What you need to know:
In Fifth Third Bancorp v. Dudenhoeffer, et al., decided earlier this month, the Supreme Court seemingly handed a victory to the plaintiff’s bar, striking down a presumption of prudence that ERISA ESOP fiduciaries have come to rely upon to help them defeat claims that they had breached their fiduciary duties by investing in or holding company stock when bad things were happening to the company. But the Court may simply have replaced one nearly insurmountable pleading bar for plaintiffs with another. The Court also affirmed that ERISA’s duty of prudence cannot require a fiduciary to violate other laws, such as by selling company stock on the basis of inside information.
What you need to do:
For ESOP fiduciaries, the decision means that ESOP investments in company stock are subject to the same fiduciary standards as any other investment, except the duty to diversify assets. While the lower courts clarify the issues left open by the decision in Fifth Third, ESOP fiduciaries should consider reviewing existing procedures for monitoring company stock investments; engaging an independent fiduciary to make decisions on buying, holding and selling company stock; and reviewing ERISA fiduciary insurance and D&O policies to determine coverage for claims relating to company stock. Private company ESOPs should consider starting a dialog with their independent appraiser about the prudence of their valuation methods.
For nearly 20 years, beginning with Moench v. Robertson, courts have held that ESOP fiduciaries’ actions with respect to holdings of company stock in ESOPs, 401(k) plans or other profit-sharing plans are presumptively reasonable – and will not provide the basis for a breach of fiduciary duty claim under Section 404 of ERISA so long as the company is not in a “dire situation” and there is no indication that the company’s “viability as a going concern” is threatened. Under this long line of cases, including In re Citigroup ERISA Litig., Kirschbaum v. Reliant Energy Inc. and Quan v. Computer Scis. Corp., ERISA fiduciaries are not liable for investing ESOP funds in company stock unless they abused their discretion, a level of deference that has helped protect fiduciaries from frivolous lawsuits every time company stock prices dip by offering a way to defeat such claims – often at the pleadings stage. The Sixth Circuit, on the other hand, had held in Pfeil v. State Street Bank and Trust Co. that a presumption of prudence applies only at summary judgment. That conflict among the Circuits eventually found its way to the Supreme Court.
Despite the prevalence of the presumption, in Fifth Third, the Supreme Court quickly disposed of the arguments made in its favor by the defendants. First, the Court held that even though ESOPs have a “special purpose” endorsed by Congress – encouraging the investment of participants’ savings in the stock of their employer – this does not call for a presumption at any stage of litigation that such investments are prudent. While Congress plainly granted a variety of advantages to ESOPs, including tax incentives and exemption from ERISA’s diversification requirement, the Court did not find evidence that Congress sought to promote ESOPs by relaxing the applicable duty of prudence.
Second, the Court did not accept the argument that the duty of prudence “should be read in light of the rule under the common law of trusts that the settlor can reduce or waive the prudent man standard of care by specific language in the trust instrument.” Supporters of the presumption argued that by commanding an ESOP fiduciary to invest primarily in employer stock (as ERISA and the tax code require for ESOPs) the plan documents waived the duty of prudence to the extent that it conflicts with investment in such stock. The Court viewed this question as controlled by its previous holding that trust documents cannot excuse trustees from their duties under ERISA.
Third, the Court found that even though ERISA fiduciaries may be caught in a conflict between the duty of prudence and prohibitions on insider trading, this, too, was not enough to merit the presumption – even though it is a “legitimate” concern. The Court noted that any fiduciary – ESOP or otherwise – could find itself in possession of material non-public information that would trigger a “disclose or abstain” choice under the federal securities laws and, thus, no special exception should be created for ESOPs.
Finally, the public policy argument that the presumption helps prevent costly and meritless lawsuits and that without it, companies will be less likely to offer ESOPs, was unavailing in the eyes of the Court. Here, the Court noted that “careful, context-sensitive” scrutiny of allegations in the motion to dismiss setting is the appropriate response – not a presumption that “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.”
The Court then discussed how, in light of its decision, motions to dismiss ESOP breach of fiduciary duty claims ought to be evaluated in certain recurring fact-patterns. Of some help to fiduciaries, the Court noted that “where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances” that would make reliance on the market price imprudent. The Court did not elaborate on what might qualify as “special circumstances.”
Then, in the section of the decision that may come to vex the plaintiff’s bar, the Court wrote that to state a claim where the basis for the alleged breach of fiduciary duty is non-public information, “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 fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.” Plaintiffs may find this requirement hard to satisfy because the securities laws will generally prevent ESOP fiduciaries from selling without disclosing the inside information. And, disclosing runs the risk of causing a sell-off in company stock that drives down the price to the detriment of plan participants who hold shares. So, too, would a decision to simply stop making additional purchases, “which the market might take as a sign that insider fiduciaries viewed the employer’s stock as a bad investment.” Since selling would be unlawful in most cases and both disclosing and discontinuing purchases are both potentially harmful, it is not clear what “alternative action” plaintiffs will be able to allege ESOP fiduciaries ought to have taken.
For ESOP fiduciaries, the question now is what additional steps should be taken to further protect themselves from costly stock-drop litigation while the lower courts clarify the open issues discussed above. Certainly, such steps are available and include reviewing existing procedures for monitoring company stock investments; engaging an independent fiduciary to make decisions on buying, holding and selling company stock; and reviewing ERISA fiduciary insurance and D&O policies to determine coverage for claims relating to company stock. Private company ESOPs should consider starting a dialog with their independent appraiser about the prudence of their valuation methods.