Company stock and inside information: DOL’s view
In the aftermath of the Supreme Court’s 2014 decision in Fifth Third Bancorp et al. v. Dudenhoeffer, the stock drop lawsuits that are getting the most traction with courts generally involve claims that plan fiduciaries were aware of inside information on the basis of which they could have reasonably concluded that the company stock’s market price was “artificially inflated.” Plaintiffs are asserting that in those circumstances plan fiduciaries should (at a minimum) have stopped buying company stock. (“Stock drop” cases involve company stock held in, e.g., a 401(k) plan that has lost significant value (hence, “drop”), in which the plaintiff argues the plan’s fiduciaries had an obligation to sell plan stock (or not continue to buy it) before or during the “drop.”)
In this article discuss the Department of Labor’s theory of the issue – what an ERISA fiduciary can (and, by implication, should or must) do when she possesses such inside information – as outlined in its amicus brief recently filed with the Supreme Court in Whitley v. BP.
We begin by briefly reviewing the analysis the Supreme Court laid out in Fifth Third.
Background – Supreme Court decision in Fifth Third
In Fifth Third, the Supreme Court rejected the “presumption of prudence” standard that had been applied by lower courts in stock drop cases. It replaced it with, for public companies, what might be called a “presumption that the market price is fair” standard. With respect to claim based on inside information, the Court held generally that:
To state a claim for breach of the duty of prudence on the basis of inside information, a plaintiff must plausibly allege an alternative action that the defendant could have taken that would have been consistent with the securities laws and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it. [Emphasis added.]
Recent inside information-stock drop cases
Several current stock drop cases, including Harris v. Amgen and Whitley v. BP, involve allegations that plan fiduciaries had inside information that the market price of company stock was “artificially inflated.” In January 2016, the Supreme Court (in a per curium opinion) reversed and remanded the Ninth Circuit’s (post-Fifth Third) decision for plaintiffs in Harris v. Amgen, finding that the Ninth Circuit had “failed to assess whether the complaint in its current form ‘has plausibly alleged’ that a prudent fiduciary in the same position ‘could not have concluded’ that the alternative action ‘would do more harm than good.’” As discussed further below, Whitley is currently before the Supreme Court on a defendants’ appeal of a lower court’s interpretation of this same “more harm than good” standard.
This is as good a place as any to observe that not only is the “more harm than good” standard logically somewhat problematic (see below), it’s also difficult to formulate except as an (awkward) double negative. As in: plaintiffs’ complaint must plausibly allege “that a prudent fiduciary in the same position ‘could not have concluded’ that the alternative action ‘would do more harm than good.’” We apologize for the difficulty this presents in parsing the language courts use with respect to this standard. The point the Supreme Court seems to be making is that the standard favors defendant fiduciaries. Many (even the vast majority) of fiduciaries may think that, e.g., disclosing inside information would not do more harm than good. But if some prudent fiduciary could conclude that it would do more harm than good, then (apparently and according to the Supreme Court) there is no ERISA claim.
Whitley v. BP
Whitley v. BP is a “classic” stock drop claim: after the 2010 Deepwater Horizon explosion, BP’s stock lost significant value. Plaintiff-participants in the BP DC plans sued, alleging that the sponsor fiduciaries breached their ERISA duties of prudence and loyalty by not selling and by continuing to buy stock in the plans’ company stock fund.
In January 2015, responding to plaintiffs’ motion to amend the Whitley complaint to reflect the Fifth Third decision, the district court found that “Defendants [BP plan fiduciaries] knew, or should have known, that the market price of BP ADSs [American Depository Shares] was distorted due to non-public company information.” In light of that knowledge, the lower court found that plan fiduciaries could have done two things – (1) disclose the non-public information and (2) freeze, limit, or restrict company stock purchases – that would not have conflicted with the securities laws. And the court found that it could not determine “that no prudent fiduciary would have concluded that removing the BP Stock Fund as an investment option, or fully disclosing the state and scope of BP’s safety reforms, would do more good than harm.”
Trying to put this in English (and parsing the double negatives) – the lower court found that plaintiffs in Whitley met the Fifth Third standard for an inside information-based ERISA stock drop claim to survive a motion to dismiss. The actions that plaintiffs claim defendant plan fiduciaries with inside information should have taken (but did not take)(1) did not violate or conflict with the securities laws and (2) might conceivably not do more harm than good.
Defendant fiduciaries then requested leave to appeal to the Supreme Court the question: “What plausible factual allegations are required to meet the ‘more harm than good to the fund’ pleading standard [of Fifth Third]?” and the Supreme Court granted that request. On March 11, 2016 DOL filed an amicus curiae brief in the case; at the same time the Securities and Exchange Commission filed a brief “intended to supplement” DOL’s brief.
The critical question: what must an ERISA fiduciary with inside information do?
This is an article about the DOL’s view of the issue. As DOL stated in its amicus brief: “Although the certified question addresses the ‘more harm than good’ portion of Fifth Third’s ruling, the question necessarily turns on the antecedent question of what alternative actions an ESOP fiduciary could have taken in this case consistent with the securities laws.” Thus, in what follows, we discuss DOL’s view on both issues: (1) What actions may an ERISA fiduciary with inside knowledge that a company stock’s market price is “artificially inflated” take that are consistent with the securities laws? (2) When might those actions do “more harm than good?”
Plaintiffs’ allegations in Whitley
The Whitley plaintiffs’ allegations (assumed to be true for purposes of this appeal) are that “three individual defendants and corporate defendant [BP] (all allegedly ERISA fiduciaries) acted imprudently by offering the [plan’s company stock fund] as an investment option despite knowing it [that is, BP company stock] was artificially inflated (1) before the [Deepwater Horizon] explosion, by BP’s misrepresentations regarding its safety improvements and the risk of future accidents, and (2) after the explosion, by BP’s misrepresentations concerning the oil spill’s magnitude.”
Critically, DOL in its brief is assuming that there was an “ongoing fraud” with respect to these matters. That’s an important assumption to keep in mind. Not all inside information claims involve an “ongoing fraud,” and fiduciaries may be confronted with “grayer” situations than the one (assumed) in this case.
Actions consistent with the securities laws
In this situation – where plan fiduciaries are aware of an ongoing securities fraud – what actions may plan fiduciaries take that are consistent with the securities laws? The SEC brief provides the most succinct summary of DOL/SEC’s answer. Plan fiduciaries may:
Disclose the fraud. … Under the securities laws, an ESOP manager who made or was responsible for misstatements or omissions constituting the fraud has a duty to make a disclosure that renders the prior statements not misleading. … [A] manager who was not responsible for the fraud, but who knew about it, may nevertheless elect to disclose it if possible. Any such disclosure must be public; an ESOP manager of a publicly traded issuer cannot disclose the fraud solely to ESOP participants because that would either cause a violation of the selective disclosure rules under Regulation FD of the Exchange Act or it would constitute an illegal tip under the securities laws’ insider trading prohibitions.
Suspend ESOP transactions. … ERISA may require the ESOP manager to refrain from effecting purchases of additional shares of overvalued employer stock. To avoid violating the securities laws, a plan manager in such circumstances must concurrently refrain from effecting sales of shares on behalf of plan participants in order to completely abstain from trading on the basis of inside information about the employer’s fraud.
Other alternatives. DoL’s amicus brief proposes other measures that, while not required by the securities laws or independently sufficient to meet obligations under the securities laws, would not be inconsistent with the securities laws. The DoL amicus brief’s view that an ESOP manager could urge the persons responsible for the fraud to disclose it does not conflict with the securities laws and could lead others to fulfill the disclosure duty they already owe under the securities laws. Such an approach would not satisfy any independent obligation that the ESOP manager might have under the securities laws to correct misstatements or omissions for which the manager was responsible. Similarly, the DoL amicus brief’s view that the ESOP could report the fraud to DoL and/or the SEC would not conflict with the securities laws.
The “more harm than good” standard
As noted, for a plaintiffs’ inside information-based stock drop claim to survive a motion to dismiss, the proposed alternative actions must not only be consistent with the securities laws, but that a prudent fiduciary could have concluded that such actions might not do “more harm than good.” Here’s how the Supreme Court put it:
[C]ourts 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.
On the face of it, the Court seems to be implying that there may be cases where, because of the (greater) amount of stock already in the plan relative to the (lesser) amount of ongoing purchases, disclosure of inside information might “do more harm than good.” Because (again, by implication) there would be greater losses on the stock already held by the plan than on subsequent purchases. And, on the other hand, there may be other cases where it would not “do more harm than good,” because of the (lesser) amount of stock already in the fund relative to (greater) amount of ongoing purchases.
Which is, when you think about it, kind of an odd standard.
The lower court in Whitley “struggled” with the Supreme Court’s “more harm than good” standard, suggesting that Fifth Third “itself is inconsistent,” and concluding in the end (and with “consternation”) that it “cannot determine, on the basis of the pleadings alone, that no prudent fiduciary would have concluded that removing the BP Stock Fund as an investment option, or fully disclosing the state and scope of BP’s safety reforms, would do more good than harm.”
Thus, it’s not surprising that the Supreme Court took defendants’ appeal for clarification of the “more harm than good” standard.
DOL’s solution: disclosing ongoing fraud will never do more harm than good
DOL’s solution to this puzzling question is simple – where there is an ongoing fraud, the inside information must be disclosed:
Given the ongoing fraud that [BP CEO] Hayward was required to disclose under the securities laws, the plaintiffs have plausibly alleged that a prudent fiduciary could not have concluded that taking the sort of corrective action described above would have caused more harm than good to Plan assets.
DOL’s rationale is that the ongoing fraud will, at some point, have to be disclosed by someone. Thus the “harm” to the plan that the Supreme Court is concerned with cannot be avoided, and the sooner the fraud is exposed, the better.
All of this is both confusing and intimidating, especially for plan fiduciaries who are not experts in the securities laws. Boiling it down, here are our takeaways:
1. We are discussing a DOL brief (that is, an argument). The standards it articulates are not law (yet), but the brief does indicate what DOL thinks the law should be.
2. At its narrowest, DOL’s position can be summarized as follows: where an ERISA fiduciary of a plan with a public company stock fund knows, based on undisclosed (inside) information, that the market price for the stock is “artificially inflated” because of an “ongoing fraud,” the fiduciary can (and, by implication, should or must) (i) disclose the inside information and (ii) suspend plan trading in (buying or selling of) the company stock until the fraud is cured (and the market price stops being artificially inflated).
3. The actions the DOL is calling for in these cases – disclosure and suspension of plan company stock transactions – are fairly drastic. They may bring the fiduciary into conflict with company management. And they involve the plan fiduciary in matters with respect to which he (typically) will not have any expertise (the “complex” rules under the securities laws with respect to the disclosure of material information) and others in management (e.g., company securities lawyers) will have expertise.
4. That (all of 2 and 3) is, according to DOL, just tough luck:
It is not anomalous that an ERISA fiduciary who is also a corporate insider may have broader obligations to disclose inside information in the face of an ongoing fraud than what the securities laws alone require. That is merely the “consequence of the corporation’s own decision to establish an ESOP and to install its own officers as plan fiduciaries.”
5. Note that the disclosure must be to “the public” not just to participants. And note that the suspension must be of both purchases and sales. So that participants wanting to get out of the stock fund will be prevented from doing so. Indeed, if the fiduciary suspends company stock sales improperly (if he is wrong about her ERISA and securities law obligations), he may be sued by participants who were prevented from selling (or, for that matter, buying) during the suspension.
6. All of the foregoing may encourage sponsors and sponsor-fiduciaries to consider delegating (outsourcing) management of a company stock fund to an outside fiduciary. An outside fiduciary will (typically) not have access to compromising inside information and thus may not confront the challenges described in 3-5. The question will then become whether and in what circumstances a delegating fiduciary with inside information may have a duty to inform the outside fiduciary of that information.