Court Dismisses 401(k) Stock Drop Case

Jane Edgar was saving for retirement by putting money in a 401(k) plan, which included the option of investing in the stock of her employer, Avaya Inc. It seemed like a good investment until April 2005, when the communications network provider announced it wouldn't meet its forecasted earnings goals because of problems with integrating an acquisition and implementing a new delivery system. The next day the stock price dropped 25 percent--from $10.69 to $8.01 per share-.

Edgar thought the company should have protected its employees' savings from this loss. In July 2005 she filed a class action lawsuit in U.S. District Court for the District of New Jersey, claiming the company and some of its officers breached their fiduciary duty under ERISA. Edgar argued the company artificially inflated the stock price with inaccurate earnings forecasts.

The plan's fiduciaries should have removed the company stock from the plan when they realized the price would tank and should have warned plan participants that a negative earnings announcement was coming, she said.

The district court disagreed. In April 2006 it dismissed Edgar v. Avaya, ruling Edgar failed to prove a breach of fiduciary duty. In upholding that decision in September 2007, the 3rd Circuit agreed the terms of the plan required the fiduciaries to offer company stock and that the company's circumstances were not dire enough to warrant withdrawing Avaya stock as an option. The court also rejected the idea that the defendants should have disclosed the company's financial plight to plan participants. If they had, the court said, the SEC might have charged them with insider trading.

"Edgar is an important development in the jurisprudence surrounding employer stock in 401(k) plans," says Doug Hinson, partner at Alston & Bird, the firm that represented Avaya. "It raises the bar for plaintiffs to survive motions to dismiss such cases, and it adds to the growing list of opinions that reject these claims."

Presumption of Prudence
A key factor in the decision was language in the Avaya plan documents providing that investment options "shall include the Avaya Stock Fund, which shall be invested primarily in shares of Avaya common stock." ERISA requires fiduciaries to honor the terms of the plan as long as doing so is "prudent."

"The plan mandated one of the investment options had to be company stock and it was that mandatory language on which the court based its decision," says Gregory Ash, partner at Spencer Fane Britt & Browne in Overland Park, Kan.

Because the Avaya 401(k) plan required that company stock be offered, it was similar to an Employee Stock Ownership Plan (ESOP), which invests primarily in company stock, the court reasoned. Therefore, the court extended the "presumption of prudence" standard protecting ESOP fiduciaries to cover
fiduciaries of 401(k) plans. Defined by the 3rd Circuit in 1995 in Moench v. Robertson, that standard generally protects ESOP fiduciaries from lawsuits following a stock price drop on the grounds that the plan required them to offer the stock. To bring a case, a plaintiff must establish that the fiduciary "abused its discretion" in offering the stock.

Having determined the Moench standard applied to this case, the 3rd Circuit found the Avaya trustees did not abuse their discretion. The facts of the case, the court said, did not create "the type of dire situation which would require the defendants to disobey the terms of the plans by not offering the Avaya Stock Fund as an investment option or by divesting the plans of Avaya securities." In fact, doing so could have made them liable for failing to follow the terms of the plan. The court noted that by July 26, 2005, the stock price had rebounded to $10.74, five cents more than its price prior to the drop.

The circuit court also rejected the arguments that the defendants should have disclosed the company's financial problems to plan participants or divested the plans of company stock prior to making the earnings announcement. The court said the defendants met their disclosure requirements by warning participants in the plan description that the value of their investment would fluctuate with the company's performance and that "investing in a non-diversified single stock fund carries more risk than investing in a diversified fund." Disclosure of adverse financial information prior to the earnings release could have resulted in the same stock drop and led to SEC charges of insider trading, the court reasoned.

Language Lesson
The Edgar decision illustrates the importance of word choice in drafting employee plan documents. Because the Avaya plan said trustees "shall" invest in company stock, it qualified for the protection of the Moench standard. That means companies that make their stock available in 401(k) plans should craft the language to say the plan "shall include" versus "may include" company stock.

"If I were an employer in the 3rd Circuit, I'd have more comfort now in offering a 401(k) plan that has company stock in it, but I would be very careful to look at the terms of my plan to make sure it has the kind of language the court pointed to in this case," Ash says.

While the immediate effect is only on 3rd Circuit employers, John Nixon, partner in Wolf, Block, Schorr and Solis-Cohen, notes the Moench standard has been adopted by other circuits in cases involving ESOPS and predicts they may extend the standard to 401(k) and other employee savings plans. That's good news for plan sponsors because it will be easier to win early dismissals of cases filed by employees after the company stock takes a dive.

"This case is a very big win for the defense bar in the ERISA stock drop world, and it has far-reaching implications," Hinson says. "We were able to convince the 3rd Circuit that ERISA is not broad enough to support these types of claims, so they can be disposed of on a motion to dismiss."

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