On June 25, 2014, in a unanimous decision, the US Supreme Court struck down the “presumption of prudence” afforded ERISA fiduciaries with respect to employer stock investments in employee stock ownership plans (ESOPs) and defined contribution plans. The decision was a surprise, because the defense-friendly presumption has been applied — in one form or another — by virtually all lower courts and courts of appeals for nearly two decades. But the Supreme Court held last week in Fifth Third Bancorp v. Dudenhoeffer that ESOP fiduciaries are subject to the same duties of prudence applicable to fiduciaries of all ERISA plans, with the sole exception being the duty to diversify plan assets, which is explicitly carved out in the statute.
Initially, at least, Dudenhoeffer is likely to increase stock-drop litigation. The presumption of prudence standard had resulted in the early dismissal of numerous cases alleging breaches of fiduciary duty with respect to employer stock investments. But now, Plaintiffs may not be stymied by a tough pleading standard that had made it extremely difficult to proceed past a motion to dismiss. However, the news is not all bad for fiduciaries. While eliminating the presumption that ESOP fiduciaries act prudently when investing in company stock, the Supreme Court emphasized that courts should continue to scrutinize ERISA stock-drop claims carefully, including at the pleadings stage. In doing so, it has provided defendants with new, albeit different, ammunition to attack these cases.
The case originated in the Southern District of Ohio, where a putative class of former Fifth Third Bankcorp (Fifth Third) employees and participants in the company’s ESOP plan filed suit alleging that fiduciaries of the ESOP, who were insiders at Fifth Third, knew or should have known that Fifth Third’s stock was overvalued and excessively risky based on both public and insider information about the subprime mortgage market. The district court dismissed the plaintiffs’ claims because they failed to overcome the presumption that ESOP fiduciaries act prudently by investing and remaining invested in company stock. On appeal, the Sixth Circuit reversed the district court and revived the case because, it held, the presumption of prudence is an evidentiary rule that should be applied only at the summary judgment — rather than at the pleadings — stage of the case.
Reflecting the fact that ESOPs are designed to promote employee ownership of employer stock, the presumption of prudence did exactly what its name implies — it imposed a presumption that plan investments in employer stock were prudent, and that holding and acquiring employer stock in a plan that provided for such investments was, generally, not a breach of fiduciary duty. To overcome the presumption that fiduciaries acted prudently by investing in company stock, plaintiffs had to make a special showing that would not be required in an ordinary duty-of-prudence case, such as that the employer was on the brink of collapse. While all courts of appeals to have considered the issue have applied some form of the presumption of prudence in stock-drop cases, they interpreted the nature of the presumption — and how and when plaintiffs could overcome it — differently.
Fifth Third petitioned the Court for certiorari to gain clarity on when and how to apply the presumption of prudence. Instead, the Court struck down the rule in its entirety based on the plain language of ERISA.
The Court acknowledged that there exists a tension between the fiduciary duty of prudence spelled out in §1104(a)(1)(B)-(C) of ERISA — which requires plan fiduciaries to, among other things, diversify assets — and ERISA’s acknowledgement that ESOPs are designed to invest primarily in the employer’s stock in §1107(d)(6). The Court reasoned that ERISA itself, in §1104(a)(2), addresses this tension by expressly exempting ESOP fiduciaries from the duty to diversify assets and from the duty of prudence “only to the extent that it requires diversification.”
Because ERISA itself does not impose any special presumptions to be applied where employer stock is concerned, the Court concluded that fiduciaries of ESOPs and plans holding employer stock funds must be subject to the same duty of prudence requirements as other ERISA fiduciaries, with the sole exception that they are not required to diversify plan assets. The presumption of prudence, in the Court’s estimation, made it “impossible for a plaintiff to state a duty-of-prudence claim, no matter how meritorious, unless the employer is in very bad economic circumstances.” The Court concluded that this approach is simply not supported by the language of the statute.
However, while the Court took away the presumption with one hand, it gave with the other, by providing defendants new ammunition to dismiss a complaint at the pleadings stage.
First, the Court essentially eliminated claims for breach of fiduciary duty that rest on publicly available information. The Court explained that it is insufficient to allege that the fiduciary should have recognized that the market was over- or under-valuing the stock based on publicly available information because investors are entitled to rely on a stock’s market price as an “unbiased assessment of the security’s value in light of all public information.” The Court pronounced that as a “general rule,” allegations of this nature would implausibly state a claim, “at least in the absence of special circumstances.” We can expect many plaintiffs to latch on to that phrase, and argue that their case is the “special circumstances” case. If they are successful, some of these claims may still live on, but we would expect true “special circumstances” cases to be few and far between.
Second, the Court clarified and narrowed the spectrum for fiduciary breach claims based on nonpublic (i.e., insider) information. To survive a motion to dismiss, these claims 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.” Thus, courts at the pleadings stage must apply three principles:
- The duty of prudence cannot require an ESOP fiduciary to break the law — that is, “ERISA’s duty of prudence cannot require an ESOP fiduciary to perform an action — such as divesting the fund’s holdings of the employer’s stock on the basis of inside information — that would violate the securities laws;”
- If a complaint faults fiduciaries for continuing to make additional stock purchases based on insider information, or for failing to disclose inside information to the public, courts must consider whether this obligation would conflict with the complex insider trading and corporate disclosure requirements imposed by the federal securities laws; and
- Courts should consider whether the complaint has plausibly alleged that a prudent fiduciary under the circumstances could not have concluded that declining to disclose negative information or halt future stock purchases would cause more harm to the fund’s current investments than good, by causing a drop in the stock price that would decrease the value of the stock already held by the fund.
As the Dudenhoeffer Court itself acknowledged, lower courts will be forced to grapple with these considerations to clarify the pleading standards in stock-drop cases now that the presumption of prudence has been eliminated. Nevertheless,Dudenhoeffer has clearly provided the defense bar with new ammunition to fend off meritless litigation against the fiduciaries of plans holding employer stock.