31431588, at 4] The court further stated that "the presumption may be rebutted by showing that a prudent fiduciary acting under similar circumstances would have made a different investment decision." [Id.]

Accordingly, given the standards by which to decide a motion to dismiss, the court dismissed the diversification claim without prejudice pending plaintiffs' ability to meet the court's requirements in the amended complaint.

The Imprudence Claim

The court dismissed with prejudice plaintiffs' claim that defendants violated ERISA because they failed to divest the plan of employer stock after they discovered the financial irregularities at HBOC. In their motion to dismiss, defendants argued that plaintiffs failed to allege a cognizable claim because plaintiffs would not be able to show, under any theory, that defendants' failure, even if it was a violation of ERISA, caused the plan any harm. The court agreed.

The court noted that defendants could not have sold the employer stock and not disclosed the accounting irregularities without violating federal securities law. Federal securities law prohibits a person from trading securities based on nonpublic insider information. [See Securities Act of 1933 § 17, 15 U.S.C. §77(q); Securities Exchange Act of 1934 §10(b), 15 U.S.C. §78j(b); SEC Rule 10b-5, 17 C.F R. § 240.10b-5] If defendants had disclosed the accounting irregularities before divesting the plan of the employer stock, the court concluded the plan would likely have experienced the alleged losses before any sale could have occurred at the inflated price. [See McKesson, 2002 WL 31431588, at 5] As the court explained, "under the efficient capital markets hypothesis" the disclosure of such information would have caused the market price of the company to "swiftly" adjust, in this case drop precipitously. [Id.] Thus, the court decided that the plan could not have sold the stock at the "artificially high price," and there was no way for the fiduciaries to lawfully sell the stock, noting that "[n]ot even a fiduciary ... is permitted to engage in insider trading." [Id.]

Plaintiffs argued that defendants had options that did not involve violating federal securities law. Plaintiffs argued that defendants could have (1) bought the company stock back from the plan in a private sale, (2) retained an independent fiduciary to determine whether prudence dictated a deviation from the plan terms, or (3) bought insurance. The court said all three proposed options were impractical.

With respect to buying back the company stock, the court ruled that plaintiffs "cite no authority for the proposition that ERISA would require McKesson...to harm its public shareholders by knowingly acquiring an asset at greater than its fair value simply because that transaction would benefit Plan participants." [Id. at 6] The court also noted that an independent fiduciary or any other consultant would have been bound by the same Securities and Exchange Commission (SEC) rules that McKesson was bound to follow and therefore retaining an independent fiduciary would not have prevented the losses to the plan. Finally, with respect to purchasing insurance, the court noted that McKesson would have had to disclose the accounting irregularities and accordingly the impending losses to the plan, and under these circumstances, it would have been highly unlikely that it could have obtained coverage.

Commentary

The McKesson court provides a definite view on how it might rule on the diversification claim. Specifically, the court said that plaintiffs had to supply evidence that defendants had investment discretion under the plan. Drawing from Kuper and Moench and assuming their application, the court stated that it would likely presume that defendants were bound to follow the plan documents, and accordingly, that they did not breach any ERISA duty. [Id. at 5] The court further stated, to rebut that presumption, plaintiffs would have to show that defendants "abused their discretion" by following the plan document and "that a prudent investor under the circumstances would not have hollowed the Plan." [Id. at 5] The court placed a fairly high burden on plaintiffs. Whether other courts under similar circumstances will follow with a similarly high burden remains to be seen.

The diversification claim is certainly one that runs through the Enron-type litigation. The McKesson ruling is directly tied to the degree of discretion the plan bestowed on the fiduciaries in making investment choices. How the McKesson court and other courts ultimately rule on this issue may also depend on how narrowly or broadly the court interprets ERISA Section 404(a)(1)(D), which provides that a fiduciary shall administer a plan according to the terms of the plan document insofar as the documents are consistent with, among other things, ERISA's fiduciary obligations. Thus, if the plan did not allow discretion, but the court finds that it was imprudent to continue to invest in company stock after the accounting irregularities were known, the court will need to apply the proviso in ERISA allowing a fiduciary to override the plan's design. A broad interpretation of the proviso could end up swallowing the rule that plan design matters are not subject to fiduciary rules. How the court applies that proviso may determine plaintiffs' claim.

In deciding to dismiss with prejudice plaintiffs' claim that defendants had a duty to divest the plan of employer stock after defendants discovered the accounting improprieties, the court sidestepped the prudence issue completely. Instead, the decision was based on whether continuing to hold the company stock caused the plan harm. The resolution of this claim highlighted the friction between insider trading rules and ERISA's fiduciary obligations.

Defendants' argued that before they could sell the stock on the open market, the insider trading rules would have obligated them to disclose the accounting irregularities. Any disclosure would have had the effect of immediately reducing the value of the stock. Thus, defendants argued, holding onto the stock did not cause the plan any harm. This was a clean, logical, and difficult-to-rebut argument. Refusing to elevate ERISA fiduciary obligations above corporate fiduciary duties to shareholders, the court rejected plaintiffs' argument that the company could have purchased the stock in a private sale because purchasing the stock at the artificially high price would have put the brunt of the losses on the remaining shareholders.

Conclusion

The McKesson decision is an early decision in the string of litigation currently pending in courts around the country and an introduction to the complex issues these Enron-type cases raise under ERISA. These issues will continue to evolve in the courts and opinion will likely not all be consistent. It will be interesting to follow their development not just in McKesson, but also in other courts deciding similar claims. This column will continue to report on this and other cases as they make their way through the courts. To those interested, stay tuned.