On June 25, 2014, the U.S. Supreme Court issued its long-awaited ruling in Fifth Third Bancorp v. Dudenhoeffer, a case involving an ESOP fiduciary’s duties in deciding to sell or hold employer stock in an ESOP. The U.S. Supreme Court unanimously rejected the “presumption of prudence” that had been adopted by a majority of Circuit courts. ESOP fiduciaries are now subject to the same prudence standard that applies to all retirement plan fiduciaries. According to ESOP Association President J. Michael Keeling, “[t]he decision is not a victory for ESOPs… the Court flat out overrules the pro-ESOP legal doctrine-first enunciated in the mid-90s.....and endorsed by all lower federal courts since then.” However, there is some very useful guidance in Dudenhoeffer that will help ESOP fiduciaries, particularly with public companies, meet their ERISA obligations.
Fifth Third Bancorp maintained a 401(k) plan that allowed for participant-directed investments. The plan also offered a company stock fund that was structured to qualify as an ESOP for purposes of ERISA and the Internal Revenue Code. Fifth Third Bancorp experienced a substantial decline in its stock price from July 2007 to September 2009, causing the company stock fund to lose tens of millions of dollars (approximately 74% of the stock’s value).
Plaintiffs (a class of participants in the plan) filed a complaint against Fifth Third, arguing that the plan’s fiduciaries violated their fiduciary duties under ERISA by holding and purchasing company stock long after it ceased to be prudent to do so. The district court dismissed the lawsuit, citing case law from around the country that the plan’s fiduciaries were entitled to a presumption that the continued investment in company stock was reasonable. On appeal, the Sixth Circuit reversed, reasoning that plaintiffs had sufficiently alleged that the fiduciaries had violated their fiduciary duty of prudence, which caused losses to the plan. The Sixth Circuit rejected the so called “presumption of prudence.”
Fifth Third Bancorp appealed to the Supreme Court because seven other Circuit courts of appeal had held that the congressional policy of encouraging employee stock ownership requires that ERISA fiduciaries be entitled to a Presumption of Prudence when offering participants an option to invest in company stock.
The Supreme Court’s Decision
The Supreme Court found that despite Congress’s desire to encourage employee stock ownership, there was no statutory justification for a presumption of prudence regarding an ESOP fiduciary’s decision to invest in employer securities. The Supreme Court held that ESOP fiduciaries are subject to the same duty of prudence that applies to ERISA fiduciaries in general except that they are not required to diversify a plan’s assets and are not liable for losses that result from a failure to diversify.
Practically, this means that ESOP plan sponsors cannot simply rely on the terms of the plan document requiring the plan to invest in employer securities, but must demonstrate prudent decision making in accordance with ERISA. In rejecting the special presumption of prudence, the Supreme Court provided an alternative mechanism for scrutinizing allegations against ESOP fiduciaries.
Evaluating a Claim of Violation of the Duty of Prudence
The Supreme Court held that in evaluating breach of fiduciary duty claims against ESOP fiduciaries, courts must consider the following:
- 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 not sufficient to state a claim.
- To state a claim for violation of the duty of the prudence, a complaint must plausibly allege an alternative action that the defendant could have taken, that would have been legal, and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the plan than to help it.
- The 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.
- Where a complaint faults fiduciaries for failing to act or not act based on negative inside information, the courts should consider the extent to which imposing an ERISA-based obligation could conflict with the complex insider trading and corporate disclosure requirements set forth in the federal securities laws.
- Courts should consider whether the complaint has plausibly alleged that a prudent fiduciary in the defendant’s position could not have concluded that taking the prescribed actions (e.g., stopping purchases) would do more harm than good to the plan by causing a drop in the stock price and an accompanying drop in the value of the stock already held by the plan.
Conclusion and Next Steps
Although the Dudenhoeffer opinion appears to expose ESOP fiduciaries to a higher standard of review, the Supreme Court acknowledges many of the challenges faced by ESOP fiduciaries and leaves room for courts to defer to fiduciary decisions even during periods of underperformance in the value of the company stock. Fiduciaries of plans that invest in employer securities will want to review Dudenhoeffer closely and consider taking the following actions:
Revisit the plan’s fiduciary governance process, training and documentation.
Verify plan documents take full advantage of the exemption from the diversification requirement of ERISA.
Coordinate all fiduciary decisions closely with securities counsel for publicly traded companies.
In making fiduciary decisions, consider and document alternate courses of action and the impact or expected impact the alternatives would have on the underlying value of the company.
If you have any questions regarding fiduciary governance issues or ESOPs, please contact your Kutak Rock LLP attorney or a member of our Employee Benefits Practice Group.