The United States Court of Appeals for the Third Circuit has affirmed the dismissal of a case against our client Avaya Inc., in which plaintiff alleged defendants breached their fiduciary duty by (1) imprudently offering employer stock as an investment option to 401(k) plan participants and (2) failing to disclose material information to those plan participants. Edgar v. Avaya, Inc., et al., __ F.3d __, 2007 WL 2781847, Case No. 06-2770 (3d Cir. Sept. 26, 2007). In the unanimous panel opinion authored by Judge Julio M. Fuentes, the court holds that a deferential “abuse of discretion” standard applies to a 401(k) plan fiduciary’s decision to follow plan terms that require employer stock to be an investment option. Further, plaintiffs must plead facts that, if true, would show the defendants abused their discretion or the case should be dismissed.
Edgar v. Avaya, Inc., et al.
In Edgar, plaintiff alleged defendant Avaya Inc. and certain of its officers breached the fiduciary duty of prudence imposed by the Employee Retirement Income Security Act (“ERISA”) when they offered Avaya common stock as an investment option to participants in several different Avaya 401(k) savings plans. According to the plaintiff, the price of Avaya stock was artificially inflated by inaccurate earnings forecasts issued by Avaya in late 2004 and early 2005. Plaintiff contended that defendants were aware of the alleged inaccuracy in the earnings forecasts – and corresponding inflation in the stock’s price – and breached their fiduciary duties by failing to sell the Avaya stock or remove it as an investment option. Plaintiff asserted that once Avaya’s “true” financial condition was disclosed to the market the stock’s price declined and the plans’ participants suffered a loss. Additionally, plaintiff alleged that defendants breached their fiduciary duty by failing to disclose to the plans’ participants the alleged materially adverse facts that led to the stock price’s inflation prior to disclosing that information to the market in connection with its quarterly earnings release.
The “Duty of Prudence”
The court began its analysis by holding that the deferential standard of review first articulated in Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995), applied to the Avaya defendants’ decision to offer Avaya stock as an investment option. Edgar, 2007 WL 2781847, *3-*4.
The plan in Moench was an employer stock ownership plan (“ESOP”) which required the plan trustee to invest all employee contributions in company stock. Edgar, 2007 WL 2781847, *3. After the price of the employer’s stock declined dramatically, a former participant in the company-sponsored ESOP sued the plan’s fiduciaries, claiming they should have diversified plan assets in light of the company’s financial deterioration. Id. The Moench court determined that an “intermediate abuse of discretion standard” would apply to the Moench defendants’ decision to invest in employer stock. Id., *4. This standard, commonly known as the Moench “presumption of prudence,” states that “an ESOP fiduciary who invests [plan] assets in employer stock is entitled to a presumption that it acted consistently with ERISA by virtue of that decision. However, the plaintiff may overcome that presumption by establishing that the fiduciary abused its discretion by investing in employer securities.” Id.
In cases subsequent to Moench, plaintiffs have argued – with some success – that the Moench presumption does not apply to non-ESOP plans. However, the Third Circuit squarely rejected that argument in Edgar:
Edgar argues that Moench’s presumption of prudence does not apply here, because the Plans at issue in this case are not ESOPs. We are not persuaded. An ESOP is one of several types of pension plans categorized under ERISA as “Eligible Individual Account Plans” or “EIAPs.” . . . It is undisputed that the Plans at issue in this case are EIAPs. Because one of the purposes of EIAPs is to promote investment in employer securities, they are subject to many of the same exceptions that apply to ESOPs. See Wright v. Oregon Metallurgical Corp., 360 F.3d 1090, 1094 (9th Cir. 2004). . . . Consequently, EIAPs, like ESOPs, “place employee retirement assets at much greater risk” than traditional ERISA plans. Wright, 360 F.3d at 1097 n.2. Given these similarities, we conclude that the underlying rationale of Moench applies equally here. In sum, we conclude that the District Court correctly determined that Moench’s abuse of discretion standard governs judicial review of defendants’ decision to offer the Avaya Stock Fund as an investment option.
Having determined that the Moench presumption applied, the Third Circuit next explained what was required to show an abuse of discretion. Relying on Moench, the court stated “[i]n order to rebut the presumption that a fiduciary acted prudently in investing in employer securities, a ‘plaintiff must show that the ERISA fiduciary could not have believed reasonably that continued adherence to the ESOP’s direction was in keeping with the settlor’s expectations of how a prudent trustee would operate.’” Id. Thus, a plaintiff must show that “owing to circumstances not known to the settlor and not anticipated by him, investing in employer securities would defeat or substantially impair the accomplishment of the purposes of the trust.” Id.
The court found the plaintiff’s allegations in Edgar insufficient to establish an abuse of discretion:
Edgar’s allegations, if true, indicate that during the Class Period, Avaya was undergoing corporate developments that were likely to have a negative effect on the company’s earnings and, therefore, on the value of the company’s stock. In fact, this is precisely what happened when the price of Avaya stock declined by $2.68 per share following Avaya’s April 19, 2005, earnings announcement. We cannot agree, however, that these developments, or the corresponding drop in stock price, created the type of dire situation which would require defendants to disobey the terms of the Plans by not offering the Avaya Stock Fund as an investment option, or by divesting the Plans of Avaya securities. Indeed, had defendants divested the Plans of Avaya common stock during the Class Period, they would have risked liability for having failed to follow the terms of the Plans.
Finally, the court rejected plaintiff’s argument that applying the Moench presumption at the motion to dismiss stage was “inconsistent with the liberal pleading standards in Rule 8 of the Federal Rules of Civil Procedure.” Id. The court noted that “[q]uite simply, if a plaintiff does not plead all of the essential elements of his or her legal claim, a district court is required to dismiss the complaint pursuant to Rule 12(b)(6).” Id. Accordingly, the court saw “no reason to allow this case to proceed to discovery when, even if the allegations are proven true, Edgar cannot establish that defendants abused their discretion.” Id.
The “Duty of Disclosure”
The Third Circuit also soundly rejected the plaintiff’s argument that, even if defendants were not required to divest the plans of Avaya stock, they were required to disclose to the plans’ participants the alleged adverse facts relating to Avaya’s financial prospects prior to any earnings announcement. Id., *7. In rejecting this argument, the court reasoned that:
The Summary Plan Descriptions inform Plan participants that their investments are tied to the market performance of the 17 funds; that each fund carries different risks and potential returns; that participants are responsible for investigating the investment options; and that, in doing so, they might consider seeking the advice of a personal financial advisor. In addition, the Plan Descriptions explicitly warn participants that there are particular risks associated with investing in a non-diversified fund. Nowhere in the Plan Descriptions or the Plans themselves are participants guaranteed a particular return on their investments. These disclosures were sufficient to satisfy defendants’ obligation not to misinform participants about the risks associated with investment in the Avaya Stock Fund.
The court further reasoned that “[u]nder Third Circuit law, [defendants] did not have a duty to ‘give investment advice’ or ‘to opine on’ the stock’s condition.” Id. Additionally, the court specifically rejected plaintiff’s argument that there was a duty to disclose the adverse developments under ERISA before the quarterly earnings announcement. The court reasoned that had defendants “publicly released any adverse information they had prior to the April 2005 announcement, under the ‘efficient capital markets hypothesis,’ such a disclosure would have resulted in a swift market adjustment . . . and the Plans would have sustained the same losses they incurred when the Company publicly announced the quarterly results . . . .” Id. In addition, the court noted that defendants could have faced potential liability under the securities laws for insider trading if they had decided to divest the plans of company stock based on non-public information. Id. Thus, the court concluded that the failure to inform participants about the adverse corporate developments prior to the earnings announcement did not “constitute a breach of their disclosure obligations under ERISA.” Id.
Edgar is an important development in the jurisprudence surrounding employee stock in 401(k) plans. It raises the bar for plaintiffs to survive motions to dismiss such cases, and it adds to the growing list of opinions that reject these claims.