Employee Benefits & Executive Compensation

The United States Supreme Court issued a decision yesterday that will result in significant changes to employee stock ownership plan ("ESOP") administration and design, which could jeopardize the viability of stand-alone traditional ESOPs.

Fifth Third Bancorp v. Dudenhoeffer is a standard "stock drop" case. Hundreds of similar cases have been filed over the last few years. The employer, Fifth Third Bancorp, sponsored a defined contribution 401(k) plan subject to ERISA. The plan provided for participant investment direction among 20 investment alternatives, one of which was designated as an "employee stock ownership plan" and was invested primarily in Fifth Third publicly traded common stock. The plan document required the offering of an ESOP and even required that employer contributions be initially invested in the ESOP. According to the complaint, from July 2007 through September 2009, the value of Fifth Third shares declined 74%, resulting in a similar decline in the retirement accounts of those participants in the plan to the extent they had directed that their accounts be invested in the ESOP.

Plaintiffs alleged that the plan’s fiduciaries knew or should have known from public and non-public information that the Fifth Third stock was overvalued and therefore ERISA’s duty of prudence required them to sell the stock, refuse to invest additional contributions in the stock, cancel the ESOP as an investment option under the plan, and/or publicly disclose the non-public information available to them.

ERISA fiduciaries are subject to four general duties: the duty of loyalty to plan beneficiaries; the duty to act prudently; the duty to diversify plan assets in order to avoid the risk of large losses; and the duty to follow the terms of the plan document insofar as the document is consistent with ERISA. The focus of the Dudenhoeffer case is the duty of prudence.

For 20 years, since Moench v. Roberston (3rd Cir. 1995), the federal circuit courts have generally held that ESOP fiduciaries are presumed to act prudently when they invest plan assets in employer stock as directed by the plan document. According to the Moench court and virtually every other court that looked at the issue, ESOP fiduciaries are entitled to the presumption of prudence because Congress intended to favor ESOPs and employee stock ownership. Unlike standard pension plans, employee ownership was the goal, in addition to or perhaps instead of, maximizing retirement income. Such presumption is typically overcome only when the value of the stock is in free-fall or the employer is near bankruptcy. Consistent with this "Moench presumption," the district court in Dudenhoeffer dismissed the lawsuit because the complaint did not allege facts sufficient to overcome the presumption. The Sixth Circuit agreed that the presumption applies, but reinstated the suit to give the plaintiffs an opportunity to develop evidence that the presumption could be overcome.

In Dudenhoeffer, the Supreme Court categorically rejected the special presumption for ESOP fiduciaries, holding that the same standard of prudence applies across the board to all ERISA fiduciaries. By itself, and limited to the facts of the case, this holding may have limited effect. Fiduciaries of 401(k) plans that include an ESOP investment alternative among many other investment alternatives have been on notice since DeFelice v. US Airways (4th Cir. 2007) that they may have to justify how the full menu of funds allows a participant to build a proper investment portfolio. If they can demonstrate that, they should have protection under the "safe harbor" provision in ERISA § 404(c). But the breadth of the Supreme Court’s reasoning is very problematic for fiduciaries of traditional stand-alone ESOPs that invest only in employer stock and offer no participant direction:

• The Court rejected arguments that fiduciaries could take into account "nonpecuniary" interests such as employee ownership. The fiduciaries’ duties are limited to providing financial benefits to the beneficiaries. This may mean that only on rare occasions will a particular stock stack up well against thousands of alternative investments, but such an analysis may be difficult for fiduciary committees;
• The Court rejected arguments that the fiduciaries’ actions could be supported by reference to plan documents that specifically directed investment in employer stock. If such investment is imprudent, then such directions must be ignored since they are not consistent with ERISA;
• The Court rejected the contention that but for the special presumption, ESOP fiduciaries will be "between a rock and a hard place"—sell the shares and face a lawsuit for violating the plan document if value increases or keep the shares and face a lawsuit if the value declines. Indeed, it appears that the Court does not agree that the directives of the plan document provide any protection at all; and
• The Court rejected the argument that company insiders should not be expected to disclose non-public information.

We expect that many of these issues—especially as they pertain to traditional ESOPs—will be vetted by the courts and a more practical direction will emerge. In the meantime, we remind fiduciaries that ERISA requires only procedural prudence. ERISA does not guarantee a result; it guarantees only a prudent process. Fiduciaries of traditional ESOPs find themselves in a position that their 401(k) brethren have been in for a long time: meeting regularly; hiring an investment advisor; preparing a good record of looking at alternatives; and reviewing a participant’s total employer-provided investment portfolio with an eye toward justifying the ESOP as part of a comprehensive program of employer-provided retirement income.