ESOPs’ Fables: On Winning Wars but Losing Battles

by Cozen O'Connor
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As the end of the Supreme Court term approached, decisions came down fast and furious. Last week’s big decisions, at least around our nerdish water cooler, were Halliburton and Fifth Third Bancorp v. Dudenhoeffer. (Yes, we know that there were major rulings on Obamacare, public unions, buffer zones, digital copyright, recess appointments and the groundbreaking cell phone warrant case that my twelve-year old daughter tried to cite until I either astounded or bored her with an explanation of state action and, just in case, issued a warrant for my wife to review the poor girl’s Pinterest account).

Fifth Third is one of those decisions that starts off really poorly (or really well, depending on which side of the “v” you happen to be on), gets worse (or better) for a while, and then suddenly turns about to be pretty good (or pretty bad). That’s probably about the way that James Madison felt when reading Marbury v. Madison.

Fifth Third involves ESOPs (Employee Stock Ownership Plans), creatures of ERISA. ESOPs are tax-deferred retirement plans that are managed by fiduciaries who have all of the same duties as ERISA fiduciaries, save one: they do not have the duty to diversify their portfolios. And that makes sense because the whole purpose of an ESOP is to invest primarily in the company’s own stock.

Of course, bad things happen occasionally, stock prices fall, and employees who were heavily invested in their companies’ ESOPs lose a lot of money. Class actions follow, typically alleging that the plan fiduciaries breached their duties of prudence by not selling the company stock, continuing to buy the company stock, or not disclosing material non-public information to “correct” the company’s stock price. Over the years, in many of the Circuits, a presumption arose that ESOP fiduciaries’ decisions to buy or hold company stock were prudent. This presumption became known as the “presumption of prudence,” which may or may not also be the title of an Agatha Christie mystery. The presumption, in most of the Circuits, could be rebutted only by a showing that the fiduciary acted while the company was in dire financial condition, bordering on collapse.

Without getting too deeply into the weeds, as a result of the subprime mortgage meltdown, many Fifth Third employees who had invested in the company’s ESOP lost a significant amount of their retirement income when the price of Fifth Third shares declined precipitously. In the complaint, some of those employees on behalf of a purported class alleged that by July 2007, the fiduciaries “knew or should have known that Fifth Third’s stock was overvalued” for two reasons: (1) there was publicly available information with early signs that the subprime lending market was going to blow up; and (2) the fiduciaries had access to nonpublic information (given that they were insiders) indicating that Fifth Third had deceived the market through misrepresentations about the company’s financial prospects. They alleged that a prudent fiduciary would either have sold the company stock; stopped buying more; cancelled the ESOP altogether; or disclosed the material nonpublic information that would correct the market.

The District Court dismissed the claim, citing the presumption of prudence, but the Sixth Circuit reversed, holding that, while the presumption exists, it is an evidentiary presumption that cannot be relied upon at the pleading stage. The Circuit found the allegations to be sufficient to state a claim.

It turns out that everyone was wrong about everything. Dear Prudence.

With one fell swoop, the Court obliterated the “presumption of prudence,” finding that “the law does not create a special presumption favoring ESOP fiduciaries.” (We note that a similar sentence could have also have been drafted in the Halliburton decision—the last time we checked we did not see a “presumption or reliance” anywhere in the ’34 Act.) The result in Fifth Third must have been fairly surprising to the litigants since, prior to oral argument, the case was really about how and when the presumption should be applied—not whether it existed at all.

The result is a big win for the Respondents and a huge loss for the ESOP fiduciaries. But—and to quote Pee Wee Herman, “everyone I know has a big ‘but’—let’s talk about [the Supreme Court’s] big ‘but’”: while both the district court and the Circuit were wrong about the presumption of prudence, the Circuit, according to the Supreme Court, was probably also wrong that the allegations in the complaint were sufficient to withstand a motion to dismiss.

The Court noted that there are other protections for ESOP fiduciaries, namely the new rigors of federal pleading. The Court held that a plaintiff’s allegation that a plan fiduciary should have known that a company’s stock was overvalued because of publicly available information (absent some “special circumstances” not alleged in Fifth Third) fails as a matter of law under TwIqbal. Second, the Court made clear that a plan fiduciary is under no obligation to break the insider trading laws and act based on material nonpublic information—though the Court left open whether a fiduciary could refrain from purchasing additional company stock consistent with the securities laws. Lastly, the Court noted that courts must consider, under TwIqbal , whether allegations that a fiduciary should have acted or refrained from acting in a particular way are actually plausible. A plaintiff must plausibly allege that there was a more prudent course of action that did not involve running afoul of the securities laws and did do more harm than good.

Perhaps the only scenario that would give rise to such “plausible” pleadings is the scenario where a company is on the brink of financial collapse. In other words, it’s possible that not much has actually changed, except that the battle will assuredly be fought at the pleading stage. We will certainly watch and see as “special circumstances” and the tension between the securities laws and an ESOP’s fiduciary duty of prudence get fleshed out over the years.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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