What the Supreme Court's Dudenhoeffer Decision Means for ESOPs
Loren Rodgers, Corey Rosen, and Scott Rodrick
- The Supreme Court ruled that there is no presumption of prudence to protect fiduciaries of plans designed to invest in company stock, and specifically employee stock ownership plans.
- While the decision eliminated the presumption of prudence rule, it replaces it with a pleading requirement that plaintiffs demonstrate the fiduciary acted imprudently. Most observers agree this will continue to make it difficult to challenge fiduciary decisions about employer stock.
- Based on this ruling, plaintiffs will be required to plausibly allege that (1) there were "special circumstances" requiring fiduciaries to recognize on the basis of public information that the market was over- or undervaluing the stock or (2) based on nonpublic information, the fiduciaries should have taken an alternative action that would not violate securities laws and would not do more harm than good.
- The Court clearly viewed this issue through the lens of a public company. The analysis and guidance it provides do not fit easily into a closely held company ESOP model. All of the cases decided on the presumption of prudence have been in public companies. This, combined with the enhanced pleading requirements, suggests the impact of this decision on private company ESOP fiduciary decisions will be minimal.
- As of this writing, there are 6,941 ESOPs and 1,985 ESOP-like plans in the United States (see the end of this document for more statistics).
- The Fifth Third ESOP contributed company stock to employees' retirement accounts as a match to their salary deferrals. Most ESOPs make contributions that are not linked to employee contributions.
Note: The Supreme Court's ruling is a substantial departure from the approaches adopted by several Circuit Courts. We will update this article and provide more resources on the implications of the Court's ruling in this case. Last update: July 21, 2014, 4:00 pm (Pacific time)
In Fifth Third Bancorp v. Dudenhoeffer the Supreme Court ruled unanimously that "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" (p. 8). This ruling overturns the so-called Moench presumption of prudence rule that has been applied to plan fiduciaries for certain 401(k) plans investing in company stock and ESOPs that gave a presumption of prudence to plan fiduciaries unless they knew or should have known the company was in dire financial circumstances.
Fifth Third Bancorp v. Dudenhoeffer concerned a publicly traded company with a 401(k) plan in which the company matched employee contributions by contributing employer stock to an ESOP that was a component of the 401(k) plan. The plan document required the ESOP to invest primarily in company stock. The stock dropped precipitously and employees sued. The trial court said fiduciaries were entitled to a presumption of prudence in continuing to offer the shares and dismissed the case. Upon review, the Sixth Circuit applied a stronger test for the presumption and rejected its applicability at the pleadings stage in this case, stating that the plaintiffs had stated a plausible duty-of-prudence claim. In its decision, the Supreme Court vacated the Sixth Circuit's decision and remanded the case to the Sixth Circuit for consideration in light of the Court's opinion.
Standard of Prudence
Fifth Third argued that, since promoting employee ownership was a purpose of the plan, trustees can buy and hold company stock even if such a decision was not prudent in terms of securing financial retirement benefits while avoiding excessive risk. The Supreme Court rejected that argument, saying "we cannot accept the claim that underlies this argument, namely, that the content of ERISA's duty of prudence varies depending on upon the specific nonpecuniary goal set out in an ERISA plan" (p. 10). The Court said that ESOP fiduciaries, like all ERISA fiduciaries, must act to provide financial benefits to plan participants. After noting that ERISA provides that fiduciaries are to follow plan documents insofar as they are consistent with the fiduciary requirements of ERISA, the Supreme Court concluded that defining the duty of prudence by reference to the goals set out in a plan "would make little sense" since otherwise "the duty of prudence could never conflict with a plan document." (p. 11).
The ruling means that there is no special protection for plans that hold company stock, even when holding company stock is a stated purpose of such plans. The ruling means that fiduciaries of ESOPs and other plans designed to invest in company stock can no longer use the so-called Moench presumption of prudence. The presumption often resulted in suits brought against plans being dismissed in the pleadings stage.
The Court, however, was careful to note, including reciting the statutory language, that Congress meant to encourage employee ownership through ESOPs. The decision is careful not to overturn that intention, but rather to clarify a standard for ESOP lawsuits that can more effectively separate the "plausible sheep from the meritless goats." "That important task," the Court said, can be better accomplished through "careful, context-sensitive scrutiny of a complaint's allegations" (p. 15).
The Supreme Court revised the standard for determining the prudence of buying and holding company stock in an ESOP, namely that the complaint must demonstrate that an alternative action would be more prudent. For publicly available information where (as here) the stock is publicly traded, the Court stated that "as a general rule," it is implausible to allege that a fiduciary should have known from public information alone that the market was overvaluing the stock. Hence, the Court ruled that the Sixth Circuit's "decision to deny dismissal...appears to have been based on an erroneous understanding of the prudence of relying on market prices." For issues concerning inside information, the Court stated three points to consider.
- First, ERISA's duty of prudence does not require ESOP fiduciaries to take actions based on inside information, such as divesting employer stock, that violate securities laws.
- Second, courts must consider how an ERISA-based obligation to refrain from such purchases or disclosures may conflict with insider trading and corporate disclosure laws and the objectives of those laws.
- Third, courts must consider whether stopping purchases or disclosing information would create more harm than good by driving down the stock price and thus the value of existing employee holdings.
The model the Court had in mind for an ESOP company is clearly one that is publicly traded. The disclosure of nonpublic information to participants is only relevant in those plans that are funded by employee purchases of employer stock from a menu of investment choices. That is typical of public company 401(k) plans with company stock and combined ESOP/401(k) plans. Private companies almost never fund their ESOPs this way, instead funding the plan through company contributions. There are no investment choices for the participants. The third part of the Court's analysis concerning stopping the purchase of employer shares also fits public companies much better than private ones. Here, the Court ruled that lower courts should "consider whether the complaint has plausibly alleged that a prudent fiduciary could not have concluded that stopping purchases—which the market might take as a sign that insider fiduciaries viewed the employer's stock as a bad investment—or publicly disclosing negative information would do more harm than good to the fund by causing a drop in the stock price" (p. 20).
Conceivably, this could mean a fiduciary of a closely held company might choose not to buy ESOP shares if the fiduciary knows the company's most recent valuation is no longer valid because of changes in business conditions and/or the valuation was based on improper information given to the appraiser. Under current law and practice, however, this would already violate ERISA, and the disclosure issues the court raises here are not, in any event, applicable to private companies because there is no market for the shares. Note that the Court classified the divestment of company stock holdings (on the basis of inside information) as a securities law violation and hence not something that the duty of prudence requires. Thus, "[t]o the extent that the Sixth Circuit denied dismissal based on the theory that the duty of prudence required petitioners to sell the ESOP's holdings of Fifth Third stock, its denial of dismissal was erroneous" (p. 19, emphasis added).
Effect on ESOPs
The ruling does not mean that company stock can no longer be held in these plans, and its long-term effects, especially for privately held companies, will depend on decisions by lower courts. At this point, however, it seems most likely that the impact on privately held companies will be minimal. The Court acknowledges the stated intent of Congress, citing the Tax Reform Act of 1976, which states "The Congress is deeply concerned that the objective sought by this series of laws [concerning employee stock ownership plans] will be made unattainable by regulations and rulings which treat [ESOPs] as conventional retirement plans, which reduce the freedom of the employee trusts and employers to take the necessary steps to implement the plans, and which otherwise block the establishment and success of these plans" (p. 6). The Court observes that fiduciaries may be "between a rock and a hard place," fearing that they may be sued for imprudence by continuing to invest in company stock, or they may stop investing in company stock and be sued for disobeying the plan documents.
Although the Court "agree[s] that Congress sought to encourage the creation of ESOPs" (p. 14), it also recognizing competing congressional purposes. In this case, the Court does "not believe that the presumption at issue here is an appropriate way to weed out meritless lawsuits or to provide the requisite 'balancing'" of Congressional intent (p. 15). In ESOPs in closely held companies, fiduciaries have few options that could form the basis for plaintiffs arguing a plausible course of action. First, the law requires that ESOPs be primarily invested in company stock. Second, the only liquidity options are a company buy-back of shares, which is probably impractical if the company is already in financial distress, or a sale of the company. But a fire sale like that would mean an even lower price for plan participants. As noted in more detail below, none of the presumption of prudence cases has concerned closely held companies, probably because of these issues. Also note that Dudenhoeffer distinguished between relying on inside information to sell company stock (which it classified as illegal insider trading and thus not required by the duty of prudence) and refraining from buying more company stock (which might be a fiduciary violation). The purchase of shares by an ESOP is already subject to substantial statutory and case law requirements, and this decision is unlikely to change the way these cases are contested.
As a result of all this, the prudence presumption has so far not been an issue for closely held ESOP companies in court, and it is likely to continue not to be as plaintiffs would have a hard time indicating what fiduciaries should have done. Instead, cases will continue to focus, as they have been before where there are alleged problems, on the initial sale price of the shares of the ESOP, which is determined by the trustee and relies on an outside appraiser. It is possible that the Dudenhoeffer decision may embolden the plaintiffs' bar to initiate more lawsuits, but we would expect that to continue to be primarily in public companies. On the other hand, it seems likely that public companies with employer stock in their retirement plans will at least think more carefully about whether and how to continue to offer these shares as investment options.
Background on the Presumption of Prudence
The presumption of prudence that the Court rejected in Dudenhoeffer states that fiduciaries are presumed to be prudent in holding or offering employer stock unless there is reason to believe the company's survival is in doubt. It had been adopted in some form by the Second, Fifth, Sixth, Seventh, Ninth, and Eleventh Circuits, and no circuit specifically rejected it, although some placed limits on it. For instance, some courts aggressively applied it as grounds for dismissal at the pleadings stage, while others allowed plaintiffs to make a factual case against fiduciary decisions. Courts are also divided on whether plans must mandate investment in company stock or simply allow it to qualify for the presumption.
The presumption was first approved by an appeals court in 1995 in the Third Circuit case Moench v. Robertson, 62 F.3d 553. That case involved an ESOP at Statewide Bank, a publicly held bank holding company. Employees could choose to invest in employer securities. The company's stock declined from over $18 in 1989 to twenty-five cents in 1991 before the company went bankrupt. The court ruled that there is a presumption of prudence for holding employer stock in an ESOP. Plaintiffs could overcome this presumption only by showing that the fiduciaries abused their discretion by investing in or holding company stock when they knew or should have known the company was in imminent danger of collapse. The appeals court remanded the case to a district court because there was reason to believe the fiduciaries, who had conflicts of interest, had abused their discretion. In its decision in Moench, the Third Circuit ruled that ESOPs were specifically designed to be invested primarily in employer stock. Asking trustees to judge when to violate this requirement by refraining from additional employer stock purchases and/or not offering them as an investment could put them in the untenable position of having to predict future stock movement. Facing a sharp decline in stock value, for instance, a trustee might stop buying shares only to be sued if the stock later recovered and the low-priced shares proved to have been a good investment. However, if the trustees had information leading them to believe that things would continue to deteriorate, or had conflicts of interest, then the conclusion would be different.
The NCEO has found 27 lawsuits since 1990 involving ESOPs that reached court where the presumption of prudence rule was involved, and over 100 cases involving 401(k) plans. Notably, not one of the cases where the presumption of prudence was a core argument involved a closely held company, although it was raise din two cases that were decided on other issues. In one case, Harris v. Bruister, a court did note that the presumption did not apply, but, tellingly, it said that was because the real issue was the price the ESOP paid for the shares, not whether the trustee continued to hold them. (See ESOP and 401(k) Plan Employer Stock Litigation Review 1990-2013.)
The Presumption of Prudence in Private Companies
It is not surprising that the presumption has been such a non-issue in closely held ESOP company litigation. Trustees of these companies do not have a practical way to force a sale of shares held in employee accounts (that is a board decision) and very few ESOPs allow employees to buy stock in an ESOP. In public companies, the initial valuation of the shares is not an issue—the market sets the price. In closely held companies, where an appraiser sets the price largely based on an assessment of future earnings, the trustee must be able to show that the price paid was fair. The presumption of prudence rule could not logically be extended to the trustee's decision to buy shares at that price without vitiating the requirement that ESOPs not pay more than fair market value of the shares. In the rare cases where employees can buy stock, employers have to provide extensive disclosure material allowing employees to make informed decisions about their investments, again making the presumption of prudence less important. Trustees can sell the shares if there is an offer to buy them, but there the usual test is to make sure the offer is one that is financially preferable to holding on to the shares, a far stricter test than a presumption of prudence rule would imply. Given these issues, under the Dudenhoeffer standards for pleading, it is hard to see how plaintiffs can show a reasonable alternative action trustees can take. Private company litigation on prudence matters will continue, therefore, to largely revolve around valuation and fairness opinions.
The Presumption of Prudence in Public Companies
Most of the cases involving the presumption of prudence rules were either 401(k) plans or plans with both an ESOP and 401(k) component. Only a handful involved cases where the employees did not have an option to buy company stock. One of the more striking features of the court decisions in these cases is the extension of the presumption to plans without an ESOP feature. Courts have repeatedly said that if a plan requires that part of its holdings or options be in company stock (or, more rarely, employer stock is an optional form of investment), the plan is a de facto ESOP. Unlike ESOPs, 401(k) plans are not only not required to be primarily invested in company stock, they are required to be prudently invested, presumably by diversifying. No court has made this distinction, however. In public companies, most of the assets held in employer stock come from employee deferrals in a 401(k) plan and or combined ESOP/401(k) plans, although a minority of companies match in employer stock. Arguably, this presents different fiduciary issues than where all of the assets come from employer contributions to an ESOP, is almost universally true in private companies.
Background on ESOPs and Company Stock in 401(k) Plans
ESOPs are qualified employee retirement plans required by law to be primarily invested in company stock. Ninety-seven percent of ESOPs are in closely held companies. The Dudenhoeffer case involved an ESOP in a public company, but over 80% of the cases that have reached court involving the presumption of prudence for investing in employer stock involve 401(k) plans only. No private company case involving the prudence presumption has reached court. There were 6,941 ESOPs in the U.S. as of the end of 2011. In addition, about 8% of 401(k) assets are held in company stock.
Data on ESOPs
Total number of ESOP and ESOP-like plans in the US, 2011
|Category||Number of Plans||Participants||Employer Securities||Total Assets|
|Large public ESOP plans (plans with over $3.1 billion in assets)||68||6.6 million||$90.3 billion||$548.9 billion|
|All other large ESOPs (plans with over 100 employees)||2,832||6.7 million||$114.9 billion||$382.0 billion|
|Small ESOPs (plans with 100 or fewer employees)||4,041||165,000||$9.2 billion||$11.6 billion|
|Total for all ESOPs||6,941||13.5 million||$214.4 billion||$942.5 billion|
|ESOP-like plans (mostly profit sharing plans with 20% or more of their assets in company stock)||1,985||1.2 million||$18.6 billion||$52.8 billion|
|Total for ESOP and ESOP-like plans||8,926||14.7 million||$233 billion||$995.3 billion|
Plan Size and Account Balance
Statutory ESOPs had an average of 1,362 participants per firm in 2011 (the number reduces to 172 participants per firm in private company ESOPs), versus 56 participants per firm in ESOP-like plans. In 2011, the most recent year for which reliable data are currently available, the average account balance for a participant in a statutory ESOP was approximately $122,000, versus $84,000 for ESOP-like plans. This difference may largely be a function of the relative age of the two categories of plans; newer plans tend to have fewer assets.
Prior Impact of Presumption of Prudence in ESOP Formation
If the presumption of prudence were a significant factor in the creation and termination of ESOPs, we would expect to see an increase in the net growth in ESOPs in a circuit, relative to other circuits, after it adopted the Moench presumption. The only circuit for which there is sufficient data to look for a pattern is the Fourth Circuit, which adopted the presumption in 2007 in the case DiFelice v. US Airways, Inc. In the four years prior to adoption, the number of ESOPs grew 2% less in this circuit than in the rest of the country, while in the four years after adoption, ESOPs grew 3% faster in this circuit than in the rest of the country. There is no stable pattern, however. Some years that were higher than average and some were lower both before and after the Court adopted the presumption. The year-to-year variation and the relatively small magnitude of the difference fall well within the bounds of expected random variation, making it impossible to assert that the adoption of the Moench presumption had an impact on the rate of ESOP growth. Other useful analyses: See the article on the SCOTUS Blog site, Opinion analysis: Court rejects "presumption of prudence" for ESOP fiduciaries and the article by Larry Goldberg of the ESOP Law Group, U.S. Supreme Court Rules on Moench Presumption of Prudence in Important Case for ESOP Fiduciaries (PDF). Goldberg had submitted an amicus brief on this issue to the Court for the ESOP Association. For an analysis by the law firm Morgan Lewis on issues for public companies, see Supreme Court Rejects Presumption of Prudence in ERISA Stock Drop Cases. Thanks to Mark Bogart of Vedder Price for his comments on an earlier draft of this article. A detailed discussion of the data on this issue can be found on our site in the article titled Are ESOPs Too Risky to Be a Retirement Plan?