Supreme Court Holds No “Presumption of Prudence” Exists for ESOP Fiduciaries

Jul 1, 2014

In Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. ___ (2014), the Supreme Court held that fiduciaries of Employee Stock Ownership Plans (ESOPs) are not entitled to a “presumption of prudence” when their decisions to buy or hold employer stock are challenged. Despite its rejection of a presumption that had largely insulated plan fiduciaries from so-called “stock drop” lawsuits, the decision is not necessarily bad news for sponsors of plans that offer company stock as an investment option. This is because although it rejected a presumption of prudence, the Supreme Court enunciated a new framework for evaluating claims of fiduciary imprudence that may make it difficult for such claims to proceed, particularly when publicly-traded stock is involved.

Dudenhoeffer involved a putative class action filed by former employees of Fifth Third Bancorp. The employees were participants in Fifth Third’s retirement savings plan, a plan that allowed participants to invest contributions in Fifth Third stock. The portion of the plan that held investments in stock was an Employee Stock Ownership Plan (ESOP) that specifically required ESOP assets to be invested primarily in shares of Fifth Third common stock. When the value of Fifth Third stock fell by 74%, the plaintiffs filed suit in Ohio District Court, alleging that ESOP fiduciaries had breached their duties of loyalty and prudence by continuing to hold and buy Fifth Third stock despite knowing, based on both public and nonpublic information, that the stock was overvalued and excessively risky. 

The Ohio District Court dismissed the plaintiffs’ complaint, finding that ESOP fiduciaries were entitled to a presumption of prudence and that the allegations set forth in the complaint were not sufficient to overcome that presumption. On appeal, the Sixth Circuit Court of Appeals reversed the lower court’s ruling, holding that the presumption of prudence was not available at the pleading stage, and finding that the plaintiffs’ allegations were sufficient to state a claim for breach of fiduciary duty. The ESOP fiduciaries then asked the Supreme Court to review the Sixth Circuit’s decision. 

An ESOP is a pension benefit plan that is subject to the provisions of the Employee Retirement Income Security Act (ERISA). Section 404(a)(1) of ERISA generally requires, among other things, that plan fiduciaries discharge their duties (i) with the care, skill, prudence and diligence that a prudent man acting in a like capacity and familiar with such matters would use, and (ii) by diversifying the investments of plan assets. However, ERISA Section 404(a)(2) exempts an ESOP fiduciary from the generally-applicable diversification requirements, as well as from the requirement of prudence “to the extent it requires diversification.” The exemption under ERISA Section 404(a)(2) also extends to other “eligible individual account plans” such as profit sharing and 401(k) plans, that specifically permit buying and holding of qualifying employer securities.

A number of federal Courts of Appeals have held that a “presumption of prudence” is available to ESOP fiduciaries when decisions to buy or hold employer stock are challenged. The Third Circuit Court of Appeals was the first Circuit Court to recognize the existence of the presumption in Moench v. Robertson, 62 F. 3d 553 (1995). Under the Moench presumption, an ESOP fiduciary’s decision to hold or buy stock was entitled to a presumption of prudence that could only be overcome by demonstrating that the fiduciary abused its discretion by buying or retaining stock, i.e., by demonstrating that it was unreasonable for the fiduciary to believe that continued investment in employer stock would further the intended purposes of the plan. Following Moench, several other Courts of Appeals had also recognized a presumption of prudence, although those courts differed as to whether the presumption could be applied at the pleading stage, and what plaintiffs must prove in order to overcome the presumption.

In its ruling in Dudenhoeffer, the Supreme Court held that ESOP fiduciaries are not entitled to a presumption of prudence at the pleading stage or otherwise, but are merely exempt from the specific duty to diversify ESOP assets and from any obligation to diversify that the duty of prudence might normally require. Although the Supreme Court agreed with the Sixth Circuit that a presumption of prudence should not be applied to the plaintiffs in Dudenhoeffer, it remanded the case back to the Sixth Circuit to reconsider that court’s conclusion that the plaintiffs had sufficiently stated a claim for breach of fiduciary duty. The Supreme Court directed the Sixth Circuit to analyze the sufficiency of the claim, taking into account two principles. 

First, when a stock is publicly traded, allegations that a fiduciary should have recognized it was over- or under-valued based on publicly available information is insufficient to state a claim of imprudence absent special circumstances, because it is generally prudent for a fiduciary to rely on market price as an indicator of a stock’s value.

Second, a claim of imprudence based on a failure to act on nonpublic information must plausibly allege an alternative action that the fiduciary could have taken that would have been consistent with securities laws and that a prudent fiduciary in the same circumstances would have viewed as more likely to help the company stock fund than harm it. In analyzing whether an allegation of imprudence based on nonpublic information is sufficient, courts must take into account the following: (i) that the duty of prudence does not require a fiduciary to break the law; (ii) the extent to which ERISA’s duty of prudence conflicts with federal securities laws or their objectives; and (iii) whether the complaint has plausibly alleged that a prudent fiduciary could not have concluded that the alternative actions available to it would do more harm than good to the fund.

The Newport Group will continue to follow the progress of the Dudenhoeffer case as it is reconsidered by the Sixth Circuit. In the meantime, if your company sponsors an ESOP or other eligible individual account plan that allows participants to invest in company stock, we believe the following steps should be considered in order to minimize the plan’s risk of litigation:
  • Persons with the most sensitive and material inside information regarding the company (usually the key decision makers) should not be appointed as members of the plan’s investment committee. When feasible, an independent third party should be appointed to advise the committee regarding the valuation of company stock inside the plan.
  • The plan’s investment committee should periodically review whether it is prudent to continue to offer stock as an investment option inside the plan and those discussions should be documented. Reviews should occur at least annually, and more often where circumstances warrant (for example, if there is a significant change in the stock price).
  • Purchases and sales of stock must be for adequate consideration. If the stock is publicly-traded, fiduciaries may generally rely on market price as representing the fair value of the stock. If the stock is not publicly-traded, regular valuations by an objective third party should be obtained.
  • Participants should be reminded on a regular basis of their rights to diversify investments in company stock and of the importance of diversifying plan investments.
  • The company should ensure it has adequate fiduciary liability insurance.
  • Plan documents should expressly permit investments in employer stock.

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Newport Group, Inc. and its affiliates provide recordkeeping, plan administration, trust and custody, consulting, fiduciary consulting, insurance and brokerage services. Fiduciary consulting services are provided through Newport Group Securities, Inc., an SEC-registered investment adviser and FINRA-registered broker-dealer, and InterServ, LLC, an SEC-registered investment adviser. Newport Group Securities, Inc. and InterServ, LLC are affiliates of Newport Group, Inc. All securities transactions are provided through Newport Group Securities, Inc., in its role as broker-dealer. All fiduciary consulting services are provided through the registered investment adviser. when offering variable insurance products, Newport Group Securities, Inc. acts solely in its capacity as a broker-dealer.
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