The U.S. Supreme Court has unanimously decided that the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), does not contain a presumption of prudence for employee stock ownership plan (“ESOP”) fiduciary actions, rejecting the presumption adopted by many U.S. Courts of Appeals and returning to the plain terms of ERISA. Fifth Third Bancorp v. Dudenhoefer, No. 12-751 (June 25, 2014).
Justice Stephen G. Breyer, writing for the Court, relied on the general language of the ERISA statute and the common law presumptions that a prudent fiduciary cannot be obligated to violate the law. The Court rejected the complex series of presumptions developed in ESOP cases commonly referred to as the Moench presumption. Finding no such presumption exists under ERISA, the Court returned to the specific statutory terms to define the fiduciary obligations under an ESOP.
Fifth Third Bancorp addressed facts involving an ESOP holding publicly traded securities. With the Court’s reliance on the plain language of ERISA, its reasoning would apply equally to ESOPs holding non-publicly traded securities, thus ensuring that the Court’s guidance will be relevant to all ESOPs, their fiduciaries and plan sponsors.
In Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995), the U.S. Court of Appeals for the Third Circuit concluded that an ERISA fiduciary of an ESOP is entitled to a presumption that its decision to invest in the plan sponsor’s securities is prudent. A plaintiff, however, was permitted to rebut the presumption with evidence that an investment, in the language of a Restatement (Second) of Trusts, would “defeat or substantially impair the accomplishment of the purposes of the trust,” to show that ERISA plan fiduciaries are not required to follow the plan’s document. Because an ESOP trust is designed to invest “primarily in qualifying employer securities,” under standards set forth in the Internal Revenue Code of 1986, as amended, and ERISA, plaintiffs’ efforts to rebut the Moench presumption has met with only limited success.
Widespread Adoption of Moench Presumption in Stock Drop Cases
The Moench presumption had been widely accepted prior to the Supreme Court’s acceptance of this case for review. The federal circuits were in conflict over the appropriate stage at which to apply this presumption — at the pleadings stage or as an evidentiary rule — as well as over the proper standard for overcoming the presumption. These issues, however, were rendered moot by the Court’s conclusion that ERISA does not contain a presumption of prudence for ESOP and ERISA fiduciary actions.
ESOP-Specific Presumption of Prudence Rejected
The presumption of prudence was derived by the lower courts trying to reconcile application of the ERISA prudence standard with the definition of ESOPs as designed to invest primarily in qualifying employer securities. While the Supreme Court acknowledged that “these congressional directives are in some tension with each other,” because the standards of prudence applied under ERISA to all fiduciaries of employee benefit plans, including fiduciaries of ESOPs, it found that an ESOP-specific rule applicable to such prudence standards was precluded. That ERISA contains such an ESOP-specific exception to the prudence standard, insofar as prudence mandates diversification, indicates that Congress did not intend an unwritten standard “to promote ESOPs by further relaxing the duty of prudence as applied to ESOPs,” according to Justice Breyer.
The Court rejected the view that a presumption of prudence was necessary for ESOP ERISA fiduciaries to comply with insider trading laws applicable to publicly traded securities, endorsing the common law principle that an ERISA fiduciary cannot be required to violate the law. The Court also rejected high exposure to litigation risks as a rationale for endorsing an ESOP-specific presumption of prudence.
Lawsuits in Absence of ESOP-Specific Presumption of Prudence
The Court acknowledged the need to balance Congressional directives (i.e., encouraging the establishment of ESOPs while also ensuring the enforcement of ERISA rights); however, it artfully rejected an ESOP-specific presumption of prudence as an appropriate method to “readily divide the plausible sheep from the meritless goats.” Instead, the Court pointed out that a more appropriate method of achieving such balance is through a motion to dismiss for failure to state a claim. The Court provided the following guidance for evaluating such motions:
- With respect to publicly traded stock, absent publicly known fraud in the marketplace, ERISA fiduciaries are not imprudent to consider the market price as the best evidence of fair market value based on all publicly available information.
- Furthermore, if the alleged breach of the ERISA duty of prudence is based on insider 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.”
In reviewing a complaint upon a motion to dismiss, the Court held that lower courts must consider the following:
- fiduciaries are not required to violate the law to satisfy the ERISA duty of prudence;
- the extent to which the alternative actions (either refraining from additional investments on the basis of such insider information or public disclosure of the insider information) could conflict with federal securities laws or their objectives (including provisions applicable to complex insider trading and corporate disclosure requirements); and
- whether a prudent ERISA fiduciary could not have concluded that the alternative action (i.e., freezing additional investments in employer securities or public disclosure of the insider information) would more likely harm the fund (i.e., result in a decrease in the value of the employer securities that the plan already holds).
Implications for ESOPs Involving Non-Publicly Traded Securities
The Court’s reliance on the general standard of prudence under ERISA means that all ESOPs, regardless of the type of securities they hold, are to be held to a standard of prudence without the benefit of a presumption of prudence. This applies to the ERISA fiduciary actions related to the acquisition and sale of qualifying employer securities, not merely the holding of such securities. Because much of the authority under ERISA has held that rigorous standards of procedural prudence are integral to demonstrating a plan fiduciary prudent course of action, fiduciaries for ESOPs holding non-publicly traded employer securities or considering the acquisition of non-publicly traded employer securities should clearly document all actions, omissions, and deliberations with respect to such investments and transactions to reflect their procedural prudence.
Furthermore, individuals and entities not intending to assume an ERISA fiduciary role for such ESOPs need to ensure that the ESOP and ERISA fiduciaries establish the procedural context of their independence. The Court plainly recognized that ESOP and ERISA fiduciaries “are often company insiders.” While the Court focused on implications of this to insider trading laws, the Court implicitly recognized that the “multiple hat” role of an ESOP and ERISA fiduciary is frequent and not inconsistent with prudence as long as prudence is duly exercised by such ESOP and ERISA fiduciary.
The insider trading discussion in Fifth Third Bancorp arguably may assist an ERISA fiduciary for an ESOP holding non-publicly traded securities. After describing the difficulties of predicting market returns, the Court stated, “ERISA fiduciaries may, as a general matter . . . prudently rely on the market price.” Lower courts now may conclude that the reliance on a valuation report that is fully compliant with long-recognized standards included in the U.S. Department of Labor’s (“DOL”) proposed “adequate consideration” regulations for valuation reports represents such reliance, where the ESOP and ERISA fiduciary’s determination of the value of qualifying employer securities occurs in good faith on the basis of such valuations in the form described in the proposed DOL regulations. That is the optimistic view. The more pessimistic view is that the floodgates of litigation predicted by petitioners in Fifth Third Bancorp will be opened because of the stringent standards enunciated by the Court for addressing ERISA prudence claims at the pleadings stage of a case. Time will tell how the lower courts react. In the interim, increased attention to procedural prudence and its documentation should be the hallmark of ESOP and ERISA fiduciary action as well as of actions of ERISA fiduciaries addressing other complex issues.