How Has Supreme Court Decision in Fifth Third Bancorp v. Dudenhoeffer Affected Litigation Over Company Stock in Retirement Plans?
In June of 2015, in Fifth Third Bancorp v. Dudenhoeffer, the Supreme Court ruled unanimously that “the law does not create a special presumption favoring ESOP [Employee Stock Ownership Plan] fiduciaries. Rather, the same standard of prudence applies to all ERISA fiduciaries, including ESOP fiduciaries, except that an ESOP fiduciary is under no duty to diversify the ESOP’s holdings.”
“ESOPs” are actually a specific kind of statutory retirement plan with a specific set of rules, including a requirement that the plan be “primarily invested” in company stock. Despite this, courts at all levels ruled that 401(k) plans that owned company stock could also be considered ESOPs, particularly if they specifically required that company stock be an investment option and/or a match from the company. That seems a dubious conflation given that 401(k) plans have a very different purpose and should be diversified. Nonetheless, this view was adapted by virtually every court that looked at so-called “stock drop” issues.
Many observers believed the decision would significantly increase litigation concerning company stock in retirement plans. That clearly has not happened. In tracking this type of litigation since 1990, there have been far fewer lawsuits initiated over stock-drop issues after the Dudenhoeffer ruling than in the years before the decision.[i] The strong stock market largely explains this phenomenon, but not all companies with company stock have prospered. There have been no remanded cases concerning closely held ESOP companies, which account for over 90% of the plans, and most of the remands deal with 401(k) plans, not ESOPs. While the number of remands is still fairly small (and probably will not grow by much), the trends have shown that the new standards are at least as strongly pro-defendants as the presumption of prudence rule was.
The Supreme Court Drops the Presumption and Creates a New Test
The Dudenhoeffer ruling overturned the so-called Moench presumption of prudence rule that had been applied to plan fiduciaries for certain 401(k) plans investing in company stock and in ESOPs. The presumption was first laid out in Moench v. Robertson (Third Cir., August 10, 1995), in which the court ruled that fiduciaries of ESOPs could be presumed to be prudent for investing in company stock unless they knew or should have known that the company was in dire circumstances. Dudenhoeffer concerned a publicly traded company with a 401(k) plan in which the company matched employee contributions by contributing employer stock to an ESOP that was a component of the 401(k) plan. The plan document required the ESOP to invest primarily in company stock. The stock dropped precipitously, and employees sued. The trial court said fiduciaries were entitled to a presumption of prudence in continuing to offer the shares and dismissed the case. Upon review, the Sixth Circuit applied a stronger test for the presumption and rejected its applicability at the pleadings stage in this case, stating that the plaintiffs had stated a plausible duty-of-prudence claim. In its decision, the Supreme Court vacated the Sixth Circuit’s decision and remanded the case to the Sixth Circuit for consideration in light of the Court’s opinion.
The Court stated that "as a general rule," it is implausible to allege that a fiduciary should have known from public information alone that the market was overvaluing the stock. Hence, the Court ruled that the Sixth Circuit's "decision to deny dismissal...appears to have been based on an erroneous understanding of the prudence of relying on market prices." Instead of using a presumption of prudence standard, the Court ruled created a new three-part test.
First, it said, ERISA's duty of prudence does not require ESOP fiduciaries to take actions based on inside information, such as divesting employer stock, that violate securities laws. Second, courts must consider how an ERISA-based obligation to refrain from such purchases or disclosures may conflict with insider trading and corporate disclosure laws and the objectives of those laws. Third, courts must consider whether stopping purchases or disclosing information would create more harm than good by driving down the stock price and thus the value of existing employee holdings.
The model the Court had in mind for an ESOP company is clearly one that is publicly traded. The disclosure of nonpublic information to participants is only relevant in those plans that are funded by employee purchases of employer stock from a menu of investment choices. That is typical of public company 401(k) plans with company stock and combined ESOP/401(k) plans. Private companies almost never fund their ESOPs this way, instead funding the plan through company contributions. There are no investment choices for the participants.
The third part of the Court's analysis concerning stopping the purchase of employer shares also fits public companies much better than private ones. Here, the Court ruled that lower courts should "consider whether the complaint has plausibly alleged that a prudent fiduciary could not have concluded that stopping purchases—which the market might take as a sign that insider fiduciaries viewed the employer's stock as a bad investment—or publicly disclosing negative information would do more harm than good to the fund by causing a drop in the stock price.” Conceivably, this could mean a fiduciary of a closely held company might choose not to buy ESOP shares if the fiduciary knows the company's most recent valuation is no longer valid because of changes in business conditions and/or the valuation was based on improper information given to the appraiser. Under current law and practice, however, this would already violate ERISA, and the disclosure issues the court raises here are not, in any event, applicable to private companies because there is no market for the shares.
After the Decision
A number of cases have been remanded to lower courts after the Supreme Court eliminated the presumption of prudence for company stock in ESOPs and for 401(k) plans designed to have company stock as a match or a deferral option. In most of the remands, plaintiffs continued to be unsuccessful.
In one of the first stock-drop cases to be remanded, a district court dismissed a stock-drop case against UBS. In In re UBS ERISA Litig., (S.D.N.Y., No. 1:08-cv-06696-RJS, Sept. 29, 2014), the court held that the plaintiff had claimed only indirect harm from the plan fiduciary’s decision to continue holding UBS shares during which the price declined 69%. To prove standing, the plaintiff would have needed to show that the alleged fiduciary breaches caused her to suffer an individual loss. The judge noted that the Dudenhoeffer ruling had “little impact” on this case because the court had found that the Moench presumption did not apply, since the plan in question was not required or encouraged to hold company stock. In a footnote of his opinion, judge Richard J. Sullivan noted, however, “It could be argued that the Supreme Court’s decision in Dudenhoeffer has, if anything, raised the bar for plaintiffs seeking to bring a claim based on a breach of the duty of prudence,” referring to the deference the Supreme Court allowed fiduciaries to give to the impact of company stock in retirement plans.
In Pfiel v. State Street Bank and Trust, No. 14-1491 (6th Cir., Nov. 10, 2015), the Sixth Circuit again dismissed a claim by plaintiffs from GM arguing that GM stock should not have been an option in the company’s 401(k) plan. The court had previously ruled that the presumption of prudence rule protected the plan’s fiduciaries, but after the Supreme Court eliminated the defense, the case was remanded. On rehearing, the court ruled that the efficient market theory provided that trustees could not be expected to outguess the market as to whether a particular stock is overpriced at any time. The court also ruled that State Street’s process for reviewing investments, including GM stock, met fiduciary standards.
In In re Lehman Bros. Sec. & ERISA Litig., No. 1:08-cv-05598-LAK (S.D.N.Y., July 10, 2015), a district court again dismissed a lawsuit over a drop in Lehman Brothers stock in the company’s 401(k) plan. The court had originally dismissed the case based on presumption of prudence. On remand under the new rules of the Dudenhoeffer decision, the court again ruled against the plaintiffs, this time saying they had failed to meet the heightened pleading standards that the Dudenhoeffer ruling set out. Concerning public information, the plaintiffs must be able to show that there were “special circumstances” that would require removing company stock as an optional investment. Nonpublic information is not required to be disclosed or acted on if doing so violates securities laws.
In In re Citigroup ERISA Litig., 2015 BL 148422, S.D.N.Y., No. 1:11-cv-07672-JGK (S.D.N.Y., May 13, 2015), Citicorp prevailed in a stock-drop lawsuit. The case had originally been decided on the presumption of prudence rule. On remand, the district court ruled that the statute of limitations had passed because the suit was filed more than three years after the alleged violations of fiduciary duties concerning employer stock in the 401(k) plan occurred. However, the court added that even had this not been the case, the plaintiffs could not sustain an argument that “special circumstances” would have required that the fiduciaries remove Citicorp stock. The court said that the allegation that Citicorp stock was excessively risky was insufficient to meet the Dudenhoeffer requirements and that it was implausible to allege that fiduciaries had undisclosed insider information.
In June, the plaintiffs asked for reconsideration, arguing that the recent Supreme Court ruling in Tibble v Edison required that trustees be held responsible for actions dating back to 2008 when they knew or should have known that Citicorp stock was under pressure. In In re Citigroup ERISA Litig., No. 1:11-cv-07672-JGK (S.D.N.Y., July 6, 2015) the court ruled, however, that the three-year statute of limitations period still applied because plaintiffs themselves had already said the information on which they argued trustees should have removed Citicorp stock was public. Thus they had actual knowledge as early as 2008 and could have filed based on that. Interestingly, the court also ruled that Tibble applied to buying mutual funds at too high a price, creating an accrual of problems over time, whereas this case concerned holding on to company stock, a decision the court ruled distinguishable.
In In re HP ERISA Litig., No. 3:12-cv-06199- CRB (N.D. Cal., June 15, 2015), a district court said that actions of Hewlett Packard 401(k) plan trustees in not selling or removing company stock as an option in the plan did not violate ERISA. The court originally based its ruling on the presumption of prudence. On remand, it said the new standards under the Dudenhoeffer decision also protected fiduciaries. The court said that plaintiffs could not show that fiduciaries had a viable alternative in dealing with employer stock after improprieties in accounting for an HP acquisition were discovered that, when disclosed, would cause the stock to fall. If they did have insider information, they could not disclose it under SEC rules, and any action they could have taken to reduce stock in the plan could have sent a signal to the market that would harm plan participants.
In one case, however, the new rule has, at least for now, allowed plaintiffs to continue their litigation. In Harris v. Amgen, Inc., No. 10-56014 (9th Cir., opinion amended and en banc review denied, May 26, 2015), the Ninth Circuit denied an en banc review of its prior opinion in this stock-drop case, but amended its prior decision. The case involved a sharp drop in Amgen stock. Plaintiffs had argued that fiduciaries had nonpublic information that, when it became known, would cause a sharp drop in share value. Defendants argued that if they had acted on that information by selling the shares, it would have caused the very decline the plaintiffs wanted to avoid. The defendants prevailed, but the Supreme Court remanded the case after it rejected the presumption of prudence standard in the Dudenhoeffer case. The Ninth Circuit said that the fiduciaries should have removed Amgen stock, which would have the same effect on the market as disclosure of the potentially adverse information. The court said that securities laws would ultimately require that decision anyway. In a sharp dissent, Judge Alex Kozinski, joined by three others concurring, said that the decision failed to incorporate the heightened pleading standards of Dudenhoeffer and would result in fiduciaries scrambling to remove or sell stock any time any potentially adverse news arose. The Court stayed enforcement of its decision, however, pending an appeal to the Supreme Court.
In Smith v. Delta Air Lines, Inc., No. 14-696, (U.S., summary disposition 2/23/15) the Supreme Court ruled that as a result of its decision in in Dudenhoeffer the Eleventh Circuit must reconsider its decision in a case involving employer stock in Delta Airlines’ ESOP. That case is still pending, so the effect of the Supreme Court’s decisio0n here is unknown.
Finally, in Gedek v. Perez, No. 6:12-cv-06051- DGL, (W.D.N.Y., 12/17/14), a district court allowed Kodak workers to continue their lawsuit over employer stock in the company’s 401(k) plan. The court ruled that the Supreme Court’s Dudenhoeffer decision on the presumption of prudence rule did not apply here because the plan participants could reasonably argue that the plan fiduciaries knew or should have known from publicly available information that Kodak was in serious trouble. The defendants argued that plaintiffs had to argue that there was a specific date when fiduciaries should have known, but the court rejected this defense as unreasonable. The case is thus unlikely to throw any further light on how courts will use the Dudenhoeffer ruling.
[i] National Center for Employee Ownership, ESOP and 401(k) Plan Employer Stock Litigation Review, 1990-2015.