Compliance June 3, 2020

Phillips 66 ERISA Lawsuit Dismissal Affirmed by 5th Circuit

The underlying allegations in the case involve the 2012 spinoff of Phillips 66 from the ConocoPhillips Corp., a large oil and gas company.

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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.

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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.

Compliance June 3, 2020

DOL Issues Guidance About Private Equity Investments in DC Plans

An Information Letter addresses private equity investments as a component of a professionally managed asset allocation fund and outlines what plan fiduciaries should consider.

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The U.S. Department of Labor (DOL) issued an Information Letter under the Employee Retirement Income Security Act (ERISA) concerning private equity investments as a component of a professionally managed asset allocation fund offered as an investment option for participants in defined contribution (DC) plans.

In the letter, Louis J. Campagna, chief of the Division of Fiduciary Interpretations in the DOL’s Office of Regulations and Interpretations, says “a plan fiduciary would not, in the view of the department, violate the fiduciary’s duties under Sections 403 and 404 of ERISA solely because the fiduciary offers a professionally managed asset allocation fund with a private equity component as a designated investment alternative for an ERISA covered individual account plan in the manner described in this letter.” The DOL points out in a news release that the letter refers to a professionally managed multi-asset class vehicle structured as a target-date, target-risk or balanced fund. The Information Letter, however, does not authorize making private equity investments available for direct investment on a standalone basis. 

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Jon W. Breyfogle, an attorney with Groom Law Group, who asked for the DOL’s view on behalf of Pantheon Ventures (US) L.P. and Partners Group (USA) Inc., tells PLANSPONSOR, “Private equity is a common investment for DB [defined benefit] plans and endowments. There has been a lot of litigation in the DC space that has chilled innovation. This guidance provides a roadmap for plan fiduciaries to prudently offer private equity in a DC plan as part of a target-date fund [TDF] or other diversified managed investment option. We did not ask DOL to address standalone private equity options in DC plans, as such they were not addressed in the letter.”

For years, DB plans have unwound their exposures to public equities, and diverted some of their risk investments into alternative assets such as private equity, real estate and hedge funds, among others. These can offer not only diversification away from volatile equities, but also risk-adjusted returns that are superior to public market counterparts. Results of a study published last year by Neuberger Berman research partner the Defined Contribution Alternatives Association (DCALTA), in collaboration with the Institute for Private Capital (IPC), suggest that including private equity funds in DC plan portfolios both improves performance and has diversification benefits that lower overall portfolio risk.

Serge Boccassini, head of institutional global product and strategy at Northern Trust Asset Servicing in Chicago, previously told PLANADVISER that plan sponsors in the U.S. may have concerns about including private investments in DC plan fund menus. As a fiduciary, plan sponsors worry whether they are making an appropriate decision to include investments that are not necessarily understood. There is concern about the cost of alternative assets and how that plays into participants’ savings accumulation, and there are concerns about the illiquid nature of some private investments.

In addition, the case Sulyma v. Intel Corporation Investment Policy Committee may have discouraged plan sponsors from including alternative investments in plan options. While the case is well-known for reaching the U.S. Supreme Court and the high court’s interpretation of “actual knowledge” in ERISA cases, when it was initially filed, Christopher M. Sulyma claimed that the defendants breached their fiduciary duties by investing a significant portion of two DC plans’ assets in risky and high-cost hedge fund and private equity investments through custom-built target-date funds.

Campagna addresses these concerns in the letter, noting that “there are important differences between a fiduciary’s decision to include private equity investments in the portfolio of a professionally managed defined benefit plan, and the decision to include an asset allocation fund with a private equity component as part of the investment lineup for a participant-directed individual account plan.” He mentioned the complex organizational structure, potentially higher fees, illiquidity and complexity of valuations, among other things.

“The letter was sought so that plan sponsors know what the relevant considerations are when considering offering private equity as part of a target-date or other managed fund, which might serve as a QDIA [qualified default investment alternative],” Breyfogle says. The letter includes five paragraphs detailing considerations for plan fiduciaries in evaluating and monitoring investments that include private equity. “The letter addresses how plan sponsors can meet their fiduciary obligations if they wish to offer exposure to private equity as part of a larger investment strategy. As the information letter notes, there is a lot of evidence that private equity can offer benefits of improved diversification and investment returns,” Breyfogle adds.

Groom’s summary of the guidance is here.

Both Pantheon and Partners Group issued press releases following the DOL’s announcement about the Information Letter welcoming the agency’s view.

“The illiquid structure of traditional, closed-end private equity vehicles renders them incompatible with the U.S. DC pension system, which prefers all underlying fund allocations to provide daily liquidity and pricing and highly standardized purchase and redemption procedures,” Partners Group notes. It says it introduced a private equity offering structured specifically to meet these requirements in 2015. Pantheon says it introduced a product in 2013 with daily pricing and liquidity that is intended to be used in target-date, target-risk or balanced funds. The firms say they have advocated for greater parity between the investment options available to DB and DC pension plans.

“The Information Letter is a critical step toward improving retirement outcomes at a time when research estimates 50% of households are ‘at risk’ of not having enough income to maintain their living standards in retirement,” says Susan Long McAndrews, partner and member of Pantheon’s Partnership Board. “We believe private equity has an important role to play in enhancing potential retirement outcomes and today’s announcement provides necessary clarity to plan sponsors that private equity can be incorporated as an allocation option under ERISA.”

“The Department of Labor has taken a major step toward modernizing defined contribution plans and providing participants with a more secure retirement. At a time when working families are struggling to save, this guidance gives fiduciaries the certainty they need to finally provide main street Americans access to the same types of high-performing, diversifying investments as wealthy and large institutional investors, all within the safety of their 401(k) plans,” says Robert Collins, managing director, head of Partners Group’s New York office.

“This Information Letter will help Americans saving for retirement gain access to alternative investments that often provide strong returns,” U.S. Secretary of Labor Eugene Scalia says. “The letter helps level the playing field for ordinary investors and is another step by the department to ensure that ordinary people investing for retirement have the opportunities they need for a secure retirement.”

Chairman of the U.S. Securities and Exchange Commission (SEC) Jay Clayton commends the department’s efforts to improve investor choice and investor protection, saying the Information Letter, “will provide our long-term main street investors with a choice of professionally managed funds that more closely match the diversified public and private market asset allocation strategies pursued by many well-managed pension funds as well as the benefit of selection and monitoring by ERISA fiduciaries.”

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