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After two and a half decades of litigating the duties of public company employee stock ownership plan (ESOP) fiduciaries, on Jan. 14, 2020, the United States Supreme Court disappointed most of the industry when it vacated and remanded the Second Circuit’s decision in Retirement Plans Committee of IBM v. Jander.¹ The much-anticipated case was set to clarify the Court’s holding in Fifth Third Bancorp v. Dudenhoeffer, 134 S. Ct. 2459 (2014), and potentially provide plaintiffs with a roadmap for success against ESOP fiduciaries. The following is an overview of the historical context of ESOP litigation and legal exposure that ESOP fiduciaries face in the wake of Jander.

The ERISA Landscape and the ESOP’s Role in the Retirement Plan Industry

Employee benefit practitioners continue to digest the impact of the 2019 U.S. Supreme Court term on a seldom discussed law entitled, the Employee Retirement Income Security Act of 1974 (ERISA). For those who are not versed in jurisprudence of employee benefit plan litigation, ERISA is the federal statute that governs private retirement plans, such as 401(k) plans. Over the past few decades ERISA has found itself in the crosshairs of the nation’s most contentious employee benefit plan litigation ranging from so-called “stock-drop” litigation, to overfunded pension plans, and excessive retirement plan fees.

To provide some historical background, ERISA was born out of the Studebaker bankruptcy in the early 1960s, which resulted in 4,400 workers with vested pension benefits losing some or all of their pensions when their pension plan was terminated due to an automobile plant shutdown in South Bend, Indiana. Sixty years later and with trillions of dollars at stake, retirement plans are still taking center stage in the nation’s highest courts.² The Investment Company Institute estimated that heading into the fourth quarter of 2019 retirement plan assets were $30.1 trillion, with $8.5 trillion alone in defined contribution retirement plans.³ Last year’s headline ERISA case related to a special subset of retirement plans known as ESOPs.

ESOPs are qualified retirement plans designed to invest primarily in employer securities. Though these retirement plans existed, both in practice and in theory, prior to the enactment of ERISA,⁴ Congress statutorily provided a variety of tax incentives to encourage the use of ESOPs as a way to finance retirement plan contributions in the mid 1980’s.

Public company ESOPs and ESOP components of 401(k) plans, otherwise known as KSOPs, became vogue in the late 1980s as a potential defense to hostile takeovers.⁵ The strategy utilized was that a public company would sell a percentage of its stock to an ESOP in order to provide employees with the opportunity to enjoy equity ownership in the company, thereby aligning incentives for employees to increase profitability and shareholder value. In addition to the ESOP, most companies would incorporate in a pro-corporate Delaware law jurisdiction that contains anti-hostile takeover provisions that prevents would-be corporate raiders from merging the target company or selling company assets unless they acquire more than 85% of the publicly traded stock in a single tender.⁶ Leveraging this 85% threshold, public companies began creating 15% ESOPs to place shares in friendly hands, thereby defending against hostile takeover attempts.

Fast forward to today and around 415 public company have ESOPs or KSOPs, which amounts to approximately 11 million participants, $126 billion in employer securities, and US $1.1 trillion in total ESOP/KSOP plan assets.⁷ Given the vast amount of wealth contained in these plans, it is evident that these retirement vehicles are not only important to the employees who participate in them, but to the economy as a whole. However, administering these plans can carry unique risk, as corporate executives often are forced to wear dueling and conflicting hats as both a corporate fiduciary and an ESOP fiduciary.

In the early 2000s, with large dollars continuing to pile into public company ESOPs, plan administrators experienced a wave lawsuits as stock values dropped due to the deflating tech bubble, which inevitably led to a significant loss of value in ESOP retirement plan balances.⁸ These types of lawsuits became so popular that they were coined “stock-drop” cases; however, a majority of these cases were dead on arrival and dismissed at the pleading stage due to a court-created presumption of fiduciary prudence, as set forth in Moench v. Robertson.⁹ The Moench presumption stood for decades — that is, until the Sixth Circuit disagreed and forced the Supreme Court to weigh in.

Presumption of Prudence Does Not Apply to an ESOP

Under ERISA fiduciary law, fiduciaries owe a duty of prudence whereby such fiduciary must “discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and for the exclusive purposes of:

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Providing benefits to participants and their beneficiaries, and
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With the care, skill, prudence, and diligence…prevailing a prudent man acting in a like capacity and familiar with such matters.”¹⁰
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ERISA practitioners know this as the “Prudent Man Standard of Care” or the “Presumption of Prudence Standard.” In addition, ERISA provides a duty to diversify a retirement plan’s assets in order to decrease its risk of loss.¹¹ In 1995, the Third Circuit, in Moench, analyzed legislative intent and statutory construction of the ERISA ESOP statutes, stating that “ESOP fiduciaries are exempt from the presumption of prudence duty as it relates to the diversification requirement … [and] under normal circumstances, ESOP fiduciaries cannot be taken to task for failing to diversify investments”.¹² The court further justified its reasoning by pointing out that ESOPs were “designed to invest primarily in qualifying employer securities.”¹³ This decision stood for the next two and a half decades, until Dudenhoeffer.

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Dudenhoeffer – No ESOP Fiduciary Presumption of Prudence

To set the stage and provide historical context to Dudenhoeffer decision, think retirement plan investing during subprime lending crisis and pre-Great Recession. Dudenhoeffer centered on Fifth Third Bancorp’s sponsored a 401(k) savings and ESOP plans. Under these plans, employer-matching contribution were automatically invested into Fifth Third stock via the ESOP.¹⁴ Unfortunate for plan participants, the subprime crisis caused Fifth Third’s stock to plummet 74% between July 2007 and September 2009. Then, in July 2007, plan participants sued the ESOP fiduciaries, claiming that company stock was overvalued and an excessively risky investment.

The Fifth Third employees and ESOP participants (the plaintiffs) alleged that publicly available information, such as newspapers, provided early warning signs that subprime lending was risky, and further alleged that the retirement plan fiduciaries had non-public knowledge of financial statement misstatements that caused the Fifth Third stock to become overvalued.¹⁵ In addition, the plaintiffs alleged that a prudent fiduciary would have responded to this information in the following fashion:

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By selling the ESOP holdings of Fifth Third stock before the stock declined;
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By refraining from purchasing more Fifth Third stock;
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By removing the retirement plan’s ESOP component; and
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By disclosing insider information so that the market would adjust its valuation of Fifth Third stock downward and the ESOP would no longer overpay for such stock.¹⁶
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The district court used the Moench presumption of prudence to dismiss the plaintiff’s lawsuit on the premise that “plan fiduciaries start with a presumption that their decision to remain invested in employer securities was reasonable.” However, the Sixth Circuit Court of Appeals reversed on grounds that, though a presumption may exist, such presumption does not apply at the pleading stage. Moreover, the Sixth Circuit found that the allegations contained in the complaint were sufficient to state a claim for a breach of fiduciary duty. The Sixth Circuit ultimately held that the plaintiff “need not show that an employer is on the brink of collapse…[but] only show that a prudent fiduciary acting under similar circumstances would have made a different investment decision.”¹⁷

The Supreme Court went even further, stating that no special presumption applies to ESOP fiduciaries.¹⁸ The Court arrived at this conclusion by analyzing statutory language; the Court reasoned that, though an ESOP fiduciary is exempt from diversification requirements, there is no basis to altogether exempt fiduciaries from a duty of prudence.¹⁹

The Corporate Insider – Wearing Two Hats Problem

The retirement plan community generally accepted the Dudenhoeffer Court’s interpretation of ERISA as consistent with both the statutory intent and trust law, generally. However, adhering to this duty created an “elephant in the room” for public company fiduciaries, who were also insiders. A majority of retirement plan fiduciaries wear two hats — they are both officers of the company, generally chief financial officers or vice presidents of human resources, and they are fiduciaries of the company’s retirement plans. This duality places many executives and corporate committees in conflicting positions, as it was not clear to what extent they were required to act upon insider information for the benefit of the ESOP.

Dual Roadmaps for ESOP Fiduciaries and Plaintiffs

For public company ESOP fiduciaries, the Supreme Court in Dudenhoeffer provided that, absent “special circumstances,” there is no need for a fiduciary to attempt to determine if company stock is over or under valued.²⁰ The Supreme Court made clear that it is not a fiduciary’s job to predict the company’s stock performance.

Conversely, in order for a plaintiff to state a claim for breach of the duty of prudence, such plaintiff must provide an alternative action that a prudent fiduciary in the same circumstances could have taken that would have been both, consistent with securities laws and done “more harm than good.”²¹

However, the Supreme Court clarified that an ESOP fiduciary should not be required to divulge inside information at the risk of violating securities laws.²²

Nor should the fiduciary be required to stop investments to an ESOP, as such action could be highlighted it in the marketplace, which in and of itself could cause the stock value to drop. The Dudenehoeffer opinion acknowledges that courts are required to consider the extent to which an ERISA-based obligation could conflict with the insider trading and corporate disclosure rules. After establishing a new framework, the Dudenhoeffer Court vacated the Sixth Circuit decision and remanding the case for further proceedings.

Legal scholars would debate the “special circumstances” language penned by Justice Breyer over the next five years. Most commentators, however, came to agree that meeting the “special circumstances” threshold would take financial fraud or, at a minimum, an accounting irregularity known by an insider fiduciary. Fast forward to 2018, with a bevy of stock-drop plaintiff cases in its wake, the Supreme Court got another bite at the apple to explain its “special circumstances” language.

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A Rare Stock-Drop Win for ERISA Plaintiff Attorneys

Jander created the perfect storm to test the “special circumstances” threshold and insider disclosure theories established in Dudenehoeffer. The case centered on IBM’s retirement plan fiduciary committee, which included the chief accounting officer and chief financial officer. The committee permitted the ESOP to continue investing in IBM stock while simultaneously selling off a division of the company that would ultimately trigger a $4.7 billion write-down. This write-down caused the company’s stock to drop by $12 per share. The issue presented to the Second Circuit was whether IBM’s executive insiders, who were also on the retirement plan committee, had breached ERISA’s duty of prudence by failing to disclose insider information that would eventually cause the stock value to drop.

In a surprising win for the plaintiffs, the Second Circuit reversed the district court decision, holding that the plaintiffs had plead a plausible claim for violation of ERISA’s duty of prudence. To support its decision the court noted the following:

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The ESOP fiduciaries knew the stock was inflated through accounting violations;
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They had the power to disclose the accounting violations; and
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They failed to promptly disclose the true value of the division.²³
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The Second Circuit ultimately hung its hat on an “inevitable disclosure” theory – that is, if plan fiduciaries knew that disclosure of the insider information was inevitable, then delaying such disclosure could cause more harm than good to the ESOP plan.

It should also be noted that several federal agencies, including the US Securities and Exchange Commission (SEC), joined in submitting an amicus brief. These amicus requested the Court to reverse the Second Circuit decision and hold that, absent extraordinary circumstances, ERISA fiduciaries have only a limited duty to disclose material, nonpublic information regarding a company’s publicly traded stock, particularly when doing so would do more harm than good.²⁴ This is an important amicus, as the Court tends give weight to government agencies with specific expertise.

The Supremes – The Jander ESOP Fiduciary and Plaintiff Roadmap

Though brief, the Supreme Court’s Jander decision is instructive to both lower courts and ESOP fiduciaries. First, it reiterates that the “more harm than good” standard is the correct standard for evaluating ESOP fiduciaries. Second, it reinforces that the “duty of prudence does not require fiduciaries to break the law” by disclosing financial information in violation of securities laws.²⁵

The Jander decision also highlights the fact that the two-hat issue remains unresolved and appears dependent on the future guidance provided by the SEC. In recognition of this, the opinion briefly noted that lower courts should weigh an ESOP fiduciary’s ERISA-based obligations against disclosing inside information that could conflict with the SEC corporate disclosure requirements. In addition, the Court informs lower courts on appropriate pleading standard – that is, it instructs courts to assess whether a complaint has sufficiently alleged that a defendant did “more harm than good” by choosing one course of action over another.

Most ESOP fiduciaries were hoping that Jander would end the wave of stock-drop litigation, but there is little doubt – Jander will not be the end. Still, the “more harm than good” disclosure standard remains a difficult hurdle for plaintiffs and a strong shield for plan fiduciaries.

Stock-Drop Litigation Road Ahead for ESOP Fiduciaries

As previously mentioned, many ESOP fiduciaries have the burden of wearing “two hats.” They wear the hat of a business executive, having a duty to operate the business using business judgment with the best interest of shareholders in mind, and they also wear a hat of ERISA fiduciary, having a duty to ensure the ESOP is operated in the best interests of plan participants and beneficiaries. These dueling roles can be at odds when determining whether public company stock should continue to be utilized as an investment option in qualified retirement plan, such as an ESOP.

However, companies do have tools available to help insulate ESOP fiduciaries from stock-drop complaints. An ESOP fiduciary may utilize the ESOP plan document as a shield if such document incorporates language requiring employer contributions to be invested in employer stock. Plan provisions requiring investments into a certain asset may reduce the decision to a settlor function, as opposed to a fiduciary function, allowing the decision-maker to avoid the strict ERISA fiduciary duties altogether.

Further, ESOP fiduciaries should heed the advice of the Supreme Court in Tibble v. Edison, which established that ERISA investment fiduciaries have “a continuing duty to monitor investments.”²⁶ As the Court expressly stated in Dudenhoeffer, sponsor company stock is no different from any other investment. As such, fiduciaries should monitor ESOP or KSOP company stock as if it were no different from any other investment. Thus, it is profoundly important for plan fiduciaries to be proactive in establishing, engaging, and documenting a process that monitors the plan’s investment performance. And, above all, fiduciaries should remember that “a pure heart and an empty head are not enough” to overcome the duty of prudence.²⁷

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Endnotes

1. Retirement Plans Committee of IBM v. Jander, 2020 WL 201024 (S. Ct. 2020).

2. The Employee Retirement Income Security Act of 1974:The First Decade – An Information Paper for the Special Committee on Aging, United States Senates (August 1984, page 8).

3. Investment Company Institute Research Report, America Views on Defined Contribution Plan Savings, 2019 (January 2020) found at https://www.ici.org/pdf/20_ppr_dc_plan_saving.pdf.

4. IRS Rev. Rul. 69-65.

5. See, Shamrock Holdings, Inc. v. Polaroid Corp., 559 A.2d 257 (Del. Ch. 1989).

6. 8 Del. C. § 203.

7. National Center for Employee Ownership, “Employee Ownership by the Numbers,” (September 2019, page 2).

8. The John Marshall Law Review, “ERISA Stock Drop Cases: An Evolving Standard, 38 J. Marshall L. Rev. 889 (2005).

9. Moench v. Robertson, 62 F.3d 553, (3rd Cir. 1995).

10. ERISA Section 404(a).

11. ERISA Section 404(a)(1)(C).

12. Moenchat 568.

13. Id at 569.

14. Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. 409 (U.S. Supr. Ct., 2014).

15. Id at 413.

16. Id.

17. Id at 418.

18. Id at 418-419.

19. Id.

20. Id at 426.

21. Id at 428.

22. Id at 429.

23. Jander v. Retirement Plan Committee of IBM, 910 F.3d 620 (2018).

24. Retirement Plans Committee of IBM v. Larry W. Jander, Brief for the United Stated as Amicus Curiae Supporting Neither Party.

25. Retirement Plans Committee of IBM v. Jander, at _______ (page 1).

26. Tibble v. Edison, Int’l, 135 S. Ct. 2459 (May 18, 2015).

27. Donovan v. Cunningham, 716 F.2d 1455, at 1467 (5th Cir. 1983).

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