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From Securities Regulation Daily, April 3, 2014

Justices probe ESOP trustee’s securities law quandary, puzzled by lack of SEC views

By Mark S. Nelson, J.D.

The Supreme Court heard oral arguments yesterday in a case that pits Fifth Third Bancorp’s (Fifth Third) trustee for its employee stock ownership plan (ESOP) against the plan’s participants. Fifth Third employees who participated in the plan alleged that the bank’s inside trustee breached its fiduciary duties by keeping plan assets invested in the bank’s stock after the trustee allegedly gained inside information showing the bank’s stock was overvalued (Fifth Third Bancorp, et al. v. Dudenheoffer, et al., April 2, 2014).

The Supreme Court agreed to hear the case last December, but limited arguments to just one question in Fifth Third’s petition: Whether an ESOP participant must plead that the plan’s trustee abused its discretion in order to trump the presumptive appropriateness of an investment decision. The Sixth Circuit held that the plan participants plausibly alleged a breach of fiduciary duty, and reversed the district court’s dismissal of the case.

Securities law dilemma. In questioning by the justices, Robert A. Long, Jr., Fifth Third’s lawyer, tried to convince the court that the plan’s special “character and aims” favored ongoing investments in company stock. Long argued that ERISA ensures that this type of investment decision by an ESOP trustee is presumptively prudent. Justice Kennedy had asked if the plan had a “coach class trustee.”

Justice Sotomayor pressed Long regarding whether the plan had to invest all of its assets in company stock. The justice noted that the plan documents said it must “primarily” invest in company stock, but did not require the plan to keep buying company stock. Long replied that the plan’s terms instructed the trustee to invest in company stock, except for small amounts needed for short-term liquidity.

The justices also asked Long about what the plan’s trustee was supposed to do with possible inside information showing that the bank was financially troubled and its stock likely overvalued. In reply to a question from Justice Kagan, Long said securities law would come into play and that the duties of prudence and loyalty would not require the trustee to violate securities laws. Justice Kagan also asked whether withholding information might not hurt plan participants. Long said a public announcement that the bank’s ESOP had stopped buying the bank’s own stock might cause the bank’s stock price to fall precipitously.

In a related question, Chief Justice Roberts likened the trustee’s decision to “putting all your eggs in one basket.” Said the chief justice, “I mean, the dilemma we're talking about, which is you've got inside information and if you do something with it, it's going to hurt the beneficiary, I mean, isn't that just a reflection of the fact that these are really bad investments?”

Long acknowledged that ESOPS are undiversified. He also said that is why ESOPS have special characteristics that make them appealing for purposes beyond just retirement benefits. In reply to a later question by Justice Kennedy, Long reiterated that the federal appeals courts have for nearly 20 years agreed that ESOPS have special characteristics that make it “presumptively prudent” to invest all plan assets in company stock and that, barring an extreme situation that requires the plan to be closed, there is no “bright-line standard.”

Grand bargain. Counsel for the plan participants, Ronald Mann, began by telling the justices that ERISA makes a “grand bargain” that imposes fiduciary duties on ESOPs. He also said it was wrong for the trustee to choose the bank over the plan participants by doing nothing about the bank stock, despite having information that showed Fifth Third’s stock was overvalued.

Justice Breyer asked for an example of a case where a court said the trustee must use inside information. Mann said he was unaware of any case. The justice then asked, “The person has an obligation to act prudently in respect to the fiduciaries – to the beneficiaries, of course. But he cannot, irrespective of that, have an obligation to use inside information. End of the matter. What – what's wrong with saying just that?”

Mann later said that what got the trustee here into potential trouble was the trustee’s putting itself into a position where it may have to serve conflicting interests. Justice Sotomayor then asked what the trustee could have done without breaking the securities laws. Mann said the court need not resolve that issue.

Chief Justice Roberts asked if a trustee would be imprudent if they bought company stock when its share price was down. The chief justice also noted that plan participants should know they will get only company stock. Mann replied to this and other questions from the chief justice by citing Justice Scalia’s Finkopinion, which Justice Scalia wrote as a judge on the U.S. Court of Appeals for the District of Columbia before joining the Supreme Court. Then-Judge Scalia said in Fink that “procedural prudence” is the touchstone. Mann said Fink posed the question, “… What would a reasonable trustee of a billion-dollar fund have done to investigate the situation?”

Justice Alito then asked if the trustee must get inside information. Mann said a trustee’s failure to act as a prudent fiduciary would violate the duty of loyalty. When Justice Alito pressed Mann for a more direct answer, Mann said that a trustee violates the duty of prudence if he does not make the investigation required of a prudent fiduciary.

Government’s view. Deputy Solicitor General Edwin S. Kneedler, at the court’s invitation, presented the U.S. government’s views. Kneedler began by emphasizing that ERISA only treats employees’ interests in terms of their being plan participants, and not in a broader sense. Kneedler was answering a question Justice Alito had asked earlier of Long regarding whether ERISA treats participants as employees or as investors, because a plan participant’s interests may vary depending on their status.

Kneedler also confirmed, in reply to a question by Justice Sotomayor, that a mere stock drop would not implicate the trustee’s duty of prudence. Kneedler later clarified that there may be “unusual circumstances” that may require a different conclusion.

Justice Sotomayor also followed-up on Kneedler’s reply to a question by Justice Breyer, in which Kneedler suggested that a fiduciary has a duty to use their discretion to investigate. Justice Sotomayor asked what the fiduciary was to investigate. Kneedler said the trustee would investigate the potential impact of the inside information. Said Kneedler, “So the – the fiduciaries of a plan like this do have an ongoing obligation to investigate and to keep themselves apprised of how the company is doing.”

Justice Sotomayor also asked Kneedler about the pleading stance of the case, noting that the court was grappling with a pleading presumption. Kneedler answered that an evidentiary presumption, such as the one the Sixth Circuit found, would not have to be pleaded. Kneedler noted, however, that a substantive item would need to be pleaded in the complaint.

Inside or outside trustee. In questioning Mann, Justice Alito rekindled a line of questioning Justice Kennedy had begun by asking the trustee’s counsel how often insiders serve as ESOP trustees. Long had previously said on behalf of Fifth Third that it was “common” for a trustee to be an outsider.

Justice Alito asked whether an ESOP should always have an outside trustee. Mann said that outsiders were not required, but analogized the inside trustee’s situation to corporate directors who must give way to independent persons, who then look out for shareholders’ interests, a theme Justice Breyer would return to later in the context of trying to conjure the SEC’s views, had they been briefed.

Justice Alito asked, “So you're basically saying that if it's not flatly prohibited, it is very unwise. It generally shouldn't happen. You're putting yourself in an impossible position if you are an insider and you're going to serve as a trustee of an ESOP.” Mann said this scenario ought to raise red flags about the trustee’s potential conflicts.

Earlier, in reply to Justice Kennedy, Long said the alternatives to inside trustees were imperfect. Long said the appointment of a lower-level employee to be the monitoring trustee raised issues of whether that person would have so little knowledge as to violate ERISA, and noted that outside trustee would still get the inside information from the monitor.

During rebuttal by Long, Justice Sotomayor returned to the inside-versus-outside trustee issue. The justice noted that problems can arise any time a person who could acquire inside information becomes an ESOP’s trustee. She also noted that the plan participants had argued that Fifth Third brought the dilemma on itself.

Long reiterated that ESOP trustees are “different” because their mandate is to invest in company stock, which he said justifies giving them “leeway” as the federal appeals courts have done in many opinions. Long also said that ESOP trustees are equally likely to get sued in a situation like the one before the court where the trustee kept buying the company’s stock, and when a plan is closed, but the company’s share price has later rallied.

Justice Kennedy again raised the inside information issue, asking the deputy solicitor general, “Is inside information just an added issue in the case or is it the key issue in the case?” Kneedler replied that is the “key issue.” Said Kneedler, “We are focused here on inside information that materially enhances the value of the stock, overvalues it, and in that situation, we think that a fiduciary of an ESOP, just like the fiduciary of any other plan, has a – has a duty of prudence not to remain invested in or to purchase materially overvalued stock.”

Where is the SEC. Justice Breyer asked several times for the SEC’s views. The justice first raised the question in querying Mann about the precise nature of the trustee’s dilemma. “There is no rule of trust or ERISA law that you can breach a duty to a beneficiary by failing to use inside information, period. I don't know what the SEC's brief is. I'm going to ask – [brief reply of Mann omitted] – the SEC what their opinion is because they don't seem to appear on this brief.”

Justice Breyer raised the question again with the deputy solicitor general. Justice Breyer asked, “… I would like to know directly, not indirectly, what the SEC thinks.” Justice Breyer added, “And maybe you can tell me. But the SEC isn't here. And at least there's no SEC lawyer that signed your brief.”

Kneedler replied that the case mostly involved labor law. But Justice Breyer pressed on, asking what the court should tell ESOP trustees, and remarking that the AFL-CIO brief may offer an answer.

The AFL-CIO urged as amicus curiae that Fifth Third could have appointed an independent trustee. Citing the Restatement (Third) Trusts (2007), the AFL-CIO said, “Were the Petitioners personally disabled from disposing of Company stock, because of their inside knowledge of the Company’s financial conditions, the proper course would be for them to turn management of the fund over to an independent financial manager, who would not be similarly disabled.”

Kneedler told Justice Breyer that one option is to have an outside trustee, citing WR Grace’s woes as an example. Kneedler then tried to agree with counsel for the plan participants that a fiduciary must investigate. This was the exchange that led to Justice Sotomayor’s question about exactly what the trustee must investigate.

The case is No. 12-751.

Attorneys: Edwin S. Kneedler, Deputy Solicitor General, for the U.S. as amicus curiae, supporting John Dudenhoeffer, et al. Ronald J. Mann, for John Dudenhoeffer, et al. James E. Burke (Keating, Muething & Klekamp, PLL) and Robert A. Long, Jr. (Covington & Burling LLP) for Fifth Third Bancorp, et al.

Companies: Fifth Third Bancorp; AFL-CIO; WR Grace

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