Pension litigation class action is likely to increase in 2007
Pensioners save little by little most of their working life, sharing in their mind the spirit of Leonard Cohen’s soulful lyrics about hoped for independence: ‘Like a bird on a wire… I have tried in my way to be free.’ Unfortunately many at Enron, Tyco and WorldCom have ended up as birds on a wire with little freedom and few retirement benefits. Cohen himself had his investment fund recently pillaged and wiped out by his own fund managers. Forensic accountants discovered that $8.4 million had evaporated in questionable transactions. He went to court to get it back and succeeded, only to have lawyer’s fees take what was left. Cohen, 70 years old and broke, now has to go back to work to feed himself, a fate he has accepted with his legendary resignation and fatalism. But unlike this famous poet and singer, most of those bilked out of pension benefits do not have an artist’s license to print money.
They do, however, have an increasingly powerful case against those who mismanage pension funds. This is of importance to corporate officers who manage financial reporting because the cases brought by aggrieved pensioners are based for the most part on the fact that somehow, in some way, pensioners were not properly informed about their company’s stock in their 401K plan. When Lynn Lincoln Sarko, managing partner at Keller Rohrback and co-lead counsel representing Enron pension plan participants along with Steve Berman, managing partner at Hagens Berman Sobol Shapiro, was asked if the current deluge of ‘stock drop’ cases by pensioners was ushering in a higher standard of corporate disclosure, he replied: ‘In a word, yes!’ A class of suit almost unheard of until the Enron fiasco and Sarko’s litigation, there have now been over 130 stock drop cases before the courts. Why is this of importance? Because Erisa is enforced under trust law and according to judgements under the law, the fiduciary duty of plan sponsors is ‘the highest known to the law.’ We are looking at a much higher bar on corporate reporting.
Rocky ground for employer stock pensions
The employee ESOP and 401K investor who owned stock through a pension plan has been welcomed and then largely taken for granted by management. A recent Fortune survey shows that 86 percent of all Fortune 100 company 401K plans hold company stock. Figures are difficult to verify, but estimates indicate that at least 2,000 companies feature company stock in their plans. Hewitt Associates’ 2005 biannual survey, which involved 458 plan sponsors with a total of 2.5 million participants and $264 billion in assets, noted that where the employer stock option was available, only 25 percent chose that option in 2005, down from 41 percent in 1991. Enron did not close the book on pension fraud and employee investor reporting requirements. It opened it.
Ken Lay’s famous words, ‘I love employee ownership. It is important to the company. But in the future we will be doing it differently,’ still attract attention. ‘His words remain sizzling in my mind,’ recollects fellow Texan Michael Keeling, president of the ESOP Association, with both anger and irony in his voice. In any case, Lay was at least right on this one. The birds are now getting revenge big time. On the legislative side, the big bird of prey out hunting irresponsible management is the Pension Protection Act of 2006 (PPA), referred to occasionally as the Enron Act. The PPA puts more fiduciary and reporting requirements on management’s shoulders including an annual report to plan participants, and sets stringent requirements on a variety of liquidation and diversification issues. Christopher Rillo, a partner at Groom Law Group, cites the Guidant case in which, due to a product recall, the stock price dropped only to soar when a takeover bid materialized, and the case was before the courts. Another case he uses to illustrate the ambiguities of this litigation is the Grace case, where pension fiduciaries were sued because they held onto Grace stock for too long while the price plummeted, and in another class action because they sold it prematurely at too low a price. In two cases decided in 2006, State Street Bank/United Airlines and US Airways, the judiciary decided that maintaining company stock in a plan was not necessarily imprudent.
Other cases, however, have been successful. In corporate frauds typified by Enron, WorldCom, Tyco and the dotcom era where issuers were in bankruptcy and the securities worthless, the courts have been generous in extending Erisa provisions.
The second variety of stock drop cases involves companies whose share price has diminished significantly and allegations of management incompetence or malfeasance are levelled. Most speaking for industry are angry or at least impatient with the frivolous nature of some of these claims. They are often filed simply to get management to settle without prejudice out of court.
Doing more harm than good
One of the most patient perspectives in this regard comes from Janis Gregory, senior vice president of the Erisa Industry Committee, who reflects, ‘I hope that in the long term we don’t look back and realize we did more damage than good.’ There is some statistical evidence indicating that both employers and employees are pulling away from 401K plans. Gregory comments that philosophical reasons for shared ownership rather than financial gain are, in her view, the inspiration for most employee stock ownership plans. Others feel differently. Sarko notes that defined benefit plans do not carry these kinds of risks for the employer or the employee. In his opinion, ‘Defined contribution plans were created to put the risk of providing benefits in the hands of employees. Defined benefit plans are insured to a large extent by the federal government.’
These cases have been divisive, expensive and time consuming. Beyond litigation and settlement costs, fiduciary insurance costs have risen and policies have become more restrictive. There are a number of key arguments which may or may not be a part of a stock drop action. Some are legalistic based on the regulations governing plan management and fiduciary duties, but almost all feature the point that corporate insiders did not act to fulfill their fiduciary responsibilities in terms of financial reporting. Rillo emphasizes the importance of a well thought-out defense strategy involving pension portfolio reassessments, consistency of reporting, procedural prudence, plan and fiduciary restructuring, and a host of other factors. But one of his main points of emphasis is on the need to rethink communications and reporting. Where stock drop litigation becomes of concern to investor relations officers and others providing corporate financial information, is that participant communications are one of the most frequent and controversial elements of litigation. The divide between what a fiduciary overseeing a pension plan must report to a plan participant and act upon, and what a company director is obligated to report to other investors, is an issue that is being defined in the courts.
Sarko emphasizes this point in his arguments against Ford. ‘Their bonds were junk – non-investment grade. Hedge funds trade in junk bond companies. But pension funds should not do so. They have a fiduciary duty to invest prudently.’ He summarizes his arguments to the judiciary: ‘If you go into a restaurant and order a meal from the menu and when it comes to the table it is not what you had in mind, that is your problem. But if they serve you food that is unfit for human consumption, that is their problem.’
The revised pension act
In August, the deeply divided ‘do nothing’ Congress found one issue it could tackle with united enthusiasm: pension reform. The thought of some of the most prosperous business leaders in the country walking away with obscene compensation packages, while their crooked incompetence left mom and pop destitute in their old age, focused their mutual talent for disgust. According to Mark Bogart, a lawyer at Vedder Price whose practice centers on ESOP litigation, fines for not fulfilling new PPA requirements could be expensive and unflinching. Others, including Valerie Kupferschmidt, internal benefits counsel at Hewitt Associates, are less pessimistic: ‘I would hope that they will not come down too hard on someone who is making a good faith effort to comply.’
The PPA provisions deal with a broad number of nuts and bolts issues: solvency, premiums, contributions and loopholes. All are complex but commonsensical and achievable. But what will be onerous and demanding are the stringent new reporting requirements that come into play next year. The new pension reporting requirements will ensure that all participants are kept well informed of the performance of any company in their 401K plan, including their employer. Employees are also to be given advice on the importance of diversification.
Section 901 of the PPA sets out the new diversification rules, and section 507 enforces the how and when of diversification notices. The basic rule states that a participant has the right to diversify any company stock they have paid for at anytime. As for the employer’s contribution, any participant that has worked for three years can diversify the employer’s contribution as they wish. In a transition rule, the PPA allows a three-year period, during which an employer can limit diversification of their contribution to one-third each year. How these new reporting and diversification instructions will add to the growth of pension investor litigation is unclear. The mandatory diversification rules may undermine the basic reasoning behind some stock drop litigation. However, given the proliferation of cases over the last few years, it may be that the interpretation of the PPA’s intent will be taking up an increasing amount of the court’s time beginning January 2007 when it comes into effect.
Where do we go from here?
There can be little doubt that the PPA and current employee investor litigation will usher in a new era of more demanding disclosure and reporting. But predictions of the demise of the direct contribution 401K pension seem very premature. David Wray, president of the Profit Sharing/401K Council of America, concedes that the PPA ‘will foster a redesign of employee-sponsored 401K and other defined contribution plans.’ But he also emphasizes that because of increased security drafted into the PPA and the fact that ‘the barriers to automatic enrollment have been removed,’ there will be an increase in plan participants. Others do not entirely agree with him. Companies have used stock as compensation, in some form or the other, for well over 100 years. The advantages are straightforward. The company does not have to tax its cash flow and the employee gets a piece of the action. What is different as of 2006 is that there is a far larger burden of responsibility because of new legislation and litigation.
The new challenges of pension legislation and litigation will be addressed in a number of ways: restructured pension plans, legal counsel and fiduciary insurance. But at the end of the day, the best defense is often a good offense. Many, if not most of the potential problems can be mitigated with a well structured, corporate-wide financial communications program that re-examines employee investors and their new mood.
