On Remand, Plan Fiduciaries’ Decision to Divest Nabisco Stock Fund Found Prudent

Practical Law Legal Update w-001-4562 (Approx. 6 pages)

On Remand, Plan Fiduciaries’ Decision to Divest Nabisco Stock Fund Found Prudent

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).

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 RJR 401(k) plan, officially known as the RJR Tobacco Capital Investment Plan (Plan), held units in both RJR and Nabisco. Shares in the Nabisco Funds were frozen, which allowed participants to maintain their existing investments in the Nabisco Funds but prevented them from purchasing additional shares in those two funds. The Plan document was amended to provide language stating that the Nabisco Funds were frozen, but did not limit the duration that the Plan would hold the Nabisco Funds.

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's decision was then reported to the 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 (see Investment Review Checklist for 401(k) Plan Committees). Soon after, officials took steps to implement the decision by notifying Plan participants that the Nabisco Funds would be eliminated within approximately six months.

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

In October 1999, RJR considered changing the working group's decision to sell the Nabisco Funds, but ultimately decided to abide by it. RJR then sent letters to Plan participants stating that it would eliminate the Nabisco Funds from the Plan.

In January 2000, the plaintiff, Richard Tatum, who was an employee of RJR before and after the spin-off and a participant in the Plan, sent an e-mail requesting that the Plan not force the sale of the 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%.

Procedural Background

In May 2002, Tatum filed a class action lawsuit against RJR, the Benefits Committee, and the Investment Committee alleging a breach of their ERISA fiduciary duties in managing the Plan and specifically by choosing to divest the Nabisco Funds.

The district court held that:

RJR's decision to remove the Nabisco Funds from the Plan was a breach of its fiduciary duties under ERISA because RJR did not properly investigate the prudence of that decision (see Practice Note, ERISA Fiduciary Duties: Overview: Duty of Prudence).
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.

On appeal, the Fourth Circuit affirmed the district court's holdings that RJR breached its duty of procedural prudence, but found that the district court did not apply the correct legal standard in determining RJR's liability. The Fourth Circuit held that RJR's decision to remove the Nabisco Funds was objectively prudent if a hypothetical prudent fiduciary would have made the same decision anyway (see Legal Update, Fourth Circuit Applies More Stringent Standard for Breach of Duty of Procedural Prudence by Retirement Plan Fiduciaries).

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.

Outcome

On remand, the district court explained that, because of its lack of procedural prudence, RJR bore the burden of proving that, despite its imprudent decision-making process, its ultimate decision was objectively prudent. According to the Fourth Circuit, a decision is objectively prudent if a hypothetical fiduciary would have made the same decision.

The district court held that, by a preponderance of the evidence, had a prudent fiduciary reviewed the information available to it at the time, it would have decided to divest the Nabisco Funds at the time and in the manner that RJR did.

In making its decision, the court considered the:

Requirements of the plan documents (Requirements of the Plan Documents).
Risk of the investment compared to its return characteristics (Risk v. Return).
Timing of the divestment (Timing of the Divestment).

Requirements of the Plan Documents

ERISA requires plan fiduciaries to act in accordance with the plan documents. A fiduciary's lack of compliance with the plan terms may be evidence in favor of a finding that the fiduciary did not act as a prudent fiduciary would under the circumstances.

Here, the Plan document required the Nabisco Funds to remain frozen in the Plan. The Fourth Circuit found that it was an error for the district court not to factor into its analysis RJR's lack of compliance with the Plan document.

The court explained that, regardless of the testimony given that the amendment was invalid, the evidence demonstrated that:

Plan participants were aware that the Nabisco Funds would be frozen and subsequently eliminated.
Committee members were not intentionally acting in disregard of the Plan document.

The district court held that the failure to act in accordance with the plan terms did not affect the substantive issues that a prudent fiduciary should consider when determining whether the Nabisco Funds should have been divested or retained.

Risk v. Return

The Fourth Circuit explained that risk is a consideration in evaluating a divestment decision, but that an objectively prudent fiduciary's decision will not rest on risk alone. The district court reasoned that a prudent fiduciary should balance the risk with the return characteristics of the investment option and how they fit within the context of the plan.

Here, the court stated that the context includes, among other things:

The Plan's purpose to help participants meet long-term savings goals.
The consideration that investors are generally reluctant to sell investments that have fallen in price.
Findings that 401(k) plan participants generally make few or no changes to their investments.

In finding that the risk of holding the Nabisco Funds outweighed the likely return, the court balanced the considerations that a prudent fiduciary would have taken into account, including:

The Plan was not diversified and included single-stock funds, which are four times riskier than a diversified portfolio of mutual funds.
Considerable litigation risk from ongoing litigation against tobacco companies.
Noteworthy bankruptcy risk as a consequence of the tobacco litigation.
The Nabisco Funds' returns were highly correlated with RJR. During the time period at issue, Nabisco stock was losing value and RJR was continuing to experience adverse rulings and verdicts related to the tobacco litigation.
Research at the time would have shown that there was no reason to expect extraordinarily high returns from the Nabisco Funds because the market for the Nabisco Funds was generally efficient. In efficient markets, investors are not able to predictably make extraordinary returns based on publicly available information.

Timing of the Divestment

RJR provided a six month time frame for the divestment in order to give employees notice and allow them to reallocate their funds.

The district court explained that the prudence of the timing of the divestment decision requires an analysis of whether:

A prudent fiduciary would have also decided to remove the Nabisco Funds from the plan approximately six months after the spin-off.
A fiduciary, under the duty to continually monitor the prudence of the divestment decision, would have decided to go forward with the divestment as planned in light of any changes in circumstances (see Practice Note, ERISA Fiduciary Duties: Overview).

The court found that, although the timeline for divestment was arbitrary, six months was a long enough period to give notice to all plan participants and coordinate the process of divestment. It also noted that there was actually approximately nine months between when participants were first notified and when the divestment occurred.

Practical Implications

This lengthy divestment decision provides helpful information to plan fiduciaries considering a divestment of employer stock from their participant-directed 401(k) plans. It also provides comfort that, at least within the Fourth Circuit, a plan fiduciary’s decision to divest a frozen employer stock may be considered to be prudent, even in light of a failure to abide by the procedural prudence requirements of ERISA, if a hypothetical plan fiduciary would have made the same decision based on the totality of the circumstances.

On Remand, Plan Fiduciaries’ Decision to Divest Nabisco Stock Fund Found Prudent | Practical Law