Wednesday, November 21, 2012

Enron: Fiduciary Duties, Conflicts of Interest, and the Impracticality of the “Two Hats” Doctrine by Mahmoud Fadli


Enron: Fiduciary Duties, Conflicts of Interest, and the Impracticality of the “Two Hats” Doctrine 

By Mahmoud Fadli


Introduction

        The Enron catastrophe marked a turning point in both public opinion and public interest regarding corporate practices and misfeasance. The company, having been ranked seventh in the Fortune 500, went from “boom” to “bust” in a matter of eleven months, with their stock going from just above $80.00 to $0.40.[1] In particular, Enron’s 401(k) plan, which held over sixty percent of its assets in the form of company stock, saw its value plummet, leaving thousands of employees with nothing more than a feeling of betrayal. A combination of conflict of interests, risky accounting practices, and sheer failure of the company to properly act as a fiduciary in managing and appointing others to manage its own plans led to this disaster.

        This paper will focus first on giving the reader a brief overview of the pertinent parts of the Enron catastrophe. I will look at specific instances of Enron’s accounting practices, primarily looking at the “mark-to-market” method and analyzing whether or not such a method contributes to a sense of fiduciary disloyalty towards the administration of a plan – in other words, I will evaluate whether this is actually beneficial to plans, or simply a method that does not in and of itself ensure adequate funding of a plan. The first part of the paper will briefly look at the structure of Enron’s board and its inability to properly act in the interest of the 401(k) plan participants.

            Second, this paper will look to ERISA itself to determine the duties a fiduciary owes to its plan participants, and the various court holdings that pertain to Enron. I will then relate the law to Enron’s actions to showcase specific instances of violations of fiduciary duties that highlighted important conflicts of interests in the company’s board of directors.

            Third, I will briefly look at business ethics and its overall contribution to Enron’s management philosophies and practices, relating them to the breaches of various fiduciary duties owed to plan participants.

            Finally, I will sum up the findings and argue that, due to the sheer size and variety of interests involved in the management of Enron and companies of similar size and structure, the “two hats” doctrine becomes impractical as the ability to separate a company’s strategic considerations and motives from the sole interest of a plan’s participants becomes so difficult as to render it impractical. 

I. Introductory Note: Definition of the “Two hats” Doctrine

            Under ERISA § 3(21)(A), a person is a fiduciary with respect to a plan, and thus subject to ERISA fiduciary duties, “to the extent” that they exercise any “discretionary authority or discretionary control” respecting the management of a plan.[2] Moreover, this discretionary authority or discretionary control applies to the administration of the plan as well.[3] The very construction of the “to the extent” language implies that an individual or a corporation can be both an employer and a benefit plan administrator, which is permitted under ERISA.[4] The “two hats” doctrine stands for the proposition that under ERISA, an individual or corporation may act as both a plan administrator, and an employer, though not at the same time.[5]

As ERISA requires absolute loyalty in fiduciary duties[6], employers are expected to be able to transition between their roles as administrators and employers when needed. In other words, employers may wear the plan administrator hat and the employer hat, though it may not act in their capacity as an employer in such a way that would be detrimental to the plan or its participants and beneficiaries.[7] The purpose of this is to ensure practical administration of an ERISA plan – if employers were required to have separate departments or practices for both plan administration and its every day duties as an employer, the costs of pension and benefit plans would rise, thus creating a disincentive for individuals and employers to create benefit plans. The “two hats” doctrine is simply a realistic way to promote the creation of benefit plans without overburdening an employer with costly mechanisms of administering its plan.[8]




II. Brief Overview of the Enron Catastrophe & Its Relation to ERISA

Enron was known to tout about being the world’s largest energy company, boasting itself as the world’s “leading electricity, nature gas and communications companies.”[9] However, laying claim on twenty five percent of the world’s energy trading contracts was no small matter, and as a result, Enron was praised as one of the most innovative companies in the United States by Fortune Magazine.[10] Despite this claim to fame, there was a secret behind Enron that very few people knew; a secret that had to do with the company’s accounting practices that led to over-valuation of stock, and set the stage for Enron’s dramatic collapse.[11]

During the late 1990s, Enron engaged in a series of structural changes to the company’s operations.[12] These changes included taking the company from primarily dealing with energy trading to leveraging hedge funds.[13]Moreover, Enron created various trusts that it used to transfer its own assets to, reporting these transactions as gains and using them to artificially inflate Enron’s stock prices.[14] Enron also used these trusts to transfer debt, playing with accounting regulations so that the end result would be for Enron to omit reporting any owed debt transferred to these trusts, thus increasing Enron’s net worth.[15]

Moreover, Enron engaged in a type of accounting called “mark-to-market” accounting.[16] This accounting method, which was not against the law nor heavily regulated at the time that Enron engaged in these practices, allowed a corporation to post expected gains from long term contracts in their current financial statements.[17] Stated another way, a corporation could estimate its profits and then report a portion of these speculative earnings on their financial statements.[18] While the company would not have any of the money from the future contracts, this practice would allow for the company to report it, thus increasing, at least on paper, its net profits for that year, marking up its assets to their fair market value based on the “profits” reported.

This practice, however, was neither reliable nor prudent. According to Marianne M. Jennings in her law review article entitled A Primer on Enron: Lessons From A Perfect Storm Of Financial Reporting, Corporate Governance And Ethical Culture Failures, the numbers used in the computation of these statements were completely subjective, requiring company managers to “develop formulas used for [valuing future contracts].”[19] The subjectivity of these numbers were due to the fluctuation of energy prices as well as human error; both the likelihood of error and the formulas used in calculating these numbers were not reported in financial reports, leaving shareholders, investors, and plan participants in the dark with regards to the financial integrity of the company.[20] These “unrealized gains” that were nonetheless reported by Enron accounted for half of the $1.41 billion profit that the company annually reported.[21]

Despite the reporting of the enormous gains and profits, there was very really “hard money” to actually account for these figures. In the ERISA context, as a large percentage of its benefit plan’s funding was in the form of stock, there could be an argument that an employer’s duty to ensure that a plan is adequately funded would be undermined by this practice. Since the requisite amount of funds would not be guaranteed in the long term, the assets upon which the plan depends could be lost in an instant in the event that the calculations regarding the future value of contracts and oil prices were incorrect. To state it another way, the value of the assets held in the form of stock, which comprised of the majority of Enron’s benefit-plan funding, were essentially subject to a gamble wherein the arbitrary method of calculating the estimated profits from the company’s venture would determine whether or not the plan was adequately funded.

            Enron’s complications, however, were not just represented in its accounting practices or methods of doing business. The members of the board of directors for the company, which comprised of individuals “handpicked” by Enron CEO Kenneth Lay, were chosen not for their particular qualifications or skills, but for the “appearance of depth and possible connections” that they brought to Enron.[22] This led to numerous conflicts of interests, both in the political and ERISA arenas, which would later prove to be fatal for the company. These conflicts of interest, however, were never disclosed, and there is no suggestion that such interests had to be disclosed in the first place.[23]

            These conflicts of interests, coupled with risky accounting practices and irresponsible management, contributed to Enron’s eventual collapse in 2001, and made it nearly impossible for Enron executives to act in a manner that could have minimized the losses to plan participants who placed all their assets in Enron stock.[24] Despite knowledge of the risky accounting practices and the various conflicts of interest, in 2001 Enron’s board of directors, presumably acting in a fiduciary capacity[25], directed 401(k) plan managers to place a “lockdown” on company stock while the plan was “switched to a new record keeper and trustee.”[26] This decision came amidst heavy controversy regarding Enron after the company made a surprise announcement wherein it took a “$1.2 billion charge against its third quarter results” for that year.[27] The “lockdown” period, coupled with the major news of Enron’s accounting irregularities and growing suspicion in the previous year of Enron’s practices, caused the stock’s price to drop from a high of $80 to $0.40 by the time Enron filed for bankruptcy at the end of 2001.[28]

            As a result, Enron’s 401(k) plan participants initiated a class action lawsuit against Enron for breaches of fiduciary duties.[29] The participant’s claimed that they were unable to move investments from one plan investment fund to another despite the “exigent circumstances” that made the blackout “imprudent.”[30]Furthermore, plan participants alleged that Enron breached its fiduciary duty by appointing other fiduciaries to manage the plan assets that Enron knew or should have known were not qualified to manage them properly due to their conflicts of interest.[31]

Moreover, plan participants alleged that Enron failed its fiduciary duty by failing to monitor adequately the investing fiduciaries investment of plan assets, failing to monitor adequately the plan’s other fiduciary’s implementation of the terms of the plan, and by failing to disclose to investing fiduciaries material facts concerning Enron’s financial condition that they knew or should have known were “material to loyal, prudent investment decisions concerning the use of Enron stock in the plans and/or with respect to the implantation of the terms” of the plans.[32]

            Finally, plan participants charge Enron with violating its fiduciary duties by failing to remove fiduciaries that Enron knew or should have known were not “qualified to manage [plan assets] loyally and prudently,” by “knowingly participating in investing fiduciaries’ breaches by accepting the benefits of those breaches, both personally and on behalf of Enron,” by “knowingly undertaking to hide acts and omissions of the fiduciaries that [Enron] knew constituted fiduciary breaches,” and “by failing to remedy those fiduciaries’ known breaches.”[33]




III. ERISA & Fiduciary Duties

A. Applicable Law

            ERISA § 3(21)(A) states that a person is a fiduciary with respect to a plan “to the extent” that they exercise “any discretionary authority” or control with respect to plan management, or management or disposition of the plan assets, render investment advice for a fee or other compensation or have the responsibility or do so, or whether they have any discretionary authority or responsibility in the administration of the plan.[34]

Moreover, ERISA § 3(21)(A) also refers to ERISA § 405(c)(1)(B)[35], which states, in pertinent part, that a fiduciary is liable for a breach of fiduciary duty of another fiduciary when they knowingly participate in, or conceal, acts or omissions of another fiduciary, knowing that such an act is a breach of duty.[36]This is effectuated by engaging in activity that enabled another fiduciary to commit a breach, or if they have knowledge of a breach of another fiduciary and do not take reasonable steps to remedy the breach.[37]

            Courts have held that the phrase “to the extent,” found in ERISA § 3(21)(A), should been read to mean that “a person is a fiduciary only with respect to those aspects of the plan over which [they] exercise[] authority and control.”[38] Moreover, once found to qualify as a fiduciary under ERISA § 3(21)(A), fiduciaries are held personally liable for breaches of “any of the responsibilities, obligations, or duties” imposed upon them by ERISA.[39] Such personal liability encompasses making good on any losses to the plan resulting from the breach, and to restore any profits of the plan which the fiduciary has used, as well as being subject to other equitable or remedial relief “as the court may deem appropriate.”[40]This includes the removal of a fiduciary from their position.[41]

            In addition to the above, ERISA imposes very stringent standards for fiduciaries under § 404. Section 404 states, in pertinent part, that fiduciaries must work for the exclusive purpose of providing benefits to participants and their beneficiaries with the care, skill, prudence and diligence of a reasonable person in like circumstances with the knowledge and abilities of the fiduciary in question.[42] Moreover, ERISA § 404 requires fiduciaries to both diversify investments to minimize the risk of large losses (unless it is clearly not prudent to do so), and to act in accordance with the plan documents so long as they are consistent with the requirements of ERISA.[43]

            As can be noted, ERISA has very high standards for fiduciaries that opt to create plans that fall under the reach of the act. The Supreme Court in Varity Corp. v. Howe made it clear that Congress enacted ERISA to provide “extra protections for both employers establishing ERISA benefit plans and for plan participants and beneficiaries that the law of trusts lacked.”[44] Moreover, the Supreme Court in Varity Corp. held that one of the fundamental duties under ERISA that fiduciaries owed to plan participants is the duty of complete loyalty under § 404(a)(1)(B), which requires a fiduciary to “exclude all selfish interest and all consideration of the interests of third persons” when acting as a plan fiduciary.[45]

            The “prudent man” standard noted in ERISA § 404(a)(1)(B) requires that a fiduciary give “appropriate reconsideration to those facts and circumstances” that a fiduciary knows or should know are relevant to the particular investment involved.[46] This includes the role the investment course of action plays in the portion of the plan’s investment portfolio to which the fiduciary has a duty.[47] Of course, after these considerations are taken, to fulfill the “prudent man” standard of care, a fiduciary must “act accordingly” after taking into consideration the factors noted above.[48]This requires objective assessment of whether fiduciaries, at the time of the transaction in question, utilized “proper methods to investigate, evaluate, and structure the investment,” and acted in a manner similar to others who are familiar with such matters, having exercised independent judgment when making their final decision.[49]

            The subsequent litigation in the aftermath of Enron’s demise focused squarely on whether or not the company acted in accordance with the duties listed. The next section will focus on Enron’s failures to meet their requisite duties of care in management the plan.





B. Enron’s Breaches of Fiduciary Duty

            Enron, through engaging in its “mark-to-market” accounting practice, as well as failing to adequately notify plan participants of the upcoming “lockdown” period for the company’s stock, breached its fiduciary duty that it owed its plan participants.[50] Having known that the nature of Enron’s reported financial status to be highly speculative, and having induced so many Enron employees to invest in Enron stock despite the potential problems with the accounting method, violated it fiduciary duty by not acting in the sole interest of the plan participants. For example, in 2001, the Enron board of directors was told that roughly 64% of the company’s assets were, at the very least, “performing below expectations;” prior to that report, the board was told that roughly 67% of the company’s asserts were “underperforming.”[51]

While the particularities dealing with the extent of the underperformance are far too complex and entrenched in economic theories and transactions to address here, the overall point of the report delivered to Enron in early 2001 was to make the company aware that roughly 45% of the original 67% noted in the first report had essentially become worthless.[52] Stated in terms of assets, the company realized then and there that it has overstated $2.3 billion in assets on the company’s balance sheet.[53] Despite this, Enron did little or nothing to attempt to alleviate any possible damage that could arise from holding company stock. Despite ongoing media speculation as to the financial integrity of Enron, the company did nothing to remedy any potential problems.

            To that end, the plan participants In re Enron alleged that the defendants “induced” plan participants to direct or allow the fiduciaries of the plan to maintain such investments in company stock beginning in 1998, at a time when Enron should have become aware of potential problems with their practices.[54] Moreover, the plan participants alleged that Enron, through an appointed committee, violated its fiduciary duty to provide information necessary for plan administration because they ‘allegedly withheld from the administrative committee (which in turn purportedly failed in its fiduciary duty to investigate) material information regarding the actual financial condition of Enron.”[55]

            Moreover, as if the failure to investigate legitimate questions regarding the financial integrity of the company was not sufficient enough to trigger an affirmative duty to investigate the matter, plan participants alleged that Enron’s CEO, along with other high ranking company officers, sold substantial amounts of their personal Enron stock while continuing to encourage plan participants and beneficiaries to purchase more of the company’s stock, “tout[ing] Enron’s financial strength” whiling disclosing none of the legitimate, material concerns that were floating around.[56] These material concerns were voiced not just internally, but publically, noting that in March of 2001 there was a Fortune magazine article that discussed “Wall Street worries about Enron’s increased secrecy, growing debt, bullish expectations, [and] ‘opaque accounting and dubious rationalizations’ for its high stock price…”[57] However, these red flags were never heeded to, and Enron continued to spiral downward under the watch of its board of directors.

            There were instances, however, when members of the board of directors spoke out about the current financial situation of the company.[58]One member of the Enron board wrote an anonymous memorandum detailing their particular concerns over the company’s financial status. While not necessarily related to the plan itself, the matter was of concern to the overall financial integrity of the plan, and had a direct effect on the administration of the plan and the integrity of the assets.[59] However, consideration must be given to the fact that despite attempts to, at the very least, bring the issue to the attention of the Enron board of directors, there was a culture of “arrogance” and “intimidation” in Enron that made the possibility of bringing such information forward a “job-terminating move.”[60] Such necessarily raises the question of what should a reasonable fiduciary do under such circumstances?

            Given the nature of the duties imposed upon fiduciaries and their role to ensure co-fiduciaries, at least to their knowledge, do not violate the pertinent sections of ERISA, it would seem that at the very least they [fiduciaries and co-fiduciaries] should make it known that a breach occurred and attempt, in some fashion, to remedy it.[61] But what if, as in the situation here, a fiduciary must come face to face with the possibility of losing his or her job in order to adequately perform their duties; what would the reasonable choice be? According to ERISA § 409(b), it may be best to bring it to the attention of a “higher up” and risk job-termination than it is to simply lay quiet.[62] Though the intimidation did not end simply at the board level; it was rampant throughout the company itself.

            Despite Enron’s problems now going to the public, employees “remained in a culture of intimidation and fear.”[63] One employee was reportedly filed after he posted a question regarding Enron’s use of “aggressive accounting” methods to “overstate its profits” on an internet company discussion board.[64]Another employee was terminated for questioning the payment of “$55 million in retention bonuses paid to officers in early December 2001;” both employees having been fired for postings reportedly categorized as “offensive.”[65]

            It must be noted that while some of the matters noted may not be directly related to the management of the plan or its assets, courts recognize that there are special circumstances with a “potentially extreme impact” on a plan as a whole, and that in such situations participants could be negatively affected.[66] Such circumstances could in and of themselves support the imposition of an affirmative duty of disclosing such essential information to plan participants as part of an organization or fiduciary’s duty.[67] These circumstances may have been in existence long before 2001 – in fact, they may have occurred when the company began using the “mark-to-market” accounting method that resulted, to a large degree, in an over-valued stock. Irrespective of what view is taken with regards to at what point the affirmative duty, at the earliest, could have arisen, it can be widely agreed to that such a duty arose the moment massive public speculation with regards to Enron’s financial integrity began.

            Even at that point, however, Enron did little, with plan participants In re Enron alleging that not only did Enron give material misrepresentations of its financial consideration, but it induced employees to continue to purchase and or hold onto Enron stock despite having notice that the underlying calculations pertaining to the valuing of the stock were imprecise and under investigation during employee meetings.[68] Thus it seems regardless of whatever circumstances may be pertinent to the established 401(k) plans, the Enron board of directors did little to nothing to alleviate the matter[69]. In fact, Enron executives sold their stock before the price plummeted, leaving thousands of plan participants and beneficiaries with essentially nothing.[70] This is similar to the situation in Varity Corp. v. Howe, wherein Varity Corporation devised a way to move the unprofitable aspects of its operations to a newly created subsidiary in hopes of securing the financial integrity of the Corporation.[71] In doing so, the management of Varity Corporation induced plan participants and beneficiaries to switch to their current plans to that of new subdivision, the corporation maintaining that the plans would be safe and secure in the new subdivision despite knowing that the subdivision was unfeasible and expected to be unprofitable.[72] The Enron board, here, induced its employees to attend meetings conducted by members of the board, wherein participants were “reassured” of the safety of their 401(k) funds, and that participants should continue to maintain their investments in the company’s stock.[73]

Despite these gross violations of fiduciary duty, there is a pressing question that must be answered: what are the underlying factors that allow for these types of practices to arise in the first place? The public’s view that Enron fell as a result of greed and mismanagement is only half the story; there is an entire culture of ethical (or unethical, rather) conduct that occurs in the context of business management that makes fulfilling a fiduciary’s duty to their plan participants and beneficiaries more troubling. The next section will attempt to shed light on the ethics and culture of business management, and its contribution to breaches of fiduciary duties.

IV. Business Ethics & Enron In Relation To ERISA

            An in depth analysis can be found in Marianne Jennings’ article. Jennings looks to the “Enron Culture” to determine where the company’s ethnical failure began.[74] Jennings noted that Enron was not the most “conducive [company with regards to] open feedback.”[75]As noted in the previous sections, discussing concerns about the integrity of the company itself could get an employee, or even a high ranking board member, fired. However, it was not just a culture of intimidation that contributed to Enron’s collapse, it was a “culture of arrogance” that truly sheds light on the practices and methods employed by the Enron corporation.[76]

            Jennings noted that “when companies implode, generally because of financial reporting issues [due to an inability] to sustain outstanding financial performance, there is a clear pattern in terms of the culture” that is present in the company.[77] This “culture” consists of an “autocratic CEO,” fear among employees that is “so expansive” that it is unlikely that they will raise “even the most obvious issues,” and most notably, “punishment for employees who [do] question company processes or procedures.”[78] Examples can shown on the board itself when an employee of another subdivision noted that the Enron had moved assets to a subsidiary so that the main division could look “profitable,” stating however that some observers would say that “the house of cards are falling.”[79] As a result, the commenting employee was “counseled on employee morale,” and even when this particular employee openly questioned the matter in board meetings and referenced their memo, all they were met with were empty assurances that the matter would be investigated.[80] Not surprisingly enough, none of the employers who were assured that their matters would be invested were ever contacted.

            This can be attributed to what Jennings calls a “culture of wizards and hubris.”[81]She notes the highly educated status of Enron’s senior management, most of whom were well-trained MBAs, “given the hyper-technical tools typical of financial education in MBS programs in the 1980s, with some coming from schools such as Harvard, Northwestern and Columbia Universities.”[82] She further notes that the curriculums of these schools contain “no specific references to issues such as honesty, disclosure, and fairness,” in essence arguing that the executive management of Enron simply did not consider basic canons of ethical behavior in the execution of their duties.[83]

            However, Jennings points to the irony in the fact that despite there never being any ethics training in many of the universities that granted the senior executives of Enron their degrees, many of them were highly involved in their communities and engaging in “philanthropic” activities.[84] The fact that despite being so involved in philanthropic activities in their communities, their respective companies all fell as a result of “accounting improprieties,” becomes a striking irony.[85] Moreover, Jennings notes that there is a “topic of debate” as to whether “economic self-interest does, indeed, benefit society,” and whether “such a goal supersedes [the] responsibility[ies] to [company executives have towards their] shareholders.”[86]

            Given these debates, Jennings concludes that in the minds of these executives, they have no problem viewing themselves as being “on the side of angels,” mainly due to the fact that they perceived their actions as consistent with their training in business school.[87]This is amplified by the fact that the MBA curriculum is “sterile,” emphasizing financial models and doing well through volunteer work, completely oblivious to the disconnect between financial skills and ethics; understanding that “social contributions are not a substitute for candor in financial reports and honesty in company transactions” simply does not exist in the curriculum.[88]

            Moreover, as Jennings notes, the MBA curriculum responsible for producing these “Enron executives[,] and many other ticking time bombs[,]” carries little regard for traditional business principles: “low cost, quality, service, and real profits.”[89]Enron’s practices of “spinning debt off the balance sheets” is nothing new, nor is it, as Jennings notes, particular to Enron: it is something that most MBA students will study through cases of the practice being successful.[90] What is shocking is the fact that in many of these “case studies” that MBA students engage in, the corporate executives were subject to litigation but simply “lived to tell about it.”[91] In other words, the practice is legitimate so long as you get away with it; such seems to be the message. In the ERISA context, this can be troubling, as no aspect of the “culture” of a corporation such as Enron promotes the need for loyal fiduciaries. The whole purpose of a board member’s position is to ensure the continued existence and feasibility of the corporation. In so doing, interests pertaining to the benefits of plan participants and beneficiaries would seemingly take a back seat. Like in Varity Corporation’s circumstances, Enron’s board was looking out for its own interest as board members sold their stock and continued to induce plan participants to continue to purchase more, perhaps to offset the amounts that they were selling. The business “culture” of Enron likely saw the plans as a way to increase employee morale and promote productivity, though the benefits themselves merely a reflection of the cost of such productivity that can be alleviated and minimized when the time came.

With this in mind, the discussion of whether it is even practical, given the “culture” of business as it is today, to expect that a company as large and as intertwined as Enron (though this could apply to any fortune 500 company) could legitimately be expected to adhere to the “two hats” doctrine, and act solely in the interests of plan participants. It should be no surprise that I will answer in the negative.

V. Conflicts of Interest & The Impracticality of the “Two Hats” Doctrine as applied to Enron Given The Culture Of The Corporation

            In enacting ERISA, Congress continued to rely on “voluntary action by employers” by giving them substantial tax advantages” for the creation of “qualified retirement programs.”[92] “Neither Congress nor the courts are involved in either decision to establish a plan or in the decision concerning which benefits a plan should provide… courts have no authority to decide which benefits employers must confer to their employees.”[93] However, Congress acknowledged plan sponsors could wear “many hats,” although according to the “Two-Hat” doctrine, could only wear one at a time.[94]It is with this in mind that ERISA requires that when a fiduciary is making the types of decisions that are particular to the role of a fiduciary, only the “fiduciary hat” may be worn.[95] This bears in mind, however, that the statutes states that a fiduciary is only a fiduciary “to the extent that [they] act[] in such a capacity in relation to a plan.”[96]
            Incidental to the “Two-Hat” doctrine is the concept of the “settlor function,” wherein a plan sponsor may act in a manner which results in the termination, amendment, or even adopting a plan; a manner held not to consistent with that of a fiduciary but instead, as a business employer.[97] Such activity is not regulated by ERISA, and courts have held that when a company is acting as the plan’s settlor, and makes a decision regarding the “form or structure of the plan such as who is entitled to receive plan benefits and in what amounts, or how such benefits are calculated,” such activity will be deemed that of a settlor and not a fiduciary.[98] This, it is reasoned, gives employers the necessarily flexibility and control over matters such as whether or when “to establish an employee benefit plan, how to design a plan, how to amend a plan, whether to terminate a plan” and any other “non-fiduciary” function of plan management.[99]

            While it is understood that plan sponsors should have the ability to control their own plans and operate them in manner that is not hurtful to the financial integrity of the company, expecting larger, more heavily intertwined corporations to do so may be unrealistic. Taking the Enron example, it becomes clear that when you have corporations whose executive boards are engaging in more than one function and have conflicting interests and goals in the course of their management, decisions that are more generous to those interests are more likely. For example, instead of investigating potential acts of mismanagement with regards to plan assets and company stock, board members of Enron simply ignored the complaints and lectured the parties making the observations about employee morale. This seeming hostility was likely grounded by the theory that the loyalty to the corporation as a whole outweighs any loyalties or duties to plan participants and beneficiaries, who essentially come and go as a result of the employment process.

For example, Enron CEO Kenneth Lay’s continued touting of Enron’s financial integrity during the final months of the corporation, while selling off his own assets, was clearly an act of a fiduciary, albeit a disloyal fiduciary.[100] However, given that business ethics is expected but not taught in the typical business school curriculum, it may be difficult to rationalize any breach of duty as, in fact, a breach. For example, Mr. Lay could have been acting as a private investor in selling his stock, but seeing it as a reasonable action to motivate employees to buy company stock to ensure the company’s stock is strong. Even in Varity Corp., the corporation defended itself on the theory that it was acting as a “settlor” or an employer when it was convincing its participants to transfer their assets to the newly created subdivision.[101] While Mr. Lay’s possible view that he was acting as a private investor is inconsistent with ERISA’s fiduciary obligations[102], it may be “rational” to an individual whose primary motivation is not necessarily their shareholders or plan participants, but the overall integrity of the company.

Moreover, given the lack of attention to traditional notions of business which value “low cost, quality, service, and real profits,” the “Two-Hat” doctrine might be difficult to comprehend when presented to a board executive who has vital information regarding potentially devastating effects on the company’s stock, as in Enron. Is it at all realistic to expect an executive, part of a board that is a named fiduciary in the company’s plan, to act in a manner that both jeopardizes their jobs and the integrity of their company?  While the law may require them to do so, the Enron case shows such is what does not happen.

Perhaps at this point in time, given the “culture” of the modern corporation and the executives that run it, the “Two-Hat” doctrine may be impractical. If the main purpose in business is to shift debt elsewhere and report positive gains in order to get a bonus, or to tout non-existent financial “vigor,” then the “Two-Hat” doctrine would be seen as an obstacle to achieving those goals. Indeed, the fact that Enron’s executives saw the red-flags from miles away and did nothing goes to that point. As Jennings points out in her article, the problem with any changes that may attempt to remedy such problems is that they are too technical and generic.[103] “Additional signatures, additional jail sentences, additional oversight Boards, and additional rules for Boards are the types of changes that seem logical, punitive, and satisfying for an investor class hungry for the restoration of trust."[104] They do not, however, get to the root of the problem: a business culture that is focused on profits, how to achieve them and avoid the long arm of the law in the process.

Perhaps, as Jennings points out, the implementation of accounting oversight boards, regulations on the independence of auditors, corporate responsibility and governing issues including the structure of audit committees, certification of financial statements, forfeiture of bonuses and options, codes of ethics for senior financial officers, and professional responsibility rules for attorneys working with companies on certification of financial statements, will assist in alleviating the problems that make the “Two-Hats” doctrine impractical.[105]

While some of these proposed changes are being considered, changes to ERISA and the law have been made since Enron. These include the “White-Collar Crime Penalty Enhancement Act of 2002,” which increases the penalties for mail and wire fraud from five to twenty years.[106]  Moreover, violations of EIRSA now carry “great penalties with $5,000 fines for individuals increased to $100,000;” increased prison sentences of up to ten years, and company fines now increased to $500,000.[107] Moreover, the enfacement of the Sabranes-Oxley act provides greater protection to “whistle blowers” who call breaches of fiduciary duties or issues with pension plans to the attention of fiduciaries. In addition, the Department of Labor strengthened the requirements for “blackout periods,” requiring employers give participants and beneficiaries at least 30 days notice before the blackout is to occur, enforcing the provision for civil penalties for breach of this duty.

Despite these changes and the resulting protections to participants and beneficiaries, they are still generic. They do not address the ethical part of business that encourages breaches – they simply act within the already accepted “carrot and stick” approach, and while this approach is useful, it still requires another important aspect: changing the way business is viewed, and adding a human element that makes it possible for fiduciaries and corporate executives to consider more than just numbers in “the green.” Until then, it would not be realistic to expect that such corporations act in a manner that can truly be said to comply with the “Two-Hats” doctrine.




[1] Stuart L. Gillan & John D. Martin, Financial Engineering, Corporate Governance, and the Collapse of Enron, U of Delaware Coll. of Bus. and Econ. Ctr. for Corp. Governance Working Paper No. 2002-001, November 2002.
[2] Varity Corp. v. Howe, 516 U.S. 489, 498 (1996).
[3] Id.
[4] Varity Corp., 516 U.S. at 489. (noting that Varity Corporation was acting as both an employer, in some instances, and a plan administrator, in other instances.)
[5] See generally Varity Corp., 516 U.S. at 489.
[6] ERISA 404(a)(1)
[7] G. Bogert & G. Bogert, Law of Trusts and Trustees §§ 121, 543 (Rev.2d Ed.1993); (requires plan fiduciaries to not act in a manner that would violate their duty of loyalty to a plan participant.).
[8] Musto v. American General Corp., 861 F.2d 897, 912 (6th Cir. 1988) (Congress relies upon the voluntary action of employers in their creation of qualified retirement programs, and there is no involvement by courts or congress in the decision of what benefits an employer should provide.)
[9] Pl.’s Compl. At 1; see Newby v. Enron Corp, 542 F.3d 463, 466 (5th Cir. 2008).
[10] Marianne M. Jennings, A Primer On Enron: Lessons From A Perfect Storm Of Financial Reporting, Corporate Governance And Ethical Culture Failures, 39 Cal. W. L. Rev. 163, 168 (2003).
[11] Id.
[12] Id. at 172
[13] Id.
[14] Id. at 180
[15] Jennings, Enron, supra, at 180.
[16] Id. at 174
[17] Paul Krugman, Cronies in Arms, N.Y. Times, Sept. 17, 2002, at A29.
[18] Financial Accounting Standards Board (FSAB) § 133 (permits energy traders to include in their current earnings future expected earnings on contracts and “related derivative estimates.”).
[19] Jennings, Enron, supra, at 176.
[20] Id.
[21] Jonathan Weil, After Enron, “Mark to Market” Accounting Gets Scrutiny, Wall St. J., Dec. 4, 2001, at C1.
[22] Jennings, Enron, supra, at 198.
[23] Id. at 200.
[24] See generally In re Enron Corporation Securities, Derivative & “ERISA” Litigation, 284 F.Supp. 2d 511, 545 (S.D. Tx. 2003).
[25] See generally Varity Corp., 516 U.S. at 502; in this case, such an action would seem to be an “exercise of power ‘appropriate’ to carrying out an important plan purpose.”
[26] In Re Enron, 284 F.Supp. at 532.
[27] Id. at n.11.
[28] Jennings, Enron, supra, at 196.
[29] In Re Enron, 284 F.Supp. at 535, n10.
[30] Id.
[31] Id. at 537.
[32] Id.
[33] Id.
[34] ERISA § 3(21)(A)(i)-(iii)
[35] ERISA § 405(c)(1)(B) states that a “named fiduciary would otherwise be liable in accordance with subsection [405](a).”
[36] ERISA § 405(a)(1)-(3)
[37] Id.
[38] Drug Stores Co. Employee Profit Sharing Trust v. Corrigan, 883 F.2d 345, 352 (5th Cir. 1989); Brandt v. Grounds, 687 F.2d 895, 897 (7th Cir.1982); American Federation of Unions Local 102 Health & Welfare Fund v. Equitable Life Assurance Society of the United States, 841 F.2d 658, 662 (5th Cir. 1988); Sommers Drug Stores Co. Employees Profit Sharing Trust v. Corrigan Enterprises, Inc., 793 F.2d 1456, 1459-60 (5th Cir. 1986).
[39] ERISA § 409(a)
[40] Id.
[41] Id.
[42] ERISA § 404(a)(1)(A) & (B)
[43] ERISA § 404(a)(1)(C) & (D)
[44] Varity Corp. v. Howe, 516 U.S. 489, 497 (1996)
[45] Id.
[46] Id. at 547.
[47] Id.
[48] Id.
[49] Id. at 548.
[50] Jennings, Enron, supra, at 176.
[51] Id. at 204.
[52] Id.
[53] Id.
[54] In re Enron, 284 F.Supp. 2d. at 657 (emphasis in original).
[55] Id.
[56] Id.
[57] Id. at n.146.
[58] Jennings, Enron, supra, at 220-221.
[59] Id. at 225.
[60] Id.
[61] See ERISA § 405(a)(3).
[62] ERISA § 409(b) states that “[n]o fiduciary shall be liable with respect to a breach of fiduciary duty under this title if such breach was committed before he became a fiduciary or after he ceased to be a fiduciary.”
[63] Jennings, Enron, supra, at 225.
[64] Id.
[65] Id.
[66] In re Enron, 284 F.Supp. 2d. at 560.
[67] Id.
[68] Id. at 561.
[69] Id. at 658 (the breach of fiduciary duty occurred when the board failed to disclose to other board and committee members that they knew, or should have known, though “prudent investigation,” that there was a threat to the pension plans and that remedial action would be required.); See also Varity Corp., 516 U.S. at 502-3 (“Supreme Court found that ‘conveying information about the likely future of plan benefits, thereby permitting beneficiaries to make an informed choice about continued participation,’ was part of a plan administrator’s duty ‘to offer beneficiaries detailed plan information’ and, that misinformation about such provided in conjunction with misrepresentations about the business health of the company, constituted an act of plan administration subject to fiduciary standards.”) (emphasis added).
[70] See generally In re Enron, 284 F.Supp. 2d 511, 545 (S.D. Tx. 2003).
[71] Varity Corp., 516 U.S. at 493.
[72] In re Enron, 284 F.Supp. 2d at 494.
[73] Id. at 561.
[74] Jennings, Enron, supra, at 223.
[75] Id.
[76] Id.
[77] Id.
[78] Id.
[79] Id. at 225.
[80] Id.
[81] Id. at 226.
[82] Id.
[83] Jennings, Enron, supra, at 226.
[84] Id. at 227. (Jennings uses Mr. Andrew Fastow, Enron’s CFO and a defendant currently serving a 6 year sentence, as and example, showing that he was a very “prominent in Houston’s Jewish community,” being highly active in the city’s art museum, and a “voracious fundraiser for the city’s Holocaust museum.”)
[85] Id.
[86] Id.
[87] Id.
[88] Jennings, Enron, supra, at 227.
[89] Id. at 230 (emphasis added).
[90] Id.
[91] Id.
[92] In re Enron, 284 F.Supp. 2d. at 656.
[93] Id.
[94] Id. at 550.
[95] Id.
[96] Id.
[97] In re Enron, F.Supp. 2d. at 551.
[98] Id.
[99] Pegram v. Herdrich, 530 U.S. 211, 226-27 (2000).
[100] In re Enron, 284 F.Supp. 2d. at n6.
[101] Varity Corp., 516 U.S. at 504.
[102] See Generally ERISA § 1106 (detailing a prohibited transactions by a fiduciary).
[103] Jennings, Enron, supra, at 243.
[104] Id.
[105] Id. at 244 (citing various articles and opinion editorials) (citations omitted).
[106] Id. at 254.
[107] Id.

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