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-timlng 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 the New York Attorney General, the SEC, and a number of other regulatory agencies investigating mutual funds for improper trading practices, many executives, human resource professionals, and other individuals who serve on retirement plan committees and/or who are involved in communicating benefits to employees have concerns about their obligations under ERISA. Fresh on everyone's mind are the Enron and WorldCom decisions in which executives and HR professionals were alleged to have violated ERISA through their inaction and lethargy in the face of corporate scandals. In addition, as the news brings more and more evidence of improper mutual fund practices to light, the mere job of keeping track of the different funds implicated is challenging in itself and has been likened to "trying to stop a dam from bursting by using your fingers to fill the holes."
The selection of a mutual fund as an option for investment in a 401(k) plan subjects those who are responsible for making the selection to ERISA's fiduciary standards. Those who serve as ERISA fiduciaries must monitor the mutual funds offered to participants on a continuing basis and determine whether or not they remain suitable investment options for participants. In connection with these fiduciary standards, the Department of Labor (which is in charge of ERISA enforcement) recently made the following comments about the mutual fund scandals:
What should plan fiduciaries do in light of the allegations? ERISA requires that plan investment decisions, including the selection of mutual funds, must be prudent and solely in the interest of the plan's participants and beneficiaries. Allegations of improper mutual fund practices where a plan is invested must be factored into the fiduciary's determination of the continuing appropriateness of that investment. . . .We expect that fiduciaries will be attentive to activities that materially affect the plan's investment in the mutual fund or expose the plan to additional risk. . .[We] hope that the issues raised by Enron and similar cases have focused corporate officials on the important role fiduciaries play in protecting plan participants and has provided a necessary wake up call for people to take their fiduciary responsibilities seriously.
Plan fiduciaries should obtain information and stay on top of what is happening with respect to the mutual fund companies in their 401(k) plan line-up. While the New York Attorney General and the SEC have been investigating mutual fund practices, plan fiduciaries should be proceeding with their own independent investigation as well. In order to take appropriate action such as removing funds from a plan's line-up, fiduciaries should gather accurate information about a mutual fund's involvement in the current investigation. This would include seeking and keeping track of information from various news sources, from consultants who advise the plan, and most importantly from the fund managers themselves. Many plan fiduciaries have already sent letters to all of their investment providers (even those not implicated) asking that a checklist of information be completed by them in order for the fiduciaries to be able to prudently monitor the provider's status and involvement in the mutual fund scrutiny. Included in this checklist would be such questions as to whether or not the mutual fund complex represented in the plan has been implicated in market timing or late trading as well as what procedures the mutual fund has in place to prevent such practices.
Plan fiduciaries should analyze information and evaluate alternatives. It is apparent that, of the mutual funds under scrutiny, not all are engaged in the same level of activity as others and that different levels of involvement would require that different actions be taken with respect to the various mutual funds implicated. Here are a few of the questions that plan fiduciaries may want to consider in evaluating their mutual fund providers who have been involved in market timing or late trading:
The investment policy statement can also be very helpful in evaluating the information collected and determining whether or not fund offerings continue to meet the standards set forth in the investment policy statement.
Plan fiduciaries should act prudently based on available information and in accordance with applicable laws. Plan fiduciaries should not "act in a vacuum" without considering the following legal constraints:
Plan fiduciaries should also consider the following courses of action with respect to an implicated mutual fund offering, depending on the information gathered and the results of the analysis performed:
Plan fiduciaries should communicate with participants and beneficiaries where necessary and appropriate. Recent developments in the law have further emphasized the principle that participants and beneficiaries need to be informed on an ongoing basis of any material information which would affect participants' and beneficiaries' interests in the plan. In the wake of mutual fund scandals, plan fiduciaries including HR professionals who communicate benefits to participants will be faced with difficult decisions regarding their disclosure obligations to plan participants, particularly if the plan is a 401(k) plan where participants direct their own investments. These individuals must determine whether or not prudence requires them to disclose to participants that a fund's manager is under investigation and what steps the fiduciaries are taking in response to the allegations. They must also decide whether or not prudence requires them to issue a communication to all participants or to simply respond to individual inquiries. Many of these questions should be answered with the help of legal counsel who has been apprised of all of the pertinent facts and circumstances. Certainly if funds are removed and new ones offered, section 404(c) of ERISA would require participants to receive reasonable advance notice of such changes. However, the replacement of a fund would not constitute a "blackout period" requiring a Sarbanes-Oxley type advance notice, according to language in the preamble to regulations finalized by the DOL this year, unless the replacement constituted a "temporary" replacement, or unless in connection with implementing a permanent replacement, some rights would be temporarily suspended, limited or restricted.
Additional Note to Fiduciaries:
Document, document, document! It is important that all aspects of the prudent processes described above be fully and carefully documented. Plan fiduciaries should keep communication logs, recording relevant information that has been considered, and should document the decisions made and the decision-making process through preparation of minutes of their plan fiduciary meetings.
Plan Committees should meet frequently as needed. In addition, while retirement plan committees may normally meet on a quarterly basis, the current mutual fund scrutiny will likely require more frequent meetings otherwise known as "special meetings" to be called and attended by plan fiduciaries. In the recent Enron decision, the judge mentioned the lack of frequent meetings by plan committee members as one indication that fiduciaries may not have met their fiduciary standards under ERISA.
"Lawyers Are Warned on Mutual Fund Roles": the New York Times is reporting. According to the article, the SEC is saying that regulators may soon open a new front in their investigation of possible wrongdoing at mutual funds, focusing on the role of lawyers who represent them. This focus on lawyers was revealed in a speech by SEC Commissioner Harvey J. Goldschmid, entitled "Mutual Fund Regulation: A Time for Healing and Reform," before the ICI 2003 Securities Law Developments Conference on December 4, 2003. Here are some of his remarks:
Fund lawyers, under SEC rules that became effective August 5, 2003, have a similar "reporting up" duty. The SEC's attorney conduct rules apply to any attorney employed by an investment manager who prepares, or assists in preparing, materials for a fund that the attorney has reason to believe will be submitted to or filed with the Commission by or on behalf of a fund.Under these rules, an attorney who is aware of credible evidence of a material violation of the securities laws, or a material breach of fiduciary duty, must report this evidence up the chain-of-command or ladder to the fund's chief legal officer, and ultimately, to the independent members of the mutual fund board.
This "reporting up" requirement should significantly enhance the flow of key legal information (involving "reasonably likely" material violations) to independent members of the fund board. "Reporting up" also empowers lawyers. The requirement will allow dispassionate, independent fund directors — not conflicted fund investment managers — to resolve key securities law and conflict-of-interest issues. Everyone should understand that the SEC's rules are now a matter of substantive federal law. As of August 5, available for violations are the Commission's traditional broad spectrum of remedies, penalties, and other sanctions.
Mike O'Sullivan at Corp Law Blog weighs in on this development here as well as Professor Bainbridge here.
Regarding the mutual fund scandals in general, the December 15th issue of Business Week has an article entitled "Breach of Trust." The article makes the interesting point that "changes in retirement plans--particularly innovations in 401(k) plans"--provided fuel for the mutual fund scandals. The article states that just a decade ago, "participants had few funds to choose from and were limited to one trade each quarter." The article goes on to say that with plans offering so many choices and participants being able to trade daily, it is these innovations which "paved the way for abuses, such as market timing by 401(k) participants."
The Wall Street Journal today has this article discussing how employers and fund companies "are cracking down on workers who make frequent in-and-out trades in their 401(k) plans": "The Crackdown on Funds Hits Your 401(k)." Here are what some of the companies are doing to curb market-timing, according to the article:
Finally, CBS Market Watch reports: "It's the expenses, stupid: Illegal timing and trading are distractions." The article describes how mutual funds are skimming off your money in what is called the "fund industry casino."
From the New York Times: "Memo Shows MFS Funds Let Favored Clients Trade When Others Couldn't."
And would you believe the "Fed Cracks Down on Trading in Its Own Employee Fund." (From Yahoo! News.com)
With all of the talk about changing mutual fund providers in the current mutual fund scrutiny, one of the key elements in the decision-making process will be the costs involved in changing providers. For those who do not know, the SEC provides a Mutual Fund Cost Calculator at its website. Here is what the SEC has to say about the calculator:
The Mutual Fund Cost Calculator enables investors to easily estimate and compare the costs of owning mutual funds. . . Mutual fund costs take a big chunk out of any investor's return. That's why it's important for investors to know what costs they are paying, and which cost structure is best for them. By using the Cost Calculator investors will find answers quickly to questions like this: Which is better, a no-load fund with yearly expenses of 1.75% , or a fund with a front-end sales charge of 3.5% with yearly expenses of 0.90%?
The SEC states at its website that "costs aren't the only thing that should be considered when investing in a mutual fund" (an understatement after recent mutual fund scandals) and that the investor should consider the following in deciding whether or not to invest in a certain mutual fund:
The Office of Investor Education and Assistance publishes the "Online Publications for Investors" which provides information regarding the following aspects of mutual fund investing:
In addition, the SEC provides additional information entitled "Publications on Mutual Funds, Fees, and 401(k)s."
Finally, regarding the mutual fund industry problems in general, Newsday.com is reporting today: "Outflows Cause Concern For Mutual Fund Investors." Also, the Seattle Times reports: "When employer makes 401(k) changes, doing nothing can cost you." The latter article notes that "[s]ome companies, such as drug maker Merck, of Whitehouse Station, N.J., are eliminating certain equity investments and then transferring participants' balances into money-market accounts" and this "puts the onus on participants to reallocate the investments or risk not having them keep up with inflation."
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 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 . . .