A unanimous US Supreme Court has declared that the circuit courts have been unanimously wrong: Fifth Third Bancorp v. Dudenhoeffer, decided June 25, 2014, holds that fiduciaries of an employee stock ownership plan (“ESOP”) are not entitled to a presumption that their decision to do what the plan mandates – buy and hold employer stock – is prudent. Instead, that decision is subject to review under ERISA § 404(a)(1), the same prudence standard generally applicable to all ERISA fiduciaries, except that ERISA § 404(a)(2) exempts ESOP fiduciaries from the statutory diversification requirement. The decision thus puts to rest the so-called “Moench presumption” of prudence that largely had governed this area. While the Court rejected the Moench presumption, its decision clearly is not the “game changer” the plaintiffs’ bar had hoped for. Far from leaving a wide-open door for future stock drop suits, the decision places significant obstacles in the way of complaints challenging the prudence of fiduciary decisions to buy or hold employer stock. The Court’s focus on “divid[ing] the plausible sheep from the meritless goats” through “careful, context-sensitive scrutiny of a complaint’s allegations” validates the concerns of plan sponsors and fiduciaries about meritless and costly stock drop litigation and makes clear that these cases remain ripe for disposal at the motion to dismiss stage. In particular, the opinion eviscerates the basic theories that plaintiffs have attempted to advance in the stock drop context. The Court states firmly that fiduciaries cannot trade on the basis of insider information and are entitled to rely on prices set by the market. Those pronouncements largely sound the death knell for divestment claims – the big money claim in this area. Claims that fiduciaries should halt trading or make public pronouncements that are not required by the federal securities law should fare no better given the Court’s recognition that such “alternatives” generally would cause more harm than good. A more detailed discussion of the Court’s opinion is provided below. Background The facts of Dudenhoeffer were similar to many other stock drop complaints that have been filed over the years. Fifth Third Bancorp maintains a 401(k) plan that allows participants to choose among 20 or so different investment options. One option is a fund that invests solely in Fifth Third stock (except for a small pool of liquid assets held to facilitate transactions into and out of the fund). The stock fund is designated as an “employee stock ownership plan” (ESOP), a status that requires that its assets be invested primarily in “qualifying employer securities” (generally common stock, though some types of preferred stock and publicly held debt can also qualify).1 The crisis in subprime real estate lending that emerged in the first part of 2007 and accelerated over the following months had an adverse impact on many banks, Fifth Third among them. The bank’s stock declined in value by almost 75 percent between July 2007 and September 2009, the period that the Dudenhoeffer plaintiffs focused on in their class action complaint. The complaint alleged that the plan fiduciaries were aware of Fifth Third’s supposedly dangerous subprime exposure and that their duties to act prudently and for the exclusive benefit of participants, as set forth in ERISA, mandated that they cut off new investments in the employer stock fund while divesting the plan of Fifth Third stock. Their failure to do so supposedly caused plan participants to suffer substantial losses. The plaintiffs also alleged that false statements in the bank’s SEC filings, incorporated by reference into the ESOP’s summary plan description (SPD), misled participants into selecting the stock fund over other, safer investment options. (The disclosure issue didn’t reach the Supreme Court but, as noted later in this article, has important ramifications that are sure to be the subject of post-Dudenhoeffer litigation.)
The fiduciaries’ first line of defense was the so-called “Moench presumption”: that an ESOP’s investment in employer stock is not a fiduciary violation, unless the evidence very clearly shows otherwise. This presumption – named after the case that introduced it, Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995), cert. denied, 516 U.S. 1115 (1996) – was widely adopted by circuit and district courts. Moench’s holding was that an ESOP fiduciary’s decision to invest in employer stock – a decision directed or encouraged by the plan’s terms – could be judged imprudent only if it was “arbitrary and capricious.” Moench and its siblings proved to be a formidable barrier to stock drop claimants. The general view was that plaintiffs could prevail only by showing that ESOP fiduciaries had recklessly maintained investments in employer stock despite facts intimating a likelihood of bankruptcy or comparable disaster. In Dudenhoeffer, the defendants won in the district court, 757 F. Supp. 2d 753 (S.D. Ohio 2010), which held that the facts set forth in the complaint didn’t rise to the level of plausibly alleging abuse of discretion and that the statements in the SEC filings weren’t actionable under ERISA, because they were not made in a fiduciary capacity. The court granted the defendants’ motion to dismiss – thus sparing them from discovery, motions for summary judgment and, in the worst case, a trial on the merits, all of which can involve huge effort and expense even if the plaintiffs’ case is not particularly meritorious. The US Court of Appeals for the Sixth Circuit reversed. It had endorsed the Moench presumption almost immediately after its first appearance (Kuper v. Iovenko, 66 F.3d 1447 (6th Cir. 1995)). Recently, however (and after the district court decision in Dudenhoeffer), the Sixth Circuit had decided that its version of Moench was somewhat different from that of most other courts and that the difference required the full development of evidence before the “presumption” could be applied. Pfeil v. State Street Bank and Trust Company, 671 F.3d 585 (6th Cir. 2012). In the Sixth Circuit’s view, Moench did not establish a standard of conduct against which a fiduciary could be judged but only an evidentiary presumption that the plaintiff could rebut “by showing that a prudent fiduciary acting under similar circumstances would have made a different investment decision.” As an evidentiary presumption, it could not be invoked until after the parties had the opportunity to discover and present evidence. The defendants sought review by the Supreme Court, which granted certiorari on the seemingly narrow question of whether a motion to dismiss can be granted on the basis of the Moench presumption. (The Sixth Circuit had also reversed the district court on the disclosure issue, but the Court denied certiorari on that question.) Appearances were deceiving, though, because the question whether the presumption exists logically precedes any determination of the proper stage of litigation for applying it. Is an ESOP fiduciary entitled – indeed, compelled – to invest plan assets in employer stock save in extraordinary circumstances where the company is on the brink of collapse, or are his or her actions to be evaluated under ERISA’s more general prudence standard?
The Supreme Court’s Analysis A. The Court Rejects the Presumption Justice Breyer, writing for a unanimous Court, rejected the Moench standard, finding no basis for a presumption of prudence in the text of ERISA: In our view, the law does not create a special presumption favoring ESOP fiduciaries. Rather, the same standard of prudence applies to all ERISA fiduciaries, including ESOP fiduciaries, except that an ESOP fiduciary is under no duty to diversify the ESOP’s holdings. This conclusion follows from the pertinent provisions of ERISA. Slip Op. at 8. The opinion then considered and rejected four arguments advanced for an implicit presumption protecting the fiduciary. The key argument was the one to which the Court devoted the greatest attention: that since ERISA defines prudence in terms of “what a prudent person would do ‘in the conduct of an enterprise of a like character and with like aims,’” prudence in the ESOP context must be interpreted in light of the goal of promoting employee ownership of employer stock. The Court rejected the notion that “the content of ERISA’s duty of prudence varies depending upon the specific nonpecuniary goal set out in an ERISA plan.” Slip Op. at 10 (emphasis added). Concluding that the “enterprise” referenced in ERISA § 404(a)(1)(B) is one whose “exclusive purpose” is to “provid[e] benefits to participants and their beneficiaries” while “defraying reasonable expenses of administering the plan,” id. (emphasis added), the Court read the term “benefits” to include only “the sort of financial benefits (such as retirement income) that trustees who manage investments typically seek to secure for the trust’s beneficiaries,” and not “nonpecuniary” benefits arising from employee ownership. Id. at 10-11 (emphasis in original). The Court likewise found the remaining arguments in favor of the presumption – that general trust law allows settlors to vary the duty of prudence, that the Moench presumption was necessary to avoid conflict with prohibitions against insider trading, and that the absence of the presumption would expose plans to vexatious litigation – unpersuasive. It held that the first contradicts ERISA, that the problem of insider trading can be dealt with by other means, and that a broad presumption is not “an appropriate way to weed out meritless lawsuits.” B. Stock Drop Claims Remain Subject to Careful Scrutiny for Plausibility Having rejected the Moench presumption, the Court went on to emphasize that stock drop claims remain subject to dismissal under existing Iqbal and Twombly pleading standards. In the process, it recognized a number of significant obstacles to a plaintiff’s ability to allege a plausible ERISA stock drop claim that leaves such claims ripe for disposition on a motion to dismiss. First, it opined that: In our view, 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.
Slip Op.at 16 (emphasis added). As a result, where public information is involved, a plaintiff faces a daunting burden – he or she must plausibly allege facts that, if proven, would overcome the rule that fiduciaries “may, as a general matter, … prudently rely on the market price” of stock or face dismissal of his or her complaint. Second, the Court made it clear that ESOP fiduciaries have no duty to violate securities law prohibitions against trading on nonpublic information: As every Court of Appeals to address the question has held, ERISA’s duty of prudence cannot require an ESOP fiduciary to perform an action – such as divesting the fund’s holdings of the employer’s stock on the basis of inside information – that would violate the securities laws. Slip Op. at 19. Third, with respect to claims that ESOP fiduciaries with inside information had an obligation to refrain from further stock purchases or disclose the information to the market, the Court emphasized that the complaint must plausibly allege an alternative action that could have been taken consistently with the securities laws and that a prudent fiduciary would not have viewed as more likely to cause harm than good: The 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. . . . . [L]ower courts faced with such claims should also consider whether the complaint has 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. Slip Op. at 19-20. As noted previously, the Court chose not to review the Sixth Circuit’s holding that an ERISA fiduciary claim can be based on allegedly false statements in Securities and Exchange Commission (SEC) filings that are incorporated by reference into an SPD. The Sixth Circuit’s ruling on that issue conflicts with the Second Circuit’s decisions in Gearren v. McGraw-Hill Cos., Inc., 660 F.3d 605 (2d Cir. 2011) and Fisher v. JP Morgan Chase & Co., 469 Fed. Appx. 57 (2d Cir. 2012). Whether the Sixth Circuit’s view will be adopted by other courts remains to be seen. As a practical matter, plan fiduciaries simply do not have either the time or resources to “fact check” every statement made in SEC filings that are incorporated by reference in plan documents. Nor does it make sense to require plan fiduciaries to engage in any such exercise – SEC filings are independently verified and certified by the company and its officers, and the securities laws provide remedies for false or misleading statements in documents filed with the SEC. Conclusion In the short term, the Court’s rejection of Moench may be somewhat disappointing. The lower courts had come up with a workable rule that provided guidance to plan sponsors and fiduciaries and protected them from meritless claims that could not find traction in the area in which they really belong – the federal securities laws. Nonetheless, while the decision initially may result in a new wave of these cases, it may not change their ultimate outcome. As noted above, while rejecting Moench, the decision also rejects the basic theories that plaintiffs have attempted to advance in the stock drop context. The Court also recognized that the lower courts can and should continue to dispose of these cases where appropriate on a motion to dismiss. And the opinion gives them the tools to do so by rejecting as “implausible” claims based on little more than the fact of a stock drop and allegations of insider information.