Author: jfortenberry@fortenberrylaw.com

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:

• 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 . . .

There is very little time to comment right now, but the Wall Street Journal reports this morning that the House has passed mutual fund legislation: “House Passes Bill to Curb Mutual-fund Corruption.”

By the way, a good article on the mutual fund saga appeared in the New York Times on Monday and quotes Rick Meigs of the 401khelpcenter.com: “Feelings Are Not Mutual in 401(k)’s.” (For those who would like to put a name with a face, the article also features a great picture of him.)

The 10b-5 Daily here and the New York Law Journal here discuss this opinion and order issued by Judge Denise Cote in the In re: WorldCom, Inc. Securities Litigation. Judge Cote in the opinion takes a law firm to task for not presenting “a forthright description of the advantages and disadvantages of both the individual action and class action options” as it pursued representation of pension funds in individual actions. The judge accused the law firm of “running the coordinated individual actions much as a de facto class action” and held that efforts to enlist plaintiffs had “resulted in some confusion and misunderstanding of the options available to the putative class members.” As of October 3, 2003, the law firm had filed at least 47 individual actions on behalf of over 120 pension funds, many of them public employee or union pension funds.

While the primary focus of the case is on the law firm and its alleged failings, the case also serves as a warning to ERISA plan fiduciaries and other fiduciaries who will be making decisions as to whether or not to sue and/or join class action lawsuits which may inevitably be filed on behalf of plans’ affected by recent corporate and mutual fund scandals. A decision to sue or not to sue on behalf of a pension fund is a fiduciary act subject to all of the fiduciary duties and responsibilities under ERISA. (Granted, the issue is more important with respect to 401(k) plans and other defined contribution plans where individual participant accounts must bear the risk of investment losses.) While the case mentioned also involved public funds which are not subject to ERISA, nevertheless even fiduciaries of these plans are subjected to state and common law fiduciary obligations and requirements. What the case reminds us of, I think, is how important it is for plan fiduciaries to engage in prudent processes, and document such processes, in reaching a decision as to whether or not to sue on behalf of a pension plan, whether or not to join a class action lawsuit, and in selecting a law firm for representation. As the opinion indicates, there is much to be wary of in making a prudent decision and selection.

Continue reading for excerpts from the opinion, keeping in mind that the term “investor” is referring to the various pension funds which are plaintiffs in the Individual Actions:

1) It is appropriate to begin with some bedrock truths. Every investor who has suffered a loss has the right to seek recovery. Every investor has the right to bring an individual action if it chooses to do so. Every investor will have the right to opt out of the certified class action.

2) [The law firm] has engaged in an active campaign to encourage pension funds not to participate in the class action and instead to file Individual Actions with [the law firm] as their counsel.

3) At this stage, [the law firm] is running the coordinated Individual Action much as a de facto class action.

4) [The law firm] has targeted a relatively sophisticated audience with important and serious fiduciary duties to its membership and beneficiaries. The private and public pension funds can be expected to have access to independent legal advice should they seek it, and to have attorneys on retainer or on their staffs who would be in a position to obtain alternative advice from that offered by [the law firm] should they desire it.

5) There is no reason to believe that the funds that have filed Individual Actions have done so with any but the best of intentions to obtain the maximum recovery for their constituency. And it is important to remember that constituency. After all, behind the lawyers and the pension fund officers stand the many individual state, local, public, and private employees whose lost retirement savings and benefits the funds seek to recover.

6) There may be sound and good reasons for filing an Individual Action and choosing to opt out of the class action. But, given the seriousness of the claims, and the gravity of the losses the defendants are alleged to have caused, every putative member of the class should have access to all of the relevant information about their legal options and the consequences of each choice. The are entitled to no less.

7) The communications with [the law firm] have resulted in some confusion and misunderstanding of the options available to putative class members. The deficiencies include the following:

a) From these submissions, [the law firm] does not appear to have presented a forthright description of the advantages and disadvantages of both the individual action and class action options.

b) It does not appear that the advantages and disadvantages of excluding Exchange Act claims from the Individual Action complaints have been adequately described.

c) The potential impediments to bringing claims based on the 1998 and December 2000 bonds are not fully described.

d) The potential statute of limitations impediments to bringing certain of the more recently filed Individual Actions do not appear to have been described. This could be a very serious problem for a litigant who chooses to opt out of the class, only to learn that the Individual Action it had filed was barred by the statute of limitations and it had lost all right to recovery. This very issue is not sub judice.

e) It is unclear whether those who have filed Individual Actions and who also had losses from investments in WorldCom stock have been adequately advised of the as yet undetermined risk that they may lose an opportunity to share in any recovery for their stock losses.

f) It does not appear that investors have been adequately advised that a fund does not need to file an Individual Action in order to obtain recovery for its losses. Without doing anything, each fund is a member of the class certified in this litigation, with the right to share in any recovery won on behalf of the class, free of the burden of pursuing its own separate action.

g) It does not appear that investors have been adequately advised that, within the class action, bondholders are represented by their own named representatives, and should there be any reason to believe that the allocation of any settlement between the bondholders and shareholders is not fair, then not only the named representatives of the bondholders, but also members of the class, will have an opportunity to object and to have their objections heard.

h) It does not appear that investors have been adequately advised that no distribution will be made to class members without the Court approving the fairness of the distribution.

i) It does not appear that investors have been adequately advised that before there is any award of attorneys’ fees to Class counsel, there will be an opportunity for objections to be heard and a careful review by the Court.

Note: Many of you may remember an article on a related subject–The Invasion of the Class Action Securities Lawyers–which was the subject of a previous post here as well as one at EthicalEsq? here.

The Wall Street Journal today has an interesting article: Is Pension Crisis a Scapegoat? The article notes that “[c]ompanies across the country have been taking an ax to their pensions, citing rising costs and the declining health of their pension plans.” The article goes on to say that “[e]mployers eager to cut pensions blame the “perfect storm” of falling stock prices and low interest rates” but that “employees say their pension plans aren’t as sick or costly as their employers claim.” The article mentions a Bear Stearns report released last week which said that pension plans are now on a “path to recovery,” predicting that by the end of 2004, pension underfunding for the 100 companies with the biggest benefit obligations in the Standard & Poor’s 500-stock index will drop to 2%, from 12% at the end of this year.

The most interesting part of the article:

In August, the American Bar Association’s leadership announced that it would be cutting the pension plan for 900 staffers, citing stock declines and low interest rates, even though both trends had reversed themselves this year. But 400 skeptical ABA staffers passed the hat and collected more than $10,000 to hire legal counsel and an actuary to go over the pension plan in detail. The actuary, Kathleen E. Manning of MWM Consulting Group in Chicago, found that the pension plan was well funded, and, in a report presented to the association in August, noted that the liability — and future costs — of the pension looked unreasonably high because the association’s projections assumed that interest rates and investment returns would remain seriously depressed. She added that a likely rise in interest rates and the stock market’s continuing recovery could solve much of the ABA’s potential pension problem.