CAP GUIDELINES
Most employer-sponsored plans are subject to the CAP Guidelines and, as such, so is the employer’s selection of the investment options. However, the CAP Guidelines are just that: guidelines. They aren’t a complete code that a company can follow and then rest comfortably, knowing that its actions are impermeable. Nevertheless, a sponsor must take steps to apply them, and will be in a better position to defend its choices than a sponsor who doesn’t.
While the CAP Guidelines cover a wide range of tax-assisted plans in which members direct the investment of their accounts, they don’t cover all plans. Nevertheless, it is possible that a court, if faced with members who have suffered investment losses associated with investment in their employer’s stock, will refer to the CAP Guidelines for guidance in assessing the employer’s actions. Even if an employer’s plan does not now strictly fall within the CAP Guidelines, it may one day be subject to them.
The Guidelines set out the considerations a CAP sponsor should keep in mind when selecting the investment options. These include: the purpose of the CAP, the number of investment options to be made available, the diversity and demographics of CAP members, the degree of diversification among the options, the liquidity of the options, and the level of risk associated with the options. If the plan is a retirement plan, these factors become even more relevant.
It is not sufficient for an employer to simply say, “I’m going to offer our shares as an investment option because we want our employees to be invested in our business.” Rather, that employer must consider whether a single stock in general is an appropriate investment given the characteristics of the plan and the plan members, and further, whether the features of the employer’s own stock make it an appropriate option. For example, if the corporation’s financial situation is volatile, a company might decide that its shares should not be offered in a plan where a large portion of a member’s savings for retirement will lie, or establish limits on how much of an employee’s account can be invested in company stock. These concerns may be magnified if certain contributions are automatically directed to purchase company shares, and even more so if those shares must be held for a set period, preventing members from selling when the time is right.
The Guidelines also address what kind of information CAP sponsors should provide to members. The most important of this guidance is the requirement to disclose the risks associated with investing in a single security. While this requirement sounds simple, in practice, it may not be easy to implement. CAP sponsors are in uncharted territory when they have information about events that may affect the company’s share price, but which have not yet been made public.
FIDUCIARY DUTIES
Pension standards legislation imposes a standard of care on the administration of a DC pension plan and on the investment of the pension fund. In Ontario, a DC plan administrator is responsible for administering the pension plan and investing its assets using “all relevant knowledge and skill that the administrator possesses or, by reason of the administrator’s profession, business or calling ought to possess.” A pension administrator must also administer and invest the pension fund in a manner “that a person of ordinary prudence would exercise in dealing with the property of another person.” This standard of care in respect of the investment of the pension fund has been described as the “prudent investor” standard.
Independent of its duties under pension legislation, a pension plan administrator is considered a fiduciary at common law. A fiduciary is a person who is in a position to affect the interests of others on whom that person may be dependent. As such, the fiduciary is obliged to take action to protect the interests of beneficiaries and to avoid putting beneficiaries at risk. A fiduciary is also required to avoid any potential conflicts of interest.
Given the mandatory nature of many non-pension CAPs(such as Group RSPs and DPSPs), it is possible that members could claim that a CAP sponsor is a fiduciary under common law. To date, there has been no case law in Canada finding that an employer who establishes a nonpension CAP is a fiduciary. Nevertheless, based on the common law principles applicable to fiduciaries, it is possible that this could be the outcome if the issue were litigated. With this in mind, like pension plan administrators, sponsors of non-pension CAPs who are considering adding company stock to the list of investment options available under the plan should also be aware of these duties and their implications.
In evaluating whether employer stock is a prudent investment option for a CAP, it is interesting to note that a report from the University of Laval has shown that when a company’s own stock is one of the available options, many plan members invest a significant portion of their discretionary contributions in the stock of their employer. Pension legislation does contain quantitative limits on the concentration of investment in one stock. For example, the 10% rule provided in the investment regulations under the federal Pension Benefits Standards Act prescribes a minimum level of diversification in pension fund investment. While this limit is imposed on pension plans, it does not apply to non-pension CAPs.
However, if 10% or more of an employee’s retirement portfolio is invested in only company stock, it is possible that the member is not adequately diversified. With this in mind, a CAP sponsor should consider whether to monitor the concentration of company stock in each member’s portfolio. It may also consider offering enhanced member education to counter any natural tendency to invest too much of their portfolios in company stock and to ensure they understand the importance of diversification.
A fiduciary is also prohibited from allowing its personal interests to conflict with its duties in respect of the plan. Any plan sponsor offering its stock as an investment option under a CAP may need to review its reasons for doing so, especially where such an option includes a mandatory or minimum investment requirement.
LESSONS FOR CANADA
While reforms like those in the U.S. are not on our immediate Canadian horizon, the U.S. experience, coupled with the CAP Guidelines and fiduciary considerations, should encourage plan sponsors to examine the reason for offering company stock as an option and consider the prudence of offering company stock as an investment option using the factors set out in the CAP Guidelines.
If appropriate, plan sponsors should make sure there are a sufficient number of other options available under the plan, so that members can adequately diversify their investments. It’s important to review member education materials to determine whether members are provided with adequate information about the importance of diversification and the risks of investing a significant portion of their portfolio in a single stock.
Plan sponsors must also consider the age and demographics of their employees. If the purchase of company shares is mandatory, the employer should look at whether the rule is appropriate for employees who are approaching retirement age. And if the plan sponsor is changing the plan’s carrier or administrator, they might want to minimize any stock purchase or sale blackout period and clearly inform employees in advance of the blackout period and its meaning.
As always, good governance practices dictate that the plan sponsor’s decisions and reasons for those decisions be documented and retained. While, to date, Canadian employers have not faced the same line of fire as U.S. employers, we can be certain that a class action lies brewing. And when that happens, plan sponsors will most likely be the target, and regulatory intervention may not be far behind.
A Southern Wind Since the Enron scandal, a number of U.S. cases highlight the variety of claims that have been made by members against employers who offered company stock as an investment option under a DC plan. Employees of Schering-Plough Corp. had participated in savings plans that allowed up to 50% of the investments to be in company stock. Due to a decline in the pharmaceutical company’s stock value, the members suffered large investment losses. The members claim that the defendants breached their fiduciary duties of prudence, care, and loyalty by continuing to offer the company stock as one of the investment options when they knew that Schering’s stock price was unlawfully and artificially inflated. The members also allege that the defendants failed to disclose negative material information about Schering and that they did not loyally serve the plan members by avoiding a conflict of interest. WorldCom, Inc. employees alleged that the company’s directors and officers and its trustee, Merrill Lynch, failed to act prudently when they allowed the 401(k)plan to continue to offer WorldCom stock as a plan investment in the face of corporate accounting irregularities. ADC Telecommunications, Inc. offered an ADC Stock Fund holding primarily ADC’s own common stock as an option under its 401(k). The employees alleged that the company failed to prudently and loyally manage plan assets, to monitor, to provide complete and accurate information, and breached the duty to avoid conflicts of interest. The claims were based on the defendants’ failure to consider the negative forecasts of the company during the telecom downturn and continuing to allow the plan to hold ADC stock. While none of these cases have been fully litigated, the nature of the allegations should prompt Canadian employers to take notice, just as U.S. legislators have already done so. With the passing of the Pension Protection Act of 2006, a fiduciary will not be protected during a blackout period that prevents a participant from selling shares unless certain requirements are met. As well, members must be allowed to immediately sell employee contributions invested in employer securities, and shares purchased with employer contributions after three years of plan membership. |
Stephanie Kalinowski and Susan Nickerson are partners with Hicks Morley in Toronto. sjk@hicksmorley.com; sln@hicksmorley.com
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