The Enron 401K Retirement Plan
The Enron failure was not just about a company that had gone from being one of the largest, seemingly most successful companies in the U.S. during the 1990s to the most striking example of corporate greed gone amok. It is also about being the first company where 18,000 to 20,000 employees lost money because their retirement accounts were invested in Enron stock in large part because of consistently favorable results that were reported internally to employees even when the stock price was going down.
To many observers it was shocking to learn after the fact thatcorporate insiders (allegedly) knew the whole, truthful story, and some even sold their own shares for millions of dollars while the fraud unraveled. On May 25, 2006, Ken Lay and Jeff Skilling, the chief executives who were at the helm of Enron during the fraud, were convicted of fraud and conspiracy (Lay and Skilling) and insider trading (Skilling).[1]
The Blackout Period
Enron limited employees’ investment freedom from the beginning by matching employee contributions only with company stock and by preventing employees from selling that stock until age 50.
During the time period that the company’s problems were becoming public knowledge, Enron chose to change administrators of its 401K plan and the company locked employees into the decisions they had already made for a period of about three to four weeks.[2] The timing was bad for employees as they watched Enron’s stock price decline further and further from it’s once peak price of $90 in September 2000 to below $9 per share in mid-November 2001. After the company restated its earnings by almost $600 million in 2000 and took an additional charge of $1.2 billion to its stockholders’ equity, the stock price dropped to below $1.
The Tittle Class-Action Lawsuit…and Others
Prior to Enron filing for bankruptcy in December 2001, a consolidated class action lawsuit that was motivated by an individual suit filed by Enron employee Pamela Tittle, who had lost $140,000 on Enron stock in her retirement account, was brought on behalf of Enron employees who had lost almost $1 billion on Enron stock held in their 401K retirement accounts. The suit alleges the company breached its fiduciary duty to employees by encouraging them to invest in Enron stock at artificially inflated prices.
On September 12, 2005, a partial settlement was reached in the lawsuit that will allow a claim in Enron’s bankruptcy proceedings in the amount of $356.25 million (less attorney’s fees and expenses). Another partial settlement for $1.25 million was reached to pay claims to all persons who were participants or beneficiaries in the 401K plans during the period from January 1, 1995 through December 28, 2005, the effective date of the settlement. This settlement resolves claims against Arthur Andersen LLP and David B. Duncan, the lead auditor for the firm, for the alleged breach of fiduciary duties by violating the Employee Retirement Income Security Act of 1974 (ERISA), and for negligence.[3]
On March 31, 2006, Northern Trust Company, a Chicago financial services company, settled for $37.5 million a retirement plan participant lawsuit filed against it in connection with the collapse of Enron. Northern Trust served as the administrator for Enron’s 401K and employee stock ownership plans.
ERISA Requirements
The federal Employee Retirement Income Security Act of 1974 (ERISA) protects the interests of plan participants and their beneficiaries. The Law is enforced by several federal agencies including: the Department of Labor (enforces fiduciary rules, reporting and disclosure requirements); the Internal Revenue Service (oversees the provisions of the Law regarding tax treatment of plans and contributions); and the Pension Benefit Guaranty Corporation (PBGC) that administers a government insurance program for terminated underfunded pension plans.
In recent years, corporate America has witnessed an increase in the number of claims alleging ERISA violations and the costs associated with these claims. The average indemnity payment has increased over 22 percent, from $715,000 to $875,000, and the average cost of mounting a defense has gone up 471 percent from $70,000 to $400,000.
ERISA imposes certain obligations on the individuals or entities that are responsible for the administration and management of employee benefit plans such as 401K plans. The fiduciaries of a 401K plan are required to observe two rules – “Exclusive Benefit Rule” and the “Prudent Man Rule.” A 401-K plan fiduciary also must administer the plan in accordance with its terms and is subject to ERISA’s co-fiduciary liability and prohibited transaction rules.
The Exclusive Benefit Rule
ERISA section 404(a)(1)(A) requires that a fiduciary discharge duties with respect to a retirement plan for the exclusive benefit of plan participants and their beneficiaries and for the purpose of defraying the expenses of administering the plan. Section 403(c) provides that “the assets of a plan shall never inure to the benefit of any employer and shall be held for the exclusive purposes of providing benefits to participants in the plan and their beneficiaries and defraying reasonable expenses of administering the plan.”
The Prudent Man Rule
Under the “Prudent Man Rule” of ERISA section 404(a)(1)(B), the duties of a 401-K plan fiduciary must be discharged with the care, skill and diligence that would be exercised by a reasonably prudent person who is familiar with such matters. This is a restatement of the prudent person standard developed as part of other areas of common law.
Fiduciary Liabilities
Examples of allegations of breaches of fiduciary duty include: failure to adequately diversify plan assets; failure to discharge duties in accordance with the plan documents; self-dealing transactions, such as using plan assets for personal gain or acting on behalf of parties whose interests are adverse to the plan; and allowing transactions between the plan and parties in interest, such as permitting the use of plan assets by a person who provides services to the plan.
A variety of parties can sue fiduciaries including the plan participants (employees) and their beneficiaries, who are likely to sue for recovery of benefits or enforcement of their rights under ERISA. The Department of Labor can sue to stop acts that violate ERISA and to collect civil penalties for prohibited transactions. Third-party administrators also can as can the PBGC.
The most common fiduciary liability claims are: the improper denial of benefits; failure to adequately fund a plan; conflict of interest; improper advice or counsel; improper change in benefits; imprudent investment; misleading representation; lack of investment diversity; improper termination of a plan; incorrect benefit calculation; and the unacceptable choice of insurance company, mutual fund or third-party service provider including the investment manager and actuary.
The Debate in Class
One day two students engaged in a class debate whether Enron was responsible for the 401-K mess or was it a case of employees failing to exercise prudence in making their own investment choices. Here is a selected part of the debate.
Student 1: They should hang Ken Lay, Jeff Skilling, and Andy Fastow and then
parade their bodies in the public square.
Student 2: Get real. TheEnron employees made their own investment choices. They failed to conduct their own due diligence before allowing their
401-K funds to be invested in Enron stock. After all, the company didn’t require them to put funds into company stock.
Student 1: That’s unrealistic. Don’t you recall the class discussion the other day? Overall, about 19 percent of 401-K assets are in company stock. I mean, you’re going to trust the managers who hired you and are running the company on behalf of the shareholders, of which you are one.
Student 2: So what you are saying is so long as the stock was a good buy from the beginning and there was no misleading information or arm-twisting – I mean it wasn’t a shoddy investment – then if the stock goes south, you can’t argue after the fact there was too much company stock in the plan. Do you really believe what you are saying?
Questions
- Compare the fiduciary responsibilities of 401-K plan trustees to the due care standard of ethical behavior required of CPAs under the AICPA Code, especially auditors of public companies.
- Evaluate the ethics of top management of Enron selling off their stock holdings while the bubble was bursting at Enron. In particular, what is wrong with encouraging employees to invest their 401-K monies in company stock? Use ethical reasoning to support your answer.
- Consider the two points of view expressed by the two students in the class debate. Assume your professor asked you to craft a response to the two students. What would you say? Why?
[1] Alexei Barrionuevo and Vikas Bajaj, “Enron Chiefs Guilty of Fraud and Conspiracy,” The New York Times, May 25, 2006.
[2] Section 306 of the Sarbanes-Oxley Act of 2002 deals with the blackout period loss of employees in 401K plans by requiring the plan administrator to notify plan participants and affected beneficiaries 30-days in advance of the expected beginning date and length of the blackout period. Insider trading is prohibited during the blackout period and any profit realized by a director or executive officer from the purchase, sale, or other acquisition or transfer in violation of the Law is recoverable by the issuing company regardless of the intent for the sale.
[3] Andersen still has about 200 employees, a far cry from its 28,000 when the firm was on top of the profession. The staff is mainly consumed with fighting and settling litigation. The remaining asset of the firm is its “Q Center” comprehensive conference and training facilities outside Chicago in St. Charles, Illinois. The center has been rated highly for its state-of-the-art facilities including LAN setup, videoconferencing, interactive audience response, full audio, webcasting and event production. Meeting News rated it as one of the 25 top conference centers for service, expertise, quality of overall environment, amenities, food and recreation.