At the end of 2002, when United Air Lines declared bankruptcy, its employees (both active and retired) owned more than half the airline’s common stock through an ESOP (employee stock ownership plan).
In re UAL Corp.,
State Street is what is called a “directed” trustee, because the Committee (the fiduciary named in the plan), in accordance with the plan language that we have quoted, directed State Street to invest the ESOP’s assets exclusively in stock of United Air Lines. Directed trustees are permitted by ERISA: if an ERISA plan “provides that the trustee or trustees are subject to the direction of a named fiduciary [in this case it is the UAL Corporation ESOP Committee] who is not a trustee, ... the trustees shall be subject to proper directions of such fiduciary which are made in accordance with the terms of the plan and which are not contrary to [ERISA].” 29 U.S.C. § 1103(a)(1); see
Maniace v. Commerce Bank, N.A.,
We must first decide whether a directed trustee of an ESOP has any fiduciary duty with respect to the choice of trust assets, specifically any duty ever to replace the employer’s stock — the normal holding of an ESOP — with some other security. The
Maniace
case that we cited, along with
Herman v. NationsBank Trust Co.,
The tension among these provisions is reflected in a pamphlet published by the Labor Department’s Employee Benefits Security Administration, which affirms both that the directed trustee has a duty of prudence and that he has no “direct obligation to determine the prudence of a transaction” entrusted by the plan to another fiduciary. “Fiduciary Responsibilities of Directed Trustees” (Field Assistance Bulletin 2004-03, Dec. 17, 2004). “[D]ireet” is the critical word, inviting us to resolve the tension by ruling that the trustee can disobey the named fiduciary’s directions when it is plain that they are imprudent. (The Labor Department’s
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pamphlet, as we’ll see, is actually consistent with this approach.) The trustee physically controls the trust assets; knowingly to invest them imprudently or let them remain invested imprudently is irresponsible behavior for a trustee, whose fundamental duty is to take as much care with the trust assets as he would take with his own property. He is “an agent who is required to treat his principal with utmost loyalty and care — treat him, indeed, as if the principal were himself.”
Pohl v. National Benefits Consultants, Inc.,
Which brings us to the particulars of this case. The plaintiffs argue that State Street violated its fiduciary duty by failing to sell United stock held by the ESOP until the eve of United’s bankruptcy. State Street knew long before then, if the plaintiffs are to be believed, that the UAL Corporation ESOP Committee, the named fiduciary, had unreasonably refused to deviate from the plan and diversify the ESOP’s holdings or take other measures to reduce the looming risk to the employee-shareholders. The following chart traces the ups and downs (mostly downs) of United’s stock price between January 1, 2001, and December 9, 2002, when United declared bankruptcy: •
[[Image here]]
The price of United stock, which on September 10, 2001, was already 25 percent below the price at the beginning of the year, dropped almost 50 percent more in the immediate aftermath of the September 11, 2001, terrorist attacks. The follow-ing month, United’s CEO sent a gloomy letter to all its employees which said that the company was “in a struggle just to survive” and was not yet in “a financial *408 position that will allow us to continue operating,” that it was “hemorrhaging money,” and unless the “bleeding [was] stopped.. .United will perish sometime next year.” The price of United stock fell another 20 percent in the two days after the publication of the letter.
The price continued falling, though with occasional upticks, and the financial press began speculating on the possibility of bankruptcy. State Street observed the decline with anxiety, but not until August 15, 2002 — by which time the price had fallen to $2.70 — did it notify the UAL Corporation ESOP Committee that it might be imprudent for the ESOP to continue holding United stock. In response to this warning the Committee authorized State Street to sell the stock, and it began doing so on September 27. By that time, however, the price had fallen to $2.36. The plaintiffs argue that State Street should have started selling within 30 days after the October 2001 letter of United’s then-CEO and that had it done so the ESOP would have avoided $540 million in losses.
The plaintiffs say the letter should have alerted State Street that United was going into the tank. That is wrong. After the market “read” the letter, it valued United stock at $15.05 a share. Had the market thought that United would be bankrupt by the end of 2002, it would not have priced its stock that high in October 2001, implying a market capitalization for the company of more than $800 million. A trustee is not imprudent to assume that a major stock market (United was traded on the New York Stock Exchange) provides the best estimate of the value of the stocks traded on it that is available to him.
In re UAL Corp., supra,
Thus, at
every
point in the long slide of United’s stock price, that price was the best estimate available either to State Street or to the Committee of the company’s value,
In re UAL Corp., supra,
Such a threat would be of little moment to people who held United stock as part of a diversified portfolio, because the risks of the various components of such a portfolio tend to cancel out; that is the meaning and objective of diversification. The Modem Theory of Corporate Finance 6 (Clifford W. Smith, Jr., ed., 2d ed.1990). Probably, however, shares of United stock were the principal financial assets of most of United’s employee-shareholders — at least those who, unlike pilots, have modest salaries — and hence their principal source of retirement income. And probably most of those non-wealthy employee-shareholders were risk averse; that is, they would prefer $10,000 certain to a 1 percent chance of obtaining $1 million, even though these are actuarial equivalents. They would be especially risk averse with regard to provision for their retirement, where they would be more dependent on their financial assets since they would no longer have earned income. Being risk averse, they would have preferred that the bulk of their financial assets not be invested in a single stock that, while worth as much as its market valuation (as far as anyone not possessing inside information could know), was extremely risky. “Because the value of any single stock or bond is tied to the fortunes of one company, holding a single kind of stock or bond is very risky. By contrast, people who hold a diverse portfolio of stocks and bonds face less risk because they have only a small stake in each company.” N. Gregory Mankiw, Principles of Economics 546 (1998). That is why ERISA fiduciaries have a duty of diversification as part of their overall duty of prudence — unless as in this case they are directed pursuant to an ESOP to invest everything in stock of the participants’ employer.
The employee-shareholders’ total wealth included not only their stake in the ESOP but also — and for those not yet retired or approaching retirement this was probably more important — their expected earnings and fringe benefits as employees of United. The financial distress that pushed United’s stock price down also jeopardized that expected wealth (insofar as United employees could not expect to land equally good jobs at other companies) and so depressed the employee-shareholders’ overall wealth by more than the fall in the price of the stock. Brett McDonnell, “ESOP’s Failures: Fiduciary Duties When Managers of Employee-Owned Companies Vote to Entrench Themselves,” 2000 Colum. Bus. L.Rev. 199, 207 (2000). State Street’s lawyers thus miss the point in arguing that American Airlines was on the verge of bankruptcy too but managed to avoid it and so might United have done so. Someone who owned American Airlines stock, and would have wanted but was unable to diversify, would have been bearing unwanted risk during American’s period of peril.
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But because an ESOP is at once a permissible form of ERISA trust and nondiversified by definition, the trustee (along with the named fiduciary) is in an awkward position. If he diversifies he violates the plan, but if he doesn’t diversify he may be imposing unwanted risk on the employee-shareholders' — for it is unrealistic to suppose that the ESOP form was chosen because the employees
wanted
to bear unnecessary risk. The goal of an ESOP is to give employees not the thrills of gambling but a larger stake in the company’s fortunes, see, e.g.,
United States v. McCord,
The tension between the goal of protection against risk and the goal of a portfolio dominated by a single stock is not acute if the participants in the ESOP have adequate sources of income or wealth that are not correlated with the risk of that stock, so that the ESOP is not their primary financial asset. But if they don’t have substantial other wealth the goals cannot be reconciled, though they can be compromised by requiring fiduciaries to begin diversifying the ESOP’s assets at the point at which an increase in the riskiness of the assets, had it been foreseen, would have induced the creators of the ESOP either to have not created it at all or to have required at least partial diversification. (We say
begin
diversifying because if the stock held by the ESOP is a very large fraction of the outstanding stock of the employer, as in this case, the sell-off would have to be gradual in order to avoid precipitating a sharp drop in price, Louis K. Chan
&
Josef Lakonishok, “The Behavior of Stock Prices Around Institutional Trades,” 50
J. Finance
1147, 1147-48 (1995); the market does not treat the stocks of different companies as being perfectly substitutable. Thus, State Street had a policy of limiting any day’s sales of a given stock to 30 percent of the volume of sales that day.) Or, as
Kuper v. Iovenko, supra,
In
Steinman v. Hicks,
The plaintiffs never sought to explore these issues. So even if the methods of litigation could feasibly determine the point at which the ESOP trustee should sell in order to protect the employee-shareholders against excessive risk, the plaintiffs have made no effort to establish that point. They think that what State Street did wrong was to fail to second-guess the market; in fact what State Street may well have done wrong was to delay selling its United stock until too late to spare the employee-shareholders from bearing inordinate risk. Of course, if State Street had sold earlier and the stock had then bounced back, as American Airlines’ stock did, State Street might well have been sued by the same plaintiffs, though the analysis presented in this opinion would have bailed it out.
There has thus been a failure of proof. But the plaintiffs can take some solace from the fact that determining the “right” point, or even range of “right” points, for an ESOP fiduciary to break the plan and start diversifying may be beyond the practical capacity of the courts to determine. The Department of Labor pamphlet that we cited earlier states that a directed trustee may have a duty to sell “where there are clear and compelling public indicators, as evidenced by an 8-K filing with the Securities and Exchange Commission (SEC), a bankruptcy filing or similar public indicator, that call into serious question a company’s viability as a going concern.” U.S. Dept, of Labor, supra, at 5-6. That is not an administrate standard; note the hedge in “may” and the fact that selling when bankruptcy is declared will almost certainly be too late.
The time may have come to rethink the concept of an ESOP, a seemingly inefficient method of wealth accumulation by employees because of the underdiversification to which it conduces (though remember that what is important is the diversification of the employee’s entire asset portfolio, including his earning capacity, rather than whether an individual asset is diversified). The tax advantages of the form do not represent a social benefit, but merely a shift of tax burdens to other taxpayers. Nor are we aware of an argument for subsidizing the ESOP form, as the tax law does, rather than letting the market decide whether it has economic advantages over alternative forms of business structure. As for the notion that having a stake in one’s employer will induce one to be more productive, the evidence for such an effect — see “Motivating Employees with Stock and Involvement,” NBER Website, Apr. 25, 2006, http:// www.nber.org /digest/may04/ wl0177.html; Joseph Blasi, Michael Conte & Douglas Kruse, “Employee Stock Ownership and Corporate Performance Among Public Companies,” 50 Indus. & Lab. Rel. Rev. 60 (1996) — is weak and makes no theoretical sense. An employee has no incentive to work harder just because he owns *412 stock in his employer, since his efforts, unless he is a senior executive, are unlikely to move the price of the stock. Nor is employee stock ownership likely to forge sentimental ties between employees and employers that might cause the former to work harder, although it may alleviate union pressures for wages or benefits that would jeopardize solvency.
A second ground of appeal argued by the plaintiffs is that the district judge should not have prevented their expert witness, Lucian Morrison, from testifying about State Street’s prudence or lack thereof in failing to sell United stock sooner. The judge thought Morrison unqualified because he lacks either a degree in economics or experience with bankruptcy. That was error. Morrison is a highly experienced trust officer and as such qualified to testify about State Street’s management of the assets of the United ESOP. “Rule 702 [of the Federal Rules of Evidence] specifically contemplates the admission of testimony by experts whose knowledge is based on experience.”
Walker v. Soo Line R.R.,
State Street has filed a contingent cross-appeal, challenging a settlement between the plaintiffs and its cofiduciary, the UAL Corporation ESOP Committee. Since we are affirming the dismissal of the plaintiffs’ claim against State Street, there is no imperative need to discuss the cross-appeal; it is academic unless this court sitting en banc, or the Supreme Court, reverses our decision in favor of State Street. But the oddity of the situation presented by that appeal calls for some comment. The Committee’s members were insured, and the settlement gives the plaintiffs $5.2 million, the limit of the insurance policy after deduction of incurred and expected legal expenses. The settlement provides that if State Street is determined to be liable for some amount of damages, the judge shall determine its fault relative to the Committee’s and State Street may then seek contribution from the Committee’s members. Suppose that State Street was ordered to pay the plaintiffs $540 million and the judge decided that it and the Committee were equally at fault. Then State Street would be entitled to a contribution of $264.8 million ($540 -4-2 = $270 — $5.2 = $264.8) from the Committee. But the Committee’s members, we are told by their lawyer, have no assets beyond the insurance policy out of which to satisfy a judgment. This is probably an exaggeration, but a slight one. Suppose improbably that the six members have a total of $4.8 million in personal assets that might be used to satisfy a judgment. Then State Street, even though adjudged only 50 percent responsible for the (supposed) wrongful injury to the plaintiffs, would have to pay almost the entire judgment — $530 million ($270 million + $270 million — $ 5.2 million (paid by insurance company) — $4.8 million (paid by the Committee members) = $530 million) out of $540 million.
The judge in approving the settlement entered an order in effect barring State Street from seeking anything from the Committee members beyond what personal assets they may have. The judge gave no reason for this action; if we may judge from the arguments of the parties’ lawyers, either he thought this result “fair” *413 or, as argued by the plaintiffs’ lawyer, thought it would make no difference because State Street could in no event obtain from the Committee members money they don’t have. But if this is what the judge thought, he was wrong. The members’ unions have agreed to indemnify them. Therefore if State Street obtained a judgment of $264.8 million (in our example) against the members, the unions would have to pay so much of that judgment as they, not the Committee members, could afford. (So we’re surprised that the union has not sought to intervene in the suit.)
The problem for which bar orders or, as they are sometimes called, “settlement bars” are a suggested solution was explained recently in
Denney v. Deutsche Bank AG,
The settlement-bar approach assumes, moreover, that there is a right of contribution, and it is unsettled whether ERISA defendants have such a right.
Lumpkin v. Envirodyne Industries, Inc.,
The judgment in No. 05-4005 is affirmed, and appeal No. 05-4317 is dismissed.