Ninth Circuit affirms dismissal of Disney prudence complaint, applying Dudenhoeffer standard

On March 1, 2019, the Ninth Circuit handed down its decision in Wilson v. Fidelity Management Trust Company, et al. (aka In re Disney ERISA Litigation), dismissing plaintiffs’ claims. The case is interesting for its consideration of DC investment prudence generally, its application of the Supreme Court’s Fifth Third Bancorp et al. v. Dudenhoeffer market price = prudence standard in a non-company stock context, and its consideration of the issue of style drift.

In this article, after beginning with some background, we briefly review the decision.

Background

This case is a class action by participants in Disney’s participant-directed individual account plan, claiming that plan fiduciaries imprudently included the Sequoia Fund in the plan’s 26-fund investment menu. 

Over the period the period 2010-2016, the Sequoia Fund invested a significant amount of its assets in Valeant Pharmaceuticals. As a result of stock purchases and increases in the Valeant share price, “on June 30, 2015, over 25% of Sequoia’s net assets were invested in Valeant.” 

Disney participants “invested more than $500 million in the Sequoia Fund, causing investments in the Fund to account for approximately 12% of all Plan assets not invested in Disney itself.”

The decline in Valeant’s stock price, from August to November 2015, from $263 to $70 a share caused the Sequoia Fund to lose more than 20% of its value, generating significant losses for Disney participants.

Plaintiffs’ claim

Plaintiffs claimed that the inclusion of the Sequoia Fund was imprudent. In support of this claim, they argued that Sequoia’s investment in Valeant involved “a material shift in its investment strategy” from investment in “value” stocks to investment in “growth” stocks, that was “inconsistent with Plan documents” and that plan fiduciaries “failed to discover or inform Plaintiffs about the shift.”

What’s interesting about this case

This case is interesting for (at least) three reasons:

It’s a DC prudence case that is not about fees or company stock; it’s about the fundamental prudence of a specific investment (fund menu choice).

The court disposed of the case by applying the Supreme Court’s market price = prudence rule in Fifth Third Bancorp et al. v. Dudenhoeffer  (a company stock case).

It raises the issue of whether “style drift” can be grounds for a prudence claim.

The court’s decision – application of the Dudenhoeffer  standard

At issue in this case was the prudence of the plan fiduciaries’ retention of the Sequoia Fund as an investment option, given the fund’s significant investment in Valeant. As a result, the prudence of the Sequoia Fund’s investment in Valeant was itself also at issue. 

Both the lower court and the Ninth Circuit, in analyzing this issue, applied the standard developed by the Supreme Court in Dudenhoeffer,  in the context of a company stock lawsuit. The lower court in Disney  quoted  Dudenhoeffer  at length:

 [W]here 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. Many investors take the view that “they have little hope of outperforming the market in the long run based solely on their analysis of publicly available information,” and accordingly they “rely on the security’s market price as an unbiased assessment of the security’s value in light of all public information.” … ERISA fiduciaries who likewise could reasonably see “little hope of outperforming the market . . . based solely on their analysis of publicly available information” may as a general matter likewise prudently rely on the market price.

We note that, while this discussion may be understood to apply to the Sequoia Fund’s investment in Valeant stock, it is also being applied to the fiduciaries’ decision to include the Sequoia Fund in the plan’s fund menu. One way of reading the court’s analysis is that the Valeant-related losses sustained by the Sequoia Fund are to be attributed to the market, not fiduciary imprudence.

Special circumstances

One of the two exceptions to the market price = prudence rule articulated by the Supreme Court in Dudenhoeffer is “special circumstances.” It’s not clear what special circumstances are in a company stock context, much less the “speculative investment fund” context of the Disney litigation.

The lower court in Disney, in any case, found no special circumstances, stating that “the cases cited by Plaintiffs as supporting their position [that Disney involved “special circumstances”] actually undermine it,” and distinguishing Disney from, e.g., Braden v. Wal-Mart because (in Braden) investment fund options were included “despite the fact that most of them underperformed the market indices they were designed to track” and revenue sharing payments were made to the provider “not … in exchange for services rendered, but rather were a quid pro quo for inclusion in the Plan.”

Style drift

“Style drift” describes a situation in which an investment fund changes (explicitly or implicitly) its investment strategy/positioning from, e.g., what it purported to be when the fund solicited investments.

In their second amended complaint, plaintiffs argued that the Sequoia Fund had been represented to be a “value fund,” which the court defined as a fund that seeks “to purchase bargain stocks which have a low stock value due to factors the investing fund perceives to be unrelated to the value of company, resulting in purchasing stocks with low price-to-earnings, price-to-book, and price-to-sales ratios.” The Sequoia Fund’s significant allocation to Valeant (which, in August 2015, had “a trade value that was 98 times higher than its earnings”) did not, plaintiffs alleged, meet the fund’s purported investing criteria.

The Ninth Circuit rejected this argument as a basis for an ERISA prudence claim:

[B]oth the Plan’s Summary Plan Description and Sequoia’s 2015 Prospectus note that Sequoia is “non-diversified” and there are risks associated with Sequoia’s investment strategy. In addition, to the extent that the Plan documents even distinguish between “value” and “growth,” we agree with the district court that these words were used simply to “describe [Sequoia’s] investments; not to also convey [its] overall investment strategy.”

Diversification more broadly

It is arguable that there are two primary components of the ERISA prudence standard, at least with respect to investments in publicly traded stock (or, again arguably, publicly traded mutual funds): diversification and price (where price is understood to include fees).

Generally, for a DC plan, investments in company stock are not subject to ERISA’s diversification requirement, and thus the diversification issue did not come up in Dudenhoeffer. The courts considering the Disney participants’ claims also did not consider the issue of diversification.

In this regard, we note that, in Schweitzer v. Phillips, involving a legacy stock claim, the United States District Court for the Southern District of Texas concluded that, because participants – at the individual account level – had the option to adequately diversify their individual plan portfolio by selecting from a diverse range of available investments, ERISA’s diversification standard was satisfied. Similarly, one could argue here (in Disney) that ERISA’s diversification requirement was satisfied by the availability of 25 other investments in the plan’s fund menu.

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The Ninth Circuit issued its decision in Disney  in an unpublished opinion. Unpublished opinions generally may be cited but do not have precedential value. The lower court decision is not subject to those restrictions.

The courts’ decisions in Disney  raise the prospect that, at least in the Ninth Circuit, a market price = prudence standard may be applied to fund menu construction generally, at least with respect to performance and subject to “special circumstances” arguments. We will have to wait to see if other courts adopt this approach.

DC sponsor-fiduciaries will want to consider whether representations made about the style of plan investment options may in fact (and unlike the representations considered in Disney) convey, or explicitly commit to, an “overall investment strategy.” Where such a commitment is made, monitoring style drift may remain a fiduciary responsibility.

We will continue to follow these issues.