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Hold It or Fold It: Keeping or Terminating the Employer Stock Fund After Dudenhoeffer and Tatum

An NCEO Issue Brief

(Print Version)

by Rosina B. Barker and Kevin P. O'Brien

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The fiduciary of an employer stock fund grasps the proverbial tiger by the tail: perilous to hold on; perilous to let go. After the Supreme Court in Fifth Third Bancorp v. Dudenhoeffer discarded the longstanding Moench presumption of prudence onto the ash heap of Employee Retirement Income Security Act (ERISA) history by a nine-zero vote, the fiduciary must review the employer stock fund like any other. If the stock price collapses or merely underperforms, the fiduciary could be sued for having breached its duty of prudence. But if the fiduciary terminates and liquidates the fund, participants could sue when the stock price rebounds. ERISA's duty of prudent investing requires prudent conduct and a prudent process. Keep or close the fund, the fiduciary needs a robust process to show its decision is prudent.

Written by two leading attorneys, this issue brief proposes a fiduciary process letting the ERISA fiduciary decide whether it may prudently offer an employer stock fund in the 401(k) plan of a publicly traded company. The authors' proposed process thus also supports an exit strategy: the fiduciary's prudent decision to terminate and liquidate the employer stock fund.

Publication Details

Format: Perfect-bound book, 32 pages
Dimensions: 8.5 x 11 inches
Edition: 1st (October 2015)
Status: In stock


Introduction: The Fiduciary Dilemma
I. Holding the Fund Open: A Fiduciary Process
(1) Public Information
(2) Inside Information
(3) Risk
II. Terminating the Fund: A Fiduciary Process
III. Supplementing the Fiduciary's Section 404(c) Protections
IV. Conclusions and Executive Summary
(1) Keeping the Fund Open
(2) Terminating the Fund
(3) Shoring Up the Fiduciary's 404(c) Protection
About the Authors
About the NCEO


From "I. Holding the Fund Open: A Fiduciary Process" (footnotes omitted)

Should the fiduciary include all ten Cammer/Krogman factors in its process? This is a fiduciary judgment call. The fiduciary might want to apply only the first eight factors, which can be established easily at low cost. Many of these eight—e.g., average weekly trading volume; bid-ask spread; whether the stock trades on the NYSE or NASDAQ; the company's market cap—might be found or calculated from a source such as the Wall Street Journal. The fiduciary might wish to determine solely on the basis of this easily obtainable information the stock trades in an efficient market, and no special circumstances make it imprudent to rely on the market's valuation.

Alternatively, the fiduciary might decide it wants its process to be more robust. To establish more firmly the prudence of its decision to buy, hold, or sell employer stock at any time at the market price, the fiduciary would perform two additional tests. First, an "event study" using statistical techniques tests whether a company's stock price reacts as predicted to new public information. For any NYSE-traded or large NASDAQ-traded company, the answer is virtually certain to be yes. Event studies have high probative value in securities litigation and should amply demonstrate a robust fiduciary process.

The second test is an "autocorrelation" study, proving the stock does not have a pattern of continuing to gain (or fall) after earlier gains (or to gain or fall after earlier losses), but instead fluctuates randomly after each up or down. This protects the fiduciary's Achilles heel: a prolonged stock price slide. If the employer stock price has dropped steadily, an autocorrelation study may specifically prove the stock's long downward slide is not a sound basis for predicting (in contrast with Gedek) the slide will continue, and not a prudent basis for closing the fund to new investment. Conversely, assume the fiduciary wants to close the fund. An autocorrelation study may show recent gains are not a prudent basis for predicting gains will continue, and recent losses are not a prudent basis for predicting (in contrast with Tatum) the price must go up. The efficient market hypothesis predicts that markets have no memory. An autocorrelation study proves this prediction applies to the specific employer stock.

To conduct an event study and an autocorrelation study the fiduciary must almost certainly retain an economic consultant. The other eight Cammer/Krogman factors can be established with less sophisticated help.

From "II. Terminating the Fund: A Fiduciary Process" (footnotes omitted)

The typical termination follows a two stage process. In Stage 1, the fiduciary closes the employer stock fund to new investments. Participants can move money out of the employer stock fund but can't move money into it. The Stage 1 transition period benefits participant-shareholders in several ways. It warns participants about the ultimate termination; it allows participants to select their own preferred sales timing and sales price, as well as their preferred investment of the funds; and by elongating the total liquidation period reduces the number of shares the fiduciary must sell into the market all at once. In addition, it anticipates the end point of the process: transfer of any remaining assets from the terminated employer stock fund to the QDIA. Only by giving participants the prior opportunity to elect investment of their account balances does the fiduciary obtain safe harbor protection under ERISA Section 404(a)(5) when it transfers non-elected assets into a QDIA. Of course, in most 404(c) plans participants have this right on an ongoing basis. But a Stage 1 warning puts participants on notice and should forestall potential claims they lacked a meaningful opportunity to invest their employer stock fund balance before its ultimate termination. Moreover the delay before involuntary liquidation begins in Stage 2 draws some of the sting from potential claims the fiduciary imprudently ignored inside information available at the time of the decision tending to predict a price increase.

In Stage 2, the fund is terminated, the stock liquidated and the proceeds invested in the QDIA. No proceeds are allocated to any single account until the end of Stage 2; at that point, each participant with a remaining balance in the employer stock fund receives a pro rata share of the proceeds, based on the weighted average share price realized over the Stage 2 liquidation period. Because each participant gets the average price, no participant gets the accidental benefit or detriment of stock price movements during the Stage 2 liquidation period. However, trades, loans, and distributions from the employer stock fund must be suspended during the entire period. Stage 2 is thus an ERISA blackout period if it is expected to last more than 3 business days. Stage 2 might also be a Sarbanes Oxley blackout period if affected participants exceed the 50 percent threshold.