On June 25, 2014, the U.S. Supreme Court in Fifth Third Bancorp v. Dudenhoeffer rejected the presumption of prudence theory that many employee stock ownership plan (ESOP) fiduciaries relied on when challenging a claim of breach of fiduciary duty. The Court also addressed a number of federal securities law issues that fiduciaries of public company ESOPs who have inside information must face and provided specific guidance for courts to consider with respect to the requirements for pleading an ERISA fiduciary breach of a fiduciary’s duty of prudence claim in connection with publicly traded employer stock drop cases. Employers sponsoring ESOPs and 401(k) plans with employer stock funds and plan fiduciaries should take heed of this “new world” set forth by the Court for analyzing an ESOP fiduciary’s breach of his fiduciary duty of prudence and determine whether to take any affirmative action in light of this new framework.
The Moench Presumption
Prior to the Supreme Court’s decision in Dudenhoeffer, a majority of the Circuit Court of Appeals had adopted some form of a presumption of prudence for ESOP fiduciaries (commonly referred to as the “Moench Presumption” for the Third Circuit case Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995), which first established this presumption of prudence for ESOP fiduciaries). This presumption of prudence had been a welcome protection for ESOP fiduciaries and created an uphill battle for plaintiffs alleging that an ESOP fiduciary breached his fiduciary duty of prudence in ERISA “stock drop” cases.
Fifth Third Bancorp v. Dudenhoeffer – The Facts
Fifth Third Bancorp sponsored a 401(k) plan for its employees and provided a matching contribution of up to 4 percent of a plan participant’s compensation. While plan participants could allocate their contributions to the plan among the 20 different investment funds available under the plan, including investment in an employer stock fund which invested in Fifth Third shares of common stock (the ESOP), Fifth Third’s matching contributions were always initially invested in the ESOP. Participants could subsequently move amounts in their ESOP account to another available investment fund in the 401(k) plan. The 401(k) plan document required that the ESOP be invested primarily in shares of Fifth Third common stock.
The plaintiffs—former plan participants—alleged that the ESOP fiduciaries breached their ERISA fiduciary duty of prudence. Specifically, the plaintiffs alleged that the ESOP fiduciaries should have known, based on public and non-public information, that Fifth Third stock was “overpriced and excessively risky.” In connection with the subprime mortgage crisis, Fifth Third’s stock price declined by 74 percent between July 2007 and September 2009.
The district court dismissed the complaint for failure to state a claim, holding that the ESOP fiduciaries were entitled to a presumption of prudence with respect to the decision to permit the ESOP’s investment in Fifth Third stock. While the Sixth Circuit acknowledged that the ESOP fiduciaries were entitled to a presumption of prudence, it reversed the district court’s decision holding that the presumption is evidentiary only so that it did not apply at the motion to dismiss stage of the case.
Supreme Court’s New Framework for ESOP Fiduciaries
The U.S. Supreme Court rejected the “Moench” presumption of prudence in connection with an ESOP fiduciary’s decision to hold or purchase employer stock and held that an ESOP fiduciary is subject to ERISA’s general standard of prudence as provided in ERISA §404(a)(1)(B), as limited by the statutory exception in ERISA §407(b)(1)(B) that an ESOP fiduciary is not subject to the duty to diversify plan investments. The Court reasoned that in applying a more expansive presumption of prudence, the courts were inappropriately going beyond the statutory exception expressly afforded to ESOP fiduciaries, which “makes no reference to a special ‘presumption’ in favor of ESOP fiduciaries.”
The Court also noted that an ESOP fiduciary’s “duty of prudence will trump the instructions of a plan document, such as an instruction to invest primarily in employer stock even if financial goals demand the contrary.” This will be unwelcome news for many plan sponsors and ESOP fiduciaries who added language to plan documents requiring that the ESOP be invested in employer stock as a method to further shield ESOP fiduciaries from a breach of fiduciary duty claim.
The Court did, however, recognize the need to protect ESOP fiduciaries from meritless claims and provided additional guidance for courts to consider at the pleading stage of a breach of fiduciary duty claim relating to ESOP plan sponsors who trade their shares on a public market in light of certain federal securities law requirements:
- Public Information: Allegations that a fiduciary should have recognized from publicly available information that the market was over- or undervaluing publicly traded stock are “implausible as a general rule, at least in the absence of special circumstances.” The Court did not give examples about what might be considered a “special circumstance” where a fiduciary’s reliance on the public market’s valuation of the employer stock would be imprudent.
- Non-Public Information: Allegations that a fiduciary should have acted based on non-public, inside information must “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 Court stated that ERISA’s fiduciary duties cannot require a fiduciary to break the law, including federal securities insider-trading laws, and the courts should consider whether refraining from making a planned transaction on the basis of inside information or disclosing inside information to the public (as a method to “correct” the employer stock price) could conflict with federal securities laws. The Court encouraged the SEC to provide its views on this issue.
- The Court also noted that courts should consider whether a prudent fiduciary could have concluded that stopping purchases of employer stock or publicly disclosing inside information could cause a drop in the employer stock that would do more harm than good to the value of the employer stock already held by the ESOP.
Next Steps for ESOP Plan Sponsors and Fiduciaries
- As a result of Dudenhoeffer, ESOP fiduciaries are no longer able to rely on plan language requiring that an ESOP invest primarily in employer stock or that a plan, like a 401(k) plan, maintain an employer stock fund as an available investment option to satisfy their duty of prudence. ESOP fiduciaries should establish and document a process for monitoring an employer stock fund similar to their review of other investment options under the plan (acknowledging that the duty to diversify plan assets does not apply to the employer stock fund). For publicly-traded employer stock, this may include periodic monitoring of market price and assessing for any potential “special considerations.”
- Many ESOP fiduciaries are employees of the ESOP plan sponsor who have access to inside, non-public information. In light of the Court’s decision in Dudenhoeffer, plan sponsors may want to consider the following alternatives to mitigate litigation risks:
- Appoint an independent fiduciary to oversee the ESOP;
- Consider limiting ESOP fiduciaries to employees who are not likely to have regular access to inside information;
- As a matter of plan design for non-leveraged ESOPs in 401(k) plans, consider offering employer stock as an investment only through a plan participant’s investment election under a 404(c) plan or a brokerage window;
- Cease to offer employer stock as an investment option under the plan and implement a 423 stock purchase plan (which is not subject to ERISA).
In all events, plan documents and communications to participants, including summary plan descriptions and plan prospectuses, should be reviewed in light of the Supreme Court’s decision in Dudenhoeffer. ¢