Supreme Court Clarifies ESOP Fiduciaries’ Obligations

by Ogletree, Deakins, Nash, Smoak & Stewart, P.C.

On June 25, 2014, the Supreme Court of the United States ruled that a fiduciary of an “employee stock ownership plan” (ESOP) is subject to the same duty of prudence that the Employee Retirement Income Security Act (ERISA) requires of fiduciaries in general. Justice Breyer, delivering the opinion of a unanimous Court, rejected a financial services firm’s argument that a challenge to an ESOP fiduciary’s decision to buy or hold company stock “cannot prevail unless extraordinary circumstances such as a serious threat to the employer’s viability, mean that continued investment would substantially impair the purpose of the plan.” In rejecting a special ESOP-specific presumption, the Court noted that plan participants who challenge a fiduciary’s decisions are not required to allege that the employer was on the “brink of collapse.” Fifth Third Bancorp v. Dudenhoeffer, No. 12–751, Supreme Court of the United States (June 25, 2014).

Fifth Third Bancorp maintained a retirement savings plan for its employees, the assets of which were invested in 20 funds, including an ESOP—a pension plan that invests primarily in the stock of the company that employs the plan participants. Fifth Third’s matching contributions were always initially invested in the ESOP; however participants could move them to another fund. The plan required the ESOP’s funds to be “invested primarily in shares of common stock of Fifth Third.”

Between July 2007 and September 2009, as a result of the market crash, Fifth Third’s stock prices fell by 74 percent. Since the ESOP’s funds were invested primarily in Fifth Third stock, the price drop eliminated a large part of plan participants’ retirement savings. Fifth Third’s employees and ESOP participants then filed a lawsuit alleging, among other claims, that the company and several of its officers were plan fiduciaries and that they violated the duty of prudence imposed by §§1109(a) and 1132(a)(2) of ERISA.

Specifically, the participants argued that the fiduciaries knew or should have known that Fifth Third’s stock was overvalued and excessively risky on the basis of publicly available information and nonpublic inside information regarding the company’s finances. The employees and participants further alleged that a prudent fiduciary would have sold the ESOP’s holdings of Fifth Third’s stocks, refrained from purchasing more of its stock, cancelled the plan’s ESOP options, and/or disclosed its nonpublic information to allow the market to correctly value Fifth Third’s stocks.

A federal district court in Ohio dismissed the complaint for its failure to state a claim. The Sixth Circuit Court of Appeals reversed the dismissal, finding that ESOP fiduciaries, unlike other ERISA fiduciaries, were entitled to a “presumption of prudence,” a defense-friendly standard that the Sixth Circuit concluded the district court had correctly invoked, but incorrectly applied at the pleading stage of the case. Because of a circuit split as to the nature of the presumption of prudence applicable to ESOP fiduciaries, the Supreme Court agreed to hear the case to decide whether, when an ESOP fiduciary’s decision to buy or hold the employer’s stock is challenged in court, the fiduciary is entitled to a presumption of prudence and whether the presumption applies at the pleading stage.

The Supreme Court noted that generally speaking §1104(a)(1)(B) of ERISA “imposes a ‘prudent person’ standard by which to measure fiduciaries’ investment decisions and disposition of assets” while §1104(a)(1)(C) requires fiduciaries to diversify plan assets. The Supreme Court held that ESOP fiduciaries are not entitled to a presumption of prudence because §1104(a)(2), which establishes the extent to which those duties are loosened in the ESOP context, does not make reference to a special presumption. Thus, the same standard of prudence applies to ESOP fiduciaries as applies to all other ERISA fiduciaries.

However, according to the Court’s holding, an ESOP fiduciary is not required under §1104(a)(1)(C) to diversify plan investments to “minimize the risks of large losses.” In arriving at this conclusion, the Court noted that Congress has recognized that ESOPs are “designed to invest primarily in” the employer’s stock, “meaning that they are not prudently diversified.”

Although the Court rejected application of a “presumption of prudence” in the ESOP context, it did appear to impose a fairly high pleading standard in such cases. With respect to allegations that the fiduciaries should have used insider information to make decisions about selling or buying employer stock, the Court held that the ERISA duty of prudence “does not require a fiduciary to break the law,” specifically referring to prohibitions under federal securities laws against insider trading. The Court held that to pursue an action for breach of the duty of prudence based on 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 that to help it.”

According to Mark E. Schmidtke, a shareholder in the Chicago office of Ogletree Deakins and chair of the firm’s Employee Benefits Litigation Practice Group, “Many, if  not most, ERISA stock drop cases are based on allegations of fiduciaries’ inside knowledge. While the Supreme Court takes away the Moench presumption in such cases, it replaces it with what appears to be a pretty significant pleading requirement. In other words, the focus continues to be on the pleading stage in these cases, which is significant, because if a case can be knocked out at the pleading stage, defendants can avoid expensive discovery. In this respect, the case has to be ‘good news, bad news’ for plaintiffs.”

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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