Court Erects Substantial Hurdles to “Stock Drop” Class Actions But Rejects Lower Court Rulings That Investing ERISA Retirement Funds in Employer Stock Is Presumed to be Prudent
On June 25, 2014, in Fifth Third Bancorp et al., Petitioners v. John Dudenhoeffer et al., the U.S. Supreme Court issued an important opinion concerning so-called ERISA “stock drop” class actions, wherein participants in an ERISA retirement plan sue the plan’s fiduciaries for investing plan assets in employer stock that later suffers a decline in share price. Although the Supreme Court rejected lower court holdings that a fiduciary’s decision to invest in employer stock is “presumptively prudent,” the Supreme Court laid down new rules that will make ERISA “stock drop” actions difficult to maintain: (1) fiduciaries facing negative public news about the employer are entitled as a matter of law to rely on the integrity of the employer’s share price in purchasing employer stock; and (2) fiduciaries are not allowed to use inside information about the employer to cause the plan to sell employer stock, and are entitled to consider whether refraining from buying additional employer stock or publicly disclosing negative inside information would do more harm than good to the fund.
Under the Employee Retirement Income Security Act of 1974 (“ERISA”), the investment decisions of retirement plan fiduciaries, including the fiduciaries of an employee stock ownership plan (an “ESOP”), are measured by a “prudent person” standard. Several Courts of Appeals, however, have recognized that, because ESOPs were established at the direction of Congress for the purpose of encouraging employee ownership of employer stock, fiduciaries should enjoy a “presumption” that their decisions to invest plan assets in employer stock are prudent.1 Under this presumption, retirement plan participants challenging a fiduciary’s decision to invest in employer stock can hold a fiduciary liable only by showing that the employer faced “dire consequences,” such as a bankruptcy or a complete collapse in share price. Defendants had used this presumption to defeat numerous ERISA “stock drop” class actions, especially those brought as a result of the recent financial crisis.
In the Fifth Third case, in 2008, participants in an ESOP sponsored by Fifth Third Bancorp (“Fifth Third”) brought claims for breach of fiduciary duty in a putative ERISA “stock drop” class action suit against Fifth Third and several of its officers who are alleged to be fiduciaries of the ESOP. The plaintiffs alleged that the plan fiduciaries knew—through public sources and inside information—that Fifth Third was invested too heavily in subprime loans and so should have divested the plan of Fifth Third stock before it suffered a resulting 74% share price decline.
Applying the presumption of prudence, the District Court dismissed the case at the outset as a matter of law. On appeal, the Sixth Circuit agreed that ESOP fiduciaries are entitled to such a presumption, but held that such presumption was evidentiary only, and would apply after the taking of discovery, rather than at the outset of a case.
The Supreme Court granted certiorari and vacated the Sixth Circuit’s opinion, holding that there is no presumption of prudence—at any stage in litigation—with respect to the investment decisions of ESOP fiduciaries.2 The Court, however, ruled that motions to dismiss, which are now governed by the Twombly-Iqbal “plausibility” test, are an “important mechanism for weeding out meritless [ERISA] claims.”3 The Court thus instructed the Sixth Circuit on remand to consider the plausibility of plaintiff’s claims in light of additional considerations relevant to these type of claims.
First, the Court held that where a stock is publicly traded, absent special circumstances, a fiduciary is “not imprudent to assume that a major stock market provides the best estimate of the value of the stocks traded on it that is available to him.”4 In other words, a fiduciary cannot be liable for investing plan assets in employer stock at market prices in the face of negative public information, because the market price is expected to reflect all public information about the company.
Second, the Court rejected plaintiff’s contention that ERISA fiduciaries should use inside information about the employer in deciding whether to cause the plan to sell plan employer stock, noting that a fiduciary’s duty to invest plan assets prudently “does not require a fiduciary to break the law.” Thus, a claim “based on the theory that” fiduciaries must “sell the ESOP’s holdings” must be dismissed.5
Third, the Court noted that where a plaintiff faults a fiduciary for failing to use inside information to stop the plan from making additional stock purchases or for failing to publicly disclose that inside information so that the stock would no longer be overvalued, courts should consider whether such actions would (i) conflict with the complex insider trading and corporate disclosure requirements set forth by the federal securities laws or with the objectives of those laws (the Supreme Court invites the views of the SEC on this aspect),6 and/or (ii) 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.7
Although the Supreme Court’s decision today will be subject to further interpretation and application by lower courts, it may not alter significantly the recent success defendants have had in defeating ERISA “stock drop” class actions at the initial stages of the litigation. The Supreme Court removed the powerful defense tool of the presumption of prudence, but laid down rules that will make it difficult for plaintiffs to plead that ERISA fiduciaries—whether based on knowledge of public or private information—were imprudent in investing plan assets in employer stock.