In Fifth Third Bancorp v. Dudenhoeffer, No. 12-751 (U.S. June 25, 2014), the Supreme Court rejected a presumption-previously adopted by most courts of appeal-that employee stock ownership plan fiduciaries act prudently by investing plan assets in employer stock. The Court did, however, issue guidance making clear that many-possibly most-claims against those fiduciaries may well fail at the pleading stage.
The Employee Retirement Income Security Act of 1974 ("ERISA") governs employee stock ownership plans ("ESOPs"), which are pension plans designed to invest primarily in the stock of the company that employs the plan participants. ERISA requires fiduciaries of all pension plans, including ESOPs, to act prudently in managing the plan's assets, but ESOPs enjoy an exemption from the normally-imposed requirement of asset diversification. See 29 U.S.C. § 1104(a). In numerous cases, plan participants have alleged that ESOP fiduciaries acted imprudently by continuing to invest plan assets in company stock, even as the company encountered financial difficulties. Most appellate courts had recognized a presumption that ESOP fiduciaries acted prudently by investing in company stock. The presumption had been judicially developed in recognition of an ESOP's special purpose to invest in the sponsoring employer's common stock. To survive a motion to dismiss under this standard, plaintiffs had to show that the fiduciary knew or should have known that the employer's survival was in serious peril. The presumption effectively precluded imprudence claims against ESOP fiduciaries based on their investments in company stock except in extraordinary circumstances.
Supreme Court's Decision
The Supreme Court unanimously held, based primarily on the text of ERISA, that "the law does not create a special presumption favoring ESOP fiduciaries." Instead, the Court held, a claim alleging that an ESOP fiduciary acted imprudently should be judged according to the general plausibility pleading standard set forth in Ashcroft v. Iqbal, 556 U.S. 662 (2009) andBell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007).
Critically, the Court went on to explain why, even applying this standard, motions to dismiss would still provide an "important mechanism for weeding our meritless claims."
Claims against ESOP fiduciaries are necessarily based on allegations that they should have known that ongoing investment in company stock was imprudent based on either public or nonpublic information. The Court appears to have sharply curtailed both types of claims.
First, the Court held that "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." It reasoned that ESOP fiduciaries are not obliged to outsmart the market. Fiduciaries can assume that the market provides the best estimate of a security's price, unless plaintiffs plausibly allege "a special circumstance affecting the reliability of the market price."
Second, the Court also held that, to state a claim based on nonpublic information, "a plaintiff 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." The Supreme Court made clear that, under this test, plan participants cannot allege that ESOP fiduciaries should have sold company stock based on nonpublic information, because that would require them to violate the securities laws.
Plaintiffs in Fifth Third alleged that as "alternative actions," the fiduciaries should have refrained from making further purchases of company stock or disclosed the nonpublic information. The Court held that these claims were only sustainable if plaintiffs "plausibly alleged that a prudent fiduciary in the defendant's position could not have concluded that stopping purchases-which the market might take as a sign that insider fiduciaries viewed the employer's stock as a bad investment-or publicly disclosing negative information 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." It directed the lower courts to determine whether, on the facts, this standard was met in Fifth Third.
The Supreme Court's rejection of the presumption that ESOP fiduciaries act prudently by investing in company stock may cause many public companies to reassess whether or not to offer an ESOP and take the risk of litigation when the stock price declines.
Nevertheless, Fifth Third makes clear that plan participants asserting imprudence claims against ESOP fiduciaries continue to carry a high burden-and this burden will continue to apply at the pleading stage and be the proper subject of motions to dismiss.
In light of Fifth Third, it appears that a plan participant should not be able to survive a motion to dismiss by alleging, based on public information, that a fiduciary should not have invested in company stock. It is likely to be the rare case in which plaintiffs can plausibly allege "a special circumstance affecting the reliability of the market price," which was known or should have been known by the defendant fiduciaries.
Participants may attempt to assert imprudence claims based on the fiduciary's access to negative non-public information, but here will face the requirement that they identify an "alternative action" that the fiduciary should and lawfully could have taken based on that information. In particular, participants can state such a claim only by plausibly alleging that a prudent fiduciary "could not have concluded" that the benefits of that alternative action outweighed its harm. But because the most obvious alternatives in most cases-stopping additional company stock purchases or disclosing negative nonpublic information-are likely to cause significant harm to plan assets, as the Court expressly recognized, this will likely be a difficult burden for participants to meet.
The Supreme Court's opinion does not consider how these rules and considerations will be applied to ESOPs established by private companies.