Viability of stock drop claims based on public information
On March 30, 2017, the United States District Court for the Eastern District of Missouri granted defendants’ motion to dismiss in Lynn v. Peabody Energy. Peabody is a “stock drop” case – a case in which defined contribution plan participants investing in a company stock fund sue after the company stock loses significant value.
The decision is interesting because it considers one of the key issues left open in the Supreme Court’s decision in Fifth Third Bancorp et al. V. Dudenhoeffer – under what circumstances can a plaintiff in a stock drop case claim a fiduciary was imprudent based solely on public information?
In this article we begin with some background on the issue. We then discuss the Peabody court’s decision, generally holding, under Fifth Third, that “impending bankruptcy” does not constitute “special circumstances” allowing such a suit. Finally, we consider how some other courts have handled this issue.
Background – stock drop claims based on public information and Fifth Third
Provided certain requirements are met, DC plan company stock investments are generally exempt from ERISA’s diversification requirement. All agree, however, that ERISA prudence does require that the plan pay no more than fair value. A question that courts and fiduciaries have struggled with over the years is whether ERISA prudence requires anything more.
In Fifth Third Bancorp et al. v. Dudenhoeffer, the Supreme Court overturned the “presumption of prudence” rule that many courts had applied in stock drop cases. In its place, the Court articulated what might be called a “market price” presumption. Oversimplifying somewhat, the Court held, among other things, that 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. Quoting the Court:
In our view, 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, at least in the absence of special circumstances. … [A] fiduciary usually “is not imprudent to assume that a major stock market . . . provides the best estimate of the value of the stocks traded on it that is available to him.” [Emphasis added.]
The Court left open the question of what those “special circumstances” might be. Assuming that a functioning market has already considered all currently available public information in producing the current market price of a stock, what “special circumstances” would permit a claim that a fiduciary should have done something, e.g., sold company stock in a company stock fund based on that public information?
Moreover, as we’ll see when we discuss the Kodak case (below), at least one court has held (post-Fifth Third) that ERISA prudence requires more than just diversification and paying a “fair price”: some investments are “such a poor long-term investments” that they are imprudent as such. And the Kodak court found that Fifth Third did not decide or even consider that issue.
Let’s look at three cases that have considered these issues, starting with Peabody.
Peabody Energy (a coal company) maintained three DC plans that included company stock funds in which, at their option, participants could invest up to 100% of their plan assets. The value of Peabody stock declined dramatically over the period relevant to the litigation. Quoting the Peabody plaintiffs: “Peabody Stock was trading at $398 at the beginning of the Class Period compared to its price of $6.39 as of March 10, 2016.”
In December 2015 Peabody appointed an outside fiduciary (Gallagher Fiduciary Advisors, LLC). According to the court, “[b]y letter dated February 26, 2016, Gallagher informed the ESOP participants that it had decided (1) to ‘restrict the [Peabody] Stock Fund to all participant activity effective as of March 9, 2016, and (2) to eliminate the [Peabody] Stock Fund as an investment option in each Plan, on or around March 16, 2016.’”
Plaintiff-participants sustained significant losses on their investments in the plans’ company stock funds and brought an action against plan fiduciaries.
Public information and special circumstances
Taking into account the Supreme Court’s analysis of such claims in Fifth Third, the Peabody plaintiffs argued that there were “special circumstances” which should have caused plan fiduciaries, based on public information, to disinvest in company stock. Those special circumstances included “Peabody’s Z-Score and unserviceable debt.” A “Z-Score” is “a formula used by financial professionals to predict whether a company is likely to go into bankruptcy.” During the relevant period, Peabody’s Z-Score was “deteriorating.”
This claim confronted the Peabody court with one of the key questions we identified above: Is “impending bankruptcy” a “special circumstance” requiring (under ERISA’s prudence rules) that the plan fiduciary disinvest in company stock, regardless of the fairness of the market price for the stock?
The Peabody court held that, while this is a “close question,” the answer is “no” – impending bankruptcy is not such a special circumstance. Quoting the court’s decision: “the Supreme Court specifically stated that the presumption [of prudence], along with the exception for ‘careening to bankruptcy’ cases, was not a good rule for weeding out meritless cases. While there is credible contrary authority, the weight of authority appears to agree with this conclusion.”
Let’s consider one of those “credible contrary authorities” – Gedek v. Perez (aka the Kodak ESOP litigation).
In the (post-Fifth Third) Kodak ESOP litigation, plaintiffs alleged that defendant plan fiduciaries violated ERISA’s prudence standard by “continuing to invest [plan] assets in Kodak stock even after it became obvious that Kodak was headed for bankruptcy and that its stock was going to plummet in value.”
In holding for plaintiffs on a motion to dismiss, the United States District Court for the Western District of New York found that “over the course of the class period it became clear to all but the willfully blind that Kodak was headed for bankruptcy, and that its stock price had no reasonable hope of turning around.” The court reasoned that “the fact that the market, on any given date, may have provided the best available estimate of the ‘value’ of Kodak stock, does not necessarily reveal much about whether defendants acted prudently in continuing to invest in that stock.”
The court framed the question before it as “whether [defendant-fiduciaries] should have realized that Kodak stock represented such a poor long-term investment that they should have ceased to purchase, hold, or offer Kodak stock to plan participants.” It found that the Supreme Court’s decision in Fifth Third provided “little explicit guidance on this question.” And it emphasized that the exemption from ERISA’s duty of prudence for company stock investments applies “only to the extent that the statute requires diversification. In all other respects … an ESOP fiduciary’s duty of prudence is no different or less stringent than that of any other ERISA fiduciary.”
On the basis of this reasoning, the court held that “a reasonable fact finder could conclude that at some point during the class period, the ESOP fiduciary should have stepped in and, rather than blindly following the plan directive to invest primarily in Kodak stock, shifted the plan’s assets into more stable investments, as permitted by the plan document, and as consistent with the plan’s and ERISA’s purposes.”
Thus, the Kodak court saw the stock drop ERISA prudence issue as not just about price. Some investments are – regardless of the market’s “best available estimate of their value” – simply imprudent as such.
That is, in effect, the opposite of the view taken by the Peabody court, which had rejected this sort of “careening to bankruptcy” argument.
Now let’s consider one other case – one that the Peabody court cited in support of its decision – the 2016 decision by the United States District Court for the Northern District of Texas in In Re 2014 Radio Shack ERISA Litigation.
In Radio Shack, plaintiffs claimed that, “because the Radio Shack Defendants knew or should have known that the Company was heading for bankruptcy based on public information, as ERISA fiduciaries they should have prevented the ESOPs from being invested in RadioShack stock.”
The court, in dismissing this claim, reasoned that “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, at least in the absence of special circumstances.” (Citing Fifth Third.) And in this regard, it viewed the issue of “special circumstances” as limited to the issue of price:
‘[V]arious courts have found special circumstances to be akin to accounting irregularities, misappropriations of insider information, or another action which affects the market’s reliability of a stock’s market price.’ … [A] special circumstance may be shown by alleging other instances which would render reliance on the market price imprudent such as ‘fraud, improper accounting, illegal conduct or other actions’ that would cause a company’s stock to trade at an inflated price. [Emphasis added.]
Thus, while the Kodak court saw the issue of prudence in company stock cases as including the issue of whether the company stock “represented a poor long-term investment,” the Radio Shack and Peabody courts see it as limited to the issue of the reliability of the market price.
For plan fiduciaries – no safe answer
In these cases (and at this point), we have the same question being decided differently by different courts. We have some idea of what the issue is – is “impending bankruptcy” a viable basis for a stock drop claim post-Fifth Third? But no clear answer, just dueling theories.
This situation presents a problem for plan fiduciaries. One might think that the more cautious approach would be to continue to apply the “impending bankruptcy” rule, selling company stock when a company’s financial condition reaches some critical state. But judging when that critical state has been reached is no easy matter. And what happens if, after the stock is sold, the company recovers? As the reverse stock drop cases make clear, those facts are also likely to generate litigation.
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We will continue to follow this issue.