On June 25, 2014, the U.S. Supreme Court unanimously rejected the "presumption of prudence" that had been applied by lower courts in cases where a retirement plan holds stock of the employer sponsoring the plan. Fifth Third Bancorp et al. v. Dudenhoeffer et al., No. 12-751. The presumption of prudence (often called the "Moench presumption" because it was first adopted in the case of Moench v. Robertson) states that when a plan is designed to invest in employer stock, a plan fiduciary is entitled to a presumption that continuing to buy or hold employer stock is prudent, and a plaintiff can overcome that presumption only by showing that the company was in such dire circumstances that no prudent fiduciary would continue to hold the stock.
Circuit courts had uniformly adopted the presumption. — Prior to the Supreme Court's decision, every circuit court to consider the issue had adopted some form of the presumption. The primary rationale was that Congress has encouraged employers to establish retirement plans which give employees an ownership stake in the company, and that goal would be frustrated if the plan's investment in employer stock were treated the same as an investment in the stock of any other company. The Supreme Court has now held that all of the circuit courts got it wrong.
The Court's decision. — In Dudenhoeffer, the Court held that a fiduciary of an employee stock ownership plan (ESOP) is subject to the same duty of prudence as any other ERISA fiduciary (except the duty to diversify fund assets). The Court acknowledged that this puts an ESOP fiduciary "between a rock and hard place," but rejected the presumption of prudence as too protective of ESOP fiduciaries — the presumption "makes it impossible for a plaintiff to state a duty-of-prudence claim, no matter how meritorious, unless the employer is in very bad economic circumstances." In the Court's words, the presumption "does not readily divide the plausible sheep from the meritless goats."
Having eliminated an ESOP fiduciary's primary shield against stock-drop claims, the Court offered a substitute shield in the form of guidance that courts should use when considering a motion to dismiss brought by the fiduciary of an ESOP that holds publicly-traded stock (and that the Sixth Circuit should use when considering this case on remand).
Guidance on Separating "Plausible Sheep From the Meritless Goats"
Claims based on public information are goats absent "special circumstances." — The Court states that if the plaintiff's claim is that the fiduciary should have taken action based on publicly-available information, that claim is implausible on its face and a motion to dismiss should generally be granted. "In our view, where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was over or under valuing the stock are implausible as a general rule, at least in the absence of special circumstances."
Therefore, in order to state a plausible claim based on publicly-available information, the plaintiff will need to plead special circumstances that take the case out of the general rule. The Court reiterates that motions to dismiss are to be decided in accordance with the Court's prior decisions in Iqbal and Twombly, which means that plaintiffs will have to plead specific facts showing these special circumstances, as opposed to just general or conclusory allegations. It remains to be seen what special circumstances plaintiffs will attempt to plead, and how the lower courts will respond.
With respect to nonpublic information, a "duty to sell" claim is a goat. — In employer stock cases, the defendant fiduciaries often include officers or other high-level employees of the company sponsoring the plan, and those employees often have nonpublic information about the company that could potentially affect the value of the employer stock held by the plan.
The Court makes clear that if the plaintiffs are alleging that the fiduciaries should have caused the plan to sell the employer stock based on this inside information, that claim should be dismissed. Trading on inside information is a violation of the securities laws, and there is no fiduciary duty to break the law. That statement should prove helpful to fiduciaries, as the duty to sell claim typically involves the largest number of shares (and thus the largest damage exposure).
Other claims based on nonpublic information may be sheep and may be goats, and it will be up to the lower courts to sort them out. — The Court notes that plaintiffs in employer stock cases often make two additional arguments relating to the insider fiduciaries' possession of nonpublic information. They allege that the insider fiduciaries (1) should have caused the plan to stop any additional purchases of employer stock, and (2) should have disclosed the inside information to the market, so that price of employer stock would drop to its "true" value and the ESOP would no longer be overpaying for new shares.
According to the Court, the overarching principle in evaluating these claims is that "a plaintiff must plausibly allege an alternative action that the defendant could have taken that would have been consistent with the 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."
With respect to the decision to abstain from future purchases, the Court first wonders whether abstention would be consistent with the securities laws. "The U. S. Securities and Exchange Commission has not advised us of its views on these matters, and we believe those views may well be relevant." In any event, the Court notes that abstention from future purchases could on balance "do more harm than good," as "the market might take [that] as a sign the insider fiduciaries viewed the employer's stock as a bad investment," which would "cause a drop in the stock price and a concomitant drop in the value of the stock already held by the fund." Thus the purported benefit of abstention might be outweighed by the harm to those participants who already hold employer stock.
With respect to the decision to disclose the insider information to the market (so that price of employer stock will drop to its "true" value and the ESOP will no longer be overpaying for shares), the Court expressed similar concerns. The federal securities laws already impose detailed requirements concerning the disclosure of information relating to the corporation, and the Court suggests that ERISA's fiduciary duties should not be read in a way that is inconsistent with the letter "or the objectives of those laws." The Court also reiterates that on balance disclosure might do more harm than good, as it will by definition cause a decline in the value of the shares currently held by participants.
Ramifications of Dudenhoeffer
Dudenhoeffer is a mixed bag for the fiduciaries and sponsors of plans that hold employer stock.
The elimination of the presumption of prudence is not a welcome development. That presumption provided a bright-line rule that was very protective of fiduciaries, and most courts had applied the presumption at the motion to dismiss stage, which meant that cases could be dismissed before the defendants incurred the significant expense and disruption that comes with discovery in class action litigation.
The Court's substitution of a "careful, context-sensitive scrutiny of a complaint's allegations" seems, just from the sound of it, far too mushy to provide adequate substitute protection. But the Court works hard to put some teeth into that standard and, importantly, the Court has characterized several commonly-asserted stock-drop claims as "meritless goats." The Court also makes clear that the lower courts are to carefully evaluate a stock-drop plaintiff's claims on a motion to dismiss.
It remains to be seen how the lower courts will apply Dudenhoeffer, and whether it will end up being a substantial change in the fiduciary landscape or just a different way of getting to essentially the same result.
Although Dudenhoeffer involved a 401(k) plan that offered an employer stock fund as an investment option, and that employer stock fund was set up to be an ESOP as defined in ERISA, the rationale would appear to apply more broadly to any eligible individual account plan that holds employer stock.
One final point deserves mention. The substitute protections suggested by the Supreme Court are tailored to plans that hold the stock of publicly-traded companies. Many companies that are not publicly traded have established ESOPs, and Dudenhoeffer offers little guidance in that context.