Remember when employees were crowing over their 401(k)s? Now they're suing over them. A wave of class-action litigation has only just begun.
By Rich Blake
November 2001
Institutional Investor Magazine
No one ever promised that 401(k)s would go up forever, but when they fell, disgruntled employees resorted to that good old American tradition: They decided to sue.
On July 19 two former Lucent Technologies employees, Warren Reinhart and Gerald Smith, filed a class-action suit in United States District Court for the District of New Jersey, alleging that Lucent breached its fiduciary responsibility by allowing employees to buy company stock as one of several 401(k) investments. When the suit was filed, Lucent shares had plunged from a December 1999 high of 82 to about 6. With some 30 percent of the company's 401(k) invested in Lucent stock, employee account balances plunged as well at the once high-flying telecommunications manufacturer, which had been carved out of AT&T Corp. in 1996. "Lucent owes damages in excess of $1 billion," contends attorney Lynn Sarko of Seattle-based Keller Rohrback, the lead plaintiffs' law firm.
Lucent denies the plaintiffs' allegations and will "vigorously fight the charges," a company spokeswoman says. "The case is totally without merit."
The Lucent suit is just the most dramatic and visible of several outstanding cases against 401(k) plan sponsors. Companies across the economic spectrum fear that this case may mark the beginning of a wave of class-action litigation.
"We're all watching the Lucent case to see how the judicial system will view an employer's responsibility for the 401(k) plan," says Timothy Pistell, treasurer of industrial products manufacturer Parker Hannifin Corp. Pistell oversees the company's $1.2 billion in 401(k) assets, about $420 million of which is in Parker Hannifin stock. "God forbid our stock ever gets into trouble, or we might be in the same boat."
"Lucent could very well be just the tip of the iceberg," says Thomas Mackell, a Washington financial consultant and a former member of the ERISA Advisory Council, which advises the Department of Labor on retirement issues. "You'll see more suits. How bad will it get? That remains to be seen."
The flurry of 401(k) litigation necessarily centers around the notion of fiduciary responsibility. The Employee Retirement Income Security Act of 1974 requires plan sponsors to offer a broad range of investment alternatives and give employees access to information about each option so they can make informed decisions. Sponsors must take "reasonable care" to provide for the soundness of their 401(k) plans. But what constitutes reasonable care during a bear market in which 401(k) balances declined for the first time, as they did last year, and are likely to drop by at least 10 percent in 2001? A judge or jury will make that determination on a case-by-case basis. To date, at least four suits have been filed.
"No one paid much attention to how much 401(k) participants were losing as a result of outrageous fees and mediocre performance during the bull market," says attorney Joel Feffer of Wechsler Harwood Halebian & Feffer, a New York-based law firm that specializes in representing plaintiffs in class-action suits. "But it's an area you can bet we are looking at carefully now. We're going to be on the lookout for major screwups, and if we find one, we'll certainly take action."
Plaintiff lawyers will likely target two points of vulnerability in 401(k) plans: investment in company stock and/or a record of poor performance. "The Lucent case and company stock issues are the obvious starting point for a legal backlash," says Rebecca Morrow, editor of "DC Plan Investing," a newsletter published by the New York-based Institute of Management and Administration. "But I think a lot of plans are waiting for the other shoe to drop."
The thud could come from two directions: from employees who say they were given poor investment choices and from those who contend that they were not properly informed about the options available to them.
Some suits will likely focus on the common practice, for many employers, of matching their workers' 401(k) contributions with company stock. The suits will also argue that employers acted irresponsibly when they encouraged employees to invest their own contributions in company stock.
A lawsuit filed in 1998 against Ikon Office Solutions, a Malvern, Pennsylvania, provider of copier and printing systems, may have set the tone for today's complaints. Filed by two employees, the suit alleges that Ikon breached its fiduciary obligation by matching employee contributions with company stock. Ikon shares fell from about 60 in the fall of 1998 to about 3 by the end of that year, after the company took a $100 million earnings charge. In March 2000 Judge Marvin Katz of the United States District Court for the Eastern District of Pennsylvania ruled that the case could proceed as a class-action suit. (No trial date has been set.)
"This is an issue that isn't going away anytime soon," says Ronald Kilgard, a Phoenix-based attorney representing the plaintiffs in the Ikon case. "Fiduciaries have an obligation to make sure these plans are efficiently run."
New York Life Insurance Co. is facing a suit that focuses on performance issues for defined contribution plans. Discovery recently began in the case, which was filed last year. Workers allege that New York Life irresponsibly placed 401(k) assets in in-house funds that carried especially high fees and thus eroded total returns. The complaint specifically accuses New York Life of "self-dealing" - exploiting roughly $900 million in 401(k) assets to jump-start the company's entry into the mutual fund business in 1991. (First Union Corp. settled a similar case for $26 million in March.)
"Without consideration of outside alternatives, New York Life was charging participants fees and expenses in some cases 25 times what the plan could have found elsewhere," says Eli Gottesdiener, a Washington attorney representing plaintiffs in the case. "We need to go after companies that aren't putting their fiduciary responsibilities first, ahead of business. I'm doing what the Department of Labor either can't do or won't do."
Although the New York Life case has attracted attention, the company stock issue has the most resonance with plan sponsors. The staggering decline of Lucent stock is an extreme case, even in this bear market, but Lucent's 401(k) is hardly alone in its dependence on the fate of a single stock. A survey by Hewitt Associates of 30 large-company plans with 1.5 million participants found that as of July 31, 28 percent of $71 billion in total assets was invested in company stock. And a recent study of 200 large companies by IOMA revealed that one in five maintain defined contribution plans in which at least half of the assets are invested in their own stock.
At Coca-Cola Co., Colgate-Palmolive Co., Pfizer and Procter & Gamble Co., to name a few, company stock accounts for upwards of 80 percent of balances.
Colgate-Palmolive employees voluntarily elect to invest in the employee stock ownership plan, and the company sees no reason to prohibit them from doing so. Of Colgate-Palmolive's $1.7 billion in 401(k) assets, about 80 percent is invested in the ESOP. "One school of thought says, Don't put all of your eggs in one basket," says CEO Reuben Mark. "Another says, Put them in one basket but watch it pretty closely. Our people feel they know the company well, they are involved in it and working their tails off to be successful, so they feel comfortable investing in Colgate stock."
Certainly, it's paid off for many plan participants: $100 invested in Colgate stock in 1984, when the company began allowing stock ownership in its 401(k), would be worth $3,700 today. The same $100 invested in the Standard & Poor's 500 index would be worth $1,200. Since December 31, 1999, the stock is off 9 percent.
Even without the burden of a 401(k) laden with company stock, employees are feeling the sting of negative returns. According to Boston-based consulting firm Cerulli Associates, the nation's pool of 401(k) assets fell 4 percent last year, to $1.8 trillion - the first decline since 401(k) plans were launched in the early 1980s. This year the declines will be steeper - perhaps as severe as 10 percent. That's a fertile breeding ground for lawsuits against plan sponsors.
"Frankly, I thought there would be more litigation by now," says Stephen Saxon, an ERISA lawyer with Groom Law Group in Washington.
Treasurers who manage 401(k) plans are most concerned about the central charge of the Lucent suit, which asserts that the company breached its fiduciary obligations merely by allowing company stock as one 401(k) investment option. Another part of the complaint alleges that Lucent "withheld material information regarding the fiscal state of the company" during a critical period: between January 1, 2000, and the date the suit was filed. As a result, plaintiffs allege, Lucent "encouraged participants and beneficiaries to continue to make and to maintain substantial investments in company stock and the 401(k) plan."
Lucent's shares began tumbling in January 2000, when the company said its fourth-quarter profit would fall short of forecasts by one third. In subsequent quarters the company kept cutting forecasts, and the shares kept plunging. In October of last year, Lucent announced that its third-quarter earnings results would be off by 22 percent and that the company would "lower its guidance for 2001." That same day Lucent revealed that CEO Richard McGinn had been dismissed.
A few weeks later Lucent stunned investors by declaring that it would have to revise its third-quarter results once again, because it had improperly recorded $679 million in sales. In all, Lucent shares dropped 82 percent last year. The stock recently traded at about 6.50.
In a spate of class-action suits independent of the 401(k) case, Lucent shareholders allege that they were fraudulently misled by accounting errors and by the company's failure to adequately warn them about revenue shortfalls. The Securities and Exchange Commission has opened a formal investigation into Lucent's accounting practices.
Lucent's defense against the July 401(k) suit will be closely watched by other companies. A spokeswoman suggests Lucent will emphasize the ways in which it encourages employees to invest responsibly, offering seminars and distributing quarterly educational newsletters that highlight the need for prudent portfolio diversification. "We are one of the more responsible companies when it comes to investment education for our employees," she says.
Seminars don't cut it, plaintiff lawyers argue. "Lucent either should have disallowed company stock as an investment option or at least provided the participants with accurate information regarding the future prospects of the investment," says attorney Sarko. "If company stock was not a safe and prudent investment, it should not have been a plan option, simple as that. It should have been pulled."
What does it mean to be a responsible fiduciary? The answer to that question has never been clear, even before the bear market.
Companies can't sit idly by and allow employees to make disastrous investment decisions. But ERISA imposes strict restrictions on how investment advice can be offered to employees. Plan sponsors can't offer direct investment guidance to participants. They may either hire independent firms that provide advice but do not also provide money management or they may deputize their plan providers to provide "education" - general guidance without specific investment recommendations.
The law currently prevents those plan providers, which include Fidelity Investments and Vanguard Group, from offering advice about their own products. But a congressional bill sponsored by Representative John Boehner, an Ohio Republican, would loosen these strictures, allowing providers to offer guidance about their own investment products as long as they disclose any potential conflicts of interest.
For the moment, though, plan sponsors must move cautiously in the advice arena. "The potential for longer-term investment disasters is very real," says Ted Benna, who designed the first 401(k) back in 1981 and now is president of the 401(k) Association, a Bellefonte, Pennsylvania- based lobbying group. "The general goal is to help employees to save for retirement, but fear of lawsuits governs how both employers and providers operate."
Adds Deedra Walkey, general counsel at consulting firm Frank Russell Co., "It's a double-edged sword. Plans are being forced to decide whether they want to put themselves open to legal risk today or down the line."
Some companies are taking steps to minimize that risk - or so they hope. In July auto-parts manufacturer Federal-Mogul Corp., which filed for bankruptcy on October 1, stopped matching its employee 401(k) contributions with its own shares, contributing cash instead. For nearly 30 years Federal-Mogul had kicked in only stock to the 401(k); by August the plan had 15 percent of its $550 million in assets invested in Federal-Mogul shares. The company was hard hit by asbestos-related lawsuits: It paid more than $600 million to settle claims in recent years, and it has seen its stock plunge to a recent 1 from a high of nearly 70 a share in 1998.
"Federal-Mogul has stepped up and taken the lead," says IOMA's Morrow. "You could see other companies follow."
Says Benna, "I suspect the primary motivation for the Federal-Mogul action was the need to reduce the company's legal liability exposure." He recommends that plan sponsors take a clear look at the structure of their 401(k)s to make sure they are soundly designed.
"Many employers are not handling this responsibility well," Benna says. "More than 90 percent of 401(k)s involve less than 100 employees. Senior executives at most of the companies lack the time and the skills needed to properly manage this function."
Although few 401(k) participants are also covered by a defined benefit plan, workers may become even more disenchanted with their defined contribution plans when they realize that defined benefit plans have handily outperformed 401(k)s during the past two years.
According to Cerulli, the total pool of corporate defined benefit assets declined just 2.5 percent, to $2.2 trillion, in 2000, compared with 4 percent for defined contribution plans, despite the fact that defined benefit plans attracted far less in new contributions than their defined contribution counterparts. Presumably, that reflects the advantages of professional money management.
"People are going to be asking, 'Why hasn't the DC plan done as well as the DB plan?'" predicts IOMA's Morrow.
"Everyone knows that DB plans are better diversified and better run, period," says consultant Mackell. "The shift to DC is going to come back to haunt the American worker in the long run."
If Lucent plaintiffs prevail, it could come back to haunt companies too. After all, 401(k)s came to replace defined benefit plans at many companies, saving employers big sums of money.
"The Lucent case is the one to watch," says David Wray, president of the Profit Sharing/401(k) Council of America, a trade association. "One way or another, it's going to set a precedent."
