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Comment on the Supreme Court Hearing the Presumption of Prudence

How Important Is the Presumption of Prudence Argument for ESOPs

January 15, 2014

The Supreme Court has agreed to review the so-called presumption of prudence rule that has provided that trustees of ESOPs and other defined contribution plans that are specifically designed to be invested in employer stock protection against lawsuits when stock prices in the plans drop dramatically. The presumption 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 has been adopted in some form by the Second, Fifth, Sixth, Seventh, Ninth, and Eleventh Circuit, and no circuit has specifically rejected it, although some have placed some limits on it. For instance, some courts have aggressively applied it as grounds for dismissal at the pleadings stage, while others have 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 Supreme Court will be reviewing the Sixth Circuit's decision in Fifth Third Bancorp v. Dudenhoeffer, a case involving employer stock that was one investment option in a non-ESOP retirement plan. The stock dropped precipitously and employees sued. The lower 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. Fifth Third appealed, and the Supreme Court granted certiorari. The court then asked the Solicitor General to weigh in on the case. The Solicitor General responded by asking the Court to rule against the presumption of prudence, instead saying the standard ESOP fiduciaries should be following is a prudent investment policy "except insofar as it requires diversification."

The Origins of the Presumption of Prudence

The presumption was first approved by an appeals court in 1995 in the 3rd 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 can only overcome this presumption 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 the decision, 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 selling shares 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 sell shares only to be sued if the stock later recovered. However, if the trustees had information leading them to believe that things would continue to deteriorate, or has conflicts of interest, then the conclusion would be different.

Since 1995, we have found 24 lawsuits 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 involved a closely held company.

The Presumption of Prudence and Closely-Held Company ESOPs

It is not surprising that none of the presumption of prudence cases involves a closely held ESOP company. 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.

The Presumption of Prudence Rule 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.

Where an ESOP is part of a public company plan, the argument for the presumption for ESOP assets is more persuasive. Asking trustees to predict market trends could open a floodgate of litigation in volatile markets.

Broader Implications

The Court may rule on the case on narrow grounds that provide little guidance for future cases or may limit its analysis to public company scenarios. If the Supreme Court does not uphold the presumption, and does so on broad grounds that suggest ESOPs per se are less prudent than other retirement plans, that could have a major impact on ESOPs, public and private, particularly if fiduciaries believe they have to undertake substantially more detailed, time-consuming, and expensive analyses of any ESOP transaction. If it does not uphold the presumption, however, it may do so by laying out guidelines that make these plans viable but within narrower restraints, particularly in public companies.