DOL and EMH
Dana Muir, a professor at University of Michigan’s business school, has co-authored an interesting article on the use of the efficient market hypothesis in two areas, one of which relates to ERISA retirement plans that hold employer stock. (The other part of the article, which was written Cindy Schipani, looks at EMH in the context of shareholder appraisal cases. Its interesting, but it is not ERISA, so barely warrants a reading by the ERISAphiles reading this blog.)
In the ERISA side of the article, Professor Muir is interested in what happens in plans—usually 401(k) plans—that are holding employer stock, and in the normal scheme of things would be purchasing more employer stock, when continuing to hold the stock, and certainly to continue to purchase it, is, at least arguably, imprudent. And Professor Muir is particularly concerned with the responsibilities/plight of a directed trustee, whose directions are to continue to hold and to continue to buy. When should the directed trustee ignore those directions because they are in violation of the statute? Since one of ERISA’s statutory commands to fiduciaries is to act prudently, presumably the fiduciary should refuse to honor the directions to purchase employer stock and should consider selling at least some of the employer stock if the fiduciary believes, or should believe, that the stock (at least if held in large amounts) is not a prudent investment for the plan.
This is an issue of multiple dimensions and extraordinary complexity. Professor Muir is interested in several aspects of that issue, but her portion of the article is focused on the Department of Labor’s 2004 field assistance bulletin (FAB 2004-03) on when directred trustees may satisfy their fiduciary responsibilities simply by following the directions given to them. The FAB indicates that under EMH, the price of securities reflects all known public information about the securities (this is the semi-strong version of EMH, since it does not assume that the price reflects nonpublic information), and thus that directed trustees generally have no duty to second-guess directions, since the directions are to purchase the securities at the “correct” price. The only exceptions that the FAB recognizes from this generally free pass to uncritically follow directions are when the directed trustee has nonpublic information or when public information calls into “serious question a company’s viability as a going concern,” or perhaps when there is public information that shows that the company, its officers or directors have been formally charged by state or Federal regulators with financial irregularities.
The reason for these exceptions (except the one dealing with a fiduciary who has nonpublic information) is not entirely apparent from the FAB, but might be either that in such situations the market cannot accurately gauge the value of the stock (but why that would be so is itself not clear if you believe in the version of EMH that DOL apparently believes in), that a company that may lack viability as a going concern is not (at least in large concentrations) a suitable investment for a retirement plan, even given that Congress has generally exempted investments in employer stock from ERISA’s diversification requirement, or that the directions—which likely come from individual employed or related to the plan sponsor—may be polluted by the dishonesty of the individuals who are engaging in financial chicanery.
Professor Muir is concerned that the FAB, which purports to be based on EMH, reflects a primitive view of EMH and ignores the substantial economic work that claims EMH is not nearly so robust as the DOL apparently believes. (That word, robust, has become a trendy adjective; it may be a bit overused these days.) In fact, as Professor Muir notes, not all publicly traded securities always trade in an efficient market. Research has shown that, for example, market noise, behavioral departures from economically rational behavior, short-selling in certain markets, can result in temporarily inefficient markets. Indeed, as Professor Muir notes, “in other contexts, courts and policy makers are far more skeptical of the robustness of EMH than is the DOL.” Professor Muir observes that in Delaware, for example, in appraisal cases, courts consider whether the market for a particular security appears efficient.
How we construct a meaningful legal standard for directed trustees out of all this is of course not simple, and there are various competing policy considerations. But the Department of Labor suggests that the issue is easy to resolve because of the DOL’s naive and dated understanding of EMH.
Professor Muir points out that courts, unfortunately, have given considerable weight to the views reflected in the FAB. Another interesting question, which I know Professor Muir is concerned about from conversations with her, is why the Department’s views were presented in an FAB rather than in a regulation project, which would have been subject to public comment.
The article, which will be in Michigan Law Review in June of next year, is easily worth the time and cost to download and read it. It is on SSRN, and you can get there by following the links from Professor Muir’s biography page: http://www.bus.umich.edu/FacultyBios/FacultyBio.asp?id=000279015. Or you can probably call her for a copy.
In the interest of full disclosure, I am a big fan of Professor Muir’s work.
I discuss the Summers decision in the article. Judge Posner's point is a specific example of my more general point. Even if a security's price is established in an efficient market that does not necessarily mean the security is a prudent investment in a retirement portfolio.
Posted by:Dana Muir | October 16, 2006 at 10:43 AM
Dana's article discusses Summers. There is a problem with Judge Posner's analysis: first, a heavy debt-equity ratio is not always the sign of a risky investment. Second, and more problematic, is that investment in employer stock is always too risky and research has shown that when employees invest in employer stock they either undervalue risk (or perhaps don't care about risk at all).
Take the extreme situation first, that employees don't care about risk (except after the fact, as we learned from Enron). If employees don't care about risk at all and want to invest in employer stock for other reasons, why should an increase in risk from a declining debt-equity ratio matter?
And if employees routinely undervalue risk, how do we know that increased risk (if in fact we can say a decline in debt-equity ratio always results in increased risk, which I don't think we can say across the board, but perhaps we can generally say in the employer stock cases)is too much when the intiial risk was itself too much? (If my memory is right, this is Dana's main point about Posner's approach). Another way of putting it, perhaps, is how do you decide when an irrational investor (someone who has already overinvested in employer stock) suddenly becomes rational? I don't think you can and I don't think Posner's idea, at least without more, helps too much.
Posted by:Norman Stein | October 16, 2006 at 07:22 AM
Judge Posner in Summers v. State Street Bank, 453 F. 3d 404 (7th Cir. 6/26/06) meanders, as is his wont, thru this thicket. He concludes that while (apparently as a matter of law) you can't outsmart the market because of EMH, it remains that if a company takes on greater debt, its stock may be too risky for retirement funds, even though its price may accurately reflect that risk.
Posted by:Ron Dean | October 13, 2006 at 06:25 PM
My draft article may be unclear (I'll check that for the next iteration). As I understand it, many plans - including 401(k) plans, KSOPs, & ESOPs - hire entities (often financial services firms) to act as directed trustees. Those entities are my focus.
I realize that some firms providing plan services have litigated the question of whether they are directed trustees, fiduciaries, etc. Enough decisions have found them to be directed trustees to create concern in the industry and lead the DOL to issue the FAB.
I'd be glad to receive comments on the draft article from anyone out there who is willing to read it. dmuir@umich.edu
Posted by:Dana Muir | October 13, 2006 at 04:37 PM
Re: DOL, EMH & “Directed Trusts”
Norman Stein’s review of the EMH concept is well worth reading and considering, as long as one keeps in mind a central legal requirement not really mentioned in the review and perhaps not mentioned in the forthcoming Muir article.
Norman starts with the stated assumption that a 401(k) plan holding employer stock is a “directed trust.” Ordinarily it is not. It ordinarily does not satisfy the requirements of ERISA section 403(a)(1) or (a)(2), that the trustee must receive directions from another person – either a named fiduciary or an investment manager. But in both cases, there is the core requirement that SOMEBODY is a fiduciary with full investment power and discretion. If not the trustee, then somebody else. The mere inclusion of a plan provision for employer stock doesn’t make it a directed trust, because ERISA 403(a) makes no “directed trustee” exception for employer stock accounts that are ostensibly “hard wired.” Even if the trust is an “eligible individual account plan” under ERISA 407(d)(3)(A), the statutes still requires that the trustee to be prudent (except to the extent that prudence requires diversification) (ERISA 404(a)(2)). The notion that imprudent buying or holding employer stock is somehow “directed” by the terms of the plan is not consistent with the express terms of the statute.
DOL’s field assistance bulletin (FAB) on “directed trusts” deals with trustees who are truly directed pursuant to 403(a)(1) or (a)(2). But most of the K plans holding employer stock aren’t “directed trusts” in the first place.
And a bad buy is still a bad buy.
Posted by:Frank Cummings | October 13, 2006 at 01:36 PM