Appellate Court Split in Recent Single Stock Fund Litigation

Ed. Note: On September 22, 2020, the Fourth Circuit denied Gannett’s petition for rehearing en banc.  On October 8, 2020, the Fifth Circuit denied Schweitzer’s petition for rehearing en banc.  We expect the defendants (in Gannett) and the plaintiffs (in Schweitzer) will petition the Supreme Court for certiorari within the coming weeks, and will update this post as new developments arise in the case.

The Fourth Circuit’s recent split decision in Quatrone v. Gannett Co., Inc., No. 19-1212 (4th Cir. Aug. 11, 2020) is sure to raise the blood pressure of sponsors and administrators of retirement plans with single stock funds.  Together with a recent Fifth Circuit decision in Schweitzer v. Inv. Comm. of Phillips 66 Sav. Plan, No. 18-cv-20379, 2020 WL 2611542 (5th Cir. May 22, 2020), the Gannett case highlights the dilemma of retirement plan sponsors and fiduciaries, who, as a result of a corporate transaction, inherit a plan investment fund consisting of a single class of stock that does not constitute an employer security for purposes of ERISA (i.e., a “single stock fund”).  Plan fiduciaries in these circumstances have been targeted in class actions brought by an aggressive plaintiffs’ bar both for liquidating a single stock fund too soon and for not liquidating a single stock fund soon enough.  While courts are still evaluating how to handle these single stock fund cases, a plan fiduciary’s potential exposure for continuing to maintain such a fund seems to turn, at least in part, on the manner in which ERISA’s duties of prudence and diversification apply to the single stock fund as a plan investment option.

Background. By way of background, a single stock fund within a retirement plan can arise in a number of ways, but often results from a corporate spin-off transaction.  For example, in the spin-off of a division, the parent corporation will contribute the assets and liabilities of the division to a new subsidiary, and then distribute shares in the subsidiary to the parent’s shareholders.  If the parent company’s shareholders include a retirement plan with an employer stock fund that holds shares of the parent, the plan—like all other shareholders—will receive shares of the subsidiary in connection with the spin-off. As a result, the plan will hold both the parent stock and subsidiary stock.  Based on developing case law, it appears that where the retirement plan is maintained by the subsidiary, the parent corporation’s stock will no longer constitute an employer security for purposes of ERISA Section 407, if the parent and subsidiary are no longer ERISA affiliates[1].  By the same token, if the post spin-off retirement plan is maintained by the parent corporation, the subsidiary’s stock will not constitute an employer security.  This is important because ERISA Section 404(a)(2) provides that acquiring or holding an employer security in an individual account plan does not violate a fiduciary’s duties of diversification or prudence.

Gannett.  The Gannett case is worth reviewing in depth for its analysis of what plaintiffs must assert in the Fourth Circuit to state a claim for breach of fiduciary duty in a single stock fund case[2] (and thereby survive a motion to dismiss), as well as its discussion of the application of the ERISA duties of prudence and diversification to a single stock fund.  Essentially, the court holds that the duty of diversification applies at both the fund level and the plan level—a seemingly impossible burden for a single stock fund and certain other types of investments.

The general details of the Gannett transaction are typical of many corporate spin-offs.  In June 2015, Gannett Co. Inc., a publicly traded company, changed its name to TEGNA, Inc. (“Old Gannett” or “TEGNA”) and spun-off its publishing business into a new, publicly traded, independent company, Gannett Co., Inc. (“New Gannett”).  Old Gannett had sponsored a participant-directed 401(k) plan.  Although the Old Gannett 401(k) plan provided participants with an array of investment options, the employer’s matching contributions were made in employer stock.  As part of the corporate spin-off, the 401(k) plan was transferred to New Gannett.  The plan was amended to freeze the TEGNA Stock Fund (i.e., the “Old Gannett” Stock Fund) to new investments, meaning that participants could only transfer assets out of, and could not increase their investment in, that stock fund.  At the time of the spin-off, TEGNA and New Gannett also entered into an Employee Matters Agreement that provided that all outstanding investments in the TEGNA Stock Fund were to be liquidated and reinvested in other investment funds on such dates as established by the plan administrator.  The New Gannett plan document stated that the Employee Matters Agreement could be used as an aid for interpreting the plan.

Allegedly, at the time of the spin-off, 21.7% of the New Gannett plan’s assets were invested in Old Gannett (now TEGNA) stock.  During the second half of 2015, the TEGNA shares fell in value by 19.3%, and in 2016, the shares decreased in value by another 16%.  In June 2017, the plan administrator (the “Committee”) decided to liquidate the TEGNA Stock Fund over a 12-month period beginning in July 2017.  At the time the plaintiffs filed their lawsuit in August of 2018, the TEGNA Stock Fund had still not been fully liquidated.  The plaintiffs alleged that the defendants (New Gannett and the Committee) had breached their fiduciary duties of prudence and diversification under ERISA by their lack of action with respect to the TEGNA Stock Fund.  Specifically, the plaintiffs alleged that the Committee breached its duty of prudence by failing to investigate and monitor the fund, as demonstrated by its failure to (1) follow the terms of the Employee Matters Agreement and (2) take any action in respond to auditors’ warnings about “concentration” risks.  The plaintiffs also argued that it was imprudent to maintain the TEGNA Stock Fund as a plan investment based on its non-diversification, a problem magnified by the fact that the plan also held a closely correlated employer stock fund (New Gannett stock).

District Court Rulings in Gannett.  The district court in Gannett granted the defendants’ motion to dismiss for two primary reasons: (i) the plaintiffs’ duty-of-prudence claims were barred under Fifth Third Bancorp v. Dudenhoeffer, 134 S. Ct. 2459 (2014) because they had failed to allege “special circumstances” related to mistakes in market valuation, and (ii) ERISA’s duty to diversify merely requires diversity among the funds offered by a plan; it does not require that every individual fund be diversified.  The district court also denied plaintiffs’ request for leave to file an amended complaint on the ground that it would be futile to do so.

Fourth Circuit Rulings in Gannett.  The Fourth Circuit vacated and remanded the district court’s decision.  In its analysis, the Fourth Circuit began with the proposition that, to state a claim for breach of fiduciary duty, “a plaintiff must plausibly allege that a fiduciary breached [a duty], causing a loss to the employee benefit plan.”  The court explained that the duty of prudence under ERISA Section 404(a)(1)(B) includes the sub-duties of investigation, monitoring/removal, and diversification; in addition, the court noted that ERISA separately specifies a duty of diversification under ERISA Section 404(a)(1)(C).  Although ERISA explicitly excludes employer securities from the diversification requirements, the court assumed (based on Fifth Circuit precedent and defendants’ failure to assert otherwise) that post-spin-off, the TEGNA Stock Fund  no longer constituted employer stock with respect to the New Gannett plan, and thus was not exempt from ERISA’s diversification requirements.  Based on this finding:

• The court rejected the defendants’ argument that a fiduciary is not obligated to ensure individual funds within a defined contribution plan are diversified so long as the plan’s investment menu allows participants to choose from a mix of options that allow them to create a diversified portfolio.  Relying on its earlier decision in DiFelice v. U.S. Airways, Inc., 497 F.3d 410 (4th Cir. 2007), the court explained that each fund offered by a plan must be prudent and, because diversification is a sub-duty of the duty of prudence, the duty to diversify applies at both the fund level and the plan level.
• The court also rejected the defendants’ argument that, because the TEGNA Stock Fund was frozen to new investments, and participants were able to withdraw their money from the fund, defendants were under no obligation to remove the fund from the plan’s investment lineup.  The court held that there was no per se rule under ERISA that a fiduciary is never required to remove a frozen investment fund and that prudence may compel the removal of such a fund.
• The court further held that it was not appropriate on a motion to dismiss to entertain the defendants’ asserted defense that participants could have divested the TEGNA Stock Fund in their discretion, because the claim that the doctrine of participant choice relieves a fiduciary of liability is an affirmative defense that is not appropriate to decide at the pleadings stage.
• The court held that Dudenhoeffer was inapposite, reasoning that Dudenhoeffer only forecloses claims that a fiduciary should be able to predict the performance of publicly traded stock absent pleading special circumstances.  In this case, the court held that the plaintiffs’ claims of imprudence were based on the defendants’ failure to diversify, not on a failure to outsmart an efficient market.

Judge Niemeyer issued a spirited dissent, explaining that he would have affirmed the district court’s “well-reasoned” decision.  He explained:

I agree with the district court’s irresistible reasoning, which the majority opinion simply sidesteps with a myopic analysis.  Specifically, the majority merges the duties of diversification and prudence and then erroneously focuses on a single investment option on the Plan’s diversified menu in concluding that the complaint adequately alleged breach of these duties.  It also fails to account for the fact that the participants were given free rein to diversify their individual accounts.  The result of the majority’s approach is a mechanically derived holding that is divorced from common sense and that will unnecessarily restrict the options offered in defined contribution plans.

Defendants have since petitioned the Fourth Circuit for a rehearing, or rehearing en banc, explaining that the panel’s decision was both incorrect and conflicts with the Fifth Circuit’s holding in Schweitzer.

Second Circuit on Diversification.  The Fourth Circuit’s decision in Gannett goes against the Second Circuit’s earlier decision in Young v. Gen. Motors Inv. Mgmt. Corp., 325 F. App’x 31, 33 (2d Cir. 2009), and the Fifth Circuit’s recent decision in Schweitzer.  In Young, the Second Circuit held that ERISA’s duty of diversification under Section 404(a)(1)(C) applies only at the plan level, and does not extend to the fund level.  In Gannett, the Fourth Circuit panel acknowledged the Second Circuit’s holding, but concluded that Young was distinguishable because it did not address the ERISA Section 404(a)(1)(B) duty of prudence, which includes the sub-duty of diversification.  (A close reading of ERISA if there ever was one!)  The panel also attempted to reconcile its holding with Young by noting that the Gannett plaintiffs had alleged a lack of diversification at both the plan level and the fund level, because the plan offered two correlated stock funds (New Gannett Stock Fund and TEGNA Stock Fund).

Fifth Circuit Holdings in Schweitzer.  Schweitzer is particularly noteworthy because the underlying facts and issues are very similar to Gannett, but Fifth and Fourth Circuit panels reached very different conclusions.  In 2012, ConocoPhillips spun-off Phillips 66 into a freestanding publicly traded corporation.  Immediately prior to the spin-off, the  Phillips 66 retirement plan held two ConocoPhillips stock funds, which continued to be maintained under the plan subsequent to the spin-off, albeit frozen to new investments.  During the first two years following the spin-off, the price of the ConocoPhillips stock increased, but thereafter fell from $86 to $50 per share over about a three year period.  As in Gannett, a group of plaintiff participants filed an ERISA class action against Phillips 66 and its retirement plan investment committee alleging they breached their fiduciary duties of prudence and diversification by retaining the ConocoPhillips stock funds.  Affirming the district court’s dismissal of the complaint, the Fifth Circuit rejected the defendants’ contention that the ConocoPhillips stock continued to be an employer security post-spin-off (which would have exempted the ConocoPhillips stock from the duty of diversification), but nonetheless concluded that the plaintiffs’ failed to state a claim:

• With respect to the duty of diversification, the Schweitzer court explained that the duty of diversification applies differently to defined benefit and defined contribution plans.  In the case of a defined benefit plan, fiduciaries must ensure that the assets of the plan as a whole are diversified.  In contrast, the fiduciaries of a participant-directed defined contribution plan “need only provide investment options that enable participants to diversify their portfolios; they need not ensure that participants actually diversify their portfolios.”
• With regard to the duty of prudence, the court held that, to the extent the plaintiffs were alleging the fiduciaries should have known that the market underestimated the risks of holding ConocoPhillips stock, their claim was foreclosed by Dudenhoeffer.  The court explained, however, that Dudenhoeffer did not foreclose the argument that it was imprudent for the plan to offer a single stock fund on the ground that such an undiversified fund is inherently risky.  The court agreed that it may be imprudent in some circumstances to offer such a fund as an investment option.
• Ultimately, the court ruled that, because the ConocoPhillips stock fund was frozen to new investments immediately following the spinoff, “the fiduciaries were not offering participants an imprudent investment option,” and that given that the plan’s participants were able to divest their investment in the fund and the plan distributed warnings about diversification, the plaintiffs failed to state a plausible claim that the plan fiduciaries should have forced divestment.

Given the similar factual circumstances, the court’s analyses in Gannett and Schweitzer share several points of commonality.  However, the Fifth Circuit in Schweitzer took the position that if a single stock fund is frozen to new investment, it should not be treated as an investment offered under the plan.  In addition, unlike the Fourth Circuit, the Fifth Circuit considered participant choice in evaluating defendants’ motion to dismiss, rather than treating it as an affirmative defense that would have to be addressed at a later stage of the proceedings.

Conclusion.  It remains to be seen whether the Fourth Circuit will review the Gannett decision en banc or the Supreme Court will agree to review the apparent circuit split between the Fourth and Fifth Circuits.  For now, however, Gannett provides plaintiffs in the Fourth Circuit with a potential roadmap to survive a motion to dismiss in a single stock fund case.  Given the sophisticated (and growing) ERISA plaintiffs’ bar, we also expect there may be a surge of single stock fund cases (both in the Fourth Circuit and elsewhere), at least until the Supreme Court resolves how ERISA’s fiduciary duties of diversification and prudence apply to single stock funds.

[1] ERISA affiliates are members of a controlled group described in Section 1563 of the Code, but substituting 50% for the 80% ownership threshold of that section.
[2] “On appeal, we consider whether and how a participant in a defined contribution plan can allege a breach of the ERISA fiduciary duties of either prudence of diversification on the basis of a plan fiduciary’s non-divestment of an allegedly imprudent frozen single stock fund.”

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