'Originally published in West's First Focus: The Subprime Crisis, a Thomson West Report .'

In recent years, plaintiffs' class-action lawyers have creatively attempted to circumvent some of the developing limitations of the securities laws by filing class actions related to stock drops under the Employee Retirement Income Security Act, 29 U.S.C. § 1001. These suits often involve cases where employers sponsor pension plans for their employees and those plans are allowed to invest in the company's own stock. Cases determining whether these are viable causes of action have been making their way from the federal district courts to the courts of appeals.

It comes as no surprise that the plaintiffs' bar is already calling upon ERISA as a means for taking on the subprime mortgage fallout. Based on the allegations of some recently filed complaints, it appears that pension plan fiduciaries charged with safeguarding the plan beneficiaries' retirement assets were investing in subprime instruments.

ERISA claims concerning subprime mortgage securities have arisen already in at least two distinct contexts. In one recently filed case, the plaintiffs seek class-action status because a financial institution that was the investment manager of an employee 401(k) plan allegedly invested in risky securitized subprime mortgage pools rather than in conservative, low-risk bonds as advertised. In another variant of the subprime issue intersecting with ERISA, a putative class-action suit has been filed on behalf of the employee participants of 401(k) plans set up by a very large bank that has suffered heavy subprime-related losses.

How ERISA Became a Tool for Seeking Damages for Stock Drops

Historically, private plaintiffs who invested in the stocks or other securities of public companies whose value took a nose-dive sought relief by filing suits, typically class action in nature, under the Securities Act of 1933, 15 U.S.C. § 77(k), and the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b). The vitality of these laws as a means for private plaintiffs to seek redress was undermined in 1994 with the U.S. Supreme Court's decision in Central Bank of Denver v. First Interstate Bank of Denver.1

There, the court said there was no private right of action for aiding and abetting violations of the securities laws. The court thereby seemingly put a number of third-party actors who usually do not make statements to the public about securities, such as attorneys and investment bankers, frequently outside the reach of plaintiffs' class-action lawyers. The court left this class of purported misconduct to be pursued by the Securities and Exchange Commission through its enforcement powers.

Adding to the difficulties of the traditional securities law class action was the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u. Among the provisions of the PSLRA making private securities class actions more onerous from a plaintiff's perspective are the automatic stay of discovery upon filing a motion to dismiss, the heightened pleading standard requiring facts supporting a strong inference of scienter, and the provisions mandating criteria for who may act as lead plaintiffs and lead counsel.2

The New ERISA Subprime Cases

One of the first ERISA cases to take on investments in subprime mortgage securities challenges the investment decisions by a fund manager with discretion under the terms of the plan to invest in subprime debt. The New York federal court suit alleges that State Street was the investment manager for a Unisystems Inc. profit-sharing plan with the discretion to make investment decisions for the plan and that the bank imprudently invested plan funds in subprime debt.3

The complaint asserts that the plan documents required 40 percent of plan funds to be invested in low-risk, fixed-income bond funds. Rather than making such conservative investments, State Street had its bond funds take significant positions—in 2007, no less, when this market was plummeting—in subprime-mortgage-backed securities, the suit says. The plaintiff alleges that State Street not only acted imprudently in these investment decisions but failed to disclose the deviation from the stated strategy of investing largely in conservative, low-risk investments.

In addition, the complaint includes unadorned claims that State Street had somehow breached its duty of loyalty, suggesting that the plaintiff hopes to develop a case that the bank had divided loyalties in pursuing subprime investments.

Notably, the suit seeks certification of a class potentially enormous in scope and not limited solely to the plan and its participants. The retirement plan, itself a plaintiff, seeks class certification not only for the individual Unisystems plan participants but for other ERISA plans and their participants and beneficiaries who also invested in certain funds administered by State Street and its affiliates. It is conceivable that such a class would have had an enormous investment in the State Street funds under scrutiny.

The other recently filed ERISA subprime suit takes on another major financial institution in its capacity as sponsor of and fiduciary for its employees' 401(k) plans. The plaintiff complains that Citigroup's plan administrators acted imprudently by allowing stock in the bank to be an investment option without disclosing the bank's tremendous exposure to subprime mortgage debt.4 Insomuch as this suit alleges that corporate executives who also doubled as ERISA fiduciaries acted imprudently and with divided loyalties by allowing employees to invest in company stock, this is more of a conventional ERISA stock-drop case with a subprime component than is the Unisystems case.

According to the complaint against Citigroup, the bank's 401(k) plans had 32 percent—amounting to $4.13 billion—of their assets in company stock and have suffered more than $1.3 billion in losses. The plaintiff asserts that Citigroup imprudently and without disclosure invested in "no documentation" and "low documentation" loans, "piggyback" loans on top of first mortgages where loan-to-value ratios exceeded 80 percent, interest-only mortgages, and hybrid adjustable-rate mortgages with unusually low "teaser" rates and also had off-balance-sheet structured investment vehicles (or "conduits") that similarly invested in subprime debt.

As a result, the suit claims, Citigroup's revenues were as much as $11 billion less than reported, its stock declined by 30 percent in less than six months and more than $81 billion in market capitalization evaporated. According to the suit, Citigroup's officers and plan fiduciaries had a duty to disclose the subprime-related risks to their employees who participated in its 401(k) plans.

Likely Issues

It is likely that these putative ERISA class actions will be among the first of many to address the subprime credit implosion. Many of the legal defenses that have been raised in the context of other ERISA stock-drop cases are sure to recur as front-line defenses in the subprime cases. The legal issues include:

  • The degree of discretion accorded to fiduciaries under plan documents and whether fiduciaries have the right and the obligation to diverge from plan documents in the interest of prudence;
  • If there are parallel securities class actions, if pending cases should be consolidated and whether settled securities class actions bar ERISA claims concerning the same events;
  • Whether there is a conflict between the ERISA duty of fiduciaries to disclose and the securities laws' requirement of not acting on material nonpublic information; and
  • Whether a plan's purchase of allegedly overvalued company stock is a "prohibited transaction" under ERISA because it is a form of self-dealing.

In fact, one hotly contested legal issue in ERISA stock-drop cases was just decided by the U.S. Supreme Court in favor of ERISA plaintiffs Feb. 20. In LaRue v. DeWolff, Boberg & Associates the court held that an individual or individuals who do not make up the entire class of plan participants may seek monetary damages for a breach of fiduciary duty under ERISA Section 502(a)(2), despite earlier Supreme Court precedent suggesting that only a plan could seek plan-wide relief under that section.5

The subprime mortgage crisis may be explored under ERISA's very exacting legal standards. ERISA, after all, is a statutory scheme based upon the common law of trusts, where fiduciaries, in the famous words of Judge Benjamin Cardozo, owe their beneficiaries "the punctilio of an honor most sensitive."

Without the benefit of hindsight, courts will be asked to judge whether subprime mortgages and securities backed by such mortgages were prudent investments before the market correction, especially for retirement funds. Companies and financial institutions that are involved in the subprime market may need to be prepared to respond both in the securities and ERISA contexts at the same time.

Footnotes

1 511 U.S. 164 (1994).

2 The Supreme Court's January decision in Stoneridge Investment Partners v. Scientific-Atlanta Inc., 128 S. Ct. 761 (Jan. 15, 2008), gives little additional comfort to private plaintiffs that the securities laws will not continue to pose daunting obstacles to expanding liability. There, the court ruled out so-called "scheme" liability for non-speaking actors, at least in the "commercial" sphere, where the defendants were suppliers that allegedly participated in the issuer's fraud. The court did leave for another day, at least in theory, whether non-speaking third parties in the financial arena, such as attorneys and bankers, may be securities violators as secondary actors.

3 Unisystems Inc. Employees Profit Sharing Plan v. State Street Bank & Trust Co., No. 07-9319, complaint filed (S.D.N.Y. Oct. 17, 2007).

4 Gray v. Citigroup Inc., No. 07-979, complaint filed (S.D.N.Y. Nov. 5, 2007).

5 No. 06-856, 2008 WL 440748 (U.S. Feb. 20, 2008). LaRue will make it easier for plan participants as individuals or as groups to seek monetary damages on behalf of themselves rather than on behalf of entire plans (all of which are often not invested 100 percent in company stock). The decision makes it easier for ERISA stock-drop class actions in general and along the way should make it easier for ERISA suits to be aimed at subprime issues.

This article is presented for informational purposes only and is not intended to constitute legal advice.