Philip Berkowitz ()
Last month, the U.S. Supreme Court issued several decisions of note for employers—but what may be the most significant case, Fifth Third Bancorp v. Dudenhoeffer,1 is the one that grabbed the fewest headlines.
The cases most closely watched on Capitol Hill were Noel Canning v. NLRB, which held that President Barack Obama’s January 2012 recess appointments to the National Labor Relations Board were unconstitutional, and Burwell v. Hobby Lobby, which may limit access to contraceptives, under the Affordable Care Act, to beneficiaries of medical plans of closely held corporations who object to that coverage on religious grounds.
Of course, these cases are important. Noel Canning will have significant short-term consequences, but will not likely affect the board’s overall agenda, at least under the current Administration.
Hobby Lobby’s impact may, in the long run, prove more significant, insofar as it recognizes the right of closely held companies, under the Religious Freedom and Restoration Act, to decline to follow legislation to which the owners object on religious grounds.
But perhaps the court’s most significant decision relates to what may appear, on its face, to be a more mundane topic—the fiduciary obligations of Employee Stock Ownership Plan (ESOP) and 401(k)-plan investment committees who trade in the employer’s company stock.
The decision applies to both publicly and privately traded companies—and, as discussed below, may particularly affect private companies.
Quite simply, the decision may put at risk what has previously, to some degree, been taken for granted—the right, except in exceptional circumstances, of ESOP fiduciaries to invest in company stock.
The decision also precariously balances the potentially conflicting obligations of fiduciaries who have insider information concerning the company, and are prohibited from trading on that information, with their fiduciary obligation to act solely in the interests of plan participants and beneficiaries.
In Dudenhoeffer, the court held that fiduciaries of these committees are not entitled to any “presumption of prudence” in lawsuits challenging their decision to invest plan assets in company stock. Instead, they “are subject to the same duty of prudence that applies to ERISA (Employee Retirement Income Security Act) fiduciaries in general, except that they need not diversify the fund’s assets.”
The plaintiffs were Fifth Third employees and participants in a defined contribution individual account plan that offered, among its twenty investment options, a company stock fund designated as an ESOP. The plaintiffs alleged that the defendants violated ERISA’s duty of prudence by continuing to hold substantial investments in company stock, and continuing to offer company stock as an investment option, even though they knew that it was overvalued and excessively risky.
The plaintiffs claimed the defendant fiduciaries were aware of the fund’s risky nature from both publicly available information, such as newspaper articles, that allegedly provided early warning signs that the stock was inflated, and nonpublic (i.e., insider) information, that the Company had, allegedly, deceived the market by making material misstatements about its financial prospects.
The plaintiffs claimed that the defendants should have (1) sold the ESOP’s holdings of company stock before its value declined; (2) refrained from purchasing any more company stock; (3) canceled the pension plan’s ESOP option; or (4) disclosed the insider information so that the market would adjust its valuation of the company’s stock downward, and the ESOP would no longer be overpaying for it.
Instead, the defendants continued to hold and buy company stock. When the market crashed, its value fell by 74 percent between July 2007 and September 2009, when the plaintiffs filed their lawsuit.
Presumption of Prudence
Consistent with every federal appellate court that had previously decided the issue, the Sixth Circuit held that ESOP fiduciaries are entitled to a “presumption of prudence.”
The Supreme Court, though, eviscerated the presumption.
ERISA subjects all pension plan fiduciaries to a duty of prudence. It requires a fiduciary to “discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries…for the exclusive purpose of…providing benefits to participants and their beneficiaries; and…defraying reasonable expenses of administering the plan….”
Fiduciaries must discharge these duties “with the care, skill, prudence and diligence under the circumstances then prevailing that a reasonably prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims….”
Fiduciaries must normally diversify investments “so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so….”
However, Congress exempted fiduciaries of ESOPs, to some degree, from these requirements. The diversification and prudence requirements (to the extent that the latter requires diversification) of ERISA are not violated by acquiring or holding company stock.
The Supreme Court noted that federal courts of appeals had gone beyond this express provision of ERISA by granting ESOP fiduciaries a “presumption of prudence” when their decisions to hold or buy employer stock are challenged as imprudent.
But the Supreme Court rejected this notion, stating, “In our view, the law does not create a special presumption favoring ESOP 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.”
The court rejected the defendants’ argument that an ESOP’s explicit requirement to invest assets primarily in shares of company stock should trump the duty of prudence—to the contrary, the court held, the opposite is true.
Stock Price and Value
Notwithstanding these rejections of the defendant fiduciaries’ position, the court nevertheless also rejected the plaintiffs’ argument that mere fluctuations in stock price should have alerted the fiduciaries to the danger of investing in company stock. The court stated: “In our view, where a stock is publicly traded, 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.”
The court agreed that normally, it is prudent for a fiduciary to rely on the stock price as a reasonable estimate of its value, and not expect to outperform the market based solely on their analysis of publicly available information—absent “publicly available information…pointing to a special circumstance affecting the reliability of the market price as an unbiased assessment of the security’s value…that would make reliance on the market’s valuation imprudent.” (Internal quotations omitted)
Perhaps the most troublesome aspect of the case involved the participants’ argument that the defendants imprudently failed to act on the basis of nonpublic, inside information indicating that the market was overvaluing company stock.
For their part, the fiduciary defendants pointed out that the participants’ position would lead to conflicts with the legal prohibition of insider trading, insofar as ESOP fiduciaries, who are often company insiders, might be compelled to use inside information in making ESOP investment decisions.
The court disposed, to some degree, of both arguments. The court first ruled that, in order for a beneficiary to state a claim for breach of the duty of prudence based on inside information, “a plaintiff must plausibly allege an alternative action that the defendant could have taken that would have been consistent with the securities laws and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.”
The court recognized, though, that the duty of prudence under ERISA “does not require a fiduciary to break the law.” Consistent with this, the court ruled that “ERISA’s duty of prudence cannot require an ESOP fiduciary to perform an action—such as divesting the fund’s holdings of the employer’s stock on the basis of inside information—that would violate the securities laws.”
The court also ruled that when beneficiaries claim that fiduciaries have failed to take into account insider information in making ESOP investment decisions, a court “should” (read as, “must”) consider whether doing so “could conflict with the complex insider trading and corporate disclosure requirements imposed by the federal securities laws or with the objectives of those laws.”2
And finally, on this point, the court expressed additional concern—lower courts, it ruled, need to consider whether a prudent fiduciary, faced with a consideration to trade on insider information, might not appropriately decide that doing so would do more harm than good to the value of the stock, insofar as the market might consider this as a sign “that insider fiduciaries viewed the employer’s stock as a bad investment” or even cause a drop in the stock price and in the value of the ESOP funds.
Impact of Decision
The court undoubtedly lessened the burden on plaintiffs in ESOP stock-drop cases, and made clear that ESOP fiduciaries do not have a free pass to invest in company stock when doing so is not prudent. However, the court also made clear that fiduciaries need not trade based on material inside information, nor do they ordinarily need to second-guess whether the market price of a publicly traded stock accurately reflects its value.
Perhaps the result will be to give a permanent “pass” to C-level executives serving on these committees—ESOP fiduciary committees may want to rethink whether their members should possess non-public information concerning the company’s finances.
In the absence of a presumption of prudence on the part of the fiduciary committee, participants in non-public company ESOPs may have a better chance of prevailing in stock-drop cases. Public information creates a stock price which is presumed to be a valid reflection of its market value.
ESOP fiduciaries of privately held companies, on the other hand, have no such basis to defend stock valuations and are more likely to be vulnerable to challenges without a clear (and, ideally, independently determined) valuation.
Philip M. Berkowitz is a shareholder and U.S. cochair of Littler Mendelson’s international law practice. Steven Friedman, shareholder and cochair of the firm’s employee benefits and executive compensation practice, assisted in the preparation of this article.
1. – U.S. -, No. 12-751 (June 25, 2014).
2. The court pointedly noted that the Securities and Exchange Commission “has not advised us of its views on these matters, and we believe those views may well be relevant.”