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More safeguards for retirement plans have been proposed
Mark L. Silow
The Legal Intelligencer
February 19, 2002
The highly publicized collapse of the Enron Corp. has focused attention on the perils of corporate retirement plans investing in employer stock. Thousands of current and former Enron employees whose 401(k) plans were invested heavily in Enron stock have suffered the loss of most of their retirement savings.
Although a statutory framework intended to protect retirement plan participants from exactly the fate suffered by the Enron employees already exists, President Bush and several members of Congress have proposed legislation aimed at providing additional safeguards and further limitations on the ability of retirement plans to invest in employer securities.
It is important to note that although Enron is currently in the headlines, there are numerous other large corporations where the retirement savings of employees is closely linked to the market performance of the employer's stock.
In a recently published survey of 401(k) retirement plans sponsored by 200 of the nation's largest public corporations, 25 had more than 60 percent of their total assets invested in the employer's stock. The most dramatic examples of significant investment in employer stock are the Coca-Cola Co., where 81 percent of Coke's 401(k) plan assets are invested in company stock; Texas Instruments, where 75 percent of its plan's assets are invested in company stock; and McDonald's Corp., where 74 percent of its plan's assets are invested in company stock. In each of those three examples, the market value of the employer's stock has declined in excess of 20 percent over the past 12 months.
ERISA AND FIDUCIARIES
ERISA, or the Employee Retirement Income Security Act of 1974, already contains an extensive set of rules relating to the investment of retirement plan assets, with special rules applicable to the purchase of company stock. As a general matter, § 404(a)(1) of ERISA requires that those individuals charged with the operation and administration of retirement plans (i.e., plan fiduciaries) are subject to the duty to act for the exclusive benefit of plan participants and beneficiaries, to act prudently and to diversify the investment of plan assets.
To satisfy the exclusive-benefit requirement of ERISA, a fiduciary must act solely in the interest of the plan's participants and beneficiaries and for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable administrative expenses of the plan.
To satisfy the requirement to act prudently, a fiduciary must act "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 in the conduct of an enterprise of a like character and with like aims."
To satisfy the diversification requirement of ERISA, a fiduciary must diversify plan investments so as to minimize the risk of large losses unless, under the circumstances, it is clearly prudent not to do so.
Although the diversification requirement of ERISA would appear to preclude the significant concentration of plan assets in employer stock, ERISA provides an exception for "eligible individual account plans" that invest in "qualifying employer securities."
Therefore, 401(k) plans such as the plan sponsored by Enron and many other large public corporations generally qualify for this exemption from the diversification requirement.
In addition to the general fiduciary duties imposed by ERISA, there are also a number of objective "bright line" limits on the amount of employer stock that may be owned by a qualified retirement plan.
Both § 406 of ERISA and § 4975 of the Internal Revenue Code prohibit various transactions between a qualified retirement plan and related parties, including the sponsoring employer corporation, its officers and directors, and certain of its shareholders. A limited exception to the "prohibited transaction" rules involves the sale or exchange of "qualifying employer securities." For this purpose, qualifying employer securities are defined in § 407(d)(5) of ERISA as either the stock (common or preferred), "marketable obligations" (such as a publicly traded bond, note or other debt obligation), or an interest in a publicly traded partnership issued by the employer whose employees are covered by the plan.
Depending upon the nature of the qualified retirement plan, ERISA imposes various limits on the amount of qualified employer securities that may be purchased and held by a plan.
In the case of a defined benefit pension plan, the plan cannot acquire qualified employer securities if, immediately after the acquisition, the plan owns qualifying employer securities with an aggregate fair market value in excess of 10 percent of the fair market value of total plan assets.
Moreover, in the case of a defined benefit plan, stock of an employer will be considered qualifying employer securities only if, immediately following the acquisition of the stock, the plan holds no more than 25 percent of the aggregate amount of stock of the same class that was issued and outstanding at the time of the acquisition of the stock and individuals independent of the employer hold at least 50 percent of the aggregate amount of stock of the same class that was issued and outstanding at the time of the acquisition of the stock. Generally, officers, directors and controlling shareholders of the employer corporation will not be considered independent of the employer corporation issuing the stock.
For individual account plans, which include profit-sharing and 401(k) plans, there is generally no overall limit on the amount of qualifying employer securities that may be owned by the plan. However, an individual account plan must explicitly authorize investments in qualified employer securities. No such express authorization is required for defined benefit plans, although most practitioners believe that plan fiduciaries would be acting prudently in the acquisition of qualifying employer securities only if explicitly permitted by the plan document.
Although not part of the Bush administration reform proposals, legislation proposed by several members of Congress would limit the percentage of a participant's retirement plan account that could be invested in employer stock. Most of these proposals would limit employer stock to 20 percent to 25 percent of a participant's retirement account.
ELECTIVE CONTRIBUTIONS
Special limitations on the ownership of employer stock are currently imposed on individual account plans, such as 401(k) plans, that permit elective employee contributions. If an individual account plan permits elective employee contributions and requires that such elective employee contributions be invested in qualifying employer securities, the aggregate fair market value of qualifying employer securities owned by the plan may not exceed 10 percent of the fair market value of all plan assets attributable to elective employee contributions and the earnings allocable thereto.
The 10-percent-of-assets limitation for a plan that requires an investment of elective employee contributions in qualifying employer securities will not apply if on the last day of the preceding plan year the fair market value of the assets of all individual account plans maintained by the employer equals no more than 10 percent of the fair market value of the assets of all retirement plans maintained by the employer or the portion of an employee's elective contribution that is required to be invested in qualifying employer securities does not exceed 1 percent of the employee's compensation.
Very few 401(k) plans mandate the investment of elective employee contributions in employer stock. However, a more common practice is for employer contributions to a plan, especially employer matching contributions, to be made in the form of employer stock. An added feature of such a plan - which apparently was a feature of the Enron 401(k) plan - is a restriction on the ability of plan participants to sell the stock contributed to the plan by the employer. One component of the Bush administration reform proposal would be to allow plan participants to direct the sale of company stock contributed to their accounts after three years from the date of contribution.
In recent years, fiduciaries of 401(k) plans have attempted to further insulate themselves from fiduciary liability by allowing participants in such plans to self-direct the investment of their accounts in the plan. Under § 404(c) of ERISA, a plan fiduciary will be relieved of any liability resulting from a participant's investment decision with respect to his or her account if the participant is afforded the opportunity to exercise control over the assets in his or her individual account and to choose from among a broad range of investment alternatives.
However, plan fiduciaries will still have responsibility for prudently selecting the menu of investment alternatives, providing participants with adequate information concerning the available investment alternatives, and adopting procedures that allow participants to effectively exercise control over the assets in their account.
MORE REQUIREMENTS
For fiduciaries of an individual account plan to avail themselves of the protections of § 404(c) with respect to an individual account plan that owns employer stock, the following additional requirements must be satisfied:
The qualifying employer securities must be traded with sufficient frequency and sufficient volume on a national exchange or other generally recognized market and in sufficient volume to ensure that a participant's direction to buy or sell the security may be acted upon promptly and sufficiently.
The information provided to shareholders of such securities also must be provided to participants and beneficiaries with retirement plan accounts holding such securities.
Voting, tender and similar rights must be passed through to participants and beneficiaries with accounts holding such securities, and an independent fiduciary must be appointed to carry out activities in which there is the potential for undue employer influence on participants and beneficiaries with regard to the direct or indirect exercise of shareholder rights.
One claim in the Enron debacle that has been reported in the media relates to the decision by Enron officials to impose a "blackout" period during which participants in the Enron 401(k) plan were prohibited from directing the sale of Enron stock held in their accounts. Officials of Enron have publicly stated that it was merely a coincidence that the blackout was imposed during a period when the price of Enron stock was collapsing and when a number of Enron officers were selling large quantities of stock. The protections of § 404(c) do not apply during any blackout period.
Another component of the Bush administration reform proposal would mandate that employers provide plan participants with 30 days' notice prior to any blackout period and that senior corporate officers be prohibited from selling their own stock during any blackout period.
Failure to comply with either the general duties of fiduciary conduct or the more specific prohibited transaction rules relating to the purchase, sale and ownership of employer stock may result in the personal liability of plan fiduciaries for any losses incurred, plus an additional liquidated damages penalty of 20 percent.
Moreover, any violation of the rules relating to the ownership of employer stock will most likely result in a prohibited transaction. Upon the occurrence of a prohibited transaction, an excise tax is imposed equal to 15 percent of the amount involved in the prohibited transaction. If the transaction is not timely corrected after the imposition of the initial excise tax, a 100 percent excise tax will be imposed.
Under existing law, there is no prohibition that keeps corporate sponsors of individual account retirement plans, such as most 401(k) plans, from affording plan participants the opportunity to invest all or a significant portion of their retirement savings in employer stock. However, the collapse of Enron highlights the dangers in allowing employees to pursue such an investment strategy.
Mark L. Silow is chairman of the tax and estates department at Philadelphia-based Fox Rothschild and serves on the firm's executive committee.