Nine former employees of Signet Banking Corp. are testing the limits of laws and regulations designed to protect plan sponsors from litigation as fiduciaries. Their class-action lawsuit on behalf of 5,000 former Signet workers was filed in May against First Union Corp. of Charlotte, North Carolina, which acquired Signet Banking in 1997.
As the first prominent court battle since the Department of Labor adopted 404(c) regulations in 1992, the court's decision may set guidelines for handling pension assets in the wake of mergers and acquisitions. Particulars are confined to First Union and perhaps financial institutions that offer proprietary options in 401(k) plans, but ramifications could set a broader precedent. "It's an important case," says Alan Lebowitz, deputy assistant secretary of the Pension and Welfare Benefits Administration. At issue are critical questions about the nature of fiduciary status, the scope of the Employee Retirement Income Security Act (ERISA) regulation, and the trade-off between consolidating pension assets and keeping new workers happy and productive.
The nine plaintiffs charge First Union with violating its fiduciary duty when it liquidated assets in the Signet plan and transferred them to proprietary funds at First Union. At Signet, a big portion of plaintiffs' 401(k) assets had been invested in Capital One, a high-flying spin-off whose stock price has more than tripled since First Union transferred the stake to its handful of mutual funds. Adding insult to injury, plaintiffs complain, First Union tacked on administrative fees it does not require some of its corporate clients to pay.
When First Union announced its intention to replace former Signet employees' stake in Capital One with shares of its own stable value fund, the plaintiffs bristled — not least because, after helping to build Capital One's lucrative credit card business from scratch, they felt they deserved to participate in its roaring success.
"We all got on the phone and tried to learn the reasoning behind the decision," remembers Sue B. Franklin, one of the plaintiffs. The bank's alleged reply: "We don't feel it's wise for you to have so much invested in a single stock."
Some ERISA attorneys believe the case may clarify key aspects of pension regulation. It may define the extent to which employers are sheltered from fiduciary liability when they design pension plans, when they are seen to be acting as employers, not fiduciaries. It may also define the extent of an employer's protection from fiduciary liability under Section 404(c) regulations, which govern participant-directed defined contribution plans.
Two Important Protections
To David Wray, president of the Profit Sharing/401(k) Council of America, the potential seems somewhat more limited. "It is unlikely to clarify any murky areas of the law," he says. The facts in this case are unique to First Union, he says, and the final ruling likely limited in its impact only to First Union. Its impact on financial institutions, if any, would depend on what the court states in its final opinion, Wray says.
The case should nevertheless remind all plan sponsors that it is necessary to: (1) design a process to make fiduciary decisions on behalf of pension beneficiaries and (2) be able to prove adherence to that process. Wray's advice, meanwhile, for plan sponsors when they act as fiduciaries on any matter, including mergers and acquisitions: "Sit down and think about it and put a note in your file." In other words, create a paper trail.
The most obvious implications are for financial institutions that provide proprietary funds in their 401(k) plans for their own employees. The First Union case could become a cautionary tale in this regard. "Financial institutions have to exercise the same level of prudence as managers to select investments for employees as they do when they manage other pension plans," says Steve Saxon, an ERISA attorney and a partner with Groom Law Group, in Washington, D.C. "They still have to evaluate the fund and have a diversified selection of investments that are performing reasonably well," he says.
Following its standard practice after mergers, First Union liquidated $250 million in investments by 5,000 Signet plan participants invested in eight different options. It shifted them to four of the seven investment options available in the First Union plan. (After a brief transition period, former Signet workers were able to invest in all seven First Union options.) In doing so, plaintiffs contend, First Union deprived them of collective gains that would have exceeded $150 million.
The plaintiffs' charge in the First Union lawsuit identifies the lion's share of the $150 million as foregone returns on a $50 million stake in the shares of Capital One Financial. Between December 1997, when First Union liquidated the pension assets, and the date the lawsuit was filed this past May, Capital One's shares more than tripled — to $170 million, a $120 million gain. Additional lost returns stem allegedly from $50 million that had been invested, premerger, in two of Signet's nonproprietary funds — the Vanguard Index Trust 500 Portfolio and the American Century/Twentieth Century Ultra Investors Fund. These two funds combined grew in value to $67 million by May 1999. This represents respective gains of 37 percent and 33 percent. During the same period, First Union's Stable Value Fund supplied modest returns consistent with similar funds.
The $150 million claim also includes unspecified "millions of dollars" that First Union allegedly has earned in administrative and other fees for managing its 401(k) plan, as well as the funds that are investment options under the plan. Subtracting those lost returns on Capitol One, Vanguard, and Ultra, it appears the suit has allocated $13 million to cover fees the plaintiffs believe should not have been charged to employees.
If the former Signet fund options continue to outperform First Union plan options, it could eventually raise the amount of the claim beyond $150 million, says Michael D. Lieder, of Washington, D.C.-based Sprenger & Lang, which is representing the plaintiffs, along with Richmond, Virginia's Hirschler, Fleischer, Weinberg, Cox and Allen. On past occasions, Sprenger & Lang has tangled successfully with First Union. In 1997, it obtained a $58.5 million settlement in a race- and age-bias class-action suit brought against First Union by former employees after their companies were acquired by First Union.
The lawsuit also faults First Union for failing to waive the administrative fee for managing the company pension plan. First Union is "forced" to waive 401(k) fees for larger plans it administers because other plan sponsors will simply go elsewhere for those services if they do not, says Lieder. "First Union doesn't waive its 401(k) fees for its own plan, even though its plan, I believe, is by far the biggest [the firm] administers."
In First Union's defense, integrating the Signet 401(k) plan and transferring assets conforms to common practice. U.S. Office Products, in Washington, D.C., for example, has made about 200 acquisitions during the past three years. In the process, it has folded approximately 55 plans into its own 401(k) plan, boosting assets from $4 million to $95 million. "Our standard practice in each case has been to map the company funds from the acquired company into a similar fund in our own plan," says benefits manager Scott Maynard.
Rare instances may call for different practices. "In some situations, where there is a merger of equals, some will reevaluate what kind of plan they need for the union of the companies, and they may come up with a new plan," says Bill Quinn, president of AMR Investment Services, in Dallas/Fort Worth, which has $20 billion under management, including $3.2 million in American Airlines's 401(k) plan.
A tough battle lies ahead, to judge from entrenched positions on both sides. In response to the lawsuit, First Union has denied the allegations, as well as assertions that its actions were those of a fiduciary.
Taking refuge behind standard legal boilerplate, the bank officially professed ignorance of some of the charges. First Union lacks "knowledge or information sufficient to form a belief as to the truth" of the allegations, according to court papers. First Union and its outside counsel have declined to discuss the lawsuit outside of court. "I'm not authorized to discuss the case," explains Greg Braden of lead counsel Alston & Bird, in Atlanta.
A prepared statement after the complaint was filed gave few hints of First Union's legal strategy. "First Union takes its responsibility with respect to its 401(k) seriously," according to the statement. "To provide our employees [with] a uniform benefit, we maintain a single 401(k) plan. Our plan provides participants with a broad range of investment options. We have [administered] and will continue to administer our plan for the benefit of the participants."
Addressing the question of fiduciary duty comes first, says Lebowitz of the Pension and Welfare Benefits Administration. The plaintiffs claim that First Union breached its fiduciary duty. Proving this "is the most significant hurdle for the plaintiffs," says Lebowitz. The court must decide "whether the allegations are governed by ERISA, or whether they are those of an employer acting as an employer," in which case they are not governed by ERISA, according to Lebowitz. The difference amounts to much more than splitting hairs. "ERISA [leaves] a great deal to plan sponsors. It allows complete discretion in the design of a plan, including whether or not the plan will continue to offer a particular investment," Lebowitz explains.
Courts have not yet sorted out how employers should map investments to their own pension plans from funds formerly managed by an acquired company. Absent such rules, First Union can argue that there was no option in its plan identical to Capital One. Thus, in its role as an employer designing a pension plan, First Union was free to map the Capital One assets to the stable value fund that it will describe, says one expert, as "a valid and prudent investment option."
Only if the court decides these issues fall within ERISA's scope will the issues surrounding the choice of options in the plan come into play, says Lebowitz. These include any fiduciary liability under Section 404(c), which governs participant-directed plans. That section provides a haven for plan sponsors, so long as plans offer a minimum number of options that participants can change in a timely manner. These rules state, however, that plan sponsors are acting as fiduciaries when they select the investment options in their plans.
Burden of Proof
The outcome of the case might ultimately turn on whether it can be shown that First Union was driven by self-interest "to feather its own nest," claims Michael S. Gordon, a Washington, D.C., ERISA attorney who helped write the legislation more than 25 years ago. If this can be demonstrated, then the actions would come under ERISA, he contends.
First Union's motivation in liquidating the nonproprietary Signet funds could decide the verdict, according to an ERISA attorney who represents plan sponsors. The burden of proving First Union's motive will fall on the plaintiffs' attorneys, who will have to convince the court that the bank did not fulfill its role as fiduciary. (There are no juries in ERISA cases.) The outcome might depend, then, on "whether the court believes your version or someone else's version" of what transpired, says an attorney familiar with the case.
"The question will arise whether First Union can demonstrate that it went through a prudent process to select the funds in its plan," says one seasoned ERISA attorney who represents employers. "If First Union's procedure was simply to conform Signet Banking to First Union's investment options," he says, "that might not be a sufficient defense."
His advice to any employer that either offers proprietary funds or acquires another company with a 401(k) plan and merges that plan into its own: "Make sure you can demonstrate that you have a basis for selecting the particular funds in a particular plan."
All this legal wrangling points to at least one unequivocal observation: "For all employers," says Groom Law Group's Steve Saxon, "the suit demonstrates how important it is to prudently select investment options under a 401(k) plan."
As mergers and acquisitions streak to record levels, more pension assets than ever are subject to changes of control. Although no one keeps tabs on the exact number, billions of dollars fall subject to murky areas of the law governing how these assets are treated in the wake of mergers.
But controversy may not end with a court decision. Should First Union prevail, attorney Gordon suggests that the outcome could trigger new legislation or regulation to protect workers who find themselves in a situation similar to that of the Signet Banking employees. Gordon suggests that there may be a need for a rule that would allow workers to keep prior investments when companies are taken over, and that employers can require only that new employee contributions to a 401(k) plan be put into the acquiring company's proprietary funds.
An Ounce of Prevention
Merger negotiations seldom attach a high priority to workers' nest eggs. Thus, details of pension programs often get short shrift. This invites trouble, as First Union Corp. learned in the wake of its merger with Signet Banking Corp. Due diligence can't avert or solve every problem, but it can improve the odds of smoother transitions. A few guidelines can help to avoid disgruntled workers and legal imbroglios, says attorney Paul Lang of Dow, Lohnes & Albertson, general counsel for the Profit Sharing/401(k) Council of America:
- Use the need to communicate to win new employees over. Nothing grabs workers' attention like information about their personal investments. Use this to demonstrate that they matter to their new employer.
- Determine timing of contributions. Did the seller make contributions annually? Quarterly? With each paycheck? Workers pay attention to this. If frequency is going to change, they'll notice. Absent an explanation, human resources will hear about it.
- Investigate recordkeeping practices and quality. Managing thousands of individual pension selections complicates recordkeeping. Terminating a plan often uncovers discrepancies that don't show up in routine accounting. Even the best intentions and the most up-to-date technology do not exempt plans from questions concerning the disposition of some pension assets.
- Find out who is making contributions. This is critical when sellers remain in business after parting with units. Who takes responsibility for pension payments? During extended negotiations, these obligations can fall behind, leaving the buyer with dissatisfied workers, if not an added expense.
- Prepare to transfer outstanding loans to plan participants. If new plans can't absorb loans right away, employers will have to develop backup plans. The process should be seamless and, preferably, invisible to employees.
- Determine allocations. How much do profit-sharing plans contribute versus matching plans or other types of contributions?
- Check out the exit clause in the seller's pension programs. Will employees have to surrender back-end loads? Will it cost new employers a penalty?