The health of the US financial markets and investors is dependent on auditors fulfilling their critical gatekeeping function. While the Sarbanes-Oxley Act led to great improvement in financial reporting, it didn’t go far enough to ensure auditor independence, says Laura H. Posner, a partner in Cohen Milstein’s Securities Litigation & Investor Protection and Ethics and Fiduciary Counseling practices. Prior to joining Cohen Milstein in 2017, Posner was the Bureau Chief for the New Jersey Bureau of Securities.

Last month, the Sarbanes-Oxley Act turned 20 years old. Sarbanes-Oxley, a landmark piece of legislation that transformed auditing and financial reporting in the wake of the Enron and Arthur Andersen scandal, has proven to be one of the most effective pieces of financial legislation passed since the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934.

Among other things, Sarbanes-Oxley led corporations to adopt and implement significantly more robust financial controls, leading to fewer and smaller restatements. But since it was enacted, both the financial markets and the Big Four accounting firms have transformed dramatically. Audit firms have expansive consulting arms, and financial products are significantly more complex. Legal developments have also made it increasingly difficult to hold fraudsters accountable when they run afoul of auditing rules and the securities laws. Perhaps most alarming is the dangerous pattern of auditors lacking independence from their clients, creating conflicts of interest that we must not ignore.

While Sarbanes-Oxley led to great improvement in financial reporting, it didn’t go far enough to ensure auditor independence. Hopefully, the necessary changes will be made before the next auditing scandal rocks the markets and harms investors.

“Independent” Auditors

Sarbanes-Oxley attempted to ensure auditor independence, requiring engagement partners to rotate off clients every five years and audit firms to bar certain consulting work for audit clients. But the concept of the independent auditor in the US has blurred as accounting firms have become increasingly ensconced in their clients, leading to erosion of investor confidence and opening the door to corporate misstatements, breaches of fiduciary duties, or worse—fraud.

An illustration of this is the recent report that Ernst & Young devised elaborate—and what federal authorities now claim were sham—tax shelters that allowed Perrigo, a leading maker of nonprescription drugs, to avoid more than $100 million in federal taxes. When Perrigo’s outside auditor, BDO, questioned the legality of the tax shelters, Perrigo replaced BDO with Ernst & Young, which then blessed the transactions its consulting arm helped create. This is a prime example of why there must be a bright line defining what it means to be an independent auditor and proscribing what activities are permitted and which run afoul of auditor independence rules.

While the Securities Exchange Commission has released some guidance on what kinds of relationships accounting firms and their auditing divisions can and cannot have with clients, it is not surprising that this activity still takes place. The client, after all, is the one who pays the bills.

Role of Litigation

Auditor independence issues often play an important role in private litigation, too. For example, investors recently settled securities litigation against Mattel Inc. and its auditor, PwC, for $98 million. According to Mattel’s own audit committee, PwC’s lead audit partner for the engagement violated auditor independence rules by providing recommendations on candidates for Mattel’s senior finance positions. A Mattel whistleblower referenced in the complaint also alleged that PwC then helped cover up Mattel’s valuation allowance misstatement that ultimately led to the need for a restatement. Mattel had improperly understated its net loss by approximately $109 million, effectively overstating earnings by $0.32 per share.

While Sarbanes-Oxley attempted to prevent such compromises of independence, the Mattel/PwC case demonstrates that the legislation did not go far enough and that further regulatory action and civil litigation is necessary to protect investors.

Call for Regulators to Get Tough

In the US, accounting firms are regulated by both the SEC and the Public Company Accounting Oversight Board, a quasi-public agency created by Sarbanes-Oxley. SEC and PCAOB rules require audit firms to keep an arms-length relationship with the companies they oversee. In 2020, the SEC clarified the auditor independence rule under then-SEC Chairman Jay Clayton. Under the revised rules, companies are required to limit the number of services they provide to a single client to ensure objectivity and impartiality in their audit work.

Unfortunately, since the fall of Arthur Anderson in the wake of the Enron scandal, the SEC and PCAOB have often failed to go after auditors playing fast and loose with the rules. The death knell of Arthur Andersen—which was one of the “Big Five” auditing firms—was a massive blow to the accounting industry and gave many regulators cold feet in bringing claims against audit firms. When the Supreme Court later overturned the government’s obstruction of justice case against Arthur Andersen, it further dampened enforcement efforts.

The SEC recently rolled out a new enforcement initiative aimed at investigating conflicts of interest in nation’s largest accounting firms—a key step to ensure auditors are acting as the independent gatekeepers. One suggestion is for the SEC and PCAOB to look across the pond at the Competition and Markets Authority and Financial Reporting Council’s recent hardline efforts to regulate the separation of the audit and non-audit practices of the UK’s largest auditing firms—the same Big Four as in the US—as a part of the UK’s “Restoring Trust in Audit and Corporate Governance.”

In addition to the Big Four establishing a separate regulatory audit board, FRC’s April 2022 proposed revisions to the Audit Firm Governance Code stipulates a maximum tenure of nine years to guard against threats to independence and requires an independent non-executive to participate in the auditing process alongside the audit board. The INE would be entirely independent from the auditor and audited entities. It also would be meant to represent the public interest and act for the benefit of the common good, including that of the shareholder and other stakeholders.

Conclusion

The health of the US financial markets and investors is dependent on auditors fulfilling their critical gatekeeping function. To do so, accounting firms must be truly independent from the companies they are auditing.

Delaware Chancery Court Vice Chancellor Travis Laster broke new ground recently by ruling that a board of directors’ failure to address an obvious “red flag” constituted a sufficient breach of fiduciary duty of oversight under the court’s Caremark1 standard to overcome a motion to dismiss, even though the board learned about it through a litigation demand.

The alleged misconduct in Garfield v. Allen2 involved a violation of an equity compensation plan approved by the ODP Corporation Board of Directors. Although Vice Chancellor Laster accepted “with trepidation” the “novel theory” of a Caremark claim advanced by plaintiff, he found that “the logic of the … theory is sound.” Vice Chancellor Laster noted that “from an analytical perspective … the source of the directors’ knowledge should not make a difference.” In short, a litigation demand by itself can now serve as a “red flag” triggering a potential Caremark claim. What remains to be seen is whether this new theory of liability becomes a viable approach to challenging a board’s breach of its fiduciary duty of oversight beyond the factual circumstances of this case.

The Garfield case arose in the context of the grant of equity awards by the directors of ODP under an existing executive compensation plan previously approved by its stockholders. The plan contained a limit on the number of shares that could be awarded to an individual in any given year. Plaintiff challenged the award granted to ODP’s CEO, claiming that the board had violated the plan by awarding him an excessive number of shares. Plaintiff made a demand on the ODP board to amend the award to comply with the terms of the plan.

In response to the demand, the board’s compensation committee chose to interpret the plan differently and applied another limitation found in the plan—one that was higher and ostensibly permitted the award to stand. Because the board denied the stockholder’s demand without taking any action, plaintiff brought a direct claim for a breach of contract based on the terms of the plan and a derivative claim for breach of fiduciary duties. Defendants moved to dismiss the claims relying on their different interpretation of the plan as the basis for not taking the action plaintiff demanded.

In denying the motion to dismiss, Vice Chancellor Laster ruled that the directors on the compensation committee breached the contractual terms of the plan and their fiduciary duties by approving the award, that the CEO breached his fiduciary duties by accepting the award, and that all the directors breached their fiduciary duty by not fixing the awards after receiving notice of the violation in the demand.

The underlying theory on the board’s failure to amend the award after receiving notice of the violation was premised on a Caremark type claim and rests on the notion that directors can be held liable for consciously not addressing “red flags” brought to their attention. Vice Chancellor Laster ruled that just because a “red flag” is raised in a litigation demand, it does not absolve directors from potential liability. Thus, the ODP directors who approved an improper award in the face of a “plain and unambiguous” contractual restriction in the plan face liability both for approving the improper award and for failing to address the issue once they were advised of the problem by a stockholder demand. Significantly, here all directors breached their fiduciary duties by failing to amend the award after being put on notice of the violation when they received plaintiff’s demand. As Vice Chancellor Laster noted: “[w]hen directors grant awards that exceed an express limitation in an equity compensation plan, the allegations support an inference that the directors acted knowingly and intentionally,” supporting a claim for breach of “fiduciary duty of loyalty by failing to act in good faith.”

Recognizing that this approach to Caremark claims was novel and without precedent, Vice Chancellor Laster cautioned against how this doctrine should be applied in future cases. His concern centered on other plaintiffs who might attempt to manufacture whistleblower-type claims as a basis for a demand and then sue directors who failed to act “because the directors did not respond to the whistle.” While this might be a concern, however, there now appears to be a pathway for stockholders to assert a Caremark claim where directors are advised of an otherwise unknown serious problem or “red flag” and fail to address the issue when given notice through a litigation demand.

1. In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 971 (Del. Ch. 1996) (Allen, C.)

2. Garfield v. Allen, et al., C.A. No. 2021-0420-JTL (Del. Ch. May 24, 2022)

To say that federal securities regulators are expanding oversight of cryptocurrencies at an opportune time would be an understatement. In fact, some industry experts say the increased attention is overdue.

Crypto assets have gone mainstream. Over the last year, several large pension funds have announced allocations to crypto or its underlying blockchain technology, while asset managers like Fidelity Investments have enabled 401(k) retirement savings plan participants to invest directly in Bitcoin1 and celebrities like Tom Brady and Larry David pitch crypto on TV to retail investors. Meanwhile, cryptocurrencies have been hit particularly hard during Wall Street’s recent downturn, losing two-thirds of their value since their November 2021 peak market capitalization of $3 trillion.2

Enter the U.S. Securities and Exchange Commission’s (SEC). On May 3, 2022, the SEC’s Division of Enforcement announced the expansion of its crypto group from 30 to 50 people and renamed it the Crypto Assets and Cyber Unit. “By nearly doubling the size of this key unit, the SEC will be better equipped to police wrongdoing in the crypto markets,” SEC Chair Gary Gensler said in a statement accompanying the announcement. The SEC said the Crypto Assets and Cyber Unit would focus on investigating securities fraud violations related to crypto asset offerings, crypto asset exchanges, crypto asset lending and staking products, decentralized finance (DeFi) platforms, non-fungible tokens (NFTs), and stablecoins. Division of Enforcement Director Gurbir S. Grewal added that the unit “will be at the forefront of protecting investors and ensuring fair and orderly markets in the face of these critical challenges.”

Formerly known as the Cyber Unit, the group began investigating crypto in 2017, around the time Bitcoin reached $10,000 per coin and several new cryptocurrencies launched Initial Coin Offerings (ICOs)3. At the time, the SEC warned investors that, due to the limited oversight, “ICOs could easily be scams or ponzi [sic] schemes disguised as legitimate investments.”4 In the past five years, the unit has brought more than 80 enforcement actions related to fraudulent and unregistered crypto asset offerings and platforms, leading the SEC to recover more than $2 billion for swindled investors.

The SEC’s enforcement expansion comes amid other proposed SEC initiatives to regulate the crypto markets and legislative activity in the U.S. Congress focusing on the best way to regulate issuers of stablecoins, which are cryptocurrencies pegged to a fiat currency like the U.S. dollar.5 The SEC’s regulatory initiatives to broaden investor protections in the crypto markets, announced on April 4, 2022 by Chair Gensler, included registering and regulating crypto exchanges, potentially separating out asset custody to minimize investor risk, and partnering with the Commodity Futures Trading Commission (CFTC) to address trading platforms for crypto-based security tokens and commodity tokens.6 The SEC’s proposed initiatives are in line with President Biden’s March 2022 Executive Order, which directed federal agencies to implement a strategy for policies and regulations on digital assets, including cryptocurrencies.7 Although Biden’s Executive Order was well received by crypto market experts —they described it as “extremely positive,” “long overdue,” and an “acknowledgment that cryptocurrency is here to stay” —it did nothing to quell the uncertainty as to which federal agency will serve as the primary regulatory of the crypto markets.8

Judging from its expansion of the Crypto Assets and Cyber Unit and proposed regulatory initiatives, the SEC views itself as the primary regulator of the crypto markets. But a bipartisan bill introduced on June 7, 2022 by U.S. Senators Cynthia Lummis (R-Wyoming) and Kirsten Gillibrand (D-New York) allocates primary oversight to the CFTC, reasoning that crypto products operate more like commodities than securities.9 Senators Lummis and Gillibrand’s bill has received a fair amount of criticism from investor protection and consumer advocacy groups, who say it indulges cryptoindustry-led efforts to marginalize the SEC.10 That criticism aside, U.S. Senators Debbie Stabenow (D-Michigan) and John Boozman (R-Arkansas) are in the process of drafting crypto legislation that also designates the CFTC as the primary regulator of the crypto markets.11

Congress will likely not act until after the midterm elections and there is no indication whether it will agree with Chair Gensler that the SEC already has the tools to properly and effectively police crypto markets. “We already have robust ways to protect investors trading on platforms. And we have robust ways to protect investors when entrepreneurs want to raise money from the public. We ought to apply these same protections in the crypto markets,” Chair Gensler said. “Let’s not risk undermining 90 years of securities laws and create some regulatory arbitrage or loopholes.”

On July 8, 2022, Federal Reserve Vice Chair Lael Brainard echoed Gensler’s comments while reflecting on the recent crypto turbulence and massive losses. “It is important that the foundations for sound regulation of the crypto financial system be established now before the crypto ecosystem becomes so large or interconnected that it might pose risks to the stability of the broader financial system,” she said.12

Securities Litigation 101

When it comes time to determine which plaintiffs will act as representatives for all class members, lawsuits brought under the U.S. federal securities laws are unlike any others. That’s because securities class actions are subject to the Private Securities Litigation Reform Act of 1995 (the PSLRA), a law that created a process to select the lead plaintiffs based on objective criteria including the size of their financial interest in the case.

Under the law, the lead plaintiff is a key player in a securities class action, acting as a fiduciary on behalf of the entire class and responsible for selecting lead counsel, signing off on litigation strategy and tactics, approving proposed settlements, and negotiating attorneys’ fees.

Prior to the PSLRA’s enactment in 1996, judges often assigned the role of lead plaintiff to the first party to file a securities lawsuit in their court or based on their knowledge of the law firm representing the plaintiff. This created a perceived “race to the courthouse,” in which specialized attorneys filed complaints soon after stock drops, sometimes relying on a stable of clients with small stock holdings in many publicly traded companies. These practices also raised criticisms that too many shareholder lawsuits were “lawyer driven,” since plaintiffs’ attorneys usually had far larger stakes in the outcome than the small investors who often brought the lawsuits.

To remove any advantage for early filers, the PSLRA1 directs judges to apply a rebuttable presumption to appoint the movant with the largest financial interest in the litigation, if the movant is also “typical” and “adequate” as defined in Rule 23 of the Federal Rules of Civil Procedure.2 When naming the lead plaintiff, the court also approves lead plaintiffs’ choice of lead counsel.

To help potentially harmed investors learn about new lawsuits and give them time to step forward, the law requires plaintiffs who filed the shareholder lawsuit to publish within 20 days a public notice containing certain information, including the claims asserted, the purported class period, the court where it was filed, the fact that any class member can serve as lead plaintiff, and the deadline for filing lead plaintiff motions. With the growth of the internet, these “PSLRA notices” have evolved from newspaper advertisements to online news releases beamed instantly around the world. Purported class members have 60 days from the first PSLRA notice to file a lead plaintiff motion with the court.

Though the PSLRA is mute on how to calculate financial interest, courts generally have looked at total class period purchases, net class period purchases, net class period expenditures, and most importantly losses, as calculated on a last-in-first-out (LIFO) or first-in-first-out (FIFO) basis. Since movants sometimes group together to file joint lead plaintiff petitions, the courts often consider whether to allow such a group to aggregate its losses in a single motion. The courts typically decide whether to permit such aggregations on a case-by-case basis. While the PSLRA does not provide any guidance about groups, the courts have considered factors such as the group’s size, whether group members knew each other before filing the motion, whether they have discussed how they plan to work together on the case, their experience as lead plaintiffs, and their choice of counsel.

When Congress enacted the PSLRA, it sought to empower institutional investors, reasoning that they would have larger losses—more “skin in the game”—and that their size, staffing, levels, and sophistication would give them better tools to fulfill their fiduciary duties to absent class members, including oversight of the attorneys. In that respect, the law certainly worked. Institutional investors, rarely involved in shareholder lawsuits prior to 1996, now are appointed lead plaintiffs in roughly half of all newly filed federal securities class actions; even in smaller cases where individual investors act as lead plaintiffs, the PSLRA’s lead plaintiff mechanism ensures an orderly, fact-based selection process. The increased involvement of institutional investors has in turn benefited all shareholders. Numerous academic studies have shown that shareholder class actions led by institutional investors are more likely to succeed than those led by individuals. Cases with institutional lead plaintiffs settle for more money and pay lower attorneys’ fees than other cases, even when controlling for the fact that institutions tend to file larger cases.

To help potentially harmed investors learn about new lawsuits and give them time to step forward, the law requires plaintiffs who filed the shareholder lawsuit to publish within 20 days a public notice containing certain information, including the claims asserted, the purported class period, the court where it was filed, the fact that any class member can serve as lead plaintiff, and the deadline for filing lead plaintiff motions. With the growth of the internet, these “PSLRA notices” have evolved from newspaper advertisements to online news releases beamed instantly around the world. Purported class members have 60 days from the first PSLRA notice to file a lead plaintiff motion with the court.

Though the PSLRA is mute on how to calculate financial interest, courts generally have looked at total class period purchases, net class period purchases, net class period expenditures, and most importantly losses, as calculated on a last-in-first-out (LIFO) or first-in-first-out (FIFO) basis. Since movants sometimes group together to file joint lead plaintiff petitions, the courts often consider whether to allow such a group to aggregate its losses in a single motion. The courts typically decide whether to permit such aggregations on a case-by-case basis. While the PSLRA does not provide any guidance about groups, the courts have considered factors such as the group’s size, whether group members knew each other before filing the motion, whether they have discussed how they plan to work together on the case, their experience as lead plaintiffs, and their choice of counsel.

When Congress enacted the PSLRA, it sought to empower institutional investors, reasoning that they would have larger losses—more “skin in the game”—and that their size, staffing, levels, and sophistication would give them better tools to fulfill their fiduciary duties to absent class members, including oversight of the attorneys. In that respect, the law certainly worked. Institutional investors, rarely involved in shareholder lawsuits prior to 1996, now are appointed lead plaintiffs in roughly half of all newly filed federal securities class actions; even in smaller cases where individual investors act as lead plaintiffs, the PSLRA’s lead plaintiff mechanism ensures an orderly, fact-based selection process. The increased involvement of institutional investors has in turn benefited all shareholders. Numerous academic studies have shown that shareholder class actions led by institutional investors are more likely to succeed than those led by individuals. Cases with institutional lead plaintiffs settle for more money and pay lower attorneys’ fees than other cases, even when controlling for the fact that institutions tend to file larger cases.

1. The PSLRA has provisions dealing with many aspects of securities litigation, notably creating an automatic stay of discovery designed to protect defendant companies from documentary “fishing expeditions” until a judge decides whether the case is properly pled; raising pleading standards to require plaintiffs to show a strong inference that defendants had knowingly acted wrongly; and providing defendants with a “safe harbor” against liability for forward-looking statements. We will leave those for a future installment of Securities Litigation 101.

2. Rule 23 requires that the lead plaintiff’s legal claims are typical of the class, broadly meaning that they arise from the same event and are based on the same legal theory, and that the movant is adequate, meaning its interests do not conflict with those of the class and it has enough experience and resources to vigorously represent the class and oversee counsel.

The Summer 2022 issue of the Shareholder Advocate includes:

Click here to download the Summer 2022 edition of the Shareholder Advocate (PDF).

Fiduciary Focus
Shareholder Advocate Summer 2022

I recently had the pleasure of moderating a session at the legal education conference of the National Association of Public Pension Attorneys (NAPPA) titled “The ABC’s of DE&I: Public Pension Plans Spell It Out”. The program was specifically designed to assist public pension attorneys in thinking about how to advise their clients regarding diversity, equity and inclusion (DE&I) consistent with the exercise of their fiduciary duties, including the exclusive benefit rule and the duties of loyalty and prudence.

In brief, as readers of this column know, fiduciaries must carry out their functions acting solely in the interest of the members and beneficiaries and for the exclusive purpose of providing benefits and defraying reasonable expenses incurred in performing such duties. They must act with the care, skill, prudence and diligence in light of the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.

The discussion began by noting that there certainly is no shortage of attention to issues of diversity, equity and inclusion these days. For example, lawyers may have noticed that the topic of DE&I recently graced the covers of both the New York State Bar Journal and the Washington Lawyer publication of the DC Bar Association. Similarly, investment professionals are likely aware that the CFA Institute recently issued a Diversity, Equity & Inclusion Code— a voluntary code developed with the recognition, as articulated by the CFA Institute, that a diversity of perspectives leads to better investor outcomes, that an inclusive investment industry better serves our diverse society, and that an organization with an inclusive culture and effective working relationships is a better place to work.

NAPPA conference attendees were very fortunate to have panelist Kellie Sauls, Director of Diversity, Equity, and Inclusion for the Teacher Retirement System of Texas, to help them think about how to address DE&I in their work advising fiduciaries. Ms. Sauls displayed a wealth of knowledge, gained through not only many years of experience in the DE&I field but also practical, concrete experience in advising a public pension plan. She presented important information and tips relevant for a range of pension plans, from those organizations with established programs to those just beginning to focus on DE&I. Here are some of my key takeaways from her presentation.

One Size Doesn’t Fit All

What diversity looks like in one area of the country is not necessarily the same as what diversity is in another part of the country. For example, certain groups that may be underrepresented in a large California city may not be the same as those underrepresented in a small Midwestern town. Likewise, people who are members of an underrepresented group in one industry— nursing, for example—may not be underrepresented in another industry, such as information technology. This requires clarity in understanding existing circumstances and developing approaches in strategic planning around DE&I.

Take this quote about diversity: “The inability to envision a certain kind of person doing a certain kind of thing because you’ve never seen someone who looks like him do it before is not just a vice. It’s a luxury. What begins as a failure of imagination ends as a market inefficiency; when you rule out an entire class of people from doing a job simply by their appearance, you are less likely to find the best person for the job.” While a reader might think this was a 2022 quote talking about racial or gender diversity, equity and inclusion, it actually comes from Moneyball, the 2003 book by business writer Michael Lewis and concerns Oakland Athletics executive Billy Beane’s recruitment of baseball players.

It’s About Risk Mitigation and Compliance

DE&I belongs in the risk management and legal compliance program. In a 2021 survey, over 50% of employers reported lack of DE&I as an enterprise risk.

For example, Ms. Sauls noted that, for many employers, the so-called “Great Resignation” resulted in female employees leaving in greater numbers than men. The business risk created when talented individuals are leaving the workforce in large numbers is something every employer must pay attention to. DE&I can mitigate risk by helping an employer recruit and retain talent critical to the effective operation of the organization. DE&I, as an integral part of onboarding, employee development, performance management, career development, and succession planning, supports an organization in acquiring and retaining talent, as well as avoiding equal opportunity challenges, thus mitigating business risk, reputational risk, and legal compliance risk.

Reiterate the Business Case

Recognizing that commitment to DE&I is consistent with the strategic objectives of the organization means that every DE&I program must emanate from leadership as part of the institutional plan. Support from the top means communication to, from, and among the board and that senior staff leadership must reiterate the business case each and every time DE&I is discussed. Identifying and communicating appropriate metrics and benchmarks are crucial to developing a culture of continuous improvement, and support from the top cannot be overstated.

Everyone Has a Role to Play

Experience shows that about 10% of employees may be characterized as overly enthusiastic or energetic, passionate, and zealous with regard to DE&I. Another 10% or so likely will not be on board and may even try to sabotage DE&I efforts. The remaining 80% or so of the workforce is the so-called “sweet spot” open to growth and learning. But it is critical to note that everyone in an organization plays a part in DE&I and it is important that people see themselves as participants. Input should and can be obtained from all. It is important to invite people with contrary viewpoints into the discussion; even (and perhaps especially) individuals who are not “on board” can provide valuable feedback. Challenges are to be expected and addressing them can assist in formulating the role of DE&I in organizational culture and how it factors into the organization’s core values.

It is important that employees see themselves as a part of the DE&I work, and one tool for consideration is the creation of affinity or employee resource groups. Some organizations have a wide range of such groups, such as Black and Latinx, LBGTQA, women in investment, caregivers, and military families. It was also noted that many affinity and resource groups include allies within the group’s membership—for example, a women in investment group may include men who support DE&I efforts in this area.

Practical Applications Appreciated

Attendees reported that the panel was a relatable conversation, with a discussion of trends in the area as well as risk mitigation and the interplay with legal and compliance systems and processes. They appreciated the discussion of practical applications, quickly attainable successes, expected challenges, and motivating imperatives for those engaged in DE&I work, and they left the program better able to advise their clients regarding DE&I and the exercise of fiduciary duties.

By Jan E. Messerschmidt

Last month, a group of three Cohen Milstein clients—the El Paso Firemen & Policemen’s Pension Fund, the San Antonio Fire & Police Pension Fund, and the Indiana Public Retirement System—filed an amended complaint as co-lead plaintiffs in a securities lawsuit against InnovAge and its officers and directors. InnovAge was among the five worst-performing initial public offerings in 2021.

The filing describes how InnovAge, a national healthcare company providing medical care to ailing seniors, focused on aggressive enrollment of patients for profit at the expense of the healthcare the company was obligated to provide. On average, during the period at issue, InnovAge received a fixed amount of $95,000 per year per enrolled patient, meaning that the fastest and simplest way to grow revenue was to increase enrollment. But unbeknownst to investors, InnovAge’s rapid enrollment growth resulted in severe staff shortages, high caseloads, significant delays, and lack of contracts from specialists, leading to systemic deficiencies and substandard care. Nevertheless, InnovAge focused its resources on hiring sales and marketing staff and ignored substandard home and clinical care for its participants.

In May of 2016, InnovAge became the first Program of All-Inclusive Care for the Elderly (PACE) organization to achieve for-profit status. PACE, a joint Medicare and Medicaid program, provides comprehensive, community-based medical and social services to frail and elderly people. For decades, PACE programs were operated almost exclusively by nonprofits. But InnovAge’s previous CEO, Maureen Hewitt, who served until January of this year, led the company’s aggressive lobbying campaign to transform InnovAge from a regional nonprofit to the first national for-profit PACE provider. To do so, Hewitt secured the partnership of Thomas Scully, the Administrator of the Centers for Medicare and Medicaid Services (CMS) under President George W. Bush and a general partner at the private equity firm Welsh, Carson, Anderson & Stowe (WCAS).

As Hewitt and InnovAge’s private equity leadership prioritized growth in enrollment, the goal was to advance InnovAge’s vision of rapid growth by providing healthcare to the burgeoning senior population in the United States, a massive market on which InnovAge was poised to capitalize. Shortly after WCAS invested in InnovAge’s for-profit conversion in 2016, Scully set a target of taking InnovAge public in as few as four years, citing the growth of the senior population and the market for PACE around the country. As Scully later put it: “I’m saying this lovingly: PACE is like community co-op grocery stores, I’m hoping someday it becomes Whole Foods.”

Over the next four years, the company’s prioritization of enrollment led to explosive growth in revenue, and by early 2020, WCAS and Scully began to implement their exit strategy by soliciting bids for a full or partial sale of InnovAge through either a strategic acquisition or an initial public offering. In July 2020, Apax Partners agreed to buy a stake in InnovAge from WCAS in a deal that valued the Company at $950 million. Under the deal, Apax and WCAS jointly controlled InnovAge, with each owning 49% stakes. The deal’s $950 million valuation of InnovAge represented a 480% increase from WCAS’s investment in the company just four years earlier.

On March 4, 2021, InnovAge launched its IPO, with the company boasting to investors that its meteoric growth was due to its provision of comprehensive care for vulnerable seniors, even though InnovAge was consistently failing to provide timely specialist care and adequate home health services. As a result, InnovAge’s market value rose to $3.2 billion on March 4 and to a high of $3.5 billion the following week, which was approximately 3.6 times its valuation by WCAS and Apax just months earlier.

In the months that followed, however, InnovAge’s systemic problems were slowly revealed. Last September, CMS notified the company that the government agency was suspending enrollment at InnovAge’s Sacramento, California center after an audit of the facility found that InnovAge “substantially failed” to “provide to its participants medically necessary items and services that are covered PACE services.” InnovAge also revealed last year that CMS and the state of Colorado had decided to suspend enrollment at InnovAge’s Colorado facilities, and the company is currently under investigation by the Colorado Attorney General. In just the first six months of 2022, CMS has suspended enrollment in existing centers or canceled agreements for new centers in Florida, Indiana, New Mexico and San Bernadino, California.

As a result of these revelations, InnovAge’s stock price plummeted to $4.71 by December 27, 2021, an 80% drop from its all-time high in March—just nine months earlier. The case is El Paso Firemen & Policemen’s Pension Fund, San Antonio Fire & Police Pension Fund, and Indiana Public Retirement System v. InnovAge Holding Corp., et al., No. 21-cv-02270 (D. Colo.).

The number of pet owners surged during COVID-19. Although the exact percentage differs among sources, the pet industry reported a three to four percent increase in the number of families who introduced furry family members in 2020 and 2021.

As product liability lawyers, we are always on the lookout for products that could bring harm to our families—toys with toxic lead paint, seatbelts that malfunction, medications that cause harm. But what about our furry family members? Are we equally as vigilant about the products that can cause them harm? A quick Google™ search reveals that the potential harm to our furry family members looms large.

The manufacture and sale of pet products is big business. In 2020, the pet industry recorded sales of $103.6 billion, an increase of $6.5 billion since 2019. Of that, $42 billion was spent on pet food & treats. While the Food & Drug Administration is responsible for regulating animal drugs, feeds/foods, and medical devices, it does not regulate animal grooming products, toys, and clothing, which are generally overseen by other governmental agencies that regulate consumer goods such as the Consumer Product Safety Commission and the Federal Trade Commission.

With 70 percent of U.S. households (90.5 million homes) reporting ownership of at least one pet supporting a $103.6 billion-dollar, quasi-regulated marketspace, the potential for product liability claims should not be overlooked.

If you’re married and enrolled in a pension plan with Intel, your plan’s Survivor Annuity may have been miscalculated in violation of the Employment Retirement Income Security Act (ERISA). Learn more about the Intel case.

If you are a married person who receives a monthly pension check from a private company, you should be on alert that the company might be shortchanging you by paying you less than the actuarial equivalent value of your pension.  A federal law, ERISA, contains many protections for the pensions of retirees including actuarial equivalence requirements, anti-forfeiture rules, and joint and survivor annuity requirements.

For example, you are legally entitled to receive the same economic value (“actuarial equivalence,” as discussed below) for your spousal pension as for if you took your pension as a single life annuity (also discussed below). In other words, ERISA requires that the pensions paid to married retirees are worth the same overall as the pensions paid to single retirees.

Several lawsuits have been filed claiming that companies are failing to pay their married retirees actuarially equivalent pensions—and specifically that they are systematically underpaying married retirees (and their surviving spouses). In cases against IBM, CITGO and AT&T (filed by our law firm), the retirees allege that their plan used outdated mortality tables to calculate their spousal pensions, which resulted in an unlawful “marriage penalty.”

Here’s what you need to know:

What Is the Survivor Annuity?

If you are a married retiree, you will receive pension benefits in the form of a joint and survivor annuity—a benefit that pays monthly pension payments for your life and for the life of your surviving spouse (unless you and your spouse opt out).

Generally, a retiree’s pension benefit is expressed as a “single life annuity,” meaning it pays a monthly benefit just to the retiree for his or her entire life.

For married retirees, however, the default pension is a joint and survivor annuity, which is a spousal annuity that provides the retiree with monthly pension payments for her/his own life, and then, pays a percentage of that monthly pension to the surviving spouse for his/her life. This joint and survivor annuity is expressed as a percentage of the retiree’s monthly payment that will be paid to the surviving spouse (i.e., 50%, 75%, or 100% of the retiree’s monthly pension).

How Is the Survivor Annuity Calculated?

To calculate the amount of a joint and survivor annuity, the plan starts with the amount of the retiree’s single life annuity, and then uses actuarial assumptions to convert it to a joint and survivor annuity. When the plan makes that conversion, ERISA requires the amount of joint and survivor annuity is “actuarial equivalent” to the amount of the single life annuity. Actuarial equivalence is a computation designed to ensure that, all else being equal, all forms of benefit payments have the same economic value.

Generally, an actuarial equivalence computation considers both an interest rate and the expected longevity of the retirees and their spouse. The interest rate reflects the time value of money, while the mortality table reflects the expected likelihood of each payment being paid to the retiree or surviving spouse based the statistical life expectancy of a person at a given age.

When plans make these actuarial conversions, ERISA provides several protections to ensure that married retirees get the same economic value from their pensions as single retirees. For example:

  1. ERISA requires that every joint and survivor annuity is “the actuarial equivalent of a single annuity for the life of the participant.”
  2. ERISA requires that, if an employee’s accrued benefit “is to be determined as an amount other than an annual benefit commencing at normal retirement age [of 65] . . . the employee’s accrued benefit . . . shall be the actuarial equivalent of such benefit[.]”
  3. ERISA provides that an employee’s right to their vested pension payments is non-forfeitable and states that paying retirees less than the actuarial equivalent value of their accrued pension results in an illegal forfeiture of their vested pensions.

Echoing the statute’s actuarial equivalence requirements, Treasury regulations make clear that actuarial “[e]quivalence may be determined] on the basis of consistently applied reasonable actuarial factors.”[i]

Why Does This Matter?

Some pension plans may violate some or all these rules by using outdated mortality and interest rate assumptions when converting a retiree’s single life annuity to a joint and survivor annuity. Using up-to-date mortality assumptions is vital to ensuring actuarial equivalence of benefits, as the average life expectancy in the U.S. has increased significantly in the last forty years. Outdated assumptions result in underestimated lifespans. Importantly, this can result in underestimated monthly pension payments for married retirees and their spouses who choose a joint and survivor annuity—in other words, a marriage penalty.

How Can I Tell If My Pension Is Affected by A Marriage Penalty?

Whether you’re already retired, considering retirement, or even just enrolled in your company’s pension plan, knowing your rights is a vital first step. Take the time to leaf through your pension resources, particularly the “Summary Plan Document,” which outlines the way your pension plan works and which you are entitled to by law. Ask yourself questions like:

  • What types of benefit options (lump sum, single life annuity, joint and survivor annuity) are available to me?
  • Does the plan state that the benefits are actuarially equivalent?
  • Which mortality table does the plan use to calculate benefits?

At the end of the day, you may want an understanding about the value of the pension that you worked years to earn. ERISA protects an employee’s right to get the full value of their vested pensions. Those rights are non-forfeitable. If a company pays a retiree less than the actuarial equivalent value of their pension, the company may be causing an illegal forfeiture of a person’s hard-earned retirement income.

Get More Information.

For further information, consider these resources:

The content above is for informational purposes only and should not be read or interpreted as legal advice. Please reach out to a lawyer for legal advice.

[i]   26 C.F.R.§ 1.401(a)-11(b)(2).

About The Authors:

Michelle Yau, chair of Cohen Milstein’s Employee Benefits/ERISA practice, has spearheaded some of the most significant ERISA class actions in the nation. In 2022, Chambers USA named her a “Top Ranked” individual in ERISA Litigation and in 2021, she was named a Law360 Benefits MVP.  Ms. Yau combines ardent dedication to protecting her clients’ retirement assets with rare insight into complex financial transactions and actuarial issues, informed by her Wall Street and government experience. Ms. Yau can be contacted at: 202 408 4600 / myau@cohenmilstein.com.

Contact us to learn how you may be affected by this lawsuit.

IBM retiree Joshua Knight has filed a proposed class action involving the IBM Personal Pension Plan, Bloomberg Law reports. The lawsuit, filed in the U.S. District Court for the Southern District of New York, challenges how IBM calculates retirement benefits for some workers who choose pensions that continue making payments to their surviving spouses after their deaths.

Read more about the lawsuit at Bloomberg Law.