2015-Issue 1— For nearly two decades, the federal courts virtually unanimously agreed that fiduciaries of employee stock ownership plans (ESOPs) were entitled to a presumption of prudence in purchasing or holding employer securities, except under extremely limited circumstances. The presumption was the basis for the dismissal of numerous cases alleging that fiduciaries had acted imprudently in not selling employer securities as they fell in value. In June, the Supreme Court stunned the ESOP fiduciary world by unanimously holding that the presumption had no basis in law and that ESOP fiduciaries are subject to the same duty of prudence as are other fiduciaries (with one exception: the duty to diversify).
Seemingly concerned that the loss of the presumption could expose ESOP fiduciaries to meritless claims whenever the value of the employer securities the ESOP held significantly declined, the Court discussed several alternative defenses it posited could provide the same kind of protection to fiduciaries. It is certainly possible, but by no means certain, that such defenses will serve that purpose. But without certainty, ESOP fiduciaries and sponsors should carefully review their plans and processes to see if action needs to be taken before the next bear market arrives.
Under the Employee Retirement Income Security Act of 1974 (ERISA), fiduciaries of retirement plans have a duty to act prudently and to diversify investments. For the avowed purpose of increasing employee ownership, Congress required ESOPs to be primarily invested in employer securities and relieved ESOP fiduciaries of the requirement to diversify. Most ESOPs explicitly require their fiduciaries to be so invested at all times. The so-called “stock drop” cases arose when an ESOP fiduciary held most or all of the plan’s assets in employer securities, the value of those shares began to fall, and the fiduciary decided that the requirement to be primarily invested precluded sale of the shares (and/or required purchases of additional shares with new contributions). The situation was further complicated when, as was not unusual, some or all of the ESOP fiduciaries were corporate officers and thus privy to inside information that, if public, might have affected the shares’ value.
Plaintiffs argued that purchasing or holding employer securities was imprudent when a fiduciary knew or should have known that the securities were potentially facing an immediate decline in value. They further argued that the fiduciaries’ duty under ERISA required them to act even if they were “insiders” of public companies who had gained their knowledge from non-public information and acting would violate the fiduciaries securities law.
Dudenhoeffer Facts and Decision
Fifth Third Bancorp v. Dudenhoeffer was an almost prototypical stock drop case. Fifth Third Bancorp maintained an ESOP, the terms of which required that the plan’s assets be primarily invested in employer securities. After the value of this stock substantially declined, the plaintiffs filed suit, claiming that, based on both public and non-public information, the fiduciaries knew or should have known that the employer stock was both “overvalued and excessively risky.” The district court applied the presumption and dismissed the complaint. The Sixth Circuit agreed that the fiduciaries were entitled to the presumption, but found that it was evidentiary only and thus not applicable at the pleadings stage. The defendants appealed that decision.
The Supreme Court agreed that Congress had actively encouraged the creation of ESOPs to increase employee stock ownership and that, to help accomplish that goal, it had relieved the fiduciaries of the duty to diversify. The Court found, however, that this evidence of Congressional intent was not enough to justify the presumption and that the same standard of prudence applied to ESOP fiduciaries as to others (except for the duty to diversify). The Court also found that employers could not avoid the issue by drafting plans that absolutely required the fiduciaries to be fully invested in employer securities.
The Supreme Court’s Teachings
The defendants in Dudenhoeffer argued that striking the presumption would act as an incentive to the filing of “meritless, economically burdensome” claims whenever the price of an employer/sponsor’s securities dropped significantly in value. The Court responded that such claims could be “weed[ed] out” by the use of pleading standards set forth in two earlier non-ERISA decisions. The Court also expressly addressed several key allegations that form the basis of most stock drop claims and the defenses available to counter them:
Allegations that a fiduciary was imprudent because he/she should have known from publicly available information that a stock was overvalued (or undervalued) and acted: The Court noted that the market was typically seen as the ultimate arbiter of fair value and that, absent "special circumstances," an allegation that the value set by a relevant market was incorrect is “implausible as a general rule." While the Court did not state this, it is obvious that this defense is only available to fiduciaries of ESOPs of publicly traded corporations.
Allegations that if a fiduciary had non-public information that informed him/her that a price decline was imminent, he/she was required to either act or publicly disclose such information: The Court held that, to state a cause of action for a breach based on this, "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 help it."
The Court emphatically added that a fiduciary is never required to break the law (expressly including the securities laws) to satisfy the duty of prudence and does not have to act if a prudent fiduciary could have concluded that acting or failing to act could have been perceived as a signal by the general market that the stock was overvalued and thus should be sold, thereby devaluing the stock already held by the ESOP.
Alvarez & Marsal Taxand Says:
The Supreme Court’s conviction that the defenses described above will allow ESOP fiduciaries to prevail at the pleadings level against future stock drop claims may well be proven correct. There obviously is no guarantee that the lower courts will agree. If they do not, the fiduciaries will have to incur the time and expense of litigating the claims, a potentially significant burden. Moreover, the loss of the presumption raises the question of whether, to be prudent, ESOP fiduciaries will have to monitor, evaluate and make decisions about investments in employer securities just as they would with any other security. If so, in a declining market, ESOP fiduciaries could find themselves between a “rock and a hard place” if prudence would have required the sale of a stock similar to the employer securities, and the sale would arguably violate the requirement to be primarily invested in such securities. In that case, fiduciaries could find themselves in court whichever way they act.
ESOP sponsors should also consider (i) discussing with counsel the wisdom of prohibiting insiders from acting as ESOP fiduciaries, since it is possible that their possession of inside information could constitute the “special circumstances” that would void their right to rely on the market value of a security, and (ii) reviewing their plans to ensure that they contain language providing the fiduciaries with maximum flexibility in acting.
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Managing the Many Risks Associated With Acquiring Multiemployer Pension Plans During M&A
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