On June 25, 2014, the United States Supreme Court issued its much anticipated “stock drop” decision in Fifth Third Bancorp v. Dudenhoeffer, ___ U.S. ___ (2014). The Court, in vacating the Sixth Circuit’s ruling, held that there is no special presumption of prudence for employer stock offered as an investment in “eligible individual account plans,” including employee stock ownership plans (“ESOPs”) and 401(k) plans, under the Employee Retirement Income Security Act (“ERISA”).
The “bad news” is that the Court has done away with the presumption of prudence or so-called “Moench presumption” that originated in the Third Circuit’s decision in Moench v. Robertson, 62 F.3d 553 (3rd Cir. 1995), and has been adopted and applied by a number of the circuits, including the Fifth Circuit, in ERISA stock drop cases. Under the presumption, a plaintiff must prove that a company was on the brink of collapse or in a similarly dire state to demonstrate that the fiduciary acted imprudently by investing in company stock. The Court has replaced the Moench presumption with a pleading standard that may yet be difficult for plaintiffs to satisfy at the motion to dismiss stage. It remains to be seen whether this new pleading standard is "good news" or "bad news" for ERISA fiduciaries.
Every employer sponsoring an eligible individual account plan or ESOP that permits investments in employer stock will want to consider its plan provisions relating to employer stock investments in light of this decision.
The case involved Fifth Third’s decision to continue offering its stock as an investment option in its defined contribution plan that included an ESOP, allegedly in the face of knowledge that the stock was significantly overvalued. While it is normally a breach of fiduciary duty under ERISA for a plan administrator not to diversify the plan’s investment options, ERISA excludes from the duty to diversify employer stock offered under an eligible individual account plan, including an ESOP. ERISA also imposes a duty of prudence. ERISA’s duty of prudence applies to all ERISA fiduciaries, including when they make decisions concerning the holding and offering of employer stock under an ERISA plan. In Dudenhoeffer, the plaintiffs alleged, among other claims, that Fifth Third was an ERISA fiduciary and as such violated its ERISA duty of prudence. The plaintiffs alleged that Fifth Third should have realized that its stock was overvalued and that a precipitous drop in share price was imminent and so should have sold off its holdings of Fifth Third stock, stopped offering the Fifth Third stock as an investment option, or disclosed information to the market that would lead to an appropriate price correction. Failing to do so was alleged to constitute a breach of fiduciary duty under ERISA.
Presumption of Prudence
Prior to Dudenhoeffer, the courts of appeals that addressed the duty of prudence with respect to employer stock held in eligible individual account plans held that the fiduciaries were entitled to a presumption of prudence. Under this presumption, a plan fiduciary’s decision to remain invested in employer securities was presumptively reasonable. In order to overcome the presumption, plaintiffs were generally required to meet a high burden, such as showing that the employer was on the brink of collapse.
However, the appellate courts differed on whether effective rebuttal of the presumption was to be assessed at the pleading stage or only after discovery and the development of an evidentiary record. In Dudenhoeffer, the Sixth Circuit, while agreeing that fiduciaries were entitled to a presumption of prudence, held that the presumption is evidentiary only and therefore did not apply at the pleading stage. In contrast, other circuits applied the presumption and required allegations sufficient to rebut it at the pleading stage. See, e.g., In re Citigroup ERISA Litigation, 662 F.3d 128 (2nd Cir. 2011). The Court granted certiorari to resolve the split among the circuits.
The Court Strikes Down the Prudence Presumption, But Did It Create a New Presumption?
While the Court ostensibly agreed to hear the case to determine when the presumption of prudence should apply, it never got to that issue. Instead, Justice Breyer, writing for a unanimous Court, held that the decision to offer employer stock as an investment option in an employee benefit plan is not entitled to a presumption of prudence at all. Thus, “fiduciaries are subject to the same duty of prudence that applies to ERISA fiduciaries in general, except that they need not diversify the fund’s assets.” In so holding, the Court observed that the “proposed presumption makes it impossible for a plaintiff to state a duty-of-prudence claim, no matter how meritorious, unless the employer is in very bad economic circumstances.”
By eliminating the presumption of prudence, it appears, at least initially, that the Supreme Court left uncertain the path that plan fiduciaries must tread in order to fulfill their ERISA duties. Plaintiffs need not meet the heavy burden of pleading and proving that a company is on the brink of collapse or in a similar state in order to hold fiduciaries to the traditional test of prudence for decisions to invest in company stock. Thus, it appeared the Court intended to lessen the pleading burden on plaintiffs. Justice Breyer acknowledged that the Court’s decision may trap plan fiduciaries between “a rock and a hard place.” If they keep investing when company stock decreases in value they may be sued for acting imprudently, but if they stop investing and the stock increases in value they may be sued for violating their duties.
The Court suggested that the way to “weed out meritless claims” is to carefully scrutinize plaintiffs' allegations under existing Supreme Court pleading precedents. Under Ashcroft v. Iqbal, 556 U.S. 662 (2009) and Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007), two recent Supreme Court decisions collectively referred to as “Twiqbal,” plaintiffs must make detailed allegations demonstrating a “plausible” claim or else face dismissal. The Court noted that on remand, the Sixth Circuit should apply the Twiqbal requirements in light of three specific considerations.
First, the Court noted “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.” (emphasis added.) Thus, it appears that a plaintiff must plead the existence of such “special circumstances” to get beyond the motion to dismiss stage. The Court did not, however, identify or provide examples of what constitutes special circumstances “that would make reliance on the market’s valuation imprudent.” The Court did note, however, that the Sixth Circuit’s decision in Dudenhoeffer to deny dismissal appeared to be “based on an erroneous understanding of the prudence of relying on market prices.”
Second, the Court stated that a plaintiff may not be able to defeat a motion to dismiss solely by alleging that a fiduciary acted imprudently by failing to rely on nonpublic information that was only available to the fiduciary because the fiduciary is an insider. The Court explained that to claim a breach of the duty of prudence on the basis of inside information requires the plaintiff to “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.”
Third, the Court stated that the lower courts should consider whether a prudent fiduciary who is an insider would have concluded that stopping purchases of employer stock might signal to the market that the fiduciary viewed the stock as a “bad investment or that 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.”
So Where Does This Leave ERISA Fiduciaries?
All in all, as noted above, it appears that while the presumption of prudence is gone, arguably the pleading standards required by the Court still set a relatively high pleading burden for plaintiffs – that is, the initial burden is on the plaintiff to plead a breach of the duty of prudence with sufficient specificity to move beyond the motion to dismiss stage. However, Dudenhoeffer leaves several important questions unanswered that could make for a bumpy ride over the next few years.
First, it is questionable whether hardwiring an employer stock fund in the plan will protect fiduciaries. Before Dudenhoeffer, some employers have required a plan to offer employer stock purportedly in the employers’ “settlor” capacity in order to arguably keep decisions related to employer stock from being deemed fiduciary decisions. The Court’s opinion calls into question the continued viability of such a strategy.
Second, the Court failed to define what “special circumstances” might support a finding that a fiduciary should have recognized from publicly available information that the company stock was over- or undervalued by the market. Until the lower courts flesh out the meaning of this phrase, we may see a rise in stock drop litigation as plaintiffs try to establish as low a hurdle as possible for what is needed to satisfy this requirement. In the end, if plaintiffs generally are unable to clear this hurdle, stock drop litigation may again, as it has recently, subside.
Third, the Supreme Court left open the possibility that employees can sue fiduciaries for failing to act on certain inside information indicating that a stock is overvalued in the public markets. While the Court was careful to point out that ERISA never requires plan administrators to break federal securities laws, it indicated that employers may be obligated to take some sort of “alternative action … that would have been consistent with the securities laws” when inside information indicates that a drop in the employer’s stock is imminent. The Court did not speculate as to what those “alternative actions” might be. Again, this could lead to increased litigation, at least in the short term.
Finally, even if fiduciaries are ultimately no worse off despite the loss of the presumption of prudence, as indicated above, there may well be a spike in litigation until the lower courts add clarity to the open issues discussed above. Some employers may decide that they don’t want to have to live through this uncertain period, with potentially substantial additional legal expense, and decide to discontinue offering employer stock as an option in their plans. While this may be a solution for an eligible individual account plan that is a 401(k) plan, this is not a viable solution for an ESOP.