In an opinion that reversed nearly two decades of lower-court ERISA class action jurisprudence, the Supreme Court axed the well-established “presumption of prudence” in ERISA “stock-drop” cases. On June 25, the Court issued its decision in Dudenhoeffer v. Fifth Third Bank, No. 12-751, 573 U.S. ____ (2014), rejecting the unanimous view among circuit courts that fiduciaries of employee stock ownership plans (ESOPs) are entitled to a presumption that their decision to continue to hold employer stock as an investment—even in the face of plummeting stock prices—is prudent. Ultimately, however, the Court’s opinion is a mixed bag for ESOP providers. While the Court struck down the “presumption of prudence”—a key defense for ESOP fiduciaries in ERISA “stock-drop” class actions—the high Court set a high bar for plaintiffs looking to bring prudence-based claims and encouraged trial courts to scrutinize such claims at the pleading stage to eliminate meritless claims early on. The Court’s decision is consistent with heightened pleading standards ushered in by Iqbal and Twombly and reiterates the importance of motions to dismiss as a means of curbing meritless litigation.
Stock-Drops and ESOPs
Dudenhoeffer involved a particular type of ERISA class action commonly known as a “stock-drop” case, in which investors allege that those charged with managing their employer-sponsored retirement plans breached certain statutory duties, causing the investors to lose retirement savings. Over the past two decades, such suits have become common complements to securities class actions.
Under ERISA, those who oversee employer-sponsored retirement plans are subject to certain fiduciary duties, including a duty to manage plan investments prudently. Dudenhoeffer focused on the duties owed by fiduciaries who oversee ESOPs—a special type of retirement plan designed to encourage employees to invest in their employer’s stock. Congress has encouraged ESOPs as a way to motivate and reward employees by giving them an ownership stake in the companies they work for. Importantly, while a retirement plan fiduciary’s duty of prudence under ERISA generally includes a duty to diversify investments to minimize the risk of large losses, ERISA expressly—and logically—exempts ESOP fiduciaries from any duty to diversify because the purpose of an ESOP is to hold a single investment: employer stock.
Dudenhoeffer’s Trip to the Supreme Court
The plaintiffs in Dudenhoeffer were former Fifth Third employees who invested in the company’s stock through its ESOP. Between July 2007 and September 2009, Fifth Third’s stock price dropped by 74 percent, wiping out much of the value of these retirement savings. According to the plaintiffs, Fifth Third was heavily invested in the subprime lending market. As is typical in ERISA stock-drop cases, the plaintiffs alleged that the fiduciaries overseeing the plan violated their statutory duty of prudence by continuing to purchase and hold Fifth Third stock when the fiduciaries knew or should have known that the stock was an unwise investment.
The plaintiffs advanced two theories as to why Fifth Third’s ESOP fiduciaries knew or should have known that Fifth Third stock was likely to plummet. First, they alleged that publicly available information suggesting the looming implosion of the subprime lending market would have tipped off a prudent fiduciary that the stock was overvalued and headed for a drop. Second, because the plan’s fiduciaries were corporate insiders, they knew that Fifth Third officers had made material misrepresentations about the company’s finances and, therefore, that Fifth Third’s stock price was overvalued. The plaintiffs insisted that Fifth Third’s fiduciaries could have taken one of several actions in light of this insider knowledge: selling the plan’s holdings of Fifth Third stock, ceasing additional purchases of Fifth Third stock, or publicly disclosing the unfavorable insider information, allowing the market to accurately price the stock and allowing the plan beneficiaries to purchase the stock at a lower, more accurate price.
The district court dismissed the complaint, relying on the well-established “presumption of prudence,” which had been adopted to varying degrees by every circuit court to take up the issue over the past two decades. The presumption provided a hefty shield for ESOP fiduciaries in stock-drop suits. As applied by most circuit courts, an ESOP fiduciary’s decision to continue to hold and purchase employer stock as an investment—despite a drop in the stock price—was presumed to be prudent, absent allegations that the company had been in truly “dire circumstances” or was “on the brink of collapse.”
The district court found that the plaintiffs had failed to allege that Fifth Third was in the type of “dire financial predicament” that could have required plan fiduciaries to stop holding stock as an investment option, and, therefore, they could not overcome the presumption of prudence as a matter of law. The Sixth Circuit reversed. Although the Sixth Circuit agreed that ESOP fiduciaries were entitled to some form of presumption of prudence, the appellate court held that the presumption was not properly applied at the motion-to-dismiss stage, nor were the plaintiffs required to plead extreme facts showing that the employer was in dire financial straits in order to overcome the presumption of prudence—two conclusions that diverged from conclusions reached by the other circuits.
The Supreme Court’s Opinion: A Mixed Bag for ESOP Fiduciaries
In a unanimous opinion written by Justice Breyer, the Supreme Court rejected the presumption of prudence, finding that it relieved ESOP fiduciaries of their statutory duties. Relying primarily on the plain text of ERISA, the Court found that the statute imposes the same set of statutory duties on all ERISA fiduciaries—except insofar as ESOP fiduciaries are expressly exempt from the statutory duty to diversify plan assets. In other respects, the Court held that ESOP plan fiduciaries are subject to the same duty of prudence and thus are not entitled to a “special presumption of prudence.”
Fifth Third had noted that ERISA imposes a duty on fiduciaries to comply with a retirement plan’s governing documents, and the documents governing Fifth Third’s ESOP—like most ESOP governing documents—require plan fiduciaries to purchase and hold employer stock as the plan’s sole asset. The Supreme Court, however, rebuffed that argument, pointing out that ERISA only requires fiduciaries to act in accordance with plan documents“insofar as such documents are consistent” with other fiduciary duties. Thus, in the event of a conflict, the duty of prudence trumps plan documents mandating the holding of employer stock. In other words, it is possible for ESOP fiduciaries to violate their statutory duty of prudence by continuing to buy or hold employer stock when it is imprudent to do so,even if the plan’s governing documents require them to do so.
However, the Court’s opinion was not a one-sided victory for plaintiffs. The Court was sympathetic to the challenges faced by ESOP fiduciaries and the very real threat of meritless stock-drop claims. Rather than affirm the Sixth Circuit outright, the Court instead vacated and remanded the Sixth Circuit’s decision for reconsideration in light of Twombly and Iqbal. In doing so, the Court made plain that it had serious concerns about the legitimacy of plaintiffs’ pleaded theories of relief. This discussion suggests that stock-drop plaintiffs will face an uphill battle in bringing breach-of-prudence claims that can survive past the pleading stage.
With regard to claims that ESOP fiduciaries should have known based on publicly available information that holding employer stock was imprudent, the Supreme Court echoed its recent opinion in Halliburton Co. v. Erica P. John and recognized that for publicly traded companies, fiduciaries—like other investors—are entitled to presume that the market price of a security constitutes “an unbiased assessment of the security’s value in light of all public information.” Thus, “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 . . . .” The Court acknowledged that it might be possible for plaintiffs to assert a viable claim by pleading “special circumstances” that would undermine the “reliability of the market price” but declined to elaborate what those “special circumstances” might be. Nor did the Court suggest what standards should apply to claims involving privately held companies. Nonetheless, the Court’s analysis suggests that plaintiffs, as a general matter, will have difficulty alleging prudence claims based on public information.
Turning to claims that plan fiduciaries should have acted based on non-public information, the Court made clear that none of the fiduciary duties imposed by ERISA require a fiduciary to break the law. ESOP fiduciaries are not expected to violate insider trading laws by selling employer stock based on non-public information. The plaintiffs had suggested that plan fiduciaries could have taken other actions—namely, ceasing further stock purchases or publicly disclosing the inside information—that would not involve trading based on inside information. The Court, however, recognized the potential that these actions could also “conflict with the complex insider trading and corporate disclosure requirements.”Moreover, the Court noted, the corrective action advocated by the plaintiffs is a double-edged sword. Avoiding additional purchases of employer stock or making unfavorable public disclosures would likely send signals to the market, resulting in a downward correction of the stock price. This might solve the problem of investors paying an inflated price for employer stock, but, of course, it would reduce the value of existing holdings, eroding the retirement savings of those who already held employer stock. Therefore, an ESOP fiduciary could reasonably believe that taking action based on inside information would actually have done “more harm than good.”
Putting all of these considerations together, the Supreme Court held that plaintiffs asserting breach-of-prudence claims involving non-public information must initially allege at least three things in order to state a plausible claim for breach of that duty:
- “an alternative action that the defendant could have taken”;
- “that would have been consistent with securities laws”; and
- “that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than help it.”
The Court did not opine on how these requirements should be applied in the Dudenhoeffer case. Instead, the Court remanded the case to the lower courts to apply them “in the first instance.” Slip op. at 20. The Court has since remanded three other ERISA stock-drop cases to different circuit courts of appeals for reconsideration in light of Dudenhoeffer. SeeKopp v. Klein, --- S. Ct. ---, 2014 WL 2931835 (Jul. 1, 2014) (5th Cir.); Rinehart v. Akers, --- S. Ct. ---, 2014 WL 126078 (Jul. 1, 2014) (2d Cir.); Harris v. Amgen, Inc., --- S. Ct. ---, 2014 WL 272014 (Jun. 30, 2014) (9th Cir.). The stringent requirements laid out in the Supreme Court’s opinion suggest that these courts should carefully scrutinize prudence-based claims with an eye toward “weeding out” meritless claims.
Although the Supreme Court’s opinion eliminated a key defense that ESOP fiduciaries had used to shield breach-of-prudence claims in ERISA stock-drop class actions, Dudenhoefferis unlikely to flood the courts with new stock-drop cases. The stringent requirements articulated by the Supreme Court will present a high hurdle for plaintiffs looking to assert prudence-based claims. It may take time for lower courts to refine these requirements, but the Supreme Court’s opinion makes clear that district courts should view such claims with a skeptical eye and provides a roadmap for ESOP fiduciaries faced with stock-drop suits.