The 5th U.S. Circuit Court of Appeals has ruled in an Employee Retirement Income Security Act (ERISA) lawsuit filed several years ago against the investment committee of the Phillips 66 Savings Plan.
In a ruling stretching to just 14 pages, the appeals court sides firmly with the lower court that ruled previously in the case in favor of the defense. The underlying allegations in the case involve the 2012 spinoff of Phillips 66 from the ConocoPhillips Corp., a large oil and gas company.
In 2012, ConocoPhillips retained its upstream business, namely oil exploration and production, while Phillips 66 took on the downstream business, including refining, marketing and transportation operations. With the separation, 12,000 ConocoPhillips employees became employees of Phillips 66.
As recalled in the appeals court ruling, many of these employees held assets in individual retirement accounts (IRAs) in the ConocoPhillips savings plan at the time of the separation. These accounts included large investments in two single-stock funds comprised of ConocoPhillips stock. As a result of the separation, each employee received one share of Phillips 66 stock for every two shares of ConocoPhillips stock held in their account. Afterward, Phillips 66 employees had $2.9 billion in ConocoPhillips plan assets, including $1.1 billion invested in the ConocoPhillips funds.
According to case documents, the ConocoPhillips plan transferred these assets to the Phillips 66 Savings Plan, the newly established retirement plan for Phillips 66 employees. After the transfer, Phillips 66 plan participants could retain or sell their investments in the ConocoPhillips funds, but could not make new investments in the funds.
The plaintiffs argued that the plan’s “overly concentrated position” caused participants to lose millions of dollars as the price of ConocoPhillips eventually fell. Participants claim the defendants also ignored the numerous warning signs that showed ConocoPhillips stock was an imprudent investment for retirement assets and then failed to take action as the price of ConocoPhillips stock dropped nearly 50% from its high of $86.50 per share.
In May 2018, the U.S. District Court for the Southern District of Texas dismissed the lawsuit. In its ruling, the court disagreed with the defense’s argument that it is exempt from ERISA’s diversification requirement because the ConocoPhillips shares retained their character as employer securities after the spinoff of Phillips 66 under ERISA Section 407(d)(1)8. However, the court agreed that the plaintiffs failed to plead sufficient facts to state a claim for breach of the duty of prudence and the duty to diversify.
Like the district court’s ruling, the appellate decision concludes that, although ConocoPhillips had employed the Phillips 66 plan’s participants at one point, Phillips 66 is the only entity now “acting” as the employer of employees covered by the Phillips 66 plan.
“The ConocoPhillips funds are qualifying employer stock only if they were issued by Phillips 66,” the appeals court states. “They were not.”
From this point, the appellate ruling sides with the defense.
“The duty to diversify under [ERISA] imposes obligations on fiduciaries for defined benefit [DB] plans that are different from those for defined contribution [DC] plans, like the Phillips 66 plan,” the ruling states. “As fiduciaries for defined benefit plans choose the investments and allocate the plan’s assets, they must ensure the plan’s assets as a whole are well diversified. The fiduciaries for a defined contribution plan, however, only select investment options; the participants then choose how to allocate their assets to the available options. These fiduciaries therefore need only provide investment options that enable participants to create diversified portfolios; they need not ensure that participants actually diversify their portfolios. Plaintiffs have not alleged that the fiduciaries did not offer sufficient investment options or failed to warn plan participants of the risk of a concentrated portfolio. … As a result, their [failure to diversify] claim fails.”
The appellate ruling then enters into an in-depth discussion of the duty of prudence. For starters, the appeals court states that the Supreme Court ruling in Fifth-Third Bank v. Dudenhoeffer precludes the plaintiffs’ first lack-of-prudence claim.
“The first claim alleges the fiduciaries should have known from publicly available information that the stock market underestimated the risk of holding ConocoPhillips stock,” the ruling explains. “Dudenhoeffer addressed this line of argument, holding that ‘where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or under-valuing the stock are implausible as a general rule, at least in the absence of special circumstances.’ In so doing, Dudenhoeffer effectively foreclosed claims, like plaintiffs’, that a fiduciary should have known from public information that the market underestimated the risk of holding a publicly traded security.”
The appellate court then stipulates that Dudenhoeffer and its related cases do not apply to the second wing of plaintiffs’ prudence argument—that the ConocoPhillips funds were imprudent because of the risk inherent in failing to diversify.
“Unlike the claim in Dudenhoeffer, this claim does not turn on publicly available information or whether fiduciaries can beat the market,” the ruling states. “Moreover, Dudenhoeffer and our subsequent decisions all involved employer securities, which are exempt from the duty of prudence ‘to the extent that it requires diversification.’ They do not address the prudence of holding a single-stock fund in the first place. As a result, this second wing of plaintiffs’ duty-of-prudence claim does not implicate Dudenhoeffer and is not foreclosed by it.”
After some additional discussion, the appeals court ultimately concludes that “it does not follow that the fiduciaries were obligated to force plan participants to divest from the funds.” The court’s reasoning is that ERISA does not require fiduciaries of a defined contribution plan to act as personal investment advisers to plan participants.
“Such a plan gives participants the control by design, and it gives employees the responsibility and freedom to choose how to invest their funds,” the ruling states. “No rule forbids plan sponsors to allow participants to make their own choices. ERISA imposed other obligations, which the fiduciaries met. They repeatedly provided plan participants with the statutorily mandated warning against holding more than 20% of a portfolio in the security of one entity.”
The ruling continues: “By closing the ConocoPhillips funds to new investments immediately after the spinoff, the fiduciaries also ensured that they were not offering participants an imprudent investment option. At that point, while blocked from adding more ‘eggs to the basket,’ plaintiffs were free to sell off their investments at any time and reinvest in other funds. With a rising market, they chose to retain the ConocoPhillips Funds for over two years, balancing the risk of a want of portfolio diversity against the rising values of ConocoPhillips stock—a risk against which the fiduciaries urged caution. They cannot enjoy their autonomy and now blame the fiduciaries for declining to second-guess that judgment.”
The full text of the 5th Circuit ruling is available here.