The U.S. Supreme Court handed down its first decision addressing ERISA claims involving the holding of employer stock in a defined contribution retirement plan. Plaintiffs regularly allege that fiduciaries breached their duty of prudence by continuing to invest the assets of such a plan in employer stock during the period when the stock price drops in value. Until yesterday, every court of appeals that addressed the question had applied a presumption that investing in employer stock as the plan documents mandate is not imprudent.
The Supreme Court’s decision in Fifth Third Bancorp v. Dudenhoeffer overturned that “presumption of prudence.” But the Court also made clear that the lower courts must still critically review complaints challenging the continued holding of company stock pursuant to a plan mandate: not only do the generally applicable pleading standards apply to such ERISA claims, but courts should also (i) dismiss – absent special circumstances – claims that it is imprudent to purchase stock at the public market price based on publicly available information and (ii) require plaintiffs alleging that nonpublic information caused the investment to be imprudent to plead how the fiduciary could have acted consistent with the securities laws and the risk that a halt to trading would depress the stock price and harm participants.
The lower federal courts will now need to determine how this guidance applies to future cases challenging the continued holding of employer stock when plan documents require such holding.
The Evolution of the “Presumption of Prudence”
In the last 20 years – since the passage of the Private Securities Litigation Reform Act (“PSLRA”) – the plaintiffs’ bar has filed hundreds of ERISA “stock-drop” cases in lieu of, or in addition to, securities class actions when employer stock held in employee stock ownership plans (“ESOPs”) or other defined contribution retirement plans, like 401(k) plans, experienced a loss in value. Some in the plaintiffs’ bar viewed these claims as a means of circumventing the PSLRA’s heightened pleading requirements. But over the past 20 years, every circuit court to address the question adopted a “presumption of prudence” for such cases – meaning that a fiduciary’s decision to allow continued investment in employer stock when required by plan documents has been presumed prudent. The circuits varied on what showing would be required to overcome that presumption, with many holding that in order to survive dismissal a complaint needed to plead that a company was on the brink of collapse or that there were other “dire circumstances” not foreseen by the employer sponsoring the plan.
Dudenhoeffer was one of these “stock-drop” suits. It was brought as a putative class action by participants in a financial services company’s ERISA-governed retirement plan. Plaintiffs had invested in one of the 20 options available under the plan, the ESOP investment option that was designed to invest primarily in the employer’s publicly traded stock. The plan document required that the ESOP would be one of the available investment alternatives. When the stock price dropped by 74% between July 19, 2007 and September 18, 2009, participants sued the company and certain company officers and employees alleging breach of ERISA fiduciary duty for allowing the continued investment of the plan in the ESOP investment option. The trial court dismissed the complaint on the pleadings, holding that participants failed to overcome the presumption of prudence applicable to such cases. The U.S. Court of Appeals for the Sixth Circuit reversed, holding, among other things, that while a presumption of prudence exists, it should not be applied at the pleading stage.
The Supreme Court Held that There Is No Presumption of Prudence for ESOP Fiduciaries
In Thursday's unanimous decision in Fifth Third, the Supreme Court unwound 20 years of lower-court precedent and held that ERISA does not afford a “presumption of prudence” to ESOP fiduciaries at any stage of litigation. Writing for the Court, Justice Breyer explained that “the same standard of prudence applies to all ERISA fiduciaries, including ESOP fiduciaries.” The decision looked closely at ERISA’s language: the statute expressly exempts ESOP fiduciaries from the requirement to diversify investments, so the Court reasoned that in all other respects ESOP fiduciaries are subject to the same obligations under ERISA as other retirement plan fiduciaries – including the obligation to act prudently with respect “to the sort of financial benefits (such as retirement income) that trustees who manage investments typically seek to secure for the trust’s beneficiaries.” According to the Court, nothing in the text of ERISA allows courts to presume that continuing to invest in employer stock is prudent, even if the plan document requires such investment. Instead, the Court explained that “the duty of prudence trumps the instructions of a plan document, such as an instruction to invest exclusively in employer stock even if financial goals demand the contrary.”
The Court Nonetheless Established Significant Hurdles for Future ESOP Stock-Drop Claims
Although the Court held that there is no presumption of prudence for ESOP fiduciaries, it also recognized that petitioners raised legitimate concerns that the threat of ERISA liability should not force them into an impossible position, such as acting on inside information. Because the Sixth Circuit had incorrectly held that the plaintiffs had stated a claim, without rigorously applying the relevant pleading standards, the Court vacated the lower court’s decision and remanded the case.
The Court acknowledged that ERISA represents a “careful balancing” of interests that courts should consider so that they do not “create a system that is so complex that administrative costs, or litigation expenses, unduly discourage employers from offering welfare benefit plans in the first place.” According to the Court, the ordinary pleading standards – those set forth in Ashcroft v. Iqbal, 556 U.S. 662 (2009) and Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007) – will provide the requisite balancing in this context to “weed out meritless lawsuits.” The Court cautioned that such balancing should be “accomplished through careful, context-sensitive scrutiny of a complaint’s allegations.”
For example, the Court explained that claims based on publicly available information – i.e., claims that public information should have induced an ESOP fiduciary to divest the plan of employer stock – will almost never survive a motion to dismiss on the pleadings. Relying on its decision earlier this week in Halliburton Co. v. Erica P. John Fund, Inc. (June 23, 2014), the Court reasoned that, typically, it is not imprudent for a fiduciary to assume that the market reacts to such information efficiently. As a result, “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 render the market price unreliable. The Court did not provide a specific example of when such “special circumstances” might exist – it simply noted that no special circumstances were alleged in this case.
With respect to claims that a fiduciary had material, non-public information that should have induced such fiduciary to divest the plan of employer stock or discontinue additional purchases, the Court set forth a general pleading requirement: “To state a claim for breach of the duty of prudence on the basis of inside 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 prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.” Although the Court noted that “the duty of prudence . . . does not require a fiduciary to break the law” – and it recognizes that ERISA expressly provides that it should not be construed “to alter, amend, modify, invalidate, impair, or supersede” any federal law or regulation, such as the federal securities laws – the Court otherwise provided little guidance as to how this new pleading standard should be applied by the lower courts. Instead, the Court raised several issues for lower courts to “consider” when ruling on motions to dismiss ESOP stock-drop claims. For example, the Court advised that:
“courts should consider the extent to which [a claim] could conflict with the complex insider trading and corporate disclosure requirements imposed by the federal securities laws or with the objectives of those laws,” and
“courts . . . should also consider whether the complaint has plausibly alleged that a prudent fiduciary in the defendant’s position could not have concluded that stopping purchases – which the market might take as a sign that insider fiduciaries viewed the employer’s stock as a bad investment – or publicly disclosing negative information would do more harm than good to the fund by causing a drop in the stock price and a concomitant drop in the value of the stock already held by the fund.”
The Sixth Circuit had considered none of these matters. Thus, the Court vacated the Sixth Circuit’s decision and remanded to have the lower courts apply the pleading standards as explained by the Court in its decision.