In Fifth Third Bancorp v. Dudenhoeffer, decided June 25, 2014, the Supreme Court unanimously rejected a presumption of prudence for employer stock held in ERISA individual account plans (known as the “Moench presumption”). This reversed a line of favorable federal appeals court cases that provided the playbook for employer strategies to mitigate risk associated with offering employer stock as a plan investment– a reversal resulting in a seismic shift for employer stock strategies in individual account plans. In doing this, the court clearly sought to avoid a flood of litigation by specifically critiquing key claims against the Fifth Third Bancorp fiduciaries that are common in stock-drop litigation. For now, however, this switches out the well-developed jurisprudence supporting the Moench presumption for defenses that will inevitably be tested and illuminated over time. Further, it will require plan sponsors and fiduciaries to redo their defensive paradigm for offering employer stock, which was constructed around this presumption.
Below we provide context for the decision and note additional detail on the case, the key takeaways and practical next steps.
- Background on Stock-Drop Litigation
In an effort to encourage broad-based ownership by employees of their companies, Congress created employee stock ownership plans (ESOPs), which are retirement plans that invest primarily in employer stock. Congress also provided an exception to ERISA’s fiduciary duties eliminating the duty of diversification with respect to employer stock in individual account plans (including ESOPs and 401(k) plans). As a result of these rules, employer stock is relatively common in individual account plans, and it often constitutes more than an insignificant share of participants’ holdings. Although Congress encouraged stock ownership by ERISA participants, fiduciaries have faced an onslaught of cases alleging it was imprudent for the plan to hold employer stock, usually following a stock price drop.
- Presumption of Prudence
The Third Circuit was the first to recognize a “presumption of prudence” for ESOP fiduciaries, finding that ESOP fiduciaries are presumed to be prudent in following plan terms requiring employer stock investments, and this presumption can only be rebutted by a showing of an abuse of discretion by the fiduciaries, such as knowledge of the impending collapse of the company. Moench v. Robertson, 62 F.3d 553 (3rd Cir. 1995). Over the years, this presumption of prudence gained widespread acceptance and was extended to 401(k) plans that included plan language requiring that employer stock be offered as an investment (known as “hardwiring”). With the adoption of the presumption of prudence by the Ninth Circuit and the Second Circuit, the presumption appeared firmly established. Quan v. Computer Sciences Corp., 623 F3d 870 (9th Cir. 2010); In re: Citigroup ERISA Litigation, 662 F.3d 128 (2d Cir. 2011).
As case law bolstered the favorable presumption, practices followed. Today, documents for plans that offer employer securities are frequently drafted to take maximum advantage of this presumption. For example, in addition to “hardwiring” the plan and trust document, the SPD and the investment policy would also describe employer securities as a required investment choice.
In Dudenhoeffer, however, the Supreme Court unanimously discards the presumption of prudence.Dudenhoeffer accords narrow significance to ERISA’s duty of diversification exception for employer stock, declining to generally reinterpret ERISA’s “prudent person” fiduciary standard in light of this exception. Thus, there is no alteration in the application of that standard on account of employer stock being “hardwired” into a plan. Specifically, a fiduciary’s duty to follow plan terms (because conditioned on the terms being consistent with ERISA) is trumped by the prudent person standard. As a result, the Court found that the fiduciary standard for managing employer stock is the same prudent person standard that applies to the management of any other investments under a plan.
- Striking a Balance – Efficient Market Theory
Nevertheless, the Supreme Court recognized the need to discourage meritless claims, noting the need to balance protection of participants with avoiding undue risks to employers that may discourage them from continuing to offer plans. The Court noted its more demanding Twomblypleading standard, in combination with defense arguments grounded in the “efficient market theory,” could make it possible to knock out meritless claims at an early stage by a motion to dismiss.
The Court explained the efficient market theory as follows: “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.” This rule recognizes that a stock price of a publicly traded company reflects the financial market’s valuation of the stock taking into account all publicly available information. Accordingly, a prudent person is entitled to rely on this valuation as “an unbiased assessment of the security’s value in light of all publicly available information.” Thus, in general, this theory should thwart arguments that an ERISA plan paid too much for employer stock when it continued buying employer stock on the market following a spate of negative public information.
However, the Court left open that there may be special circumstances where the efficient market theory would not hold. Further, fleshing out these special circumstances is left to future litigation. Presumably, thin and infrequent trading may increase the chance of there being special circumstances, but plaintiffs will likely push beyond those situations in exploring the limits ofDudenhoeffer’s efficient market theory.
Dudenhoeffer also involved claims that the plan fiduciaries breached their fiduciary duties by failing to act on nonpublic information that was available to them as insiders. The Court made three points regarding these claims:
- ERISA fiduciaries should not violate federal securities laws, including the prohibition against trading in stock on the basis of material, nonpublic information.
- When considering claims that fiduciaries should have refrained from trading in stock or should have disclosed nonpublic information, courts should consider the extent to which these claims conflict with securities laws. (The Court could not elaborate on how these conflicts would be resolved because the SEC had not given its views on the case.)
- Courts should consider the extent to which a fiduciary’s stopping trading in employer stock would cause more harm than good to participants by signaling to the market that insiders viewed the stock as overvalued, which could trigger more substantial losses to the plan.
The Court has helpfully affirmed that the federal securities laws must be followed with respect to an ERISA fiduciary’s handing of non-public information. While this rules out simpler plaintiff attacks, the exact interplay of ERISA and federal securities laws remains to be worked out.
- Key Takeaways
At least in the short-term, the elimination of the presumption of prudence increases the likelihood of employer stock drop cases being brought. While the Court suggested theories available to fiduciaries in defending against these claims, plaintiffs can be expected to formulate claims taking these theories into account.
Plan sponsors and fiduciaries should note the following points:
- Update Plan Documentation. The kind of hardwiring of plan documents that developed under the Moench presumption is no longer appropriate in light ofDudenhoeffer. Indeed, in some cases, traditional hardwiring could be a detriment, because it could be used against fiduciaries who decide to limit employer stock access in a particular situation. Accordingly, plan and trust documents should be updated for the post-Dudenhoeffer regime. Likewise, SPDs, investment policies and charters for investment fiduciaries should also be reviewed.
- The Renewed Importance of a Robust Fiduciary Process. The prudent person standard of ERISA is a process-driven standard. While the Court recognized that fiduciaries may rely on stock prices as an unbiased valuation of stock, fiduciaries may still be vulnerable if they do not apply an equally robust fiduciary process to employer stock as applies to other investments. For example, if a plan’s investment consultant regularly weighs in on other investment options under the plan, the consultant’s failure to treat employer stock the same could be a vulnerability. In the period of uncertainty that followsDudenhoeffer, an independent fiduciary may be particularly valuable.
- Addressing Participant Investment Concentration in Employer Stock. Plans that offer employer stock typically make some efforts to limit participant investment contributions in employer stock. Usually these start with simple education regarding diversification and may go as far as limiting new investments in employer stock when the concentration has exceeded a certain level. While the continuing validity of the diversification exception may make the latter unnecessary, activities in this area could also enhance the external appearance of the fiduciary process.
- Insiders. While Dudenhoeffer provides some useful clarity for insider fiduciaries, there is also much that remains to be defined. Indeed, as plaintiff’s counsel look for areas of vulnerability after Dudenhoeffer, the remaining uncertainty is likely to keep pressure on the role of an insider fiduciary.