Many employers offering employer stock as an investment option in a 401(k) plan have been subject to class action lawsuits arising from a substantial drop in their stock price causing participants to claim that the employer breached its duty of prudence and loyalty by allowing continued investment in the stock. Prior to the recent Supreme Court ruling inDudenhoeffer, a key defense for employers in "stock-drop" suits was the so-called "Moench presumption" of prudence, named after the 1995 decision by the Third Circuit Court of Appeals in Moench v. Robertson which was followed by a majority of Circuit Courts.
Application of the Moench presumption meant that a plan fiduciary's decision to remain invested in employer securities is presumed to be reasonable, unless the plaintiff can show that the fiduciary abused its discretion in continuing to make employer stock available as an investment alternative. The rationale for the Moench presumption was based on an attempt to balance competing policy concerns that, on the one hand, would promote employee ownership, and on the other, protect participants against imprudent plan investments. Thus, while ERISA requires fiduciaries to diversify plan assets and to act with prudence in making investment decisions, it also provides that in the case of plans offering employer stock as an investment, they are exempt from the duty to diversify investments and are also exempt from the prudence requirement, but only to the extent that prudence would require diversification.
Lower Court's Decision. The Dudenhoeffer case involved a 401(k) plan sponsored by Fifth Third Bancorp, which offered the company's stock as a plan investment option. From July 2007 to September 2009, the stock's price dropped 74%, causing the plan to lose "tens of millions" of dollars, allegedly as a result of Fifth Third Bancorp's shift from conservative lending practices to being a subprime lender. Participants filed a class action lawsuit in federal district court against Fifth Third Bancorp alleging that plan fiduciaries breached their duty under ERISA by continuing to include Fifth Third Bancorp stock on the plan's investment menu despite the fact that they knew or should have known that the company's business model put its value in jeopardy.
The District Court dismissed the claim on the basis that the fiduciary's decision was presumed to be prudent. On appeal, however, the Court of Appeals overturned the District Court and ruled that the presumption is to be applied at a later stage in the litigation when there is a more fully developed court record. The ruling by the Appeals Court inDudenhoeffer was at odds with the majority of courts which apply the presumption in the initial stage of litigation, meaning that in most stock-drop cases, participants are denied the opportunity to engage in discovery.
The Sixth Circuit also ruled that to rebut the presumption, participants need only show that a prudent fiduciary acting under similar circumstances would have made a decision that the employer stock was an imprudent investment. This ruling was also a departure from the majority as most courts require that a participant must demonstrate that the company was in "dire circumstances" or facing "impending collapse" in order to rebut the presumption. The Appeals Court specifically rejected these "narrowly defined" tests for rebutting the presumption in favor of one that is easier for participants to prove.
Supreme Court Decision. The Supreme Court vacated the Sixth Circuit's decision and directed the Sixth Circuit to reconsider whether the complaint inDudenhoeffer states a "plausible" claim for a breach of fiduciary duty. In reaching its decision, the Court held that there is no "presumption of prudence" in favor of ESOP fiduciaries as there is no basis in ERISA that supports a special presumption of prudence for decisions made by ESOP fiduciaries. Instead, an ESOP fiduciary's decision is subject to review under the same duty of prudence applicable to all ERISA fiduciaries, except that ESOP fiduciaries have no duty to diversify plan investments. While ESOP fiduciaries are not liable for losses that result from a failure to diversify, they are required to act with the care, skill, prudence and diligence that a prudent expert acting in like capacity and familiar with such matters would use to make and continue to hold the investment of employer stock.
According to the Court, in order to a claim for a breach of fiduciary duty, the claim must be based on plausible factual allegations of breach of fiduciary duty. 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, are insufficient to state a claim. Further, the Court instructs that in order for a complaint to state a claim for a breach of the duty of prudence, a plaintiff must plausibly allege an alternative action that the defendant could have taken, that would have been legal and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the trust than to help it. In so ruling, the Court held that a fiduciary's duty of prudence does not require a fiduciary to break the law and buy or sell company stock on the basis of insider information.
One of the arguments advanced by Fifth Third Bancorp was that without the Moench presumption, an ESOP fiduciary would be subject to costly duty-of -prudence "meritless lawsuits" every time there was a drop is stock price. The Court recognized this concern but concluded that the Moench presumption was an inappropriate way to weed out "meritless lawsuits." Instead, the Court stated that the more important mechanism for weeding out meritless claims requires a "careful judicial consideration of whether the complaint states a claim that the defendant has acted imprudently." Thus, courts must carefully scrutinize stock-drop complaints to determine whether they state a plausible claim for breach of fiduciary duty.
Implications. Even though the Supreme Court specifically rejected the application of the Moenchpresumption, plaintiffs still face a high burden as they must plead specific facts in order to survive a motion to dismiss, such as the specific alternate action that the fiduciaries should have taken. In addition, the Court has given ESOP fiduciaries several potential defenses as, according to the Court, they can rely on the stock market price as the best estimate of stock price. Complying with the rules on insider trading is yet another potential defense a fiduciary can raise. Finally, plan sponsors may want to consider the composition of their investment committees and whether an independent third party fiduciary should be hired to make the decision whether to continue to invest in or offer a company stock fund as an investment option.