I. Introduction

401k plans represent the most common employer-sponsored retirement plans for employees of private employers. They have replaced defined benefit pension plans, as well as less flexible vehicles (such as ESOPs) as the primary retirement plan.¹ However; some of these plan models have continued their legacy through 401ks through structures that tie the two together or place one inside the other. A very common and notable example is the Employee Stock Ownership Plan (ESOP). ESOPs are frequently offered by companies as an investment vehicle within 401ks that allow participants to invest in the employer’s stock as an alternative to the standard fund offerings that are pooled investments (e.g. mutual funds or institutional funds). Participants may be unaware that the company stock option in their 401k is a plan within a plan. These combination plans are sometimes referred to as KSOPs.²

Although this investment vehicle seems innocuous, KSOPs generate considerable risk to both participants and sponsors that warrants serious consideration in favor of abandoning the ESOP option. Participants face additional exposure in their retirement savings when they invest in a single company, rather than diversified investment vehicles that spread risk across many underlying investments. They may lack the necessary resources to determine the quality of this investment and invest beyond an appropriate risk level. Moreover, sponsors face substantial financial (and legal) risk by converting their plan participants into stockholders within the strict protections of ERISA.³ The risk is magnified by participant litigation driven by the two market downturns of the last decade. Given the growing risk, sponsors may best find themselves avoiding the risks of KSOPs by adopting a brokerage window feature (sometimes labeled self-directed brokerage accounts) following the decision in Hecker.⁴

II.  Overview and History of ESOPs

A.  ESOP Overview

ESOPs are employer-sponsored retirement plans that allow the employee to invest in company stock, often unitized, on a tax-deferred basis. They are qualified defined contribution plans under ERISA. As a standalone plan, ESOPs take tax deferred payroll contributions from employees to purchase shares in the ESOP, which in turn owns shares of the employer’s stock. That indirect ownership through the ESOP coverts participants into shareholders, which gives them shareholder rights and creates liabilities to the participants both as shareholders and as participants in an ERISA-protected plan. They may receive dividends, may have the option to reinvest dividends into the plan, and may be able to receive distributions of vested assets in cash or in-kind, dependent upon plan rules.⁵

 ESOPs offer employers financial benefits: they create a way to add to employee benefit packages in a manner that is tax-advantaged while providing a vehicle to keep company stock in friendly hands – employees – and away from the hands of parties that may seek to take over the company or influence it through voting. Additionally, ESOPs create a consistent flow of stock periodically drawn out of the market, reducing supply and cushioning prices. Moreover, with those shares in the hands of employees, who tend to support their employer, there are fewer shares likely to vote against the company’s decision-makers or engage in shareholder activism.⁶

B.  Brief Relevant History of ESOPs

 ESOPs are generally less flexible and less advantageous to employees than 401ks. ESOPs lack loan options, offer a single investment option, typically lack a hardship or in-service distribution scheme and most importantly, lack diversification opportunities. Individual plans may adopt more restrictive rules to maintain funds within the plan as long as possible, as long as it is ERISA-compliant. Perhaps the most important consequence of that lack of diversity is that it necessarily ties retirement savings to the value of the company. If the company becomes insolvent or the share price declines without recovery, employees lose their retirement savings in the plan, and likely at least some of the pension benefits funded by the employer. The uneven distribution of benefits to employees helped pave the way for ERISA in 1974.⁷

C.  Current State of Law on ESOPs

1.  ESOPs Within 401k Plans

After the ERISA regulatory regime paved the way for 401k plans, employers began folding their ESOPs and other company stock offerings into the 401ks. For decades employers could mandate at least some plan assets had to be held in company stock. When corporate scandals and the dot com bubble burst in 2001, it evaporated significant retirement savings of participants heavily invested in their employer’s stock, often without their choice. Congress responded by including in the Pension Protection Act of 2006 (PPA) by eliminating or severely restricting several permissible plan rules that require 401k assets in any company stock investment within 401k plans.⁸

2. ERISA Litigation of the 2000s

Participants who saw their 401k assets in company stock vehicles disappear with the stock price had difficulty recovering under ERISA until recent litigation changed how ERISA is construed for 401k plans. ERISA was largely written with defined benefit plans in mind. Defined benefit plans hold assets collectively in trust for the entire plan. Participants may have hypothetical individual accounts in some plan models, but they do not have actual individual accounts. ERISA required that suits brought by participants against the plan (or the sponsor, trust, or other agent of the plan) for negligence or malfeasance would represent claims for losses to the plan collectively for all participants, so any monetary damages would be awarded to the plan to benefit the participants collectively, similar to the shareholder derivative suit model. Damages were not paid to participants or used to increase the benefits payable under the plan.

Defined contribution plans with individual participant accounts, such as 401k plans and ESOPs, were grafted onto those rules. Therefore, any suit arising from an issue with the company stock in one of these plans meant participants could not be credited in their individual accounts relative to injuries sustained. It rendered participant suits meaningless in most cases because the likelihood of recovery was suspect at best.⁹

The Supreme Court affirmed this view in 1985 in Russell, and courts have consistently held that individual participants could not individually benefit from participant suits. Participants owning company stock through the plan could take part separately in suits as shareholders against the company, but these are distinguished from suits under ERISA. In 2008, the Supreme Court revised Russell in LaRue and held that Russell only applied to defined benefit plans. Defined contribution plan participants could now bring claims individually or as a class and receive individual awards as participants. This shift represented new risks to sponsors that immediately arose with the market crash in 2007.¹⁰

III.  Risks to Employees

The primary risk to employees is financial; a significant component of employee financial risk is the investment risk. 401k sponsors are required to select investments that are prudent for participant retirement accounts. This is why 401k plans typically include pooled investments; diversified investment options spread risk. ESOPs are accepted investments within 401k plans, although they are not diversified.¹¹ This increases the risk, and profit potential, participants can expose themselves to within their accounts. While added risk can be exponentially profitable to participants when the employer has rising stock prices or a bull market is present, the downside can also be significantly disastrous when the company fails to meet analyst expectations or the bears take over the markets.

Moreover, employees may be more inclined to invest in the employer’s stock than an independent investor would. Employees tend to be bullish about their employer for two reasons.¹² First, employees are inundated with positive comments from management while typically negative information is not disclosed or is given a positive spin. This commentary arises in an area not covered by ERISA, SEC, or FINRA regulations. This commentary is not treated as statements to shareholders; they arise strictly from the employment relationship. This removes much of the accountability and standards that otherwise are related to comments from the company to participants and shareholders. Management can, and should, seek to motivate its employees to perform as well as possible. While the merit of misleading employees about the quality of operations may be debatable, the ability to be positive to such an end is not.

Second, employees tend to believe in the quality of their employer, even if they espouse otherwise. They tend to believe the company is run by experienced professionals who are leading the company to long term success. Going to work each day, seeing the company operating and producing for its customers encourages belief that the company must be doing well. It can even develop into a belief that the employee has the inside edge on knowing how great the company is, although this belief is likely formed with little or no knowledge of the financial health of the company. The product of the internal and external pressures is a strong likelihood employees will invest in an ESOP over other investment options for ephemeral, rather than financial, reasons.¹³

Additionally, participants may have greater exposure to the volatility of company stock over other shareholders due to 401k plan restrictions. While some plans are liberally constructed to give participants more freedom and choice, some plans conversely allow participants few options. This is particularly relevant to the investment activity within participant accounts. Participants may be limited to a certain number of investment transfers per period (e.g. quarterly or annually), may be subject to excessive trade restrictions, or may even find themselves exposed to company stock through repayment of a loan that originated in whole or in part from assets in the ESOP. Additionally, the ESOP may have periodic windows that restrict when purchases or redemptions can occur. While a regular shareholder can trade in and out of a stock in seconds in an after-tax brokerage account, ESOP shareholders may find themselves hung out to dry by either the ESOP or 401k plan rules. These restrictions are not penal; they represent administrative decisions on behalf of the sponsor to avoid the added expense generally associated with more liberal rules.

Although employees take notable risk to their retirement savings portfolio by investing in ESOPs within their 401k plans, it can add up to a tremendous financial risk when viewed in the bigger picture of an employee’s overall financial picture. Employees absorb the biggest source of financial risk by nature of employment through the company because it is the major, if not sole, income stream during an employee’s working years. This risk increases if the employer is also the primary source of retirement assets or provides health insurance. The employee’s present and future financial well being is inherently tied directly to the employer’s financial well being. This risk is compounded if the employee also has stock grants, stock options, or other stock plans that keep assets solely tied to the value of the company stock. If the employee is fortunate enough to have a defined benefit plan (not withstanding PBGC coverage) or retirement health benefits through the company, then that will further tie the long term success of the company to the financial well being of the employee. Adding diversification in the retirement portfolio may be a worthwhile venture when those other factors are considered in a holistic fashion.

IV.  Risks to the Sponsor

ERISA litigation is a serious risk and concern to sponsors. Although there is exposure in other areas related to participants as stockholders, ERISA establishes higher standards towards participants than companies otherwise have towards shareholders. Sponsors once were able to protect themselves under ERISA but since LaRue participants have an open door to reach the sponsor to recover losses related to the administration of the plan.¹⁴ ERISA requires sponsors to make available investment options that are prudent for 401k plans. The dormant side of that rule requires sponsors to remove investment options that have fallen below the prudent standard. Company stock is not excluded from this requirement.¹⁵

Any time the market value of the stock declines, the sponsor is at risk for participant losses for failure to remove the ESOP (or other company stock investment option) as an imprudent investment within the plan. Participants are enticed to indemnify losses through the sponsor. Such a suit is unlikely to succeed when the loss is short term and negligible, or the value declined in a market-wide downturn. However, as prior market downturns indicate, investors look to all possible avenues to indemnify their losses by bringing suits against brokers, advisors, fund companies, and issuers of their devalued assets. There is no reason to believe that participants would not be enticed to try this route; LaRue was born out of the downturn in the early 2000s.¹⁶

The exposure for sponsors runs from additional costs to mount a defense to massive monetary awards to indemnify participants for losses. In cases where participants are unlikely to recover, sponsors still must finance the defense against what often turns into expensive, class action litigation or a long serious of suits. However, there is a serious risk of sponsors having to pay damages, or settle, cases where events have led to a unique loss in share value. Participants have filed suit under the theory that the sponsor failed to remove imprudent investment options in a timely fashion. BP 401k participants filed suit following the gulf oil leak under a similar theory that the sponsor failed to remove the company stock investment option from the plan, knowing that it would have to pay clean up costs and settlements. While it remains to be seen if these participants will be successful, they surely will not the last to try.¹⁷

Sponsors should take a good, long look at the ESOP to determine whether the sponsor receives more reward than risk – particularly future risk – from its inclusion. The risk to a company does not have as severe as the situation BP faced this year. Even bankruptcy or mismanagement that results in serious stock decline can merit suit when the sponsor fails to immediately withdraw the ESOP, since it has prior knowledge of the bankruptcy or mismanagement prior to any public release.

To hedge these risks, sponsors can adopt several options. First, sponsors may limit the percentage of any account that may be held in company stock. This is easily justified as the sponsor taking a position in favor of diversification and responsible execution of fiduciary duties. While this may not completely absolve the sponsor of the duty to remove imprudent investment options, it does act as a limit on liability. Although it does provide some protection against risk, it is an imperfect solution.

Second, ESOP plans can adopt pricing structures to discourage holding large positions of company stock for the purpose of day trading. Some 401k plans allow participants to trade between company stock and cash equivalents without restraint. When the ESOP determines share pricing based on the closing price of the underlying stock, it creates a window where participants can play the company stock very differently than the constraints of most 401k investment options.

It is a very alluring reason to take advantage of the plan structure by taking an oversized position in company stock. Add the possibility to indemnify losses in court and it becomes even more desirable. The process is simple: participants can check the trading price minutes before the market closes. If the stock price is higher than the basis, they sell and net profit. If it is below, they hold the stock and try against each day until the sale is profitable. They will then buy back into the ESOP on a dip and repeat the process. This is distinguishable from the standard diversified fund options in 401k plans, where ignorance of the underlying investments preempts the ability to game closing prices. Funds generally discourage day trading – and may even carry redemption fees to penalize it – and encourage long term investing strategies more consistent with the objective of retirement accounts.

Available solutions are directly tied to the cause of the problem; changing the ESOP pricing scheme can eliminate gaming closing prices. ESOPs can adopt other pricing schemes such as average weighted pricing and next day order fulfillment. Average weighted pricing gives participants the average weighted prices of all transactions in the stock, executed that day, by a given entity. For example, if the ESOP is held with Broker X as the trustee, it may rely upon Broker X to provide the prices and volumes of all of its executed orders that day in the stock, which is used to determine the average weighted price participants will receive that day. Alternately, participants could be required to place orders on one day and have the order fulfilled on the following day’s closing with that day’s closing price. Both of these pricing schemes introduce some mystery into the price that diminishes gaming the closing price. This is also an imperfect solution, even if combined with the first option, because it maintains the risks of the ESOP.

Sponsors may also take advantage of brokerage windows to expand employee investment options, including company stock, without the risks afforded to ESOPs. Brokerage windows create brokerage accounts within 401k plans. The brokerage window is not an investment in itself; it is a shell that allows employees to reach through the window to access other investments. Sponsors found good reason to be suspicious of brokerage windows, seeing it as liability for all the available investments that could be deemed imprudent for retirement accounts. A minute minority of participants saw it as a way to have their cake and eat it too during the last rise and fall of the markets; they could invest more aggressively within their 401ks and then demand sponsors indemnify their losses when the markets gave up years of gains on the basis of sponsor failure to review the available contents of the window under the prudence standard.

However, in Deere the court handed down a critcal decision: sponsors could not be responsible for the choices made by participants within brokerage windows. In Deere, several Deere & Co. (John Deere) employees sued the company for making available investments that were imprudent for 401k accounts that caused substantial losses in the 2007 market downturn. John Deere had not reviewed the thousands of available options under the ERISA prudence standard. Although the plaintiffs’ theory was a compelling interpretation of ERISA duties, the court rejected the theory on two grounds. First, it would be impossible for any sponsor to review every investment available through the window. Second, participants had taken ownership of the responsibility to review their investment decisions by choosing to invest through the window.¹⁸

Following the court’s decision in Deere, brokerage windows gained new life as a means for sponsors to expand investment availability at less risk. Rather than having to review a menu of funds and company stock for prudence under ERISA, sponsors can justifiably limit the fund selection directly offered through the plan and leave the rest of the options to the brokerage window. Importantly, this includes offering company stock in the window. By utilizing the brokerage window, sponsors allow access to the company stock without the liabilities of offering an ESOP through the plan. The sponsor will likely lose out on any benefits received from the ESOP, although for most established employers ESOPs are likely more of a convenience factor and a legacy offering rooted in the history of employer-sponsored plans.

Although Deere foreclosed participant abuse of brokerage windows, this option is not without its own negative aspects. Future litigation may reestablish some liability upon the sponsor for the brokerage link. Sponsors may face alternate liability under ERISA for selecting a brokerage window with excessive commissions or fees, similar to requirements for funds under ERISA.¹⁹ Given the flurry of awareness brought to 401k management fees and revenue sharing agreements between sponsors and fund providers following the market crash in 2007, it is likely that brokerage windows will be the hot ticket for participants in the next market crash. Therefore, sponsors should preemptively guard against future litigation by reviewing available brokerage window options to make sure any fees or commissions are reasonable and the categories of investment options are reasonable (even if specific investments in those categories are not).

Perhaps a lesser concern, sponsors need to consider overall plan operation and any negative impacts that may arise from shifting to a brokerage window-based investment offering. These concerns may be less of a legal risk issue than a risk of participant discontent and dealing with those effects. There are primarily two areas that brokerage windows can create discontent. First, when participants want to move from a fund to the brokerage window, they must wait for the sale to settle from the fund and transfer to the window, which generally makes the money available in the window the day after the fund processes the order. Conversely, selling investments in the window may delay transferring money into plan funds because of settlement periods and the added delay of settlement with the fund once the funds are available to move out of the window. Additionally, the settlement periods within the window may frustrate participants, although the plan has no control over those timeframes. Those natural delays in processing the movement of money may create discontent, especially for those participants trying to invest based upon short term market conditions.

Second, those same processes and delays can negatively affect plan distributions. Many plans offer loans and withdrawal schemes, and while sponsors may have their own reasons for making those options available, participants often use those offerings to finance emergency financial needs. Brokerage windows can complicate and delay releasing money to participants. Settlement periods will create delays; if money has to be transferred out of the window to another investment to make those funds available for a distribution that will add at least one more day before money can be released. If participants find themselves in illiquid investments, the money may not be able to move for a distribution at all. Although these issues may not be of legal significance but they will be significant to the people responsible for absorbing participant complaints and there may be additional expenses created in handling those issues.

An additional concern is that the Department of Labor (DOL) is still fleshing out several requirements surrounding brokerage windows and how they relate to ERISA requirements. For example, the DOL October 2010 modification of 401k disclosure rules affects plans as a whole, but it leaves open several areas of ambiguity around the specific effects on brokerage windows. Sponsors may face continuing financial costs complying and determining how to comply with DOL requirements. Future changes in the regulations may negatively affect plans that rely heavily on brokerage windows to provide access to a greater range of investment options.²⁰

These considerations are not exhaustive to the benefits or risks of either ESOPs or brokerage windows, they merely highlight some of the more salient points as they relate generally to the legal and significant financial benefits and risks to sponsors. There may be additional concerns equally salient to sponsors given their particular situation, such as participant suspicion of the removal of the ESOP or unwillingness at the executive level to retire the ESOP.

V.  Conclusion

Although brokerage windows may open the door to some new liabilities, it closes the door to the risks of ESOPs, for both participants and sponsors. Sponsor diligence in administering retirement plans will always be the most successful method of checking liability; however, as discussed ESOPs risk putting sponsors in an unwinnable position. Removing the company stock option may not be the most beneficial option in all cases but it may be time for sponsors to consider retiring the ESOP from the 401k in light of the current regulatory regime. A brokerage window option is well suited to take advantage of participant ownership of the employer’s stock, as well as other investment opportunities, while limiting the risk that normally accompanies that ownership. Ultimately, sponsors must consider what is best for the plan and its participants over both the short term and the long term.

Endnotes.

1. Chris Farrell, The 401(k) Turns Thirty Years Old, Bloomberg Businessweek Special Report, Mar. 15, 2010, http://www.businessweek.com/investor/content/mar2010/pi20100312_874138.htm.

2. National Center for Employee Ownership401(k) Plans as Employee Ownership Vehicles, Alone and in Combination with ESOPs, (no date provided), http://www.nceo.org/main/article.php/id/15/.

3. Id.; 29 U.S.C. § 1104 (2010); the term “sponsor” can be used interchangeably with “employer” for purposes of this discussion, however there are some situations where the employer is not the sponsor, such as union plans, or the employer is not the sole sponsor in the case of multi-employer plans. This discussion relates to KSOPs where the sponsor is the employer. Different rules and different liability may apply to other plan structures.

4. Hecker v. Deere & Co., 556 F.3d 575, 590 (7^th Cir. 2009), cert. denied, 130 S. Ct. 1141 (2010).

5. Todd S. Snyder, Employee Stock Ownership Plans (ESOPs): Legislative History, Congressional Research Service, May 20, 2003.

6. William N. Pugh et al. The Effect of ESOP Adoptions on Corporate Performance: Are There Really Performance Changes?, 21Managerial & Decision Econ., 167, 167-180 (2000).

7. Supra note 5.  

8. Pension Protection Act of 2006 § 901, 29 U.S.C. 401 (2010).

9. LaRue v. DeWitt, Boberg & Assocs., Inc., 552 U.S. 248, 254-55 (2008).

10. Id. at 255-56.

11. Shlomo Benartzi et al., The Law and Economic of Company Stock in 401(k) Plans, 50 J.L. & Econ. 45, 45-79 (2007).

12. Id.

13. Id.

14. LaRue, 552 U.S. at 254-55.

15.  § 1104.

16. LaRue, 552 U.S. at 250-51.

17. E.g., In Re: BP P.L.C. Securities Litigation, MDL No. 2185, 2010 WL 3238321 (J.P.M.L. Aug. 10, 2010).

18. Hecker, 556 F.3dat 590.

19. §1104.

20. 29 C.F.R. § 2550 (2010).