On March 3, 2005, the Securities and Exchange Commission voted to adopt a rule concerning mutual fund redemption fees. (Release 2005-28) The rule will require the boards of mutual funds that redeem shares within 7 days to adopt a redemption fee of no more than 2 percent of the amount of the shares redeemed or determine that a redemption fee is not necessary or appropriate for the fund. The rule is designed to permit (but not require) funds to impose a redemption fee if they determine that the fee is necessary or appropriate to recoup the costs that short term trading can impose on funds and their long term shareholders.
The rule also will require funds that redeem shares within seven days to enter into agreements with their intermediaries (such as broker-dealers and retirement plan administrators) obligating them to provide funds with shareholder trading information. This information will permit funds to identify shareholders who violate the funds' market timing policies, and oversee the intermediaries' assessment of any redemption fees. Unlike the rule the Commission proposed last year, the rule will permit fund managers to determine how frequently the fund asks for this information, and will include a provision requiring that the agreement obligate the intermediary to respond to directions from the fund to enforce the fund's market timing policies.
See also remarks made about the rule by SEC Chairman William H. Donaldson and Paul Roye, Director, Division of Investment Management, before the Open Meeting held March 3, 2005.
Suppose an employer discovers that some of its employees are market-timing* in the employer's 401(k) plan and rightly decides that such practices are detrimental to the rest of the participants. Suppose the employer asks the employees to cease the market-timing and all employees heed the request, except one. Could the employer terminate the rebellious employee who fails to comply with its request? Or how about just warning the employee that his employment and career at the company could be impacted if the employee doesn't stop? Wouldn't such action on its face appear necessary in light of recent mutual fund scandals? Does an employee have a right to engage in market-timing in a 401(k) plan?
A federal district court in Iowa grappled with these very issues in a fascinating case decided last year. The case was Borneman v. Principal Life Ins. Co., 291 F. Supp. 2d 935 (S.D. Iowa Nov. 25, 2003) [pdf (62 pages)]. According to the court in Borneman, if the plan document allows market-timing, i.e. does not contain any restrictions on market-timing, the employer could be held to violate section 510 of ERISA if it takes adverse action against an employee in order to hinder the employee from exercising his or her rights under the plan. In other words, the court reasoned that, if the plan document allows market-timing, the participant then would have a supposed right to engage in market-timing, and any adverse action taken against the employee to prevent his or her exercise of such right could violate Section 510 of ERISA. (That section provides that "It shall be unlawful for any person to discharge, fine, suspend, expel, discipline, or discriminate against a participant or beneficiary for exercising any right to which he is entitled under the provisions of an employee benefit plan, this subchapter . . . or for the purpose of interfering with the attainment of any right to which such participant may become entitled under the plan [or] this subchapter.")
The court in Borneman stated:
An integral part of Plaintiff's § 1140 claim for retaliation is a showing that he exercised a right to which he was entitled under the terms of his employee benefit plan or under ERISA itself: There is no dispute in this case that throughout the time period relevant to this lawsuit, the market timing trading that Mr. Borneman was engaging in was permitted under the terms of his Plan. Mr. Borneman freely engaged in market timing trading until approximately June 14, 2001. Until that time, there had been no market timing trading restriction in place. Principal had requested that Plaintiff voluntarily limit his trading, but such request does not constitute a limitation under the Plan. Plaintiff's trading to that point was a protected activity. After June 14, 2001, it is undisputed that Mr. Borneman did not trade in excess of the $30,000 limit imposed by Principal, which this Court has found that Principal had the right to impose. Thus, any trading after June 14, 2001 was a protected activity as well. Consequently, any retaliation by Principal on the basis of Plaintiff's market timing trading throughout the duration of his employment would have been prohibited under § 1140. At all times, market timing trading in the amounts engaged in by Plaintiff was a right to which he was entitled under his employee benefit plan.
The court went on the analyze the different actions taken by the employer, and determined whether or not they were actions which could constitute "adverse employment actions" interfering with plaintiff's right to engage in market-timing under ERISA. The court made the following interesting determinations:
(1) Amazingly, terminating the employee did not interfere with his right to engage in market-timing, said the court, since the "[p]aintiff retained his employee benefit plan after termination" and would have been "able to continue market timing trading even after his employment was terminated."
(2) However, the court held that the adverse performance reviews and even "threats" about the employee's future at the company could interfere with the employee's exercise of his "right" of market-timing and section 510 claims should be allowed to survive a Motion for Summary Judgment on those issues:
Although these threats do not immediately affect the terms and conditions of a claimant’s employment, they do materially affect whether or not such employee can freely exercise his ERISA rights. By prohibiting retaliation and interference, § 1140 creates a seamless web of protection for participants and beneficiaries. Participants and beneficiaries are protected from attempts to discourage them from exercising rights under ERISA or their employee benefit plans, and they are protected if exercise of these rights actually results in an adverse employment action. If interference did not encompass protection against threats of discrimination, employers would be free to threaten employees with severe adverse employment actions, including termination, for exercising their rights.
While many plan documents now contain such market-timing restrictions or give discretion to impose market-timing restrictions, many still do not address the issue. Putting the restrictions in the plan document may protect the employer from liability under section 510 of ERISA. In addition, the DOL has indicated (in guidance issued last February on the subject of fiduciary response to the mutual fund scandals) that plan documentation is important with respect to the market-timing issue:
The imposition of trading restrictions that are not contemplated under the terms of the plan raises issues concerning the application of section 404(c), as well as issues as to whether such restrictions constitute the imposition of a “blackout period” requiring advance notice to affected participants and beneficiaries.
*"Market-timing" is a trading strategy that involves frequent purchases and sales of securities (with the securities being held for short periods) in an effort to anticipate changes in market prices.
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:
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:
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 . . .