In its June 25, 2014 unanimous decision in Fifth Third Bancorp v. Dudenhoeffer, the U.S. Supreme Court resolved a split in the circuit as to the scope of the duties owed by fiduciaries for employee stock ownership plans (ESOPs) in holding that ERISA “does not create a special presumption favoring ESOP fiduciaries.” Counterbalancing the elimination of the presumption of prudence, the Court raised the bar for an employee both to plead and maintain an ERISA fiduciary breach claim against a fiduciary for an ESOP sponsored by a public company. Fiduciaries for ESOPs sponsored by private companies, however, not only lack the presumption of prudence, but will not be able to use defenses based on the existence of an efficient market for the sponsor’s stock. As a result, while Dudenhoeffer may spell the end of public company-sponsored ESOP claims that are not grounded on specific federal securities law violations, Dudenhoeffer may expand plaintiffs’ ability to sue fiduciaries of ESOPs sponsored by private companies.

Presumption of Prudence Rejected

The Supreme Court granted certiorari to resolve the appellate courts’ differing approaches to the presumption of prudence applicable to ESOP fiduciaries. The Second and Third Circuits had held that a presumption of prudence applies at the pleading stage and requires the plaintiff to establish that the employer was “in a ‘dire situation’ that was objectively unforeseeable by the settlor” to rebut the presumption. The Sixth Circuit, on the other hand, held that a presumption of prudence applies only at the summary judgment stage and beyond, and only requires the plaintiff to establish that “‘a prudent fiduciary acting under similar circumstances would have made a different investment decision’” in order to rebut the presumption. Cutting the Gordian Knot, the Court held that no presumption of prudence in favor of an ESOP fiduciary exists at any stage because “the same standard of prudence applies to all ERISA fiduciaries, including ESOP fiduciaries, except that an ESOP fiduciary is under no duty to diversify the ESOP’s holdings.”

Plaintiffs’ Ability to Maintain ESOP Fiduciary Breach Claims Limited

The Dudenhoeffer complaint alleged that, based on public and insider information, the ESOP fiduciaries knew that continuing to hold and purchase employer stock was imprudent. The district court dismissed based on the presumption of prudence. The Sixth Circuit reversed the district court’s dismissal on the ground that the presumption of prudence did not apply at the pleading stage. Despite rejecting application of the presumption of prudence at any stage, the Supreme Court did not affirm the Sixth Circuit’s decision on other grounds; instead, it vacated the Sixth Circuit’s judgment and remanded to the Sixth Circuit for consideration whether dismissal was required in light of factors limiting the likelihood that the complaint successfully pled a breach of fiduciary duty claim.

The Supreme Court initially suggested that ERISA fiduciary breach claims regarding publicly traded stock in ESOPs based on public information are difficult to plead or maintain. The Court reasoned that “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, at least in the absence of special circumstances.” The Court’s Dudenhoeffer rationale adheres to its securities analysis in Halliburton Co. v. Erica P. John Fund, Inc. (decided June 23, 2014) that investors, including ESOP fiduciaries, may “rely on the security’s market price as an unbiased assessment of the security’s value in light of all public information.”

The Court did not identify examples of what constitutes a special circumstance that might support rejection of the efficient market presumption. Instead, quoting Halliburton, the Court stated, fairly circularly, that a special circumstance adverselyaffects the reliability of the market price as “an unbiased assessment of the security’s value in light of all public information.”In the absence of allegation and proof of federal securities law violations, special circumstances to support a fiduciary breach involving an ESOP sponsored by a public company may not exist.

The Court also suggested that non-public or insider information, at least for publicly traded entities, likely will not support a breach of fiduciary duty claim because an ESOP fiduciary will have no viable alternative to following the terms of the plan in purchasing and holding employer stock. Noting that federal securities laws preclude an insider from trading employer stock on insider information, the Court held that ERISA does not permit a fiduciary of an ESOP sponsored by a public company to use insider information because “the duty of prudence, under ERISA as under the common law of trusts, does not require a fiduciary to break the law.” The Court further noted that insider trading may impact other aspects of federal securities law and the SEC may have views, not provided to the Supreme Court, that may be relevant to the Sixth Circuit considering dismissal of the complaint on remand. Finally, the Court noted that a fiduciary’s halting the purchase of stock on insider information not only could be problematic legally, but may itself trigger further losses to the plan by causing the market to suppress the price of employer stock.

The Supreme Court directed the Sixth Circuit to consider these factors, including potentially inviting the SEC’s views, when it determines on remand whether the complaint should be dismissed. How the Sixth Circuit weighs these factors may impact whether publicly traded companies continue to sponsor ESOPs.

Plaintiffs May Be Able to Maintain Breach of Fiduciary Duty Claims Against Fiduciaries of Private Company ESOPs

The application of Dudenhoeffer is somewhat different for an ESOP sponsored by a private company. Unlike the market for public companies, generally no “efficient market” exists for the stock of private companies.

Furthermore, the National Center for Employee Ownership states that approximately “two-thirds of ESOPs are used to provide a market for the shares of a departing owner of a profitable, closely held company.” As to these ESOPs, Dudenhoeffer not only eliminates any presumption of prudence, but it does not impose the same limits on plaintiffs’ fiduciary breach claims that it does with respect to claims against ESOPs sponsored by public companies. Private company sponsors of ESOPs will need to consider the greater litigation risk that exists post-Dudenhoeffer.

“Hard Wiring” Plans Does Not Insulate Fiduciaries from ERISA Liability

In holding that “the duty of prudence trumps the instructions of a plan document,” the Supreme Court effectively undermined plan sponsors’ efforts to insulate any ERISA fiduciary, not just an ESOP fiduciary, from ERISA liability based on the “hard wiring” of plans by mandating specific investment options, such as employer stock, in the plan document. Although some lower courts have held that deference must be provided to hard-wired plan documents, the Supreme Court, quoting 29 U.S.C. § 1104, emphasized that ERISA recognizes that the duty of prudence can conflict with the terms of a plan document by requiring that fiduciaries act only “in accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with the provisions of this subchapter.” In so holding, the Supreme Court held that ERISA precludes a fiduciary’s slavish adherence to the terms of plan documents without considering ERISA’s separate obligations. On a going-forward basis, fiduciaries of all plans should evaluate the prudence of even mandatory plan provisions in light of Dudenhoeffer.

Future of ESOPs and Stock Drop Litigation

While the final chapter of Dudenhoeffer probably will be written by the Sixth Circuit, it is likely that publicly traded companies can continue to sponsor ESOPs with little risk of liability, even without the presumption of prudence. The risk to private companies sponsoring ESOPs, however, is significantly greater in light of the absence of the presumption of prudence, the lack of an efficient market and the potential that insider information must be appropriately considered in determining whether to continue to offer the option to invest in employer stock.