In Fifth Third Bancorp v. Dudenhoeffer, the U.S. Supreme Court unanimously held that there is no presumption of prudence for fiduciaries of an employee stock ownership plan (ESOP) who invest in employer securities. The case alters what was believed to be a well-established rule for ESOP fiduciaries. Depending on how courts interpret and apply Dudenhoeffer and without a presumption of prudence, it will almost certainly be more difficult for ESOP fiduciaries to prevail against claims that an investment in employer securities was imprudent.
Dudenhoeffer eliminates the so-called “Moench presumption” that for years has been the law regarding the investment of plan assets in employer stock. In Moench v. Robertson, the Third Circuit determined that the decision of ESOP fiduciaries to invest plan assets in employer stock was entitled to a presumption that the fiduciaries had acted consistently with the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). The Third Circuit reasoned that, when a fiduciary is instructed by the terms of a written plan document to invest in employer securities, the fiduciary’s decision to do so should be entitled to a presumption of prudence and reviewed using the deferential abuse of discretion standard. The Moench presumption was widely adopted in varying forms among the federal courts of appeals.
The plan sponsor in Dudenhoeffer, Fifth Third Bancorp (Fifth Third), maintains a defined contribution plan that permits participant-directed investments in a number of funds, including an ESOP fund invested primarily in Fifth Third stock. Fifth Third’s plan required that matching contributions were always initially invested in the ESOP fund. After the price of Fifth Third stock fell by 74%, the plaintiffs in Dudenhoeffer sued Fifth Third claiming that the fiduciaries violated the ERISA duties of loyalty and prudence by purchasing and maintaining investments in Fifth Third stock that was overvalued and excessively risky based on both public and nonpublic information. Both the District Court for the Southern District of Ohio and the Court of Appeals for the Sixth Circuit applied the Moench presumption in reviewing the plan fiduciaries’ actions, although at differing procedural stages of litigation.
Duty of Prudence
In reviewing the case, the Supreme Court limited its review to the duty of prudence. It held that ESOP fiduciaries are not entitled to any special presumption of prudence. Rather, they are subject to the same duty of prudence that applies to ERISA fiduciaries in general, except that they need not diversify the ESOP assets. The Court noted that the duty of prudence trumps the terms of a plan document, such as the instruction to invest in employer stock that is present in all ESOPs, which must state that they are designed to invest primarily in employer securities. Even though the Court removed the presumption of prudence, it provided some guidance on what a plaintiff must to do establish a claim. To state a claim for breach of the duty of prudence, a complaint must plausibly allege an alternative and legal action that the defendant could have taken and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.
Where stock is publicly traded, allegations that a fiduciary should have recognized on the basis of publicly available information that the market was overvaluing or undervaluing the stock are generally implausible and thus insufficient to state a claim. With respect to allegations on the basis of inside information, the Court clearly stated that a fiduciary cannot be found to have been imprudent for failing to buy or sell stock in violation of insider trading laws. Rather, a plaintiff must plausibly allege an alternative action that the defendant could have taken, that would have been consistent with securities laws, and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it. Finally, the Court stated that lower courts should consider whether a plaintiff has plausibly alleged that a prudent fiduciary in the defendant’s position could not have concluded that stopping purchases might signal to the market that the fiduciary viewed the stock as a bad investment or that publicly disclosing negative, nonpublic information might cause a drop in the value of the stock already held by the fund.
Effect on ESOPs and Fiduciaries
While Dudenhoeffer eliminates the long-standing deferential standard previously afforded to ESOP fiduciaries, it does impose a fairly stringent pleading requirement. The full effect of the decision is not yet clear, particularly with respect to the investment in and holding of non-publicly traded employer securities. With the elimination of the Moench presumption, all ESOP fiduciaries now have less protection against claims of fiduciary breach than before; however, the fiduciaries of ESOPs with non-publicly traded stock may be especially exposed to claims that the continued holding of the stock in the ESOP is imprudent because such fiduciaries cannot rely on public exchanges to determine fair market value. As a result, there may be increased scrutiny of such plans. In recognition of this ruling, all ESOP fiduciaries should carefully document their procedural prudence in periodically reviewing plan investments in employer stock and decisions to make or retain such investments, including establishing or updating policies and procedures by which fiduciaries perform such reviews, perhaps in more detail and at more regular intervals that previously done. Such additional work will almost undoubtedly translate into additional expenses for the sponsors of ESOPs.