A federal district court ruled that R.J. Reynolds Tobacco Company (RJR) has proven by a preponderance of the evidence that a prudent fiduciary would have decided to divest Nabisco company stock funds from its 401(k) plan.

The U.S. District Court for the Middle District of North Carolina previously determined that, under the Employee Retirement Income Security Act (ERISA) prudence standard, RJR breached its fiduciary duty of procedural prudence to investigate the investment decision to eliminate the Nabisco funds from the plan. Nevertheless, RJR was found to have met its burden to show that removing the funds was an objectively prudent decision. Specifically, the court ruled “that the decision to remove the stock, under the circumstances of this case, is one which a reasonable and prudent fiduciary could have made after performing such an investigation.”           

On appeal, the 4th U.S. Circuit Court of Appeals affirmed the holding that RJR breached its duty of procedural prudence and therefore bore the burden of proof as to causation. However, the appellate court found that the district did not apply the correct legal standard in determining RJR’s liability, reversed the judgment, and remanded with instructions “to review the evidence to determine whether RJR has met its burden of proving by a preponderance of the evidence that a prudent fiduciary would have made the same decision.”

Plaintiffs also petitioned the U.S. Supreme Court to decide on this standard, but the high court denied the petition.

In coming to this conclusion, Senior U.S. District Judge N. Carlton Tilley, Jr. noted that employees from RJR and Nabisco testified at trial that it was widely believed the shareholder value of Nabisco would be enhanced after the split because the value of Nabisco’s stocks was being unnecessarily depressed by investors’ fears regarding ongoing litigation against tobacco companies (the tobacco taint).

Tilley found an RJR expert witness was right in noting that investment considerations for fiduciaries of an employer-sponsored retirement plan are different than considerations for individual investors. RJR’s expert disagreed with the plaintiff’s expert that a prudent fiduciary would use analyst ratings during its decision-making for a participant-directed defined contribution plan. He considered reliance on those reports speculation, whereas the fiduciary’s role is to manage assets carefully and prudently. “It does not involve making a short-term forecast about what the future price action of the stock might be and betting on it,” the expert said, according to the court opinion.

An analysis of “market efficiency,” found the Nabisco Group Holdings common stock funds and Nabisco common stock funds were “generally efficient,” and in an efficient market, there is no ability for investors to predictably make extraordinary returns based on publicly available information.” Even if analyst ratings or recommendations were meaningful, they would have been essentially irrelevant to a reasonable investment decision because of the efficient market hypothesis,” the analyst concluded.

In addition, RJR’s expert noted that the RJR fund and the Nabisco funds were highly correlated due to the effect of the tobacco taint. The more correlated two investments are, the less benefit is realized from diversification when holding those investments. When trying to diversify, it is better to choose investments that have low correlation to each other.

However, holding undiversified, non-employer single-stock funds was not the only heightened risk borne by plan participants invested in those stocks. Idiosyncratic risk is specific to companies and includes litigation risk and bankruptcy risk, both of which existed in the case.

Finally, the court agreed with testimony that the appreciation of the stock prices of Nabisco funds after the plan split was not foreseeable. An analysis of the S&P 500 showed 326 total episodes where a stock price dropped by at least 60%, as did Nabisco stock during the period in the lawsuit. Of those 326 episodes, 306 of them were not followed by an increase of 150% or more in order to recover fully from the loss.

“It is more likely true than not that had a prudent fiduciary reviewed the information available to it at the time, including plan documents, public disclosures, analysts’ reports and associated research as to their significance, and newspaper articles, it would have decided to divest the Nabisco funds at the time and in the manner as did RJR,” Tilley wrote in his opinion.

Tilley additionally noted that in its opinion, the 4th Circuit observed that “the governing plan document required the Nabisco funds to remain as frozen funds in the plan,” and said the district court should “factor into its causation analysis RJR’s lack of compliance with the governing plan document.” Tilley noted there is no issue of plan participants being unaware of the action anticipated nor of committee members intentionally trying to act in disregard of the plan documents. He also pointed out that “two parties, a number of lawyers, and two courts had focused on the plan and its terms and provisions for years without ever perceiving the need to do so until well into a multi-week trial.”

The new opinion in Tatum v. R.J. Reynolds Tobacco Company is here.