Another Win for 401(k) Fiduciaries

Avaya fiduciaries fulfilled their duties of prudence and disclosure

Lawsuits by participants claiming that plan fiduciaries are liable for their losses when the employer’s stock price drops significantly are on the rise. The good news for plan fiduciaries is that many of these cases are being decided in their favor. Edgar v. Avaya Inc. (Third Circuit No. 06-2770, September 26, 2007) is another in the growing number of decisions that fiduciaries are not liable for participants’ investment losses when employer stock declines in value.

Participants in the Avaya 401(k) sued plan fiduciaries because the share price of Avaya stock fell from $10.69 to $8.01 in a single day after the company announced that it was unlikely to meet its earnings forecast for the fiscal year. The company blamed the reduced earnings on the implementation of new delivery methods, recent acquisitions, and a declining market for its products. Participants sued the plan fiduciaries claiming that they breached their fiduciary duties by imprudently offering Avaya common stock as an investment option and failing to disclose material information to plan participants.

The Avaya 401(k) plan was a participant-directed individual account plan offering 23 investment options, including an employer stock fund. Participants could freely change their investment elections, and the plan complied with the requirements of Section 404(c) of ERISA, which relieves plan fiduciaries from liability for the results of participants’ investment decisions. The summary plan description specifically described the benefits of diversification and the inherent risks of a single-stock investment fund.

After dismissal by the district court, the plaintiffs appealed. On appeal the Third Circuit affirmed the district court’s ruling, holding that the plan fiduciaries violated neither the duty of prudence nor the duty of disclosure under ERISA with respect to the employer stock investment option.

Duty of Prudence
The plaintiffs argued that the defendants breached their fiduciary duty of prudence by offering Avaya common stock as an investment option during the period surrounding the date the stock value dropped. In considering this claim, the court drew an analogy between an eligible individual account plan, such as Avaya’s 401(k) plan, and an employee stock ownership plan (ESOP). The court noted that both eligible individual account plans and ESOPs are exempt from the ERISA duty to diversify investments and prohibit transaction rules on investments in employer stock and involve more risk to employee retirement assets than other types of plans. As a result, the same standard of review should apply to both types of plans.

The court held that a fiduciary’s decision to retain employer stock in an ESOP or an eligible individual account plan is presumed to be prudent unless it can be determined that the decision is an abuse of the fiduciary’s discretion. This presumption can only be rebutted if the plaintiff demonstrates that the fiduciary could not reasonably believe that retaining the employer stock fund was consistent with the company’s expectation of a prudent trustee. In this case the plaintiffs argued that the fiduciaries abused their discretion by knowingly or recklessly disregarding the facts underlying the earning reduction and the corresponding drop in the share price of Avaya stock.

 In rejecting this argument, the court stated that these facts and the drop in stock price did not create “the type of dire situation” that would require the fiduciaries to disobey the terms of the plan either by not offering employer stock as an investment option, or by divesting the plan of the stock. The opinion also pointed out that if the fiduciaries had divested the plan of the employer stock, they would have risked liability for having failed to follow the terms of the plan, particularly if the stock prices later increased.

 Duty of Disclosure
The plaintiffs claimed that even if the drop in the stock price did not require the plan fiduciaries to stop offering employer stock as an investment option, they were required to disclose the underlying facts to the plan and participants prior to the earnings announcement. The court noted that an ERISA fiduciary is liable for material misrepresentations to participants regarding a fund investment’s risk and for a failure to inform participants about an investment risk when it knows silence might be harmful. The court considered a misrepresentation material if there was a substantial likelihood that it would have misled a reasonable participant in making an adequately informed investment decision.

 Applying this rule, the court concluded that the Avaya plan fiduciaries were not liable because the summary plan description informed participants that investments were tied to fund performance, that each fund carried different risks and potential returns, and that participants were responsible for investigating the investment options. In addition, it explicitly warned participants of the risks of investing in a non-diversified fund. The court said that these disclosures were sufficient to satisfy the fiduciary obligation not to misinform or fail to inform participants about the risks associated with investment in the employer stock fund.

 The plaintiffs argued that the fiduciaries should have disclosed that Avaya would not meet profit forecasts before it did. The court also rejected this argument because the drop in stock price would have occurred no matter when the announcement was made. It also noted that if the plan fiduciaries had divested the plan of company stock prior to the public announcement, they potentially could have been liable under SEC rules against insider trading.

 The Avaya decision is a victory for plan fiduciaries on two important points. First, it applies a deferential standard of review for fiduciaries of 401(k) plans offering an employer stock investment option, which assumes that the fiduciaries’ actions are prudent unless the participant can demonstrate otherwise. Second, it provides that a fiduciary’s disclosure obligation can be satisfied by adequately informing participants of the risks related to investments in employer stock. These conclusions offer some comfort to fiduciaries of plans holding employer stock that they are not automatically going to be held liable for participants’ losses if the stock price drops.