U.S. Supreme Court Issues Important Decision Affecting Fiduciaries of ESOPs

by Wilson Elser

In a recent decision, Fifth Third Bankcorp v. Dudenhoeffer, 189 L.Ed. 2d 457 (2014), the U.S. Supreme Court vacated the “presumption of prudence” previously given to fiduciaries of employee-owned stock ownership plans (ESOPs) by many circuits, including the Second Circuit in In re Citigroup ERISA Litig., 662 F.3d 128 (2d Cir. 2011). In so doing, the Court held that ESOP fiduciaries are subject to the same presumption of prudence that applies to ERISA fiduciaries in general. However, the Court also set forth special considerations that apply to ESOP fiduciaries and that should be used by courts in determining whether a complaint states a claim when evaluating a motion to dismiss. As a result, the impact of the decision may not be as dramatic as it first appears.

Federal courts across the country have seen an increasing number of so-called “stock drop” cases, in which employees seek to hold their employers and the administrators of their 401(k) plans liable for continuing to allow the employee to invest in company stock when the employer and/or administrator allegedly knew and failed to disclose that the value of such stock was inflated or the investment was otherwise too risky. In dealing with these cases, a number of circuits adopted the “presumption of prudence,” or Moench presumption, for employee benefit plans that offer company stock as an investment option to plan participants. As noted above, this included the Second Circuit. The Moench presumption heightened the standard to be applied by federal courts at the pleading stage of these cases, making it easier for defendants to obtain early dismissals.

However, Fifth Third changes the landscape. Plaintiffs in that matter, former employees and participants in an ESOP, alleged that the defendants, Fifth Third and several officers as fiduciaries of its ESOP, breached ERISA’s fiduciary duty of prudence. They alleged that the defendants should have known, both through publicly available and inside information, that the Fifth Third stock price was overvalued and risky, and therefore should have taken action, including purchasing less company stock, selling company stock or disclosing negative inside information, which would allow the market to adjust the stock price. The complaint was initially dismissed in the U.S. District Court for the Southern District of Ohio for failure to state a claim, but that decision was reversed by the U.S. Court of Appeals for the Sixth Circuit, which held that while ESOP fiduciaries were entitled to a presumption of prudence, this was an evidentiary inquiry not applicable at the pleading stage. The Supreme Court granted certiorari to clarify the validity of the presumption of prudence.

The Supreme Court held that ESOP fiduciaries are not entitled to a presumption of prudence, but are subject to the same duty of prudence as other ERISA fiduciaries. However, unlike other ERISA fiduciaries, ESOP fiduciaries are not subject to the duty to diversify. This decision was based on the language of the ERISA statute itself:

  • § 1104(a)(1)(B) imposes a “prudent person” standard on plan fiduciaries.
  • § 1104(a)(1)(C) requires that ERISA fiduciaries diversify plan assets.
  • §1104(a)(2) provides that “the diversification requirement of [1104(a)(1)(C)] and the prudence requirement (only to the extent that it requires diversification) of 1104(a)(1)(B) [are] not violated by acquisition or holding of [employer stock]. 

The Court remanded the matter to the district court with instructions to apply the pleading standards set forth in Ashcroft v. Iqbal and Bell Atlantic v. Twombly, and to apply several special considerations: 

  • First, the Court recognized that in situations where a stock is publicly traded, it is generally not imprudent to rely on the value of a stock on a major stock market: “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, at least in the absence of special circumstances.” 
  • Second, the Court discussed the role of nonpublic information, stating that “to state a claim for breach of the duty of prudence on the basis of 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 than to help it.”  
  • The Court further clarified this with three points. First, the duty of prudence (under ERISA and the common law of trusts) does not require a fiduciary to break the law. Therefore, a fiduciary cannot be expected to take any action that would break securities laws, including acting on inside information. Second, if a complaint alleges a breach by a fiduciary for failing – on the basis of inside information – to cease additional stock purchases or to disclose inside information to the public to create a market correction, the court should consider whether an ERISA-based obligation would conflict with the various requirements and objections of the federal securities laws, including insider trading and corporate disclosure requirements. Third, the Court noted that courts should consider whether the complaint adequately alleges 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 do 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.”

    This is an important decision. Previously, under the presumption of prudence, ESOP fiduciaries were granted additional protections so long as the governing plan documents gave them the right to invest in employer stock and they invested consistent with the plan documents. Now their job is harder, in that they need to make sure that the decisions are actually prudent. The plan documents cannot waive this obligation. The value of this decision, especially for national companies that might be subject to such lawsuits in multiple jurisdictions, is that it provides clarity by resolving a previous circuit split. Further, it clarifies the use of diversification and inside information and other considerations that should be used by ESOP fiduciaries when making investment decisions, and still provides a measure of protection not available to general ERISA fiduciaries.


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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