On June 25, 2014, the Supreme Court of the United States, in Fifth Third Bancorp v. Dudenhoffer, declared that no “presumption of prudence” applied to fiduciaries of “employee stock ownership plans” (ESOPs). In rejecting the defense-friendly standard, the high court noted that ESOP fiduciaries are subject to the same duty of prudence as any other ERISA fiduciary except that ESOP fiduciaries are not liable for losses that stem from a failure to diversify. The decision is also noteworthy in that it set forth guidelines for lower courts to follow at the motion to dismiss stage that will impact how plaintiffs are able to satisfy pleading requirements in cases against ESOP fiduciaries.
Fifth Third Bancorp is a large financial institution that maintains for its employees a defined contribution retirement plan. As part of the plan, Fifth Third provides a matching contribution of up to 4 percent of an employee’s compensation. These matching contributions are always initially invested in the ESOP. The plan requires that the ESOP’s funds be invested primarily in the common stock of Fifth Third.
In 2007, the market crashed and Fifth Third’s stock fell by 74 percent between July 2007 and September 2009. Because the ESOP funds were primarily invested in Fifth Third stock, the fall in price eliminated a large portion of the savings that employees had invested in the ESOP.
Former Fifth Third employees and ESOP participants filed a lawsuit against Fifth Third and several of its officers who were alleged to be fiduciaries of the ESOP. In their complaint, the former employees alleged that the fiduciaries violated their duty of prudence under the Employee Retirement Income Security Act (ERISA). The former employees contended that by July 2007, the fiduciaries knew or should have known that Fifth Third’s stock was overvalued and excessively risky. Specifically, the former employees alleged that publicly available information should have provided early warning signs and material misrepresentations made by Fifth Third officers, which the fiduciaries, as insiders, should have known, led the market to overvalue Fifth Third stock. According to the former employees, if the fiduciaries had upheld their duty to act prudently, the fiduciaries would have responded to this information by selling off the ESOP’s holdings of Fifth Third stock or disclosing the negative inside information so that the market could correct the stock’s price downward.
The Presumption of Prudence
In a unanimous decision, the court held that ESOP fiduciaries are not entitled to the favorable “presumption of prudence” previously applied by several circuit courts, including the 6th Circuit below, when the fiduciaries’ decisions to hold or buy employer stock are challenged. Several circuit courts have defined this presumption as a requirement that the plaintiff make a showing that would not be required in an ordinary duty-of-prudence case, such as that the bank was on the brink of collapse.
The Court held that all ERISA fiduciaries are subject to the same standard of prudence, except that an ESOP fiduciary is not under a duty to diversify. The Court explained that Congress recognizes that ESOPs are designed primarily to invest in the stock of the participant’s employer. Further, according to the Court, ERISA does not include a special presumption in favor of ESOP fiduciaries. Interpreting the text of the statute, the Court “was not convinced that Congress […] sought to promote ESOPs by further relaxing the duty of prudence as applied to ESOPs with the sort of presumption proposed by petitioners.”
Fifth Third set forth three arguments to support its contrary position. First, the bank argued that the special purpose of an ESOP, to invest participants’ savings in their employers’ stock, calls for a presumption that such investments are prudent. Second, the bank contended 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.” Third, the bank argued that subjecting ESOP fiduciaries to a duty of prudence, without a special presumption, will lead to conflicts with the legal prohibition on insider trading. Finally, the bank alleged that without a special presumption, the threat of costly duty-of-prudence lawsuits will deter companies from offering ESOPs to their employees, which is contrary to Congress’ intent in passing ERISA.
In rejecting these arguments, the Court looked to the provisions of ERISA and the Congressional intent behind the legislation. The Court recognized that Congress sought to balance fair and prompt enforcement of rights under ERISA plans and the encouragement of the creation of such plans. The Court explained, however, that there was a better manner in which to accomplish this balance of interests.
The Court’s Proposed Mechanism for Weeding Out Meritless ERISA Claims
According to the Court, the “presumption of prudence” was an inappropriate way in which to weed out meritless claims or provide the requisite balancing of the competing interests that ERISA represents. Specifically, the Court explained that this important task could be accomplished at the motion to dismiss stage by careful judicial consideration of whether the complaint states a claim that a fiduciary has acted imprudently. In explaining this point, the Court considered several standard allegations made by plaintiffs in these cases.
In the Court’s view, allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing the stock are generally implausible absent special circumstances.
To state a claim for breach of the duty of prudence on the basis of inside information, moreover, the Court stated 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.” The Court noted three points for the lower courts to consider in this regard. First, the duty of prudence does not require a fiduciary to break the law by trading on inside information. Second, courts should consider whether a plan fiduciary’s decision to purchase (or refrain from purchasing) additional stock or for failing to disclose information to the public could conflict with the federal securities laws or with the objectives of those laws. Third, courts should consider whether a prudent fiduciary could not have concluded that stopping purchases or publicly disclosing negative information would do more harm than good to the stock fund.
Based on this analysis, the Court vacated the judgment of the 6th Circuit Court of Appeals below and remanded the case for further proceedings in which the court could apply the foregoing analysis to the case at hand.
As a result, defendants will no longer be able to rely on the presumption of prudence, which had become a very effective tool in many circuits, to obtain early dismissal of ERISA stock drop cases. Nevertheless, the Court’s rejection of many of the standard allegations propounded by plaintiffs in such cases as implausible or insufficient should provide defendants with ample ammunition to challenge and presumably defeat many of these claims on a motion to dismiss. The ultimate impact of Fifth Third Bank on ERISA fiduciaries and their insurers remains to be seen as the case is applied by lower courts.