In Fifth Third Bancorp v. Dudenhoeffer,1 the U.S. Supreme Court yesterday held that ESOP (employee stock ownership plan) fiduciaries are not entitled to any special presumption of prudence and are subject to the same duty of prudence that applies to ERISA (Employee Retirement Income Security Act) fiduciaries in general, except as to the need to diversify. This ruling strikes down the presumption of prudence standard that several Circuits have applied on challenges to ESOP fiduciaries’ investment decisions, and outlines new pleading considerations based on whether publicly available or insider information is involved, conflicts with federal securities laws, and the overall impact to the stock value.
The Fifth Third Plan and Subsequent Stock Decline
Petitioner Fifth Third Bancorp. maintained a defined-contribution retirement savings plan, with a 4% match for employee contributions. The Plan's assets were invested in 20 separate funds, including mutual funds and an ESOP. Participants could freely allocate contributions, but Fifth Third's matching contributions were initially invested in the ESOP, with the participant having the option to transfer thereafter. Fifth Third employees and Plan participants filed this class action claiming that Fifth Third and its officers (collectively "Fifth Third") violated their duties of loyalty and prudence because they knew or should have known, through both publicly available and inside information, that Fifth Third stock was overpriced and excessively risky and a prudent fiduciary would have sold off the stock, refrained from purchasing more stock, or publicly disclosed the negative inside information so that the market could correct the stock's inflated price downward. Instead, Fifth Third maintained and purchased additional Fifth Third stock, and when the market crashed, the stock fell drastically over a two-year period.
The district court dismissed the complaint for failure to state a claim, applying a presumption at the pleading stage that, for challenges to ESOP fiduciaries' investment decisions, the decision to remain invested in employer securities is reasonable. The Sixth Circuit Court of Appeals reversed the decision, finding that while ESOP fiduciaries are entitled to a presumption of prudence, the presumption is evidentiary and does not apply at the pleading stage.
No Authority for a Presumption of Prudence
Vacating the Sixth Circuit decision, the Supreme Court held that ESOP fiduciaries are subject to the same duty of prudence that applies to ERISA fiduciaries in general except as to the duty to diversify. It relied on ERISA §404(a)(1)(B)'s "prudent person" standard for measuring fiduciaries' investment decisions and narrowly construed the exception in ERISA §404(a)(2) for an ESOP's duty to diversify, finding no authority for the standard advanced by Fifth Third. While it rejected most of Fifth Third's arguments, it did recognize Fifth Third's concern with the prohibition on insider trading as "a legitimate one" but concluded that this concern applies equally to all plans, thereby precluding an ESOP-specific standard. The Court also recognized Fifth Third's concern over the threat of costly duty-of-prudence lawsuits that may deter companies from offering ESOPs in the absence of a presumption of prudence, but rejected the presumption as an appropriate method to weed out meritless suits. Instead, it noted that this "important task can be better accomplished through careful, context-sensitive scrutiny of a complaint's allegations."
"Weeding Out Meritless Claims"
The Court determined that the mechanism for "weeding out meritless claims"—the motion to dismiss for failure to state a claim—is still appropriate, but that lower courts should apply the pleading standard set forth in Iqbal and Twombly2 and make a context-specific inquiry, guided by the following additional considerations:
As to publicly available information, 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,…abse[nt] special circumstances."3
As to insider information, to state a claim for breach of the duty of prudence, "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 circumstance would not have viewed as more likely to harm the fund than to help it[,]" with a reviewing court guided by the following points:
ERISA's duty of prudence does not require a fiduciary to break the law, thus making any complaint about the failure to sell stock based on insider information unsupportable.
Where a complaint asserts that the ESOP fiduciaries failed to cease making additional stock purchases or failed to publicly disclose the inside information so the stock value could readjust, the courts should consider: (a) the extent to which an ERISA-based obligation either to refrain from trading or to disclose information conflicts with insider trading and corporate disclosure requirements imposed by federal securities laws or their objectives (noting the SEC's failure to advise the Court on these issues); and (b) whether the complaint has plausibly alleged that a prudent fiduciary in the defendant's position could not have concluded that ceasing the stock purchases or publicly disclosing the information would do more harm than good to the fund by causing a drop in the stock price and, ultimately, in the value of the stock held by the fund.
The Court left it to the courts below to apply this framework.
Impact to ESOPs and Their Fiduciaries
While the court eliminated a deferential standard that offered significant protection to ESOP fiduciaries for their investment decisions, it also provided a framework clearly signaling that (a) the fiduciaries' actions when confronted solely with publicly available information are still largely protected (absent special circumstances); and (b) fiduciaries cannot be expected to violate the securities laws by selling off stock based on insider information. It essentially punted on whether fiduciaries can be liable for the failure to cease purchasing additional stock or to publicly disclose the negative insider information so the market can correct the stock value—leaving it to the lower courts to analyze whether these options run afoul of the securities laws or would be prudent given the ultimate impact on the value of the stock.
Employers may also want to evaluate whether their employer stock fund is a discretionary fund or is hard-wired into the plan document. An advantage of protection likely still remains for hard-wired funds, but employers may want to consider adopting a monitoring process to evaluate whether the continued offering of an employer stock fund is prudent in appropriate cases.
1 Justice Breyer delivered the opinion for this unanimous decision.
2 Ashcroft v. Iqbal, 556 U.S. 662, 677-680 (2009); Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 554-563 (2007).
3 The Court declined to elaborate on what might constitute a special circumstance and noted that the lower court failed to consider one.