ERISA TAGALONG CLASS ACTIONS: A NEW FRONTIER FOR D&O LIABILITY
A new type of class action lawsuit is now being filed with alarming frequency against directors and officers when the market price of stock in their company drops significantly as a result of the disclosure of surprising adverse information about the company. Historically, such a stock drop would usually result in class actions filed on behalf of purchasers of the company's securities for some defined time period prior to the surprising disclosure. Those class actions would allege that the company and certain of its directors and officers who are named as defendants have failed to disclose the adverse information sooner, thereby resulting in the market price for the company's securities to be artificially inflated during the alleged class period. As a result, anyone who purchased securities at those allegedly artificially inflated prices during the class period suffered damages and are entitled to recover the difference between what they actually paid for the securities and what the market price would have been if full and accurate information had been disclosed throughout the class period.
It is very likely one or more of these types of securities class actions will be filed following a company's surprising announcement of adverse information, particularly when (i) the immediate stock drop following the disclosure of adverse information constitutes more than a 10% decline in the market price of the securities, (ii) the adverse information being disclosed is especially egregious or presumably was known or should have been known by insiders well before the disclosure (e.g., restatement of financial disclosures; dramatic and sudden decline in the company's financial performance or condition; etc.).
Although ostensibly brought for the benefit of the injured shareholders, these class actions frequently are instigated and prosecuted primarily by and for the benefit of the plaintiff lawyers. As a result of several provisions in the Private Securities Litigation Reform Act of 1995, more and more of these securities class action lawsuits are being handled by a small group of sophisticated and highly experienced plaintiff law firms. This consolidation of the opportunity to serve in the lucrative role of lead counsel for the plaintiff class has resulted in a number of plaintiff firms who otherwise would like to participate in these cases being excluded from playing an active role in the prosecution of the cases, and thus excluded from sharing in the large fee awards. This dynamic has resulted in some of those plaintiff law firms exploring other alternative means to successfully recover a large settlement in some type of class action lawsuit following a significant drop in a company's stock price, and thus recover large fee awards.
Emerging from this setting is a new type of class action lawsuit which is now being filed almost routinely against directors and officers of a company that is otherwise a target of securities class action lawsuits. Primarily beginning with the Enron debacle, these class actions are brought on behalf of participants and beneficiaries of the company's retirement plans to the extent those plans own securities of the company. The complaints in these class actions contain the same factual allegations as set forth in the securities class action lawsuits (i.e., the defendants misrepresented or failed to disclose certain material information about the company or its financial performance or condition). But instead of alleging those misrepresentations or omissions constitute a violation of the securities laws, the new lawsuits allege the defendants breached their fiduciary duties under ERISA. As a result of the alleged breaches, the plan participants and beneficiaries were allowed or induced to invest or maintain their plan assets in company stock at artificially high prices or otherwise suffered loss because their plan assets were invested in overpriced or ill-advised securities.
The specific claims asserted in these so-called ERISA tagalong class actions are generally summarized as follows:
* Claims against officers and directors for deceiving plan participants and beneficiaries by disclosing false and misleading information about the company and its financial condition and performance, either in statements to the general public, to shareholders or to employees;
* Claims against directors and officers for failing to provide accurate information about the company and its financial condition and performance;
* Claims against plan fiduciaries (many of whom are also officers) for failing to disclose the adverse information to plan participants and beneficiaries, failing to disclose such information to other plan fiduciaries who had responsibility for investing plan assets, and failing to correct misleading statements made by other officers and plan fiduciaries;
* Claims against plan fiduciaries for retaining or investing in company stock in plan accounts, permitting participants to invest in company stock by continuing to include the stock as an authorized investment option in self-directed plans, failing to adequately diversify plan assets, and failing to investigate the suitability of plan investments.
These ERISA tagalong class action lawsuits are sufficiently new that there is not yet any meaningful body of case law addressing the propriety of the legal theories underlying these types of claims. However, on their surface, these lawsuits, which typically name as defendants senior officers and the board of directors of the company as well as other designated plan fiduciaries, raise several concerns for the defendants. First, the definition of eligible class members in the ERISA class action is broader than the definition of class members in the securities class action. Whereas the securities class action is limited only to purchasers of securities during the designated class period, the ERISA class action is on behalf of all plan participants or beneficiaries who held or invested in the company's securities through their retirement plan during the class period. In other words, persons who simply held company securities in their retirement account, but who made no direct investment decision regarding those securities, may be a member of the ERISA class, but would be excluded from the securities class. Although participants and beneficiaries who purchased company securities during the class period could be a class member in both the ERISA and securities class actions (thus rendering the ERISA class action somewhat duplicative), the ERISA class action will include a potentially large number of other plaintiffs in its class.
Second, the securities class action under Section 10(b) of the Securities Exchange Act of 1934 will require the plaintiffs to prove the defendants acted with scienter (i.e., with intent to deceive or reckless behavior), whereas claims for breach of fiduciary duty under ERISA will likely require a lower threshold similar to negligence. Thus, at least on this basis, plaintiffs may be able to more easily establish liability in the ERISA class action than the securities class action.
Defendants in the ERISA class action do have several intriguing and potentially persuasive defenses unique to the ERISA class action claims. The following summarizes several of those defenses, which have not yet been fully explored by courts in the context of an ERISA tagalong class action lawsuit.
* Who is an ERISA Fiduciary? The ERISA tagalong class actions seek to expand the definition of an ERISA fiduciary to include corporate directors and officers not otherwise responsible for the management of plan assets. Traditionally, courts have recognized a person as a fiduciary under ERISA only to the extent the person exercises discretionary authority or control in connection with managing or administering an ERISA plan, providing investment advice for the plan, or investing plan assets. In addition, such a fiduciary is generally treated as a fiduciary only to the extent of the plan function over which the person exercises authority or control. In other words, a plan trustee is not automatically liable as a fiduciary for decisions involving plan administration, absent an express designation of such authority or his exercising discretion or control over those functions. Thus, under existing authority, it is doubtful that a director or officer who does not have express discretionary authority or control with respect to plan investments and does not in fact exercise such authority or control, would be treated as an ERISA fiduciary and subject to ERISA fiduciary duties. However, most ERISA tagalong class actions seek to impose such duties upon directors and officers who do not have or exercise such authority or control.
* Does ERISA Apply to Matters Regulated by the Securities Laws? For more than 70 years, the federal securities laws have regulated matters relating to the purchase and sale of securities, with the goal of assuring that all affected parties have the benefit of accurate and complete information in order to make an informed investment decision. ERISA, on the other hand, traditionally has been viewed as establishing only four general standards of conduct for fiduciaries (i.e., the duty of loyalty to act for the exclusive benefit of the plan and its participants; the duty of prudence to act reasonably with respect to plan matters; the duty to diversify plan assets; and the duty to follow the terms of plan documents consistent with the other three duties). If the ERISA tagalong class actions are successful in imposing upon fiduciaries the duty to disclose complete and accurate information about the company's securities or to preclude participants from investing in company securities under certain circumstances, new and unprecedented duties for ERISA fiduciaries would be created.
* Are Directors and Officers Acting in a Corporate or ERISA Fiduciary Capacity? Traditionally, courts have recognized that a company and its directors and officers can take actions in the ordinary course of business which may adversely affect ERISA plans without creating liability exposure (e.g., terminate or amend plans). When directors and officers who have no fiduciary responsibility for investment of plan assets make disclosures of allegedly false or misleading information to employees, shareholders or the public, such conduct arguably is not taken in their capacity as an ERISA fiduciary, but is in their "settlor" capacity in conducting the affairs of the company. Again, if the ERISA tagalong class actions are successful in creating ERISA liability for such disclosures on behalf of the company, existing ERISA liability exposure would be significantly expanded.
* What are Directors and Officers Expected to do if they Discovery Adverse Material Nonpublic Information? If upon learning of nonpublic adverse information directors and officers quickly disclose the information and sell the company stock held in the plans, the company's stock price would undoubtedly drop significantly given the large number of company shares usually held in plan accounts. Such a dramatic collapse in the stock price would likely constitute an overreaction to the adverse information and thus unnecessarily penalize plan participants and other shareholders. In addition, if the directors and officers "quietly" begin divesting company stock held in plan accounts without publicly disclosing the adverse information, they would be trading while in possession of material nonpublic information and thus would likely violate the insider trading laws. Stated differently, the underlying premise of the ERISA tagalong class actions, if supported by courts, would place directors and officers in an impossible dilemma that could result in excessive and unnecessary losses to plan participants and beneficiaries.
In summary, the ERISA tagalong class actions present difficult issues for courts to analyze. It will likely be a number of years before there is a sufficient body of persuasive case law which definitively addresses these various issues. Depending upon how courts resolve those issues, directors and officers may now be facing yet another potentially catastrophic exposure when companies disclose surprising adverse information. In the meantime, directors and officers are subjected to the uncertainty whether this exposure is real, and thus they should take appropriate steps to assure they are adequately protected financially in the event they in fact do incur significant liability in these claims.
Like other D&O exposures, directors and officers will have two potential sources of financial protection in the event they incur liability in an ERISA tagalong class action: insurance and indemnification. However, there are unique issues with respect to both types of protection as they apply to this type of new litigation. Some of those unique issues are summarized below.
A. Insurance Issues
D&O insurance policies typically exclude coverage for ERISA tagalong class actions by reason of the ERISA exclusion in the policy. Thus, any insurance coverage available to a defendant director or officer in this type of litigation will likely exist only under the company's ERISA Fiduciary Liability Policy program. Historically, that program has not been the subject of thorough analysis or negotiation by companies since it has been relatively cheap and is infrequently triggered. Today more than ever, companies ignore this important insurance coverage at their peril. When reviewing the adequacy of a fiduciary insurance program in light of this new ERISA exposure, companies should consider the following issues among others:
1. Coordinate with D&O Insurance. The scope of coverage afforded under the fiduciary policy should be coordinated as closely as possible with the scope of the ERISA exclusion in the D&O policy, so that there is no gap in coverage between the two policies. To minimize the risk of an inadvertent gap in coverage, a few Side A Only D&O insurance policies (including the standard policy form issued by CODA) do not contain an ERISA exclusion.
2. Evaluate Adequacy of Limits. Because there is now a much larger potential liability exposure for the fiduciary insurance program to cover, the size of the fiduciary insurance program should be reevaluated. In many instances, more limits of liability may be needed, depending upon the amount of company stock held in retirement plans maintained by the company.
3. Anticipate Tie-In Limits. Because the ERISA tagalong class actions arise out of and allege essentially the same wrongdoing as alleged in securities class actions which are covered under D&O insurance policies, some D&O insurers are now requiring a tie-in of limits between the fiduciary and D&O insurance policies issued by the insurer to the same company. In other words, insurers do not want to exposure multiple limits to a single incident. In response, companies should consider the advantages and disadvantages of placing their D&O insurance and fiduciary insurance policies with different insurers, thus eliminating the need for a tie-in of limits. If a tie-in of limits endorsement is attached to the D&O and fiduciary policies issued by the same insurer, two issues should be addressed. First, does the tie-in apply only to a single claim covered under both policies, or to all claims covered under one or both policies? Second, will the excess policies in the D&O and fiduciary programs drop down in the event the underlying policies are exhausted by reason of the tie-in of limits endorsement even though the underlying policy has not paid out its stated limit of liability? Even if a tie-in of limits endorsement is not required by the insurer, a potentially difficult allocation of loss between the two types of policies will be required.
4. Anticipate Significantly Higher Premiums. Fiduciary insurance historically has been priced very low, largely reflective of the insurers' positive claim experience. However, in light of this new and potentially catastrophic exposure under the fiduciary policy, insurers are and will likely continue to dramatically increase the premiums for fiduciary insurance. This greater exposure to insurers is highlighted by the fact that unlike many other types of ERISA class actions, the policy exclusion which eliminates coverage for benefits due under a plan will likely not apply to settlements or judgments in an ERISA tagalong class action.
5. Duty to Defend. Unlike D&O insurance policies, most fiduciary insurance policies state that the insurer has the right and duty to defend any covered claim. Thus, the insurer will have the right to select defense counsel for the defendant directors and officers in the ERISA tagalong class action, even though the directors and officers select their defense counsel in the tandem securities class action. If this is a concern to directors and officers, the insureds should explore either eliminating the duty to defend or adding an endorsement to the policy which states that the insurer will select certain designated defense counsel for certain types of covered claims.
B. Indemnification
In light of the increased liability exposure of ERISA fiduciaries as a result of these ERISA tagalong class action lawsuits, companies and their ERISA fiduciaries should thoroughly understand and evaluate the adequacy of not only the ERISA fiduciary insurance coverage, but also the available indemnification from the company for the ERISA fiduciaries. The indemnification issues are important to evaluate not only in order to assure the fiduciaries have maximum financial protection if the insurance is unavailable or inadequate, but also because more companies are now exploring the possibility of purchasing only coverage for non-indemnifiable fiduciary losses (similar to a Side-A Only D&O policy) as a means to manage the escalating cost of this insurance.
As a general rule, a sponsoring company may indemnify its ERISA fiduciaries in most instances. However, under federal and state law, the availability of that indemnification is less predictable than the indemnification of directors and officers for non-ERISA matters. As a result, it appears unlikely fiduciary coverage for only non-indemnifiable loss will be as widely available as D&O Side-A only coverage. The following summarizes many of the indemnification issues unique to ERISA fiduciaries.
1. ERISA Indemnification Provisions. A plan sponsor is generally permitted under Department of Labor regulations to indemnify a plan fiduciary, but indemnification provisions which encourage undesirable fiduciary behavior may be questioned by courts.
A fiduciary cannot by agreement be relieved of his responsibility or liability under ERISA. ERISA ¤ 410(a). However, a plan, employer or fiduciary may purchase insurance protection for fiduciary breaches. If the plan purchases the coverage, the insurer must have the right to seek recourse from the fiduciaries for amounts paid by the insurer on account of fiduciary breaches. ERISA ¤ 410(b).
Consistent with ERISA ¤ 410, a plan may not agree to indemnify a fiduciary for fiduciary breaches, although an employer may do so. See Pamela Perdue, Qualified Pension and Profit-Sharing Plans, ¦ 3.06[3] at 3-304 (2d ed.). The Department of Labor has permitted indemnification agreements that do not relieve a fiduciary of responsibility or liability under ERISA. See 29 CFR ¤ 2509.75-4. The regulations state that "[i]ndemnification provisions which leave the fiduciary fully responsible and liable, but merely permit another party to satisfy any liability incurred by the fiduciary in the same manner as insurance purchased under [ERISA] ¤ 410(b)(3), are...not void under [ERISA] ¤ 410(a)." Id. Thus, an employer is generally permitted under ERISA to indemnify a plan fiduciary.
However, the scope of permissible indemnification under ERISA may be limited under certain circumstances. For example, in Martin v. Nationsbank of Georgia, N.A., 16 EBC 2138 (N.D. Ga. 1993), a district court determined on summary judgment that an indemnification agreement violated ERISA. The agreement provided a plan trustee with complete indemnification if the trustee followed the directions of the ESOP participants in response to a tender offer, but eliminated indemnification for negligent or more severe misconduct if the trustee of the ESOP failed to follow such instructions. The court determined that the terms of the agreement created a financial incentive for the fiduciary to breach its fiduciary obligations under ERISA by blindly following participant directions, because the fiduciary's "exercise of independent judgment would leave [the trustee] unprotected against charges of negligence, bad faith or willful misconduct." Id. at 2141.
Another district court questioned the ability of an ESOP sponsor to indemnify the ESOP's fiduciaries under any circumstances, reasoning that such indemnification by the company was to the detriment of the company's owner, the ESOP. Donovan v. Cunningham, 541 F. Supp. 276, 289 (S.D. Tex. 1982), aff'd in part and rev'd in part on other grounds, 716 F.2d 1455 (5th Cir. 1983), cert. denied, 467 U.S. 1251 (1984). See Horahan and Hennessy, 365-2nd T.M., ERISA - Fiduciary Responsibility and Prohibited Transactions at A-67 - 68.
The implication of these cases is that while a plan sponsor's indemnification of a plan fiduciary is generally permitted, indemnification provisions which by their terms encourage undesirable fiduciary behavior may not be enforced by a court.
2. State Indemnification Provisions. A sponsor company's indemnification of plan fiduciaries is also subject to the indemnification statute in the state in which the company is incorporated.
State indemnification statutes typically permit a corporation to indemnify its directors, officers, employees and agents for loss incurred on account of claims against such persons in such capacity. Indemnification statutes also permit a corporation to indemnify any person who serves at the request of the corporation as a director, trustee, officer, employee or agent of another entity or other "enterprise." A number of indemnification statutes expressly define "enterprise" to include ERISA plans. See, e.g., Section 145(i), Delaware General Corporation Law.
As a result, in many states, a sponsoring company may indemnify plan fiduciaries only if and to the extent the plan fiduciary is serving at the request of the sponsor company. Absent such request, no indemnification would be available. In addition, even if the plan fiduciary is serving at the request of the sponsor corporation, indemnification by the sponsor corporation will only be permissive under the statute and not mandatory, unless the corporation's bylaws or certificate of incorporation require indemnification of persons serving in an outside position at the request of the corporation. Many bylaw indemnification provisions do not require such outside position indemnification.
A few states expressly authorize a corporation to indemnify fiduciaries of its ERISA plans. See, e.g., Section 207(f), California Corporations Code. In those states, indemnification of plan fiduciaries will be permitted whether or not the fiduciaries serve at the request of the corporation. However, such indemnification is simply permissive, unless mandated by the corporation's bylaws or certificate of incorporation.
In addition to the possible indemnification limitations summarized above, several of the limitations applicable to indemnification of directors and officers are also applicable to indemnification of ERISA fiduciaries under state law. For example, no indemnification will be available if the ERISA fiduciary fails to satisfy the requisite standard of conduct (e.g., the ERISA fiduciary must act in good faith and in the reasonable belief that his conduct was in or not opposed to the best interests of the corporation1). In addition, indemnification will not be available if the corporation is financially unable to fund the indemnification.
3. Indemnification Planning. Based on the foregoing, corporations should examine the following primary issues when evaluating the quality of indemnification protection for its ERISA fiduciaries:
a. Review the applicable state indemnification statute to determine if an ERISA fiduciary must be serving at the request of the company in order to be indemnified. If so, be sure any person intended to be protected is clearly serving at the written request of the corporation as plan fiduciaries.
b. Review the applicable state indemnification statute and internal indemnification provision of the corporation to confirm that the corporation is obligated to indemnify all of the persons intended to be protected without any material restrictions on that indemnification.
c. Consider whether the terms of the indemnification provisions may create public policy concerns similar to those expressed by the cases summarized above. For example, such public policy concerns are more likely to arise with respect to ESOP fiduciaries.
d. The internal indemnification provision should mandate indemnification "to the fullest extent permitted by law" in order to increase the possibility that indemnification will be available in suits by or on behalf of the sponsoring corporation.
1 In some instances, the ERISA fiduciary is required to take actions which are arguably not in the best interests of the sponsor corporation, such as collecting amounts owed by the sponsor corporation to the plan. In those instances, a question may arise whether this statutory standard of conduct was satisfied by the plan fiduciary.