Economic Analysis In ERISA Litigation over Fiduciary Duties

Plan participants may actually benefit from inflation, because they are able to sell their holdings of employer stock at a higher price than if the misstatements or omissions had been corrected. Such participants may not have a claim to a loss. Moreover, their presence may potentially result in the plan as a whole gaining from the misstatements, if in aggregate, the plan gained more from selling stock at an inflated price than it lost by purchasing stock at an inflated price. The alleged misstatements or omissions delayed a drop in the stock price that would otherwise have come earlier and caused a greater loss to the plan.

A distinction exists between ERISA damages and damages in shareholder class actions. In the latter, shares held at the start of the class period do not qualify for damages in the shareholder class action, because these class actions require a purchase of the security in question. In contrast, “holders” of stock at the commencement of the action do potentially qualify for damages in an ERISA case. If the offending investment option had been removed from the plan, holders' investments would have been switched to other, presumably prudent options, and they may have had better returns in those options.

However, if the allegations involve misstatements or omissions, it is not reasonable to claim damages for holders in the ERISA case. If plan fiduciaries were aware of the misstatements or omissions and removed the employer stock as an option, they might run afoul of securities laws against insider trading. But if they instead corrected the information, the stock would have dropped to its true value, and holders of the stock would have lost anyway. So in such a case, holders should not be able to claim a loss, and may in fact have a benefit. Not only should they be excluded from damage calculations, but any gains they might have from sales at allegedly inflated prices should be offset against their losses from subsequent purchases.

Non-Disclosure Cases

A similar argument may be made for non-disclosure cases. The removal of employer stock as an option from a plan may by itself cause the price of the stock to drop. One possible reason is that the removal may be taken as an indication that the officers of the company are pessimistic about the company's prospects, and possibly that they have non-public information, which could cause other investors to lower their assessments of the stock's value. The other possible reason is that liquidation by a plan of its holdings of company stock implies downward pressure on the stock from the volume of sales as the holdings are liquidated. In either case, holders of employer stock would suffer a loss if the fiduciaries of the plan followed the allegedly prudent course and liquidated the stock.

These issues may also give rise to serious conflicts between class members. If there is any ambiguity about the nature of the alleged misrepresentations or their timing, the class representative will have an incentive to maximize his or her own damages when resolving the ambiguities. That may not serve the interests of other class members or indeed of the class or plan in aggregate. For example, if the class representative first sold stock and then purchased additional shares, he or she would prefer that the class period begin after the sales and before the purchases, to maximize the alleged loss due to the misrepresentations. Other class members, or the plan in aggregate, may obtain larger losses with an earlier start date for the class period.

Conclusion

This three-part article has sketched out some important areas in which financial economics can provide useful insights in ERISA litigation. Financial economists analyze both the question of what investors should do and what they actually do. Although these two concepts are distinct, they both provide important insights on how fiduciaries to defined-contribution plans should act. The article also touched on some of the important issues financial economists confront when they calculate alleged damages.

John Montgomery, Ph.D., NERA Economic Consulting Senior Vice President, specializes in securities, financial economics, and valuation. He has testified on damages, materiality, prudence of investment decisions, costs of trading, and macroeconomic issues. He also provides analysis for shareholder class actions, ERISA class actions, and insider trading cases.

Numerous lawsuits have been brought under ERISA over the last decade, against the fiduciaries and sponsors of 401(k) and other defined contribution retirement plans. Part One of this three-part article discussed many of these lawsuits, which have been pled as class actions on behalf of all or many participants of the plan. Part Two discussed the implications of behavioral finance for ERISA litigation, provision of financial services with choice, and loss calculations. Part Three herein discusses damages calculations.

Damages Calculations with Allegations of
Misstatements or Omissions

As discussed in Part One, many ERISA lawsuits over employer stock involve alleged misstatements or omissions by the employer or its officers. This implies that the price of the stock is allegedly inflated. In such cases, the but-for world might involve either investment in an alternative stock or investment in a hypothetical version of the employer stock without inflation. The latter, hypothetical option can be approximated based on estimates of the alleged stock price inflation. Approaches used in shareholder class actions, where inflation is estimated from stock price reactions to corrective disclosures, using event study techniques, could be applied to ERISA cases. Analysis in these cases is generally based on the assumption that the stock trades in an efficient market and, therefore, rapidly reflects any publicly disclosed information.

Plan participants may actually benefit from inflation, because they are able to sell their holdings of employer stock at a higher price than if the misstatements or omissions had been corrected. Such participants may not have a claim to a loss. Moreover, their presence may potentially result in the plan as a whole gaining from the misstatements, if in aggregate, the plan gained more from selling stock at an inflated price than it lost by purchasing stock at an inflated price. The alleged misstatements or omissions delayed a drop in the stock price that would otherwise have come earlier and caused a greater loss to the plan.

A distinction exists between ERISA damages and damages in shareholder class actions. In the latter, shares held at the start of the class period do not qualify for damages in the shareholder class action, because these class actions require a purchase of the security in question. In contrast, “holders” of stock at the commencement of the action do potentially qualify for damages in an ERISA case. If the offending investment option had been removed from the plan, holders' investments would have been switched to other, presumably prudent options, and they may have had better returns in those options.

However, if the allegations involve misstatements or omissions, it is not reasonable to claim damages for holders in the ERISA case. If plan fiduciaries were aware of the misstatements or omissions and removed the employer stock as an option, they might run afoul of securities laws against insider trading. But if they instead corrected the information, the stock would have dropped to its true value, and holders of the stock would have lost anyway. So in such a case, holders should not be able to claim a loss, and may in fact have a benefit. Not only should they be excluded from damage calculations, but any gains they might have from sales at allegedly inflated prices should be offset against their losses from subsequent purchases.

Non-Disclosure Cases

A similar argument may be made for non-disclosure cases. The removal of employer stock as an option from a plan may by itself cause the price of the stock to drop. One possible reason is that the removal may be taken as an indication that the officers of the company are pessimistic about the company's prospects, and possibly that they have non-public information, which could cause other investors to lower their assessments of the stock's value. The other possible reason is that liquidation by a plan of its holdings of company stock implies downward pressure on the stock from the volume of sales as the holdings are liquidated. In either case, holders of employer stock would suffer a loss if the fiduciaries of the plan followed the allegedly prudent course and liquidated the stock.

These issues may also give rise to serious conflicts between class members. If there is any ambiguity about the nature of the alleged misrepresentations or their timing, the class representative will have an incentive to maximize his or her own damages when resolving the ambiguities. That may not serve the interests of other class members or indeed of the class or plan in aggregate. For example, if the class representative first sold stock and then purchased additional shares, he or she would prefer that the class period begin after the sales and before the purchases, to maximize the alleged loss due to the misrepresentations. Other class members, or the plan in aggregate, may obtain larger losses with an earlier start date for the class period.

Conclusion

This three-part article has sketched out some important areas in which financial economics can provide useful insights in ERISA litigation. Financial economists analyze both the question of what investors should do and what they actually do. Although these two concepts are distinct, they both provide important insights on how fiduciaries to defined-contribution plans should act. The article also touched on some of the important issues financial economists confront when they calculate alleged damages.

John Montgomery, Ph.D., NERA Economic Consulting Senior Vice President, specializes in securities, financial economics, and valuation. He has testified on damages, materiality, prudence of investment decisions, costs of trading, and macroeconomic issues. He also provides analysis for shareholder class actions, ERISA class actions, and insider trading cases.