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On December 10, 2018, a three judge panel of the Second Circuit Court of Appeals, in Jander v. IBM, found for plaintiffs in stock drop litigation related to financial disclosure with respect to one of IBM’s divisions. The court held that where a sale of a division and ultimate disclosure of negative information was imminent, plaintiffs could bring an ERISA action against plan fiduciaries for not making earlier disclosure, even though an action based on (more or less) the same facts might not lie under the securities laws.
We discuss the case, and some themes of inside information-based stock drop litigation generally, in detail below. But we begin with the key takeaways for plan sponsors:
Most ERISA stock drop litigation post the Supreme Court’s 2014 decision in Fifth Third Bancorp v. Dudenhoeffer has involved allegations that plan fiduciaries possessed inside information that the stock was over-valued by the market.
These cases have necessarily focused on continued plan purchases of company stock after the fiduciaries have become aware of the inside information: sale of stock already held by the plan based on inside information would (generally) violate securities laws insider trading prohibitions.
The result in these cases, most (but not all) of which defendants have won, has generally turned on the application of the Supreme Court’s “more harm than good” test – whether proposed alternative action would have done more harm than good. In this regard, to take the most obvious example, while disclosure of inside information would reduce losses related to ongoing purchases, that “good” would have to be weighed against the “harm” of the related drop in the value of stock already held by the plan.
There is a disagreement among the courts over the formulation of Dudenhoeffer__’s “more harm than good” test. As the Jander court asks, does the more harm than good standard apply to the average prudent fiduciary or any possible prudent fiduciary?
Jander does not resolve the “would have” vs. “could have” issue. Instead, the Jander court holds that, at the motion to dismiss stage at least, where disclosure of the inside information is likely in the near future (in this case, in connection with the sale of a division), in effect no fiduciary could conclude that disclosure would do more harm than good.
This holding, in the court’s view, does not conflict with related restrictions on securities fraud litigation (a related securities fraud case based on more or less identical facts was dismissed), because the ERISA action is based on fiduciary breach, not fraud.
As a general matter, sponsor fiduciaries who believe they are in possession of inside information that company stock is undervalued should consult with counsel. Given the decision in Jander, sponsor fiduciaries may have disclosure obligations under ERISA that differ from (and are more rigorous than) the company’s disclosure obligations under securities laws.
In the rest of this article we discuss the Jander decision in detail
The general theory of inside information-based stock drop cases (post-Dudenhoeffer) is that the plan fiduciaries had inside information on the basis of which they knew or should have known that the market price for the sponsor’s stock was “inflated” and that therefore the plan fiduciaries, under ERISA, were required to take some sort of action, e.g., disclosure of the inside information.
In this case, plaintiffs alleged: (1) that in 2013 “IBM began trying to find buyers for its microelectronics business;” (2) that it “failed to publicly disclose [annual losses in that business of $700 million] and continued to value the business at approximately $2 billion;” (3) that in 2014 it announced the sale of the business in connection with which it took a $4.7 billion pre‐tax charge ;and (4) that thereafter “IBM’s stock price declined by more than $12.00 per share.”
In a related securities lawsuit (International Ass’n of Heat & Frost Insulators & Asbestos Workers Local #6 Pension Fund v. International Business Machines Corp.), the lower court found that, while “the investor plaintiffs had ‘plausibly plead[ed] that Microelectronics’ decreased value, combined with its operating losses, may have constituted an impairment indicator under’ Generally Accepted Accounting Principles (‘GAAP’) … the plaintiffs ‘fail[ed] to raise a strong inference that the need to write-down Microelectronics was so apparent to Defendants before the announcement, that a failure to take an earlier write-down amount[ed] to fraud.’”
In Dudenhoeffer, the Supreme Court stated that a court’s review of this sort of claim should be informed by the following principles:
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.
Since Dudenhoeffer, courts have generally focused on clarifying the second and third principles – reconciling ERISA fiduciary obligations with respect to company stock with securities law disclosure and fraud rules and explicating the “more harm than good” test.
The principle in these cases that has received the most attention, and that has been the most common ground for dismissing plaintiffs’ cases, is the Dudenhoeffer “more harm than good” test. In recent litigation in In re: Wells Fargo ERISA 401(k) Litigation, the United States District Court for the District of Minnesota characterized that test as “very tough”: “[i]n light of the inherently uncertain nature of this task, plaintiffs will only rarely be able to plausibly allege that a prudent fiduciary ‘could not’ have concluded that a later disclosure of negative inside information would have less of an impact on the stock’s price than an earlier disclosure.”
In Jander v. IBM, the Second Circuit first notes that there is a dispute about the actual terms of this test. The Ninth Circuit, in Harris v. Amgen, held that the test was not whether a prudent fiduciary “could have” come to the same conclusion that defendant fiduciaries had but whether it “would have” come to that conclusion. As the Second Circuit explained, the “would have” version of the test (advocated by plaintiffs) “suggests that courts ask what an average prudent fiduciary might have thought.” By contrast, the “could have” version of the test (advocated by defendants) “appears to ask, not whether the average prudent fiduciary would have thought the alternative action would do more harm than good, but rather whether any prudent fiduciary could have considered the action to be more harmful than helpful.” (Emphasis added.)
The court found that the Supreme Court’s subsequent decision reversing the Ninth Circuit in Harris v. Amgen did not unambiguously resolve this issue. And neither did the Second Circuit. We discuss it here to make clearthat, at leastin the Second Circuit,claims based on a “would have” analysis, applying a “what would the average prudent fiduciary have done?” test, have not been explicitly rejected.
The reason the Second Circuit found it unnecessary to resolve the “would have” vs. “could have” issue was its finding that, in any case, the Jander plaintiffs had – at least for purposes of a motion to dismiss – satisfied the (“very tough” and “rarely” met) “could have” test.
On a motion to dismiss, plaintiffs’ allegations are taken as true, and the only question for the court is whether, “draw[ing] all reasonable inferences in plaintiff’s favor,” they constitute a valid claim. Specifically, in Jander, on appeal, the question for the court was whether plaintiffs’ allegations (if proven) “plausibly establish that a prudent fiduciary in the Plan defendants’ position could not have concluded that corrective disclosure would do more harm than good.”
In finding that plaintiffs had met this standard, the court found most persuasive that “the defendants allegedly knew that disclosure of the truth regarding IBM’s microelectronics business was inevitable, because IBM was likely to sell the business and would be unable to hide its overvaluation from the public at that point.” The court explained:
In the normal case, when the prudent fiduciary asks whether disclosure would do more harm than good, the fiduciary is making a comparison only to the status quo of non-disclosure. In this case [i.e., where the company was for sale and “any potential purchaser would surely conduct its own due diligence”], however, the prudent fiduciary would have to compare the benefits and costs of earlier disclosure to those of later disclosure – non-disclosure is no longer a realistic point of comparison.
An issue lurking in all ERISA stock drop cases is whether, and on what basis, a participant in an ERISA plan should be permitted to bring an action under ERISA when no such action is permitted to ordinary shareholders under the securities laws. As noted above, this is the third principle identified by the Supreme Court in Dudenhoeffer for consideration by courts in these sorts of cases.
The Second Circuit found that, while concern “that allowing Jander’s ERISA claim to go forward on essentially the same facts [as related securities fraud litigation] would lead to an end run around the heightened pleading standards for securities fraud suits” may have some merit, “it does not provide a basis to affirm the district court’s dismissal of Jander’s duty‐of‐prudence claim.”
In this regard, the court noted (1) that the securities fraud pleading standards do not by their terms apply to ERISA lawsuits, (2) that ERISA lawsuits do not involve allegations of fraud and the related “scienter” (intent or knowledge of wrongdoing) requirement, but rather an allegation of fiduciary imprudence, “which does not carry the same stigma,” and (3) that “ERISA and the securities laws ultimately have differing objectives.”
It is at least arguable that the court in In re: Wells Fargo ERISA 401(k) Litigation took a different view of this issue.
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As Jander demonstrates, while Dudenhoeffer has succeeded in restricting stop drop litigation, for the most part (and with exceptions) to inside information-based claims and only with respect to ongoing purchases, some courts are prepared to let some cases proceed.
We will continue to follow this issue.