Spence v. American Airlines Inc has implications for plan fiduciaries
A recent ruling from a Texas federal court has implications for every plan fiduciary who delegates proxy voting authority to an Employee Retirement Income Security Act (ERISA) plan’s external managers. The case, Spence v. American Airlines Inc, et al., was a class action lawsuit brought by an ex-pilot for American Airlines on behalf of American Airlines employees. The case addressed the relationship between corporate environmental, social and governance (ESG) initiatives and the duties of a retirement plan fiduciary under ERISA.
The specifics of the case
Bryan Spence represented a certified class of American Airlines employees who participated in two 401(k) plans operated by American Airlines. Spence alleged that the airline and its benefits committee mismanaged the retirement plans’ funds by permitting the plans’ investment managers to pursue non-financial ESG goals through proxy voting and shareholder activism ahead of the financial interests of the plans.
The lawsuit noted that the strategies of the investment managers involved covertly converting core index portfolios within the plan to ESG funds. These actions, it was argued, harmed the financial interests of the retirement plan participants by focusing on ESG objectives rather than on maximizing investment returns. The second cause of action under ERISA, alleged in the lawsuit, was that the fiduciaries breached the duty of loyalty. By continuing to use the investment manager and endorsing the investment manager’s alleged pro-ESG agenda, this was serving the defendants’ own corporate agenda and failing to act in the interests of the participants and beneficiaries.
American Airlines defended its actions and argued in part that the investments in question were not included in the 401(k) plans’ core fund lineup.
Background on ESG investing
In early 2021, then-President Biden issued an executive order (EO 13990) directing federal agencies and executive departments to immediately review all policies, regulations, and other actions of the prior four years to identify any that appeared to run counter to his administration’s climate change, public health, and labor policies.1 Subsequently, President Biden issued another executive order (EO 14030) with the goal of ensuring that the right rules were in place to properly analyze and mitigate the financial risks posed by the climate crisis and to empower Americans to make informed financial decisions.2
The Department of Labor (DOL) responded to the executive orders and published a final rule on December 1, 2022 known as Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights.3 The rule marked a significant shift in existing policy. The amended regulations outlined sought to remove existing limitations that may have prevented fiduciaries from considering climate change and other ESG factors. According to the DOL, the intent of the rule was to establish that material climate change and other ESG factors are “no different” from other traditional material risk and return factors. A fiduciary should consider them in evaluating an investment only when the fiduciary prudently determines that they are material to an investment or investment course of action under consideration.4
As things stand now, the 2022 final rule that gave a green light to plan fiduciaries to consider ESG issues as part of an overall investment selection process has been upheld by the courts despite numerous challenges and still remains in effect.
What the court found
The court ruled against the claim that American Airlines and the benefits committee breached their duty of prudence. It found that American Airlines met the prevailing fiduciary prudence standard by implementing rigorous monitoring procedures that were aligned with industry practices. The court even noted that the monitoring procedures were more rigorous than those of other plan sponsors.
The court did rule that American Airlines did breach its duty of loyalty, a duty which requires fiduciaries to act solely in the best interests of the participants in the American Airlines 401(k) plans. The court ruled that the plans allowed corporate interests and ESG considerations to exert influence on the plans’ management. In other words, it failed to maintain separation between its corporate interests and fiduciary obligations.
The court said that the investment manager had an outsized influence on the defendants, which had an impact on their decision-making for the plan. In fact, the court said that the plan fiduciaries did “not sufficiently monitor, evaluate, and address the potential impact of the investment manager’s ESG-oriented proxy voting and shareholder engagement.” In doing so, the conduct of the plan fiduciaries undermined the fiduciary requirement to act solely in the interests of plan participants.
What next?
American Airlines says that it plans to appeal the decision. The full impact of this case is yet to be determined given the expected appeal and that there has been no damage conclusion yet. However, the case is nonetheless important in that it serves as an impetus and an opportunity for plan fiduciaries to conduct a careful and thorough review of how they approach their fiduciary obligations under ERISA.
Plan fiduciaries must be mindful of several issues.
First, they must conduct greater due diligence and monitoring of the use of ESG policies by investment managers. In fact, plan fiduciaries need to be mindful that a very real risk exists that any service provider or investment manager retained by the plan could potentially draw the plan into a lawsuit.
Since the case focused on the public statements and proxy voting activities of the investment manager as well as other instances where it sought to promote ESG objectives, plan fiduciaries that delegate proxy voting should ensure robust oversight of such activities. In fact, plan fiduciaries need to pay close attention to the voting records of the investment managers. Moreover, they need to insist on reviewing documentary evidence that the investment managers are complying with applicable proxy voting guidelines.
Moreover, the case demonstrates the importance of prudence as the best defense against charges related to a breach of fiduciary duty. The plans’ employee benefits committee developed and implemented policies and procedures designed to oversee the plans’ investment performance – policies that were as good as, and often better than, the prevailing practices of fiduciaries of similar-sized retirement plans. The combination of thorough procedures with the input of outside experts were essential to the plan’s ability to overcome the charge that it breached its fiduciary duty of prudence.
It should be noted that the court’s decision does not invalidate the 2022 ESG rule, though it appears likely that the current administration may revisit its provisions. It will be interesting to see how the ESG landscape evolves.
Ensuring your plan has a robust system of internal controls
The IRS describes internal controls as policies and procedures designed to detect and prevent errors in a retirement plan. They help plan sponsors to avoid mistakes that could jeopardize their plans’ tax-favored status. What types of practices and procedures should a plan have in place when it comes to plan operations? If you are unsure that your plan’s internal control procedures are up to the task, you may find recent guidance issued by the IRS to be helpful in assessing the adequacy of your policies and procedures.
Performing a self-audit
A strong system of internal controls should include procedures for reviewing your plan’s operations and updating your plan document at least annually. An audit of your plan can help potentially uncover weaknesses in your existing internal controls. If your business has 100 or more eligible participants at the beginning of the plan year, your plan must undergo a 401(k) audit through a third-party. Plans with fewer than 100 eligible participants are not required to undergo an audit by a third-party but it is recommended that they perform a self-audit.5 A plan audit must be conducted within seven months of the end of the plan year, although plans may apply for a ten-week extension if necessary.
When conducting a self-audit, the key inquiries are: Who is responsible for a specific plan administration task, and is it being completed correctly? Other more specific issues that a self-audit should cover include:
Eligibility: Confirm that years of service are correctly calculated for purposes of determining eligibility. Verify that the list of eligible employees is complete and includes terminated employees who may have been eligible to contribute for part of the year as well as any employees at a related company with common ownership interests who could be eligible.
Plan contributions: Ensure that deposits are made according to Department of Labor (DOL) timing guidelines. Be sure to confirm that the definitions of “compensation” that are used for allocations, deferrals and testing are consistent with the language in your plan document. Verify the correct amount of applicable matching and non-elective contributions. Also, check to ensure that annual contribution and compensation limits were adhered to. Finally, compare salary deferral election forms with the amounts deducted from the wages of employees.
Loans and distributions: If your plan permits loans and hardship distributions, be sure that they are made and approved in line with DOL and IRS requirements. Moreover, check all in-service, termination, and loan distribution forms to ensure that they conform to your plan document. Marital status and spousal consent for plan distributions need to be verified also. Ensure that participants and beneficiaries received their required minimum distributions in a timely manner.
Testing and administration: Confirm that all annual testing has been completed. Ensure that all highly compensated and key employees have been correctly identified. Make certain that all applicable notices have been distributed to participants. Verify that years of service were accurately determined for vesting purposes. Finally, double-check the validity of contributions.
The plan document
The importance of the annual review of a plan document becomes evident during a plan audit. During an audit, the IRS will ask plan sponsors to produce documents that demonstrate that their plans were timely amended for current law. If the employer cannot find the document, the matter has to be resolved using an audit closing agreement with the IRS.
Talk to your counsel a few months before your plan year ends to determine if there are any legal or operational changes that will need to be in place for the coming year. If you make changes to your plan document, you will need to make corresponding changes to the summary plan description and communicate those changes to plan participants.
Key takeaway for plan sponsors
It is critically important that plan sponsors familiarize themselves with their obligations to establish strong internal controls. Plan sponsors who have any questions about their responsibilities should reach out to their legal counsel for further insights and direction.