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From Securities Regulation Daily, June 25, 2014

Employee stock plan fiduciaries not entitled to prudence presumption

By Jim Hamilton, J.D., LL.M.

A unanimous Supreme Court ruled that fiduciaries of employee stock ownership plans that primarily invest in company stock are not entitled to a defense-friendly presumption of prudence when making investment decisions. Instead, the fiduciaries are subject to the same duty of prudence that applies to ERISA fiduciaries generally, except that they need not diversify the fund’s assets. A presumption of prudence would require the plaintiff to make a showing that would not be required in an ordinary duty of prudence case, such as that the employer was on the brink of collapse (Fifth Third Bancorp v. Dudenhoeffer, June 25, 2014, Breyer, S.).

Allegations. The case involved a large financial services firm that offered an employee stock ownership plan (ESOP) with company matching contributions. The plan required that the funds be invested primarily in shares of company stock. Employees and participants alleged that plan fiduciaries violated the duty of prudence imposed by ERISA because they knew or should have known that the company’s stock was overvalued and excessively risky for two reasons. First, publicly available information provided early warning signs that the subprime lending that formed a large part of the company’s business would soon collapse. Second, company officers had deceived the market by making material misstatements about the company’s financial prospects. Those misstatements, it was contended, led the market to overvalue company stock; consequently, plan participants paid more for the stock than it was worth. The fiduciaries continued to hold and buy company stock, and then the market crashed.

No presumption of prudence. The Court vacated the Sixth Circuit’s ruling that the law creates a special presumption or prudence applicable only to ESOP fiduciaries. The same standard applies to all ERISA fiduciaries, including ESOP fiduciaries, except that an ESOP fiduciary is not liable for losses that result from a failure to diversify.

The presumption is not an appropriate way to weed out meritless lawsuits, the Court wrote, nor to balance Congress’s desire to offer employees enhanced protection for their benefits with its desire not to create a system that is so complex that administrative costs and litigation expenses discourage employers from offering plans in the first place. The Court reasoned that the proposed presumption makes it impossible for a plaintiff to state a duty-of-prudence claim, no matter how meritorious, unless the employer is in very bad economic circumstances. “Such a rule does not readily divide the plausible sheep from the meritless goats,” noted the Court. That important task can be better accomplished through careful, context-sensitive scrutiny of a complaint’s allegations. Thus, the Court stood by its conclusion that the law does not create a special presumption of prudence for ESOP fiduciaries.

Remand. The Court remanded to the Sixth Circuit to reconsider whether the complaint states a claim by applying the pleading standard from two earlier Court opinions, Ashcroft v. Iqbal (U.S. 2009) and Bell Atlantic Corp. Twombly (U.S. 2007), in light of two considerations. First, 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 thus insufficient to state a claim under Iqbal and Twombly. Second, to state a claim for breach of the duty of prudence, a complaint must plausibly allege a legal alternative action that the defendant could have taken, which a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.

Insider trading considerations. When the complaint alleges that a fiduciary was imprudent in failing to act on the basis of inside information, the analysis is informed by the following points. First, ERISA’s 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.

Second, additional considerations arise when a complaint faults fiduciaries for failing to decide, based on negative inside information, to refrain from making additional stock purchases or for failing to publicly disclose that information so that the stock would no longer be overvalued. In this situation, courts should consider the extent to which imposing an ERISA-based obligation either to refrain from making a planned trade or to disclose inside information to the public could conflict with the complex insider trading and corporate disclosure requirements set forth by the federal securities laws or with the objectives of those laws.

Third, courts 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 — which the market could interpret as insiders believing the stock to be 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 and a concomitant drop in the value of the stock already held by the fund.

The case is No. 12-751.

Attorneys: James E. Burke (Keating Muething & Klekamp PLL) and Robert A. Long Jr. (Covington & Burling LLP) for Fifth Third Bancorp. Ronald J. Mann for John Dudenhoeffer.

Companies: Fifth Third Bancorp

MainStory: TopStory ExchangesMarketRegulation

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