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Rationalizing Shareholder-Protection Laws in the Post-Enron Era

8/25/2005 --

The collision of federal and state oversight laws is reshaping the obligations of corporate officers and directors who oversee 401(k) plans that utilize employer stock as an investment vehicle.

ANN ARBOR, Mich.—Congressional passage of the Sarbanes-Oxley Act, subsequent tightening of Securities and Exchange Commission regulations in the wake of corporate scandals, and claims brought under the Employee Retirement Income Security Act (ERISA) have allowed federal regulation to penetrate the traditionally state-regulated area of corporate governance. This federal action, say two business law professors at the University of Michigan's Ross School of Business, has stirred controversy over how federal law affects the standards of conduct for corporate officers and directors and impacts their obligations to shareholders.

"The collision of federal securities law, ERISA and state corporate law is reshaping the traditional duties of loyalty and care owed by corporate leaders to shareholders," said Dana Muir and Cindy Schipani. "The long-standing principle of shareholder equality has been destabilized, and the right of corporations to remain silent unless obligated by a specific statutory provision to make disclosures also may be affected."

Under state corporate law, the duty of care and its corollary, the "business judgment rule," require that the actions of corporate officers and directors be made with due care, in good faith and in the best interests of the corporation. The duty of loyalty requires that they place corporate interests above personal interests, thereby avoiding conflicts of interest. The requirement of good faith is still developing in state corporate law and appears to be considered by some commentators and courts as a separate fiduciary duty. Employee-benefit law diverges from state corporate law in certain ways. It often includes more people as plan fiduciaries, but limits the scope of their fiduciary obligations to specified discretionary actions.

A recent trigger point for these fiduciary concerns, say Muir and Schipani, has been litigation arising from employee investments in company stock. Currently, 401(k) plans and other types of employer-sponsored defined-contribution plans hold more than $3.9 trillion. Not surprisingly, significant declines in the value of employer stock held in these plans have prompted private plaintiffs and the Department of Labor to file lawsuits against employers, company directors and individuals who oversee the plans. Enron, where employees lost $2 billion, is the most visible example of investments in employer stock gone awry.

Under ERISA, employers have some fiduciary obligations for 401(k) plans even where investment decision-making responsibility is delegated to employees. In addition, the federal securities laws, as applied to employee-benefit plans, recognize the unique character of these plans and sometimes treat employee shareholders differently than non-employee shareholders.

Employees who have invested in employer stock through a 401(k) plan and have seen the investment perform poorly rely on ERISA and the federal securities laws to argue that the company directors and officials charged with plan oversight are liable for the employees' losses. In the process of evaluating these claims, certain distinctions have begun to emerge in the rights and protection afforded to employee shareholders versus traditional investors.

In their article, "New Standards of Director Loyalty and Care in the Post-Enron Era: Are some Shareholders More Equal that Others?" Muir and Schipani analyze the traditional fiduciary duties and obligations that corporate officers and directors owe to shareholders under federal securities law, state corporate law and ERISA. They also examine the intersection of these complex legal regimes and discuss how the varying standards articulated by state and federal law can sometimes have unintended, and undesirable, consequences. Finally, the two scholars suggest ways in which the courts and policy-makers can draw from traditional well-established legal doctrine and use it to formulate a rational law of shareholder protection in the post-Enron era.

For example, they suggest a two-tiered scrutiny for evaluating decisions made by corporate officers and directors regarding the use of employer stock and other investment options in 401(k) plans. This would require, among other things, that a fiduciary be informed and undertake a reasonable investigation when making a choice of a plan investment alternative. Corporate directors and officials, they add, also could negate or at least lessen the conflicts of interest inherent in their plan-related decisions by hiring an independent expert fiduciary to make or to assist in making those decisions.

"The question still remains of what might constitute reasonable fiduciary monitoring in the context of using employer stock in a 401(k) plan," said Muir and Schipani. "In our view, it is critical that the fiduciary charged with oversight of the plan investment options perform periodic reviews, which consider the suitability of company stock as an investment choice. In this way, the oversight responsibility reinforces the fiduciary standards, which in turn should ensure prudent investment options."


Written by Claudia Capos

For more information, contact:
Bernie DeGroat
Phone:(734) 936-1015 or 647-1847
Email:bernied@umich.edu