Retention of stock of former parent company in plan following spinoff did not breach Dudenhoeffer standard of prudence

Participants in an individual account plan established following the spinoff of the plan sponsor did not plausibly allege that the retention of the former parent company’s stock as a plan investment option was imprudent, according to a federal trial court in Texas. The stock no longer qualified as employer securities, exempt from ERISA’s diversification requirements, but the participants failed to allege special circumstances that would have undermined the fiduciaries’ reliance on market price in evaluating the prudence of the investment.

Spin-off plan retains stock of former parent company

Phillips 66 was spun-off from its parent company, ConocoPhillips (CP), in 2012, resulting in nearly 12,000 former CP employees becoming employees of the new, separate and independent company. In connection with the spinoff, Phillips, in May 2012, established an individual account defined contribution plan for its employees. Assets of the former CP employees that were held in participant accounts under the CP plan were transferred to the Phillips plan. Among the transferred assets were shares of CP stock that were originally contributed by CP to an employee stock ownership plan (ESOP) and held in CP Funds, which were invested exclusively in CP stock. After the spinoff, the shares became part of the CP Funds in the Phillips plan.

The CP Funds were closed to new investment after the spinoff. In addition, participants in the Phillips plan could “exchange” out of the Funds at any time. However, the plan had more than 25 percent of its assets invested in the CP Funds at the beginning of the class period.

Citing the heavy investment in CP stock, participants in the Phillips plan brought suit under ERISA, alleging that the plan fiduciaries, in retaining the CP Funds and failing to properly diversify the plan’s investment options, breached the duties of diversification and prudence, resulting in tens of millions of dollars of losses. The fiduciaries maintained that they were exempt from ERISA’s diversification requirements because the CP shares retained their character as employer securities following the spinoff. Moreover, the fiduciaries argued that the participants failed to plead facts sufficient to state a claim for breach of the duty of prudence or the duty to diversify plan investments.

CP shares did not remain employer securities

Initially, the court explained that the fiduciaries of individual account plans that invest in qualifying employer securities are exempt from the generally applicable duty under ERISA to diversify plan investment options. The participants, however, charged that the exemption did not apply to the Phillips plan fiduciaries because the shares of CP stock no longer qualified as employer securities following the spinoff, as CP was not the employer of the employees covered by the plan. Thus, the court was required to address, for the first time, whether, after a spinoff resulting in two independent companies, shares of stock that were employer securities before the spinoff retained that character after the spinoff.

The fiduciaries maintained that, as the shares were employer securities at the time they were issued, the change in the nominal employer of the plan participants, did not, under ERISA, require divestment. The court, however, noted that plan language indicated that shares of CP stock were not employer securities of the plan after the spinoffs. In addition, IRS Letter Ruling 201427024 (July 3, 2014) supported the position that employer securities do not retain that character after a spinoff. Continued participant ownership of CP stock in the plan of an independent company, following the spinoff, further, would not promote the purpose of ESOPs acknowledged by ERISA. Accordingly, the court concluded that the shares of CP stock were not employer securities and, therefore, not exempt from ERISA’s diversification requirements with respect to the CP Funds.

Retention of CP Fund was not imprudent

The “real issue” in the case, according to the court, was not diversification, but the prudence of the fiduciaries’ decision not to force the divestiture of the CP stock. The participants charged that the CP stock was an excessively risky and volatile investment and, thus, an imprudent option. The fiduciaries countered that the participants’ complaint did not satisfy the standard established by the United States Supreme Court in Fifth Third Bancorp v. Dudenhoeffer for stating a claim for breach of the duty of prudence.

Under the Dudenhoeffer standard, fiduciaries may rely on market price in determining the prudence of an investment, absent special circumstances undermining the reliability of the market price. The participants alleged that the plan’s highly concentrated holdings in CP stock at the time of the spinoff, together with public information (e.g., Vanguard Index Fund, CP’s 10K filing, oil prices, and CP stock prices) and CP’s poor performance were “red flags” that indicated that CP stock was not a prudent plan investment. The court concluded, however, that the participants failed to identify factors that were not incorporated in the market price or special circumstances that would otherwise undermine market price as a reliably accurate measure of CP’s value. Accordingly, the participants failed to state a claim for breach of the duty of prudence based on public information.

Source: Schweitzer v. The Investment Committee of the Phillips 66 Savings Plan (DC TX).
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