The Subprime Mess Spills Into ERISA Lawsuits

Lawsuits against 401(k) plan fiduciaries and fund managers on the rise

In recent 2007 year-end studies, both Cornerstone Research and NERA Economic Consulting documented how the subprime-related litigation wave drove an increase in securities class action filings during the year. But a related development has drawn less attention — in addition to securities lawsuits, the subprime meltdown is also spurring an upsurge in litigation under the Employee Retirement Income Security Act (ERISA).

Congress enacted ERISA in 1974 to protect the interests of employee benefit plan participants and their beneficiaries by establishing standards of conduct for plan fiduciaries. The statute specifies circumstances when fiduciaries can be held liable for violations of these standards.

While there has always been a certain amount of ERISA litigation, there was an increase in ERISA litigation earlier in this decade, in connection with several of the high profile corporate scandals. In several instances, a class of employees sued their plan fiduciaries for alleged ERISA violations in connection with company shares held in the 401(k) plans. In many of these cases, the companies involved were also the target of securities class action lawsuits, so the ERISA lawsuits were sometimes referred to as “tagalong” lawsuits. Despite their label, many of these tagalong ERISA lawsuits resulted in significant settlements.

Subprime Litigation

The recent emergence of the subprime-related litigation has produced its own wave of ERISA lawsuits. These subprime-related ERISA lawsuits fall into one of two categories: lawsuits brought by or on behalf of employees against plan fiduciaries in connection with company stock held in the employees’ 401(k) plans, and lawsuits brought by plan trustees or administrators on behalf of plan participants against fund managers (such as bond funds) in connection with subprime-related investments held in the funds.

The lawsuits brought on behalf of employees in connection with their company stock in many ways resemble the tagalong cases that emerged in connection with the corporate scandals. The companies involved in the subprime-related ERISA lawsuits so far generally are large financial institutions (for example, commercial or investment banks) or residential construction companies. Among the companies whose employees have raised these kinds of allegations are Merrill Lynch, Citigroup, and Countrywide Financial.

One difference between these subprime-related cases and the earlier lawsuits is that in some instances the companies involved are not the target of separate securities class action lawsuits, so in that respect it would not be accurate to describe some of the subprime-related ERISA lawsuits as tagalong cases.

The lawsuits involving investment funds generally allege that the fund managers invested in assets that were different and riskier than specified in the fund investment plan. In particular, the lawsuits allege that, contrary to plan documents, the fund managers invested in risky mortgage-backed securities rather than safer government bonds. The most prominent of these cases involving fund managers are multiple lawsuits brought by plan trustees and administrators against State Street Corporation and its investment management arm.

The plaintiffs in these cases of course hope to recover the losses in the benefit plans. The plaintiffs’ lawyers’ interest in these cases is obviously related to the magnitude of the losses. But the plaintiffs’ lawyers may also be drawn to these cases because, as a result of recent Supreme Court case law, securities lawsuits based on the same facts may be subject to certain threshold defenses, particularly newly devised heightened pleading requirements and special requirements for pleading and proving the cause of alleged losses. By framing their cases under ERISA rather than under the securities laws, the plaintiffs’ lawyers may be able to avoid these potential litigation obstacles.

Fiduciary Liability Risk

The wave of subprime-related securities class action lawsuits, which were the subject of so much attention in the recent Cornerstone and NERA year-end reports, could represent a very serious concern for directors’ and officers’ liability insurers. But the subprime-related ERISA lawsuits are not an issue for D&O insurers because the defense expense and settlement amounts incurred in connection with an ERISA case would be excluded under the typical D&O policy. These losses would more likely be insured under a fiduciary liability policy. In the case of the claims against the fund managers, the exposures potentially could be insured under an investment management errors and omissions insurance policy.

The subprime meltdown will continue to unfold in the months and perhaps even years ahead. The fact that the resulting litigation could result in losses across a wide variety of coverage lines shows the potential seriousness of the credit crisis for the insurance industry. The spread of the insurance exposure beyond the D&O insurance arena also shows that the loss exposure from the subprime meltdown encompasses a wide variety of possibilities. While it will be some time before the magnitude of the losses from the subprime-related litigation can be determined, it is already clear that insurers face a potentially large and diverse range of potential losses.

At this point, the insurers’ response has been somewhat muted. The D&O sector remains generally competitive, at least outside the financial institutions area. So far, the other potentially affected insurance lines also remain competitive. Because insurers generally are enjoying higher profitability as a result of the low level of hurricane activity and the absence of other catastrophes, it may be unlikely that there will be any dramatic responses to the subprime-related litigation. But if the litigation continues to spread, and as the losses ultimately are tallied, capacity could become more constrained, at least in some lines and for certain segments.

Topics Lawsuits Profit Loss