On June 25, 2014, the Supreme Court, in a unanimous decision, ruled in Fifth Third Bancorp v. Dudenhoeffer that there is no “presumption” of prudence extended to fiduciaries of employer stock ownership plans (“ESOPs”) in their decisions to buy or sell employer stock. Instead, the Court found that ESOP fiduciaries are subject to the same duty of prudence as described in § 1104(a)(1)(B) of the Employee Retirement Income Security Act of 1974 (“ERISA”) (ERISA § 404(a)(1)(B), except that certain individual account plans (including, but not limited to, ESOPs) are exempt from the requirement to diversify plan holdings. This alert discusses the Court’s rationale and provides a look at what the ruling means for both public and private company ESOPs going forward.
Although there was significant variation among the specific standards adopted by circuit courts, they had generally provided that a fiduciary’s duty to sell participants’ employer stock holdings would only arise where the viability of the company was in question. As a result, many lawsuits were dismissed in the pleadings stage when the complaint alleged that plan fiduciaries should have divested employer stock based on an actual or foreseeable drop in the value of the stock. In the absence of fraud or malfeasance, plaintiffs would often need to show more than a large decline in stock price. In Dudenhoeffer, the Court found no such implied presumption of prudence in ERISA, and instead will generally apply the same duties to fiduciaries responsible for monitoring employer stock as applies to all fiduciaries under ERISA. The Court suggested, however, that a drop in a company’s stock price would not in in itself be sufficient to plead a breach of fiduciary duty, but rather, to separate the “plausible sheep from meritless goats,” courts would be required to perform a “careful, context sensitive scrutiny of a complaint’s allegations.”
The Plaintiffs’ bar are no doubt evaluating new legal theories to raise against plan fiduciaries. The most difficult claims to defend against will be those alleging that the plan fiduciaries knew that the employer’s stock was artificially inflated, but did nothing to prevent the plan from purchasing new shares – the facts found in cases such as Enron and WorldCom. On the other hand, plan fiduciaries will be able to at least argue for an early dismissal of claims based upon allegations of imprudence that are inherent in any undiversified stock fund – for example, claims that the stock fund was overly volatile, or that the fund was excessively risky. Such claims are at least arguably barred by ERISA’s diversification exemption, as they recite risks that are inherent in any undiversified stock fund. That said, however, Dudenhoeffer represents a major change in the law, and courts will have little guidance in determining exactly when and why an employer stock fund becomes imprudent.
How lower courts interpret and apply Dudenhoeffer remains, of course to be seen, but Dudenhoeffer provides a fresh opportunity for companies to re-visit their investment policies and procedures as they relate to the employer stock fund. In any given investment policy statement, it is not uncommon to see a set of benchmarks and review procedures applicable to the core investment funds, but the employer stock fund is too often set apart and excluded from this review process altogether – based on the notion that the employer stock fund serves a special non-pecuniary purpose to promote employee ownership and thus is held to a wholly different standard. In practice, many investment committees meet at least quarterly to review the performance of the core set of investment funds, but the employer stock fund may be not be reviewed, or if it is, under the “viability” standard. Even for plans that use independent fiduciaries to monitor the employer stock fund, the independent fiduciary invariably operates under some sort of viability standard, and often the engagement letter reflects that standard. All of that needs to be re-evaluated now.
The Court offered some guidance for plan fiduciaries:
For publicly traded stock, a claim will fail if it merely alleges a fiduciary should have recognized, based on publicly available information, that the stock market was under- or overvaluing the share price. In other words, a fiduciary is not imprudent by relying on the market price for the stock.
In order to properly state a claim for breach of the duty of prudence, a plaintiff must allege an alternative action that could have been taken that would have both 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.
When considering the actions of a fiduciary with respect to inside information, (i) the complaint cannot allege that the fiduciary’s actions were improper if such action would have been a violation of the insider trading laws, (ii) if the complaint alleges that the fiduciary, based on inside information, should have refrained from stock purchases or disclosed the information to the public so that the stock would no longer be overvalued, the courts must decide how such an ERISA-based obligation would conflict with the insider trading rules, and (iii) courts must decide that a prudent fiduciary could not have concluded that ceasing stock purchases (which the market may take as a negative signal for the stock’s value) or publicly disclosing negative insider information would do more harm than good to the value of the stock held in the plan.
Dudenhoeffer also presents an excellent opportunity for companies to review (with assistance from legal counsel) their ERISA fiduciary insurance policies to make sure they are sufficient. Some D&O policies will exclude ESOPs or pension plans or not cover certain fiduciaries. Companies should make sure all plan fiduciaries, plans and potential claims are covered. Companies should also check whether the cost of defending a lawsuit is included in the policy or whether the insurer is obligated to defend the company, and whether the insurer has the right to choose the counsel. Finally, the policy’s deductible should be reviewed to make sure the company receives meaningful protection.
Special Considerations for Private Companies
Arguably, the so-called presumption of prudence may prove to be not as relevant for private companies because the presumption usually arises in cases involving the fiduciary’s decision (or lack thereof) to sell the stock. Earlier this year, the National Center for Employee Ownership (NCEO) noted that since 1995, they found “24 lawsuits involving ESOPs that reached court where the presumption of prudence rule was involved and more than 100 cases involving 401(k) plans. Notably, not one of the cases involved a closely held company.” The NCEO noted, and we agree, that the result is not all that surprising because there is no market for private company stock, and therefore the plan fiduciary has no practical way to sell the stock. As a result, cases involving private companies tend to revolve around the price paid for the stock, and other issues involving conflicts of interest, corporate waste and other malfeasance that diminish shareholder value - none of which involves the presumption of prudence. That being said, Dudenhoeffer is still very relevant to private companies insofar as it clearly eviscerates the legal argument that ESOPs and other retirement plans that hold employer stock have “special” purposes – seemingly affecting any decision to buy, hold or sell employer stock.
The Court's decision, No. 12-751, 2014 WL 2864481, is available here.