On June 25, 2014, in a highly anticipated decision, the U.S. Supreme Court unanimously held in Fifth Third Bancorp v. Dudenhoeffer that employee stock ownership plan (ESOP) fiduciaries (as well as fiduciaries of other plans that hold employer stock) are not entitled to a “presumption of prudence”with respect to plan investments in employer stock.1 However, the Court also held that (i) allegations that publicly available information should have caused fiduciaries to recognize that the market was over- or undervaluing stock are generally implausible, absent “special circumstances,” and (ii) ERISA does not require fiduciaries to divest a plan’s employer stock holdings based on nonpublic information because fiduciaries are not required (or even permitted) to commit insider trading to comply with their ERISA fiduciary duties. The Court directed lower courts to consider whether plaintiffs can state a breach of fiduciary duty claim at all based on a fiduciary’s failure to act on nonpublic information, taking into account certain key considerations.
A fundamental principle under the Employee Retirement Income Security Act of 1974, as amended (ERISA), is that the fiduciaries of an ERISA- governed plan must act with the “care, skill, prudence, and diligence” of a prudent person acting under the circumstances. Over the years, there has been debate about how that standard should be applied to a fiduciary of a plan, such as an ESOP, that provides for investment in the plan sponsor’s (or a related entity’s) stock. Courts in many federal districts held that because such a plan is designed to hold employer stock, the fiduciaries of the plan are entitled to a presumption that they acted prudently by retaining the plan’s investment in such stock and continuing to offer the stock fund as an investment option in self-directed plans. For nearly two decades, this presumption of prudence served as the basis of a defense for plan sponsors and fiduciaries in “stock drop” cases, in which plan participants allege that their plan’s fiduciaries violated their ERISA obligations by allowing participants to continue investing in employer stock when the fiduciaries knew or should have known that doing so was imprudent. While the presumption of prudence generally permitted fiduciaries to continue to allow investment in employer stock, the circuit courts were split over when the presumption should apply and how the presumption could be overcome.
Defendant Fifth Third Bancorp (Fifth Third) maintained a defined contribution plan that permitted eligible Fifth Third employees to make voluntary contributions to the plan and direct them to any of the plan’s investment options. The plan designated an employer stock fund as an investment option and stated that the fund shall be primarily invested in shares of common stock of Fifth Third. Fifth Third made matching contributions that were initially invested in the plan’s employer stock fund, provided that employees could choose to transfer investments to another investment option.
Participants in the Fifth Third plan filed suit in the Southern District of Ohio after Fifth Third’s stock price fell by 74% between July 2007 and September 2009, alleging that the plan fiduciaries knew or should have known that Fifth Third’s stock was overvalued and excessively risky because (i) publicly available information provided “early warning signs” that the subprime lending industry (which formed a large part of Fifth Third’s business) would “leave creditors high and dry,” and (ii) nonpublic information indicated that Fifth Third officers had “deceived the market by making material misstatements about [Fifth Third’s] financial prospects.”
The District Court dismissed the plaintiffs’ complaint and held that Fifth Third’s decision to maintain the plan’s investment in (and not divest the fund of) Fifth Third common stock was entitled to a presumption of prudence that the plaintiffs had not overcome.
On appeal, the Sixth Circuit reversed in part based on procedural issues, but held that the presumption of prudence does not apply at the pleading stage of a case.
Supreme Court Holding
As noted above, the Supreme Court rejected the application of the presumption of prudence altogether, holding that there is no presumption that follows from ERISA with respect to ESOPs and other plans that hold employer stock.2 The Court remanded the case back to the Sixth Circuit for reconsideration and in doing so made some statements that may nonetheless provide favorable arguments for fiduciaries.
First, the Court distinguished complaints alleging a breach of the duty of prudence based on publicly available information alone from those alleging a breach of the duty of prudence based on insider information. It noted that in the first instance, such allegations are “implausible as a general rule, at least in the absence of special circumstances.” The Court noted that investors may rely on a security’s market price as an unbiased assessment of the security’s value in light of all public information, and stated that ERISA fiduciaries could prudently rely on market price. Importantly, the Court held that the Sixth Circuit had failed to identify any “special circumstances,” and noted that its reversal of the district court’s dismissal of the complaint appeared to have been based on “an erroneous understanding of the prudence of relying on market prices.”
Secondly, with respect to any obligation to act on the basis of inside information, the Court stated that a plaintiff must plausibly allege an alternative action that a fiduciary could have taken, and that any such action must be (i) consistent with securities laws and (ii) an action that a prudent fiduciary would not have viewed as more likely to harm the fund than help it. Recognizing that fiduciaries cannot be required to break the law and that divesting a fund’s employer stock holdings based on inside information would violate the federal securities laws, the Court held that the Sixth Circuit erred to the extent that its decision was based on the theory that the duty of prudence in effect takes precedence over the securities laws and therefore requires fiduciaries to sell the fund’s employer stock based on nonpublic information to comply with their ERISA fiduciary duties. The Court also held that “where a complaint faults fiduciaries for failing to decide, on the basis of inside information, to refrain from making additional stock purchases or for failing to disclose that information to the public so that the stock would no longer be overvalued,” lower courts should consider
the extent to which an ERISA-based obligation either to refrain on the basis of inside information from making a planned trade or to disclose inside information to the public could conflict with the complex insider trading and corporate disclosure requirements imposed by the federal securities laws or with the objectives of those laws.
Finally, the Court held that lower courts faced with such claims should also consider whether such action “would do more harm than good” by either directly or indirectly signaling that the employer’s stock is a bad investment, which would “caus[e] a drop in both the stock price and a concomitant drop in the value of the stock already held by the fund.”
Implications for Employers
The Fifth Third decision settles a dispute among lower courts about whether fiduciaries of ESOPs and other plans holding employer stock are entitled to a presumption of prudence. While many plan sponsors and fiduciaries may be disappointed that they can no longer rely on the presumption of prudence to defend against “stock drop” claims, the Supreme Court’s opinion includes several important holdings that may prove helpful to fiduciaries at publicly traded companies regarding how lower courts should evaluate prudence claims based on public and/or nonpublic information.