Employee stock ownership plans (ESOPs), 401(k)s, and other types of eligible individual account plans (EIAPs) are often an effective way to build employee loyalty, especially when the plans invest in the employer’s own stock. A potential downfall, though, has always been the possibility of employees bringing a class action lawsuit if the stock drops in value. Even if an employer ultimately wins the case, it could incur major costs defending itself in court. Good news: the 9th Circuit Court of Appeals, which covers California, has stepped in and made it much harder for employees to get these cases to trial.

The Employer’s 401(k) Plan
Computer Sciences Corporation (CSC), a multi-billion-dollar Fortune 500 information technology company headquartered offered certain employees the opportunity to participate in a 401(k) matched asset plan. (It was headquartered at the time in El Segundo.) Participants could contribute up to 50 percent of their salaries to their individual investment accounts.

The plan gave participants full discretion to invest their voluntary contributions among 14 diverse investment alternatives, including a fund that held only CSC stock (the CSC Stock Fund). The plan’s terms required that the alternatives include the CSC Stock Fund, so participants had the opportunity to own part of the company that employed them.

CSC matched a part of the participants’ voluntary contributions with contributions equal to 50 cents for every dollar that a participant contributed to his or her individual account, up to three percent of the participant’s salary. Before January 2007, the company’s matching contributions were automatically invested in the CSC Stock Fund, and participants could reallocate the contributions to other funds in the plan only when they met certain age and service requirements. After January 2007, participants could direct and reallocate matching contributions to any fund or funds in the plan.

The Class Action
A group of current and former CSC employees who were participants in the plan filed a lawsuit against the company under the Employee Retirement Income Security Act (ERISA), alleging that the plan’s fiduciaries (including the employer) should have sold off—or divested—the plan’s CSC stock because they knew about “material weaknesses” in CSC’s stock option granting and tax accounting practices. The employees claimed that these material weaknesses led to a loss of more than $700 million in their retirement savings.

The district court dismissed the case before trial, finding that the employees didn’t show that a prudent investor under the circumstances would not have invested in CSC stock. The class appealed.

Employers Get Benefit of the Doubt
In making its decision, the district court presumed that a fiduciary’s investment in employer stock is prudent, meaning that employees’ lawsuits must be dismissed unless they can show the investment was not prudent. In the past, though, the 9thCircuit had twice declined to adopt the presumption.

The good news for California employers? The 9th Circuit decided to protect fiduciaries from pressure to sell the employer’s stock when its value drops. It adopted the prudent investment presumption for this case, and going forward, to provide fiduciaries a “substantial shield” when plans require or encourage them to invest primarily in employer stock.

That doesn’t mean that fiduciaries are now entirely immune from liability for investments in employer stock, as employees can rebut the presumption. The 9th Circuit explained that they can do this by showing publicly known information that would prompt a “reasonable” fiduciary to investigate the merits of continued investment in employer stock.

For example, the court said, employees could cite a precipitous decline in the value of the stock along with evidence that the employer was on the brink of collapse or undergoing serious mismanagement. Mere fluctuations in stock price, however, aren’t enough to raise the red flag for an investigation.

The Class Action Fails
The court went on to find that the CSC employees didn’t overcome the prudent investment presumption, and affirmed the district court’s ruling. It found no evidence that 1) the fiduciaries had any discretion under the plan terms to sell the CSC stock, 2) they nonetheless should have sold the stock, or 3) it was unreasonable for them to believe that CSC would overcome its problems with stock options pricing and income tax accounting.

Reduce Your Risk
The 9th Circuit’s adoption of the prudent investment presumption should knock out many ERISA class actions before they ever get to trial, but you can, and should, do more to protect yourself. According to the 9th Circuit, the more discretion a fiduciary has to invest in less risky holdings than the employer stock, the more its decisions to invest in the employer will be subject to judicial scrutiny.

To obtain the benefit of the presumption in favor of plan fiduciaries, you might want to change your plan terms to require or encourage the fiduciary to invest primarily in employer stock. Check with an attorney to determine your best course of action. Quan v. Computer Sciences Corp., 9th Cir. Court of Appeals, No. 09-56190, 2010