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.