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On June 25, 2014 the Supreme Court handed down its unanimous decision in Fifth Third Bancorp et al. V. Dudenhoeffer. In this decision, the Court rejected the rule applied by many courts that ESOP fiduciaries had a “presumption of prudence” with respect to company stock investments. More importantly, however, it instructed the 6th Circuit to reconsider its rejection of the defendants’ motion to dismiss, on the principles that (oversimplifying somewhat) (1) fiduciaries with respect to publicly traded ESOP stock may generally rely on market prices, and (2) issues with respect to insider information may generally be better dealt with under the securities laws.
In this article we review the Court’s decision.
Fifth Third is a classic ‘stock drop’ case. Fifth Third Bank maintained a defined contribution plan under which participants could choose between investments in 20 separate funds. Matching contributions were invested initially in the plan’s employer stock fund (the ESOP), but participants could choose to transfer them to another fund. The plan required “the ESOP’s funds to be ‘invested primarily in shares of common stock of Fifth Third.’”
Between July 2007 and September 2009, Fifth Third’s stock price fell by 74%.
Plaintiffs sued, claiming that Fifth Third plan fiduciaries:
[S]hould have known – on the basis of both publicly available information and inside information available … because they were Fifth Third officers – that Fifth Third stock was overpriced and excessively risky. … [A] prudent fiduciary in [the Fifth Third fiduciaries’] position would have responded to this information by selling off the ESOP’s holdings of Fifth Third stock, refraining from purchasing more Fifth Third stock, or disclosing the negative inside information so that the market could correct the stock’s price downward.
The district court dismissed the plaintiffs’ case, holding that, with respect to ESOPs, “plan fiduciaries start with a presumption that their ‘decision to remain invested in employer securities was reasonable’ … and that the complaint’s allegations were insufficient to overcome it.” The Sixth Circuit reversed the district court, concluding that while ESOP fiduciaries are entitled to a “presumption of prudence” with respect to company stock purchases, that presumption is an evidentiary rule and could not be used at the pleading stage to dismiss the case.
At what stage – pleading or evidentiary – the “presumption of prudence” applies is obviously a technical question, but it can have significant consequences. If it is applied at the pleading stage – in support of a motion to dismiss – all the cost of developing evidence can be avoided, making stock drop litigation less costly for defendants. There is a split in the circuits on this issue, which is why the Supreme Court took Fifth Third’s appeal from the 6th Circuit decision.
In a sense, however, none of that matters, because the Supreme Court rejected the entire “presumption of prudence” line of decisions.
The Supreme Court held that there is no special presumption of prudence that applies to the decisions of ESOP fiduciaries:
ESOP fiduciaries are not entitled to any special presumption of prudence. Rather, they are subject to the same duty of prudence that applies to ERISA fiduciaries in general … except that they need not diversify the fund’s assets ….
This element of the Court’s decision is getting lots of headlines. But the key holding of the Court was its reversal of the 6th Circuit’s rejection of the defendants’ motion to dismiss. The logic of that sentence is a little hard to untangle – here’s a slightly longer version: The district court granted defendants’ (sponsor-fiduciaries) motion to dismiss. The 6th Circuit reversed that decision – that is, it found for the plaintiffs, holding that their case could go forward. The Supreme Court found for the defendants – it reversed and remanded, instructing the 6th Circuit to reconsider its decision in light of the following principles:
(a) Where a stock is publicly traded, allegations that a fiduciary should have recognized on the basis of publicly available information that the market was overvaluing or undervaluing the stock are generally implausible and thus insufficient to state a claim ….
(b) … Where the complaint alleges that a fiduciary was imprudent in failing to act on the basis of inside information, the analysis is informed by the following points. First, ERISA’s duty of prudence never requires a fiduciary to break the law, and so a fiduciary cannot be imprudent for failing to buy or sell stock in violation of the insider trading laws. Second, where a complaint faults fiduciaries for failing to decide, based on negative inside information, to refrain from making additional stock purchases or for failing to publicly disclose that information so that the stock would no longer be overvalued, courts should consider the extent to which imposing an ERISA-based obligation either to refrain from making a planned trade or to disclose inside information to the public could conflict with the complex insider trading and corporate disclosure requirements set forth by the federal securities laws or with the objectives of those laws. Third, courts confronted with such claims should consider whether the complaint has plausibly alleged that a prudent fiduciary in the defendant’s position could not have concluded that stopping purchases 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.
Putting this into slightly less ‘legalese’:
A plaintiff cannot sue a fiduciary on the premise that the fiduciary should know, based on public information, that a publicly traded stock is overvalued, absent special circumstances.
A plaintiff cannot state a claim that a fiduciary should have sold stock in a fund, based on private (aka ‘inside’) information that the stock was overvalued, because to do so would violate insider trading laws.
With respect to a decision to continue to buy stock or not publicly disclose insider information in such circumstances, it’s probably better to consider the conduct of company officials under the securities laws.
In any case, in considering a motion to dismiss (“whether the complaint has plausibly alleged” a breach of ERISA’s prudence rule), a court should consider whether the proposed action (stopping buying stock and/or disclosing non-public information) would do more harm than good.
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Thus, while fiduciaries may have lost the protection of the “presumption of prudence,” they may have gained something more valuable – a set of principles that recognizes that, with respect to publicly traded company stock, the idea that prudence compels a sale (or discontinuance of purchase) at market prices must overcome (1) some basic principles of economics (as the Court said, “The [6th Circuit’s] decision to deny dismissal … appears to have been based on an erroneous understanding of the prudence of relying on market prices”) and (2) a preference for regulating the issue of insider information under the securities laws.
We will have to wait to see how courts apply these principles to stock drop cases and whether they provide effective support for sponsor fiduciaries’ motions to dismiss.