Employees at a handful of companies seeking to recover losses after their employers admitted to backdating stock option grants illegally are exploring a potentially powerful avenue: the federal ERISA statute.
The Employee Retirement Income Security Act requires a laundry list of compliance obligations on companies to help protect workers’ retirement monies. It also imposes fiduciary responsibilities on the overseers of company retirement plans, and now backdating lawsuits are using that fiduciary duty clause to put company executives in their crosshairs.
In April, for example, a lawsuit was filed in U.S. District Court for the Central District of California against KB Home, its directors, and several current and former officers. The complaint, filed on behalf of all participants in the company’s 401(k) plan, alleges that the defendants breached their fiduciary duties under ERISA to members of the plan by issuing backdated option grants and failing to disclose this information to the plan participants.
KB Home’s backdating unjustly enriched the plan’s fiduciaries, including CEO Bruce Karatz, to the detriment of the 401(k) plan’s other participants, the suit alleges. By backdating the options so they had a strike price lower than the trading price of the stock on the date of grant, “KB Home insiders and the plan’s fiduciaries profited immediately upon the award of the options without doing anything to improve the company’s business or financial condition,” the suit says.
LaCroix
KB Home is not alone. Last summer, Home Depot disclosed two lawsuits seeking class-action status against the company and its executives, both alleging breach of fiduciary duty under ERISA for its return-to-vendor and stock option practices. Altogether, at least five companies that have admitted to backdating stock options are currently targets of ERISA-related suits, according to Kevin LaCroix, a lawyer and director of OakBridge Insurance Services. In addition to KB Home and Home Depot, the others are UnitedHealth Group, Affiliated Computer Services, and Analog Devices.
Where ERISA Steps In
Section 404 of ERISA requires retirement plan fiduciaries to exercise their duties for the exclusive purposes of providing benefits to participants and beneficiaries, and of defraying the reasonable expenses of administering the plan. Some of ERISA’s specific obligations are to exercise care, skill, prudence, and diligence, and to diversify the plan’s investments, among other things.
Ultimately, plaintiffs must prove the fiduciaries knew that the backdating made the stock somewhat overvalued, and therefore were not acting in the best interests of the plan participants. Because of ERISA’s wide range of fiduciary duties, however, plaintiffs can prove that breach of duty in multiple ways: by demonstrating that the fiduciaries misrepresented certain facts, or were not prudent, or by demonstrating that the fiduciaries withheld material information that the participants should have had.
Gamble
“To get in the court and withstand a motion to dismiss, you just need to show they withheld information and breached their duty as fiduciaries,” explains John Gamble, partner at the law firm Fisher & Phillips.
Still, some preconditions do need to exist before plaintiffs can try exploiting ERISA. First, the retirement plan must have company stock in it. In addition, the individuals who were allegedly involved in the backdating had to have sat on the retirement plan’s oversight committee. Experts say it is very common for the top executives to be involved in some capacity with 401(k) plan oversight.
“It varies from company to company,” says Pat DiCarlo, of the law firm Alston Bird. “Generally, the allegations are that higher-up officials sat on the committee or appointed the individuals to the committee, so they are fiduciaries of the plan.”
And, notes Scott Segal, a lawyer with the firm Holland & Knight, “The company is always a fiduciary of the plan.”
What Comes Next?
So why haven’t there been more ERISA-related suits over backdating? “Early on, I expected to see more of them,” LaCroix says. “A lot of these companies have employee shareowners and they are just as aggrieved as the outside shareholders. There must be a reason we haven’t seen more of them.”
Likewise, Gamble says, “It's surprising there have not been more of these cases.”
One theory for the dearth of ERISA-related cases is that lawyers who have filed backdating lawsuits, but not under ERISA, are unfamiliar with ERISA rules. “It may not have occurred to them that this was a way to achieve recovery from backdating,” Gamble says. “They may have looked at the facts and found that other causes of action were more viable.”
Another theory is that the supposed damages from backdating are more nuanced. Unlike other frauds, it has been very rare to see a company’s stock collapse after it disclosed backdating errors. “The damages are not significant,” DiCarlo says.
Still, attorneys say many people in the legal community will no doubt be watching how these five cases work their way through the system. DiCarlo, for example, looks at them as sort of test cases. “If they are successful you will see more,” he adds.
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