David A. Kotler
New York +1 212 698 3669
The Employee Retirement Income Security Act of 1974 (ERISA) requires that fiduciaries in charge of retirement plans “discharge [their] duties with respect to a plan solely in the interest of the participants and beneficiaries . . . with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use.” 29 U.S.C. § 1104(a)(1)(B).
These fiduciary duties are magnified and called into question when the country is plunged into an economic crisis and retirement plans suffer significant losses. Most notably, we saw an increase in the number of ERISA class action lawsuits in the wake of the Great Recession of 2008, with allegations that fiduciaries breached their duties to monitor and assess the risk of investment plans and caused participants to lose their retirement investments.
This OnPoint analyzes the ERISA litigation trends that emerged after the Great Recession, the lessons learned, and what we may expect in the wake of the economic impacts resulting from the novel coronavirus pandemic, COVID-19.
Another Great Recession?
For the second time in 12 years, the U.S. economy and stock markets are facing an unexpected crisis. In December 2019, we first learned of the novel coronavirus, also referred to as COVID-19. Originating out of Wuhan, China, this novel virus set off the largest disruption of nationwide and global markets and economies in recent memory. In the United States, the stock market suffered the largest downturn since the 2008 financial crisis, and subsequently was characterized by periods of extreme volatility. These market swings, coupled with drastic changes in societal behavior caused by stay-at-home orders, has led to a significant economic ripple effect, with an unprecedented number of companies reorganizing and laying off their workforces and filing for bankruptcy.
These losses have created an environment that is primed for plaintiffs to level hindsight accusations that ERISA plan fiduciaries breached their duties of offering prudent investment options. We therefore take a look back at the ERISA litigation arising out of the Great Recession and highlight some of the key lessons learned.
What Have We Learned?
While plan participants are likely to ignore debatable plan management practices when the stock market is climbing, they will be more apt to notice these issues when the market collapses and the value of their 401(k) investments drop. Furthermore, in light of an economic downturn, the costs of current benefit plans may become too expensive to maintain and corporate mergers and acquisitions may be abandoned. As a result, companies face significant exposure related to ERISA litigation and should take notice of the lessons learned from the cases that emerged after the Great Recession.
Operational Concerns of Existing Plans
Stock Drop Cases
Shortly after the Great Recession, there was a significant increase in the number of lawsuits that resulted from the severe drop in stock prices. These have become known as “stock drop” cases, and they made up the majority of ERISA cases that were filed after the 2008 recession. Participants in retirement plans funded with employer securities sued plan fiduciaries, alleging that they breached their fiduciary duties when the company stock price declined. Specifically, they argued that the fiduciary should have sold the plan’s investments in company stock when it learned negative information reflecting on the stock’s value, discontinued future investments in company stock, or disclosed the information to ensure the stock was properly valued.
As the stock market during the COVID-19 pandemic suffered a substantial downturn, similar to the market during the Great Recession, and continues to remain volatile, plan fiduciaries must prepare for a potential increase in the number of stock drop cases. This is especially true in industries that were most impacted by stay-at-home orders, such as the hospitality, retail, and airline industries. However, the stock market’s performance will be determinative of the future trend of stock-drop cases. That is, a strong market performance will decrease the likelihood of valid stock-drop claims. In addition, as we noted in our prior On-Point (available here), the pleading standard for stock drop cases is now steeper for plaintiffs to meet following the Supreme Court’s 2014 decision in Fifth Third Bancorp v. Dudenhoeffer.1
Failure to Diversify Investments or Improper Choice of Diversity
Many benefit plans offer a form of investment options that cater to participants’ specific risk tolerances. Stable Value Funds (“SVF”) or Target Date Funds (“TDF”) are two common choices based on the participants’ age and risk tolerance. For example, an SVF is a portfolio of bonds that is insured to protect the investor against a decline in yield or loss of capital. The owner of a SVF will continue to receive agreed-upon interest payments regardless of the state of the economy. However, plaintiffs may allege that these funds were not sufficiently diversified and, therefore, underperformed compared to other available funds.
Likewise, TDFs are mutual funds that are structured to grow assets in a way that is optimized for a specific time frame, e.g., the investor’s capital needs at a future date, such as retirement.2 After the 2008 financial crisis, TDFs lost a significant amount of value due to the market crash and were the subject of numerous lawsuits. Plaintiffs alleged that other options, like money-market options, were a more prudent choice. Even so, where there was a variety of investment options, plan participants still alleged that fiduciaries offset one risk by creating too much risk somewhere else.
Companies, plan fiduciaries, third-party administrators and recordkeepers may be subject to an increase in the number of cases filed for “excessive fees” paid for either actively managed investment funds in lieu of index funds or for recordkeeping and other administrative services. Generally, the plaintiffs attack the fee structures between plan service providers (e.g., recordkeepers and investment advisers) as providing hidden kickbacks. Additionally, actively managed funds may give rise to claims based upon alleged self-dealing or that the fiduciary lacked prudence for failing to see that the active management was generating excessive fees.
With the understanding that ERISA cases may be on the rise in the current economic environment, the key to minimizing litigation exposure is to proactively eliminate any operational risk points in existing benefit plans. For example, companies may consider conducting a review of the current benefit plan and investment funds and its related management and fees, with an eye towards implementing any additional necessary documentation processes and protocols related to the management of the benefit plan and funds. Additionally, a thorough explanation of the reasoning for making a particular investment decision, supported by a prudent process, may help to minimize legal exposure for an alleged breach of fiduciary duties.
These steps may not completely protect against liability for pre-existing problems, but it should help to limit the risks and extent of exposure going forward.
Abandoned Corporate Transactions and Forgotten Retirement Plans
Companies may face additional ERISA exposure within corporate transactions that were started before the economic downturn but will conclude in the near future or will be abandoned entirely. This exposure may be created when plans were supposed to have been merged as part of a corporate merger or acquisition, but the process was not completed and/or the deal collapsed due to the economic downturn. Additional exposure may be created when the retirement plans are effectively ignored and the corporate transaction failed to close.
Here, the short-term costs of ensuring that retirement plans are considered and successfully merged when a corporate acquisition concludes or collapses substantially outweigh the long term expenses that would arise as part of litigation.
Anticipating the Next Wave of ERISA Litigation
As we saw after the Great Recession, ERISA class action litigation seeking the recovery of lost investment value tends to increase during times of market crashes and volatility. As a result of the COVID-19 pandemic, we have seen comparable declines and volatility in the stock market, creating a set of facts that may result in allegations of imprudence and breach of fiduciary duties. While there ultimately may be strong defenses available, plan fiduciaries should consider the lessons learned from the Great Recession in an effort to minimize their litigation risk and exposure.3
1) 573 US 409 (2014).
2) See our discussion of the DOL’s June 4, 2020 Information Letter in relation to the use of Target Date Funds, available here.
3) For additional guidance on minimizing legal exposure, please watch our webinar discussion, available here.