Fourth Circuit Applies More Stringent Standard for Breach of Duty of Procedural Prudence by Retirement Plan Fiduciaries

Practical Law Legal Update 0-577-3926 (Approx. 7 pages)

Fourth Circuit Applies More Stringent Standard for Breach of Duty of Procedural Prudence by Retirement Plan Fiduciaries

by Practical Law Employee Benefits & Executive Compensation

Background

In 1985, Nabisco and R.J. Reynolds Tobacco merged to become RJR Nabisco, Inc. In March 1999, RJR Nabisco, Inc. decided to spin-off its tobacco business to improve the stock price of Nabisco, which had been harmed by the impact of tobacco litigation.

After the spin-off, there were two company stock funds holding only Nabisco stock (Nabisco Funds):

The Nabisco Common Stock Fund (which existed before the spin-off).
The Nabisco Group Holdings Common Stock Fund.

In June 1999, the RJR Nabisco 401(k) plan was divided into two plans, one for R.J. Reynolds Tobacco (RJR) and one for Nabisco. The R.J. Reynolds Tobacco 401(k) plan, officially known as the RJR Tobacco Capital Investment Plan (Plan) expressly provided for the retention of the Nabisco Funds as "frozen" funds, which would allow participants to maintain their existing investments in the Nabisco Funds but prevent them from purchasing additional shares in those two funds. The Plan documents did not eliminate the Nabisco Funds or limit the duration that they would be held by the Plan. The Plan continued to offer as investment options the six diversified funds available in the pre-spin-off plan, as well as a common stock fund.

The Plan named two committees as fiduciaries:

The Employee Benefits Committee, responsible for administering the Plan.
The Pension Investment Committee, responsible for Plan investments.

The Divestment Decision

After the spin-off, RJR decided to eliminate the Nabisco Funds, despite the language of the Plan documents providing for the Nabisco Funds to remain frozen. A working group met in March 1999 and decided to:

Eliminate the Nabisco Funds from the plan.
Sell the Nabisco Funds approximately six months after the spin-off.

The working group made this decision after only 30 to 60 minutes of discussion. The group considered factors like:

The high risk of having a single, non-employer stock fund in the Plan.
Their belief (which was incorrect) that funds like the Nabisco Funds could only be held in other companies' plans as frozen funds during times of transition.
The complexity and costs that the Nabisco Funds would add to the Plan.

However, the group did not weigh the specific costs and benefits of keeping the Funds in the Plan. The working group's decision was then reported to the Employee Benefits Committee, which agreed with the decision without having met, discussed or voted on the issue and without authorizing an amendment to eliminate the Funds.

In the months following creation of the Plan in June 1999, the Nabisco Funds declined sharply in value because of the tobacco lawsuits pending against RJR. However, analyst reports continued to rate Nabisco stock positively.

In October 1999, RJR considered changing the working group's decision to sell the Nabisco Funds, but decided to abide by it because they feared it would expose RJR to liability from employees who had already sold their shares in reliance on RJR's communications. It was also concerned that keeping the Nabisco Funds would be prohibitively costly and burdensome. However, RJR did not seek outside expertise to answer these questions and help it decide whether and when to eliminate the Nabisco Funds.

RJR then sent a letter to Plan participants stating that it would eliminate the Nabisco Funds from the Plan. The letter contained false information: it stated that the law did not permit the Plan to maintain the Nabisco Funds. The letter was not reviewed by legal counsel before it was distributed, and it was not corrected after the error was discovered. Instead, a second letter was sent to participants containing the same incorrect information.

In January 2000, the plaintiff, Richard Tatum, who was an employee of R.J. Reynolds Tobacco before and after the spin-off and participant in the Plan, sent an e-mail to high-ranking members of the Employe Benefits Committee and Pension Investment Committee, asking them not to force the sale of the Plan's Nabisco shares because it would result in a massive loss to his 401(k) account. Tatum was informed that the divestment could not be stopped. RJR sold the Nabisco shares held in employees' 401(k) plan accounts on January 31, 2000.

Shortly after the divestment, the value of Nabisco stock began to rise, and this increase accelerated after Carl Icahn made his fourth attempt at a takeover of Nabisco. Eventually, Philip Morris purchased Nabisco and later sold it. At that point, the Nabisco Holdings stock price had increased by 247% and Nabisco Common Stock increased by 82%.

Class Action

In May 2002, Tatum filed a class action lawsuit against RJR, the Benefits Committee and the Investment Committee. He argued that:

The Benefits Committee and the Investment Committee breached their fiduciary duties under ERISA by removing the Nabisco stock from the Plan on an arbitrary timeline and without conducting a thorough investigation.
This fiduciary breach caused substantial loss to the Plan because it forced the sale of the Plan's Nabisco funds at their all-time low, despite the strong likelihood that the stock price would improve.

After years of litigation, the US District Court for the Middle District of North Carolina issued a final judgment in February 2013, holding that:

RJR's decision to remove the Nabisco Funds from the Plan, which was a fiduciary act subject to ERISA's duty of prudence, was a breach of its fiduciary duties because RJR did not properly investigate the prudence of that decision.
As a breaching fiduciary, RJR bore the burden of proving that its breach did not cause the alleged losses to the Plan (the court had previously denied Tatum's motion to add the individual committee members as defendants). RJR met its burden of proof, because its decision to eliminate the Nabisco Funds was one that a reasonable and prudent fiduciary could have made after a proper investigation.

Tatum appealed to the Fourth Circuit, arguing, among other things, that the district court applied the wrong standard for determining loss causation.

Outcome

On appeal, the Fourth Circuit affirmed the district court's decision in part, vacated in part, reversed in part and remanded to the district court.

Breach of Duty of Procedural Prudence

The Fourth Circuit affirmed the district court's holding that RJR breached its duty of procedural prudence by eliminating the Nabisco Funds.

Under ERISA, employee benefits plan fiduciaries are personally liable for any losses to the plan resulting from a breach of their fiduciary duties. RJR was a fiduciary because it exercised actual control over the management and disposition of Plan assets.

The fiduciary duty of prudence requires a fiduciary act with the same care, skill, prudence and diligence that a prudent fiduciary acting in a similar capacity and familiar with the circumstances would use in a similar plan with the same goals. This standard considers the relevant facts and circumstances and looks to what a hypothetical comparable fiduciary would do under comparable circumstances, not simply what a prudent person would do. (For more information, see Practice Note, ERISA Fiduciary Duties: Overview: Duty of Prudence.)

The duty of procedural prudence focuses on the procedures that the fiduciaries establish and follow. Procedural prudence emphasizes the fiduciary decision-making process instead of focusing solely on the results. (For more information, see Practice Note, ERISA Fiduciary Duties: Overview: Procedural Prudence.) Fiduciaries must engage in a reasoned decision-making process, consistent with that of a prudent man acting in like capacity, before making an investment decision.

The Fourth Circuit upheld the district court's holding that RJR failed to engage in a prudent decision-making process because:

The working group's decision to sell the Nabisco Funds:
- was made without any research, investigation or analysis;
- was made in a discussion that lasted less than one hour;
- was made without considering alternatives to divestment within six months that would have provided a better outcome for participants; and
- was made without considering the purpose of the plan (to provide long-term retirement savings) or the spin-off (to allow the Nabisco stock price to increase).
The six month timeline for selling the Nabisco Funds was chosen arbitrarily and with no research.
RJR was concerned with its potential liability, rather than the best interests of the Plan's participants, and did not explore other options, such as temporarily unfreezing the Nabisco Funds.
RJR did not seek advice from independent analysts or outside counsel.

The Fourth Circuit rejected RJR's argument that certain types of investment decisions are subject to a lesser standard of procedural prudence.

Burden of Proof as to Loss Causation

On an issue of first impression, the Fourth Circuit held that RJR bore the burden of proof on the issue of loss causation because Tatum established that RJR breached its fiduciary duty and that a loss to the Plan occurred. In so doing, the Fourth Circuit affirmed the district court's holding that the burden of production and persuasion rested on RJR at this stage of the litigation. The Fourth Circuit held that this burden-shifting approach:

Comports with the structure and purpose of ERISA, by deterring fiduciaries from breaching their duties and preventing defendants from having an unfair advantage in litigation.
Is consistent with long-standing principles of the law of trusts.

RJR's Investment Decision: Not Objectively Prudent

Since Tatum met his burden of proof, RJR had to prove that despite its imprudent decision-making process, its ultimate investment decision was objectively prudent. The district court held that RJR's investment decision was objectively prudent because a hypothetical prudent fiduciary could have made it after performing a proper investigation. The Fourth Circuit held that this "could have" standard has no basis in Circuit precedent and would render toothless ERISA's enforcement mechanism. Rather, under Fourth Circuit precedent, a decision is objectively prudent if a hypothetical prudent fiduciary would have made the same decision anyway (Plasterers' Local Union No. 96 Pension Plan v. Pepper, 663 F.3d 210, 218 (4th Cir. 2011)).

Under the "would have" standard, a plaintiff will prevail if he proves that a fiduciary breached the duty of procedural prudence and that the plan suffered a loss, unless the fiduciary can show, by a preponderance of the evidence, that a prudent fiduciary would have made the same decision if it first had done a proper investigation and evaluation. If a fiduciary undertakes a reasoned decision-making process before making investment decisions, "it need never fear monetary liability" even if that investment decision does not produce an optimal result. The inquiry is whether the loss would have occurred regardless of the fiduciary's lack of prudence.

The Fourth Circuit noted that the "would have" standard is more difficult for a defendant fiduciary to satisfy than the "could have" standard. If a breaching fiduciary could avoid liability by simply showing that a prudent fiduciary could have made the same decision, ERISA enforcement provisions would be severely weakened.

RJR also argued that the district court's use of the "could have" standard was a harmless error because the riskiness of the Nabisco Funds established that a prudent fiduciary would have eliminated them from the Plan. The Fourth Circuit rejected this argument because:

The riskiness of a fund is not a controlling factor, but a relevant consideration, when deciding whether to divest it from a retirement plan. It is not necessarily imprudent for a fiduciary to offer a single-stock fund in a plan that also offers diversified investment options.
The Plan's governing document required it to keep the Nabisco Funds as frozen funds. Plan terms do not trump the duty of prudence, but a fiduciary's failure to follow plan documents is relevant for determining how a prudent fiduciary would act in similar circumstances. On the issue of objective prudence, the district court should have considered RJR's failure to follow the Plan's terms.
The incorrect "could have" standard may have influenced the court's decision.

The Fourth Circuit remanded the decision to the district court to determine whether, under the "would have" standard of objective prudence, RJR's divestment of Nabisco stock caused substantial losses to the Plan. The district court must consider all relevant evidence, in a totality-of-the-circumstances inquiry, including the timing of the divestment. RJR must prove by a preponderance of the evidence that a procedurally prudent fiduciary would have made the same decision. If RJR cannot do so, it will be monetarily liable under ERISA Section 409(a) (29 U.S.C. § 1109(a)).

Dudenhoeffer

In holding that RJR's investment decision was not objectively prudent, and therefore violated the duty of procedural prudence, the Fourth Circuit distinguished this case from the Supreme Court's recent decision in Fifth Third v. Dudenhoeffer (to learn more about Dudenhoeffer, see Legal Update, Supreme Court Rejects Moench Presumption of Prudence).

Both the dissenting opinion and RJR argued that the "could have" standard is supported by Dudenhoeffer, in which the Court wrote, "faced with such claims... [courts should] consider whether the complaint has plausibly alleged that a prudent fiduciary in the defendant’s position could not have concluded that [acting on insider information] would do more harm than good." The Fourth Circuit disagreed with this interpretation of Dudenhoeffer. Dudenhoeffer dealt with a fiduciary's failure to act on insider information. Tatum analyzes whether a fiduciary that clearly breached its procedural duty of prudence still acted in an objectively prudent manner and did not cause loss to the plan. The Fourth Circuit majority concluded that the Court's language in Dudenhoeffer does not mean that the "would have" standard does not apply when determining loss causation after a fiduciary breach is established.

Practical Implications

A plan fiduciary that breaches its duty of procedural prudence will be personally liable for losses to the plan unless it acted in an objectively prudent manner and did not cause those losses. The Fourth Circuit's plaintiff-friendly decision in Tatum means that courts in that circuit will not apply the more fiduciary-friendly "could have" standard when evaluating a fiduciary's investment decision. Under this standard, it will be harder to satisfy the test of procedural prudence.

To best avoid liability, plan fiduciaries must analyze and discuss a contemplated investment decision before executing it. Based on the factors discussed by the Fourth Circuit, this process could include having numerous discussions with the plan fiduciaries about the proposal, seeking advice from an independent fiduciary or outside counsel and focusing on the best interests of the plan participants (rather than trying to minimize the prospect of litigation). This process should include documenting all of these decisions and discussions.

RJR's failure to take these steps in Tatum resulted in what the Fourth Circuit described as an "unprecedented" failure to fulfill the duty of prudence in a reported ERISA case.

Fourth Circuit Applies More Stringent Standard for Breach of Duty of Procedural Prudence by Retirement Plan Fiduciaries | Practical Law