Failure To Divest Participant's Account Of Declining Closely Held Employer Stock Was Fiduciary Breach

Peabody v. Davis (2011, CA7) 2011 WL 1364427

The Seventh Circuit has ruled that fiduciaries of a close corporation's ERISA plan failed their duty of prudence to a plan participant by not diversifying his account, almost entirely invested in employer stock, when that stock's value was in rapid decline.

Background. ERISA §502(a)(2) provides for an action to be brought against a fiduciary for a breach of the duties set out in ERISA §404, which include the duties to manage investments prudently, and to diversify the investments to minimize the risk of large losses unless “it is clearly prudent not to do so.” Despite these mandates, ERISA §404(a)(2) exempts “eligible individual account plans” (EIAPs) from the diversification requirement.

Facts. The Rock Island Corporation (RIC) was a closely held securities firm co-founded by Andrew Davis and Robyn Kole. RIC had a subsidiary, Rock Island Securities (RIS), that was the sponsor of RIC's ERISA plan. Davis and Kole served as RIC's corporate officers and as trustees and fiduciaries of the ERISA plan.

Jonathan Peabody joined RIC in’98, and first invested in the ERISA plan in’99. He did so by rolling over outside investments of $167,800 into the plan, which—under an agreement with RIC management—allowed him to receive his’99 bonus of more than $212,000 in cash instead of in RIC stock which would have been the company's customary practice. After the transaction was completed, however, Peabody's ERISA plan account was highly concentrated in RIC stock (98% vs. 5% for the next highest concentration in any other employee's account).

Because RIC was closely held, there was no ready market for valuing the company's stock; instead, Davis and Kole periodically issued valuations based on the company's financial data. When Peabody made his rollover transaction, RIC stock was priced at $2,000 per share. In December 2000, following a ten-to-one stock split, RIC stock was valued at $757 per share by an outside financial analyst. In 2001, Peabody bought five additional RIC shares for his plan account at $500 per share, while a December 2001 benefits statement valued the stock at $625 per share. Finally, a 2004 statement valued RIC stock at $550 per share.

RIC's income was largely based on commissions from buying and selling securities, and after the SEC's “decimalization rule” came into effect, the company's profit margins declined by 70-80%.

Peabody's employment with RIC ended in January 2004, and he requested his plan benefits. Not satisfied with the distribution options offered to him, Peabody negotiated a loan agreement with RIC under which RIC agreed to buy all of his company stock for $350 per share. However, the proceeds would not be payable for one year. The total amount of the loan was $292,250 plus interest, but when it was time to pay the loan, RIC told Peabody that it was unable to pay. After formally demanding that his plan benefit be distributed to him, Peabody was again told that the loan proceeds could not be repaid. Sometime later in 2005, RIC went out of business.

In 2005, Peabody filed an action alleging several theories of fiduciary breach against Davis, Kole, and various other plan defendants. A district court found Davis, Kole and RIS liable to Peabody. The court rejected Peabody's argument that the defendants had violated the plan's terms or breached their fiduciary duties by allowing the initial rollover transaction, finding that Peabody had “arguably” waived these claims by agreeing to the transaction. But, the court held that the defendants had violated their fiduciary duty of prudence by maintaining the investment in RIC stock throughout RIC's decline and by failing to distribute Peabody's plan benefit to him.

As to the loan-for-stock transaction, the district court ruled that Davis (but not Kole) had breached his fiduciary duty by offering only a loan in payment for the RIC stock, and further, that this exchange was a “prohibited transaction” under ERISA §406(a)(1)(B).

The court determined that there was evidence for the breach of the duty of prudence between 2001 and 2003, based on RIC's rapid decline in profitability over that period. The court determined that the value of Peabody's shares was at least $500 in 2001, because this was the price he had paid for the additional five RIC shares for his account in that year. Thus, the court found his damages were $417,500 (835 shares of stock at $500 per share), and added prejudgment interest to arrive at a total figure of $506,000.

Seventh Circuit. The Seventh Circuit said that because the RIC plan was an EIAP, it was exempt from ERISA §404(a)(1)(C)’s duty to diversify as to employer securities. However, said the court, although ERISA's express requirement to diversify plan assets does not apply to EIAPs investment in employer securities, the ERISA duty of prudence continues to apply.

The court next looked briefly at whether the “presumption of prudence” as set out by the Third Circuit's decision in Moench v. Robertson (CA3, 1995) 62 F.3d 553 —the so-called Moench presumption—applied. The court stated that it didn't have to “grapple” with the extent to which Moench might apply in the Seventh Circuit, because even if the Moench presumption of prudence did apply in the current case, Davis and Kole still had breached their duty of prudence to Peabody for a number of reasons. First, the RIC plan did not “affirmatively require or encourage” investment in employer securities. For example, said the court, the only other employees to hold RIC stock in their plan accounts were Davis and Kole, and their concentration in RIC stock was much lower than Peabody's. Thus, divesting the RIC stock from Peabody's account would not have required them to depart from the plan's terms, so the “barriers to divestment” were low compared to other EIAP plans (for example, plans that require employer stock funds to be offered as an investment option).

Next, the Seventh Circuit agreed with the district court's finding that a prudent investor would not have kept such a high proportion of RIC stock in Peabody's plan account as the company's operations declined. Further, said the court, Davis and Kole were positioned uniquely to know of RIC's prospects and stock value, as they set the share value themselves. These facts, said the court, made it imprudent to continue to invest in RIC stock.

The Seventh Circuit then looked at whether Peabody had waived his fiduciary breach claims by agreeing to the initial RIC stock investment and by never asking the fiduciaries reduce his exposure to RIC stock. The Seventh Circuit said that this issue came down to whether carrying out the rollover transaction and then allowing Peabody to remain invested exclusively in RIC stock during the period of the company's decline met the fiduciaries' duty of prudence. Because the fiduciaries provided no justification for their failure to divest from RIC stock, said the court, the fact that Peabody had agreed to the RIC investment at the outset did not relieve them of their fiduciary duty. As a result, the Seventh Circuit held that the fiduciaries had breached their duty of prudence.

The Seventh Circuit did take issue with the district court's method of calculating damages, finding that the $500 per share basis on which damages were determined was not based solidly on the breach of fiduciary duty. In remanding the damages issue to the district court, the Seventh Circuit said that the lower court should proceed as if the fiduciaries were required to divest the RIC stock in Peabody's account when the company's profitability declined sharply. Further, the Seventh Circuit said that in determining the damages, it would be reasonable for the district court to assume that “at least a quarter to a third of the original RIC stock” could be left in Peabody's account at the time it was converted to a loan without a prudence violation having occurred. That is, the duty of prudence did not require that all of the RIC stock in Peabody's be divested immediately, even though the stock eventually became worthless. Thus, while there was a duty to divest the RIC stock, there was also a duty to do this in an orderly fashion.