[author: Mark Kelly]
In the Fifth Third Bancorp v. Dudenhoeffer decision issued June 25, 2014, the Supreme Court unanimously rejected the “Moench presumption”, a presumption of prudence for employer stock held in an ESOP or a 401(k) plan company stock fund. The Court ruled that such company stock investments are subject to the same fiduciary standards as any other investment, except for the duty to diversify fund holdings. The Moench presumption had been the primary basis on which ERISA stock-drop cases have been dismissed in recent years. While the Court may have eliminated the defense-friendly Moench presumption, it did not leave plan sponsors empty handed. The Court articulated a higher standard that will make it difficult for stock-drop claims to survive motions to dismiss, as well as addressed how fiduciaries must act when privy to insider information, both of which should be very helpful to fiduciaries in defending stock-drop litigation.
Factual Background on Dudenhoeffer
Fifth Third Bancorp sponsored a 401(k) plan which included a company stock fund investment option structured as an ESOP. While the company’s matching contributions were initially invested in the company stock fund, participants could immediately re-invest the contributions into other investment funds. In connection with the subprime mortgage collapse, Fifth Third Bancorp stock declined by 74% over a 2-year period. Participants filed suit claiming that the fiduciaries should have known that the drop would occur because (i) public information suggested that the stock was overvalued, and (ii) the fiduciaries had “insider information” regarding material misstatements that inflated the stock price.
Relying on the Moench presumption, the district court dismissed the participants’ claim that continuing to offer the company stock as an investment option was a breach of the fiduciaries’ duty of prudence. The Sixth Circuit reversed, holding that the Moench presumption was an evidentiary presumption that applied at the merits/summary judgment stage, not at the pleading stage, and allowed the case to advance to discovery. In light of the differences among the circuit courts, the Supreme Court granted certiorari to address the nature of the presumption applicable to ESOP fiduciaries--in other words, whether the Moench presumption applies at the pleading or the motion for summary judgment stage.
The Supreme Court’s Decision
The Supreme Court unanimously discarded the presumption of prudence—a surprising turn of events given that most circuit courts had adopted the Moench presumption in some form. The Court held that the same standard of prudence applies to all ERISA fiduciaries, except that an ESOP fiduciary is not required to diversify fund holdings. Further, a fiduciary’s duty to follow plan terms is trumped by the prudence standard, and adding plan language to require that employer stock be offered as an investment option (“hardwiring”) does not alter that standard.
While elimination of the presumption was unwelcome news for plan sponsors, the Court also provided guidance which should be very helpful to fiduciaries. First, the Supreme Court made it difficult for stock-drop claims to survive motions to dismiss. Embracing “efficient market theory” (i.e., the stock price of a publicly traded company reflects the financial market’s valuation of the stock taking into account all publicly available information), the Court held “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.” Coupled with the demanding Twombly pleading standard, the Court noted that meritless claims could be dispatched at an early stage by a motion to dismiss. (The Twombly case heightened the pleading requirement for Federal civil cases, requiring that plaintiffs include enough facts in their complaint to make it plausible—not merely possible or conceivable—that they will be able to prove facts to support their claims.) The Court left open that the efficient market theory may not be applicable in special circumstances. While defining those special circumstances is left to future litigation, thin and infrequent trading may be an example of where special circumstances exist.
Second, the Court provided guidance regarding how fiduciaries must act when they are privy to insider information. Fiduciaries have historically faced the dilemma that plaintiffs allege imprudence if they do not act on insider information within their possession, even if trading based on such information would violate securities laws. The Court made three points regarding these claims:
The duty of prudence never requires ERISA fiduciaries to violate federal securities laws.
If plaintiffs assert that fiduciaries should have used inside information to refrain from continuing stock purchases or should have disclosed nonpublic information to the public, courts should consider the extent to which these claims conflict with securities laws.
Courts should consider whether halting stock purchases or informing the public might be worse for participants than doing nothing. In the Court’s words: “[C]ourts faced with such claims 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 cause 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.”
What Should Plan Sponsors Do Now?
In light of the Supreme Court’s holding, plan sponsors should begin the process of reviewing plan design, plan documents, and fiduciary procedures. Among other things:
Update Plan Documentation. In the presumption-free post-Dudenhoeffer world, plan sponsors should consider whether “hardwired” plan and trust documents need to be updated. Such language may continue to be an expression of the company’s intent, but fiduciaries will be obligated to override it when the duty of prudence requires. If such language is removed or softened, be careful that such changes do not obligate fiduciaries to sell stock or take other action sooner than what the law would require.
Implement a Thorough Fiduciary Process. In the absence of a presumption of prudence, fiduciaries should implement procedures for monitoring employer stock investments to ensure compliance with ERISA’s prudence requirement. For example, the failure to evaluate employer stock as frequently or as rigorously as other investment options under the plan could be problematic. Similarly, if the plan’s investment policy statement employs a “watch list” for its mutual fund alternatives, consider whether the watch list should also apply to the employer stock fund.
Consider Plan Design Alternatives. A plan design that allows participants to freely choose whether or not to invest in employer stock may be more defensible than a plan that mandates investment of some portion of the contribution in the employer stock fund. In addition, consider imposing limits on participant investment contributions in employer stock.
Consider Use of an Independent Fiduciary. Employers should consider whether to engage the services of an independent fiduciary. While the Court’s decision offers some protection to fiduciaries who may possess inside information, many questions remain unanswered regarding the scope of such protection.