Supreme Court Strikes a Long-standing Presumption of Prudence for ESOP Fiduciaries
The Supreme Court recently issued a unanimous decision in Fifth Third Bancorp v. Dudenhoeffer , holding that employee stock ownership plan ("ESOP") fiduciaries are not entitled to a "presumption of prudence" in investing in and continuing to hold employer stock. This presumption, commonly referred to as the Moench presumption after the Third Circuit opinion that first articulated it, had been adopted in one form or another by several circuit courts. In rejecting the Moench presumption, the Supreme Court determined that ESOP fiduciaries are subject to the same duty of prudence as other ERISA fiduciaries and are only exempt from the requirement to diversify the ESOP investments.
A group of Fifth Third employees brought a putative class action against the bank and a number of its officers under the Employee Retirement Income Security Act (ERISA) for encouraging them to save in an ESOP which invests primarily in Fifth Third stock, just before that stock price plummeted when the market crashed. Plaintiffs alleged, prior to the market's crash, Fifth Third shifted from being a conservative lender to a subprime lender and its loan portfolio became increasingly at risk due to defaults. When the subprime crisis hit, the ESOP lost tens of millions of dollars, effectively shattering employee participants' retirement savings. The complaint alleged that the defendants breached the fiduciary duty of prudence imposed by ERISA by continuing to invest in and hold Fifth Third's stock, despite knowing (based on both publicly available and non-public, inside information as Fifth Third officers) that Fifth Third stock was overpriced and excessively risky. It further alleged that a prudent fiduciary in defendants' position would have responded by selling off the ESOP's holdings and refraining from purchasing more, or disclosing the inside information so that the market could correct the stock's price downward.
The trial court applied the presumption at the motion to dismiss stage and found that the complaint failed to allege facts to overcome the presumption that defendants' decision to remain invested in employer securities was reasonable, noting that the Fifth Third's viability was never in serious doubt or facing impending financial collapse, facts required to be alleged to overcome the presumption. The Sixth Circuit reversed, concluding that ESOP fiduciaries are indeed entitled to a "presumption of prudence" that does not apply to other ERISA fiduciaries, but that the presumption is an evidentiary one and therefore does not apply at the pleading stage, and may be rebutted by showing that a prudent fiduciary acting under similar circumstances would have made a different investment decision. In light of differences among the Courts of Appeals, the Supreme Court granted Fifth Third's petition for certiorari to consider "whether, when an ESOP fiduciary's decision to buy or hold the employer's stock is challenged in court, the fiduciary is entitled to a defense-friendly standard that the lower courts have called a presumption of prudence."
The Court recognized the tension among ERISA's statutory directives. Section 404(a)(1)(B) of ERISA requires all plan fiduciaries to discharge their duties to the plan with care, skill, prudence and diligence solely in the interest of the participants. Section 404(a)(1)(C) further requires a fiduciary to diversify the investments of the plan so as to minimize the risk of large losses unless under the circumstances it is clearly prudent not to diversify. On the other hand, ESOPs are designed to invest primarily in the stock of the participants' employers and thus, § 404(a)(2) expressly modifies the ERISA duties for ESOP fiduciaries, statutorily exempting ESOPs from the prudence requirement, but only insofar as the duty requires diversification-reflecting Congress's desire to encourage ESOPs. The Supreme Court held that there was nothing in ERISA that supported the imposition of a special presumption favoring ESOPs, and that the same standard of prudence applies to ESOPS as to all other ERISA plans, with the exception that an ESOP fiduciary is under no duty to diversify the ESOP's holdings. Consequently, the only difference between ESOP fiduciaries and other ERISA fiduciaries with respect to the duty of prudence, is that the former are not liable for losses that result from a failure to diversify, as precisely delineated by the statutory exemption in § 404(a)(2). The Court rejected the primary statutory argument advanced by the defendants in support of the presumption, that the "character" and "aims" of an ESOP – to promote employee ownership of stock – differ from those of an ordinary retirement investment- i.e., to maximize retirement savings while minimizing risk. The Court refused to accept the proposition that the content of ERISA's duty of prudence varies depending upon the specific nonpecuniary goal set out in the ERISA plan.
The Court found defendant's non-statutory, practical arguments more convincing: the threat of costly duty-of-prudence lawsuits would deter companies from offering ESOPs to their employees. Defendants argued that without the presumption, an ESOP fiduciary will be caught in a catch-22 situation where, if a fiduciary continues to invest in company stock and the stock goes down, he may be sued for acting imprudently in violation of 404(a)(1)(B), but if he stops investing and the stock goes up, he may be sued for missing the opportunity to benefit from good performance and disobeying the plan mandate to invest. While recognizing the valid concerns of ESOP fiduciaries, the Court decided that a presumption of prudence is not the appropriate way to weed out meritless lawsuits or to provide the requisite balancing of ERISA interests.
Although the elimination of the presumption of prudence is undesirable for plan fiduciaries, the Court outlined guidelines for lower courts to apply at the motion to dismiss stage, to protect fiduciaries against frequent, frivolous participant suits. The Court decided that the weeding out of meritless claims can better be accomplished through "careful judicial consideration of whether the complaint states a claim that the defendant has acted imprudently," and instructed the Sixth Circuit on remand to apply the Twombly and Iqbal pleading standard. Specifically, for claims based on publicly available information, "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." In other words, under most circumstances ERISA fiduciaries could prudently rely on the market price of stock to assess its value in light of all public information. On the other hand, to state a claim for breach of the duty of prudence on the basis of inside information , a plaintiff must be able to 1) articulate what course of action the fiduciary could have taken, consistent with securities laws prohibiting trading on inside information, to avoid incurring costs, and 2) show that a prudent fiduciary in like circumstances could not have believed that such an action would be more likely to harm rather than help the plan.
No longer can ESOP fiduciaries shield themselves from liability by asserting the Moench presumption and pointing to the purpose of an ESOP-to invest its assets in employer stock. Now fiduciaries bear the same responsibilities as any ERISA fiduciary, to demonstrate that continued investment in employer stock is prudent and in the best interests of the plan's participants. Although the presumption of prudence is eliminated, the Court has shaped weighty obstacles for the plaintiffs to get past a motion to dismiss. First, in the absence of insider information, a plaintiff must plead "special circumstances" that would show that the price does not reflect the value of the stock. Second, in the case of claims based on non-public information, the plaintiff must show that there was alternative conduct that would have left the plan better off and that was not inconsistent with securities laws. In light of this decision, and until lower courts work out the details left open by the Court's decision, plan sponsors will likely reconsider appointing members to investment committees who are in possession of material, non-public information, and may consider an independent fiduciary to alleviate litigation risks.
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