Benefitsblog

An Unsuccessful ERISA Legal Challenge to Market-Timing Restrictions

With recent market-timing allegations in the current mutual fund investigation, there has been much discussion around the practice of placing restrictions on frequent trading in 401(k) plans. Such restrictions are usually drafted into the prospectus, the Summary Plan Description ("SPD") and the plan document governing the 401(k) plan. Has anyone challenged the legality of such restrictions under ERISA? The answer is yes and the case is Straus v. Prudential Employee Savings Plan, 253 F. Supp 438 (E.D.N.Y. 2003).

In the Straus case, participants in the company's employee savings plan brought an action against the company, the plan, and the plan administrator (collectively the "defendants"), alleging violations of ERISA and promissory estoppel. Participants in the case brought a motion for preliminary injunction to prevent defendants from enforcing the plan's restrictions on the participants' right under the plan to transfer funds from one investment option to another in unlimited amounts.

What the Plan, SPD, and Prospectus said about market-timing: The provisions contained in the plan, the SPD and the prospectus in Straus were as follows:

• The Plan gave employees the right to reallocate their contributions to a different fund and to transfer money into and out of these funds, but indicated that there might be restrictions on some transactions. It also stated that the Administrative Committee might decline to implement investment instructions where it deemed appropriate and that the Administrative Committee had the power to adopt “rules and procedures” to govern “[a]ll Participant elections and directions under the terms of the Plan.”
• The SPD set out the rules for making changes and transfers, but then stated that in certain situations (for example, excessive trading, etc.), there might be limitations regarding transfers. The SPD referred participants to the fund prospectus(es) and/or fact sheets for more information on any trading restrictions that might apply to the investment option(s) that participants might choose, and to the online Terms and Conditions on the plan web site for more details. (The court noted that the SPD did not contain the Plan provision that stated the Committee might decline to implement investment instructions where it deemed appropriate.)
• The fund prospectuses warned that frequent trading of shares in response to short-term market fluctuations, a practice known as “market timing,” could disrupt the management of the fund and explained that fund managers might be forced to sell securities at inopportune moments in order to have enough cash available to redeem the shares of those engaging in market timing trades, thus damaging the overall health of the fund. For this and other reasons, the prospectuses advised investors that fund managers reserved the right to refuse purchase orders and fund exchanges if the fund manager believed the transaction would have a disruptive effect on the portfolio.

What the plaintiffs had to say about market-timing: The plaintiffs (as plan participants) claimed that they had "educated themselves about the various investment options and developed strategies for maximizing the return on their investment." They acknowledged that they "paid close attention to world events and market shifts in managing their investments" and explained that "understanding the economic effects of the events of September 11, 2001, the tensions in the Middle East, and the Enron and WorldCom bankruptcies, to name a few, was critical to their strategy for protecting their retirement funds." They claimed that, in reaction to these events, they had regularly transferred large amounts of money—sometimes in the hundreds of thousands of dollars—into and out of different Plan investment vehicles several times per month, that such transfers were permitted under the Plan, and that they had been investing in this manner very successfully for several years before Prudential began imposing restrictions on them.

What the court had to say about market-timing: The court held that the participants did not have a right, under the plan or ERISA, to transfer funds from one investment option to another in unlimited amounts. The court also held that in blocking participants' transfers of funds from one investment option to another and in promulgating trading policies, the plan administrator was exercising powers that it possessed under the terms of the plan and was not deemed to have amended the plan in violation of ERISA and plan procedures. The court also stated:

In their brief, plaintiffs attempt to salvage this claim by arguing that, while the SPD may have contained a general reference to limitations on excessive trading, the plan never defined excessive trading in any way, nor were plan employees able to explain what it meant when plaintiffs inquired into the matter. Since no one could explain the specifics of this limitation, they conclude, by implication “no such limitation on 'excessive trading' existed....” . . . Such reasoning is clearly spurious. A non-specific limitation is nonetheless a limitation. To argue as plaintiffs have is akin to arguing that since your mother did not tell you how long you were grounded for, you must not be grounded. Indeed, such arguments only serve to prove the opposite point, namely that a general limitation was in place and that plaintiffs were well aware of its existence.

Additional rulings of the court:

• The retroactive application of policies modifying rules governing participants' transfers of funds did not violate ERISA.
• Where defendants never made any promise of a right to have unlimited fund transfers between different investment options, defendants were not estopped from limiting participants' ability to transfer funds under the plan.

What plan sponsors can learn from the decision: The primary focus of the case in deciding against the plaintiffs was the language contained in the plan document, the SPD and the prospectus. While not entirely consistent and bullet-proof, the language was deemed to have been sufficient to inform participants (who were claiming an unlimited right to make trades) of the plan administrator's right to place restrictions on "market-timing" activities. Query: What result would been reached if the plan document had not contained the necessary language, but the prospectus and the SPD had contained this language? Query: What result would have been reached if the plan document had contained the necessary language, but the prospectus and the SPD had not contained this language?

It is important that plan sponsors examine their plan documents, SPD's and prospectuses to determine what, if any, language addresses this issue. With all of the focus now on curbing market-timing practices, it is probable that more legal challenges could ensue, and so, plan sponsors should make sure that all documents surrounding the plan comport with all of the rules, policies and procedures which are being administered.

For those companies whose employees have been market-timing in their 401(k) plans, where plan documents contained language prohibiting these types of trades, plan fiduciaries likely would be exposed to claims of fiduciary breach since fiduciaries have not administered the plan "in accordance with plan documents." ERISA section 404(a)(1)(D). Also, plans which have not been operated in accordance with plan documents could technically run the risk of disqualification with the IRS.

Where plan participants have been market-timing and the plan document is silent, but the prospectus contains language restricting such trades, plan documents should be amended to conform to the trading restrictions contained in the prospectus. If restrictions on market-timing are being instituted for the first time with changes to plan language and language in the SPD and prospectus being made, the issue arises as to whether or not Sarbanes-Oxley would require a 30-day advance notice. That issue will be saved for another day . . .

Posted by B. Janell Grenier at November 24, 2003 11:33 PM