Reading the Tea Leaves: The Supreme Court Seems Likely to Eliminate the ERISA Presumption of Prudence

By Stephen A. Fogdall

The U.S. Supreme Court heard argument this week in Fifth Third Bancorp v. Dudenhoeffer, the case that will decide whether fiduciaries of employee stock option plans (ESOPs) are presumed to comply with their ERISA duties by continuing to invest in the employer’s stock despite allegations that they know or should know that the stock is overvalued.  Although such a presumption has enjoyed wide acceptance in the federal Courts of Appeals, its days may be numbered.

Fifth Third’s lawyer argued that without the presumption, an ESOP fiduciary would be put in a position either of having to “outsmart the market” by guessing correctly that the stock is overvalued, or, even worse, violating the federal securities laws by divesting the stock on the basis of inside information about the employer.

Several of the Justices responded skeptically. Justice Scalia argued, “You have the same problems” with other types of retirement plans, so “we don’t have to adopt a special law for this.” Justice Sotomayor asked, “What’s wrong with following the law and disclosing that material information to the public and stopping the employees from losing more money in worthless stock?” Justice Kagan argued, “It just sort of defies language to say that a prudent person would retain” an investment in “overvalued stock.” Justice Kennedy suggested that a presumption of prudence would create “sort of a coach class trustee.” Justice Ginsberg was even more direct, stating, “I don’t know where this presumption comes from,” because “there is no presumption written into this statute.”

A few of the Justices seemed more receptive to the presumption of prudence. Chief Justice Roberts noted that “every Court of Appeals has recognized” that “by definition” an ESOP fiduciary acts prudently by investing in the employer’s stock unless “everything is going south and the company’s collapsing.” Then, even more emphatically, he stated, “I don’t understand how you . . . can say that [an ESOP fiduciary] has breached a fiduciary duty of prudence when the people investing in this ought to know what they’re going to get is the company’s stock.” Justice Alito observed that if “stopping purchases in company stock would be a signal that would potentially trigger bankruptcy and liquidation of the company,” that might be in the best interests of ESOP participants “if these participants were simply investors,” but “it might be very much not in their best interests as employees.” In addition, Justice Breyer suggested, “there is no rule of trust or ERISA law that you can breach a duty to a beneficiary by failing to use inside information, period.”

Notwithstanding these sympathetic statements from a minority of Justices, a majority of the Supreme Court (Justices Kennedy, Scalia, Ginsberg, Sotomayor and Kagan) seem prepared to hold that an ESOP fiduciary is not entitled to any presumption of prudence and may even be obligated to depart from the plan’s terms and cease purchasing employer stock, or divest the plan’s holdings in employer stock, if the fiduciary knows or should know, based on insider information, that the stock is overvalued. The Court should issue its decision before the end of the current term in June. We will continue to monitor the case closely.

The Solicitor General says there is no presumption of prudence under ERISA

By Stephen A. Fogdall

Last week, the U.S. Solicitor General filed an amicus brief in Fifth Third Bancorp v. Dudenhoeffer, a case in which the Supreme Court will decide whether fiduciaries of an employee stock ownership plan are entitled to a presumption that their decision to invest in employer stock complied with their duties under ERISA. This is an issue we follow closely on this blog. The Solicitor General’s position is that ESOP fiduciaries are not entitled to any presumption of prudence.

While nominally supporting the decision by the U.S. Court of Appeals for the Sixth Circuit under review in Fifth Third, the Solicitor General’s brief actually argues for a far broader conclusion than the Sixth Circuit itself reached. The Sixth Circuit in Fifth Third revived a lawsuit challenging ESOP fiduciaries’ decision to remain invested in employer stock despite their alleged knowledge that the employer’s exposure to subprime lending risks artificially inflated its stock price. The district court dismissed the lawsuit, finding that the plaintiffs had failed to plead facts to overcome the presumption of prudence. The Sixth Circuit reversed. Although the Sixth Circuit recognizes a weak version of the presumption of prudence, the court held that the presumption should not be applied at the motion to dismiss stage. Rather, the Sixth Circuit concluded, a plaintiff challenging ESOP fiduciaries’ investment decisions should be permitted to survive a motion to dismiss simply by plausibly alleging that the fiduciaries’ decisions were imprudent, just as any other ERISA plaintiff would have to do with respect to any retirement plan.

The Sixth Circuit’s approach to the presumption of prudence differs from that of other circuits in two significant respects. First, as applied in other circuits, the presumption requires the plaintiff to meet a steep burden, such as showing that fiduciaries knew, or should have known, that the employer was on the verge of collapse or the stock was in imminent danger of becoming worthless. The Sixth Circuit requires only that the plaintiff show that a prudent fiduciary would have made a different decision, such as divesting the plan’s investments in employer stock. Second, unlike the Sixth Circuit, most courts hold that the presumption applies at the motion to dismiss stage, so that the plaintiff must plausibly plead facts rebutting it in the complaint.

While the Sixth Circuit’s approach is less stringent in these respects, the Solicitor General’s brief nevertheless maintains that even its weak version of the presumption is “inconsistent with ERISA,” because it still creates a “demanding burden” at the summary judgments stage or at trial.

In the Solicitor General’s view, the presumption of prudence arose out of courts’ misunderstanding of the exemption from the duty to diversify plan assets that ERISA grants to ESOP fiduciaries. According to the Solicitor General, the “diversification exemption merely absolves ESOP fiduciaries from the ordinary obligation to reduce risk by spreading plan assets among multiple prudent investments. It does not permit them to concentrate plan assets in an imprudent investment, such as employer securities the fiduciary knows or should know are materially overvalued.” In short, the Solicitor General concludes, ERISA “obligates the fiduciary of a plan that includes an ESOP option to depart from the plan’s requirements if the initial investment options are no longer prudent.”

The Supreme Court will hear arguments in the Fifth Third case on April 2, and will likely decide it before the end of the current term in June. We will report on any developments in the case immediately.

The Second Circuit Applies the Moench Presumption to the Administration of a Lehman Brothers Retirement Savings Plan

By Eric A. Boden

The United States Court of Appeals for the Second Circuit is the latest appellate court to apply the Moench “presumption of prudence” under ERISA to protect plan fiduciaries from liability despite the total collapse of the plan’s investment in company stock.  (For more discussion of the Moench presumption, see here and here.)

In Rinehart v. Akers, the Second Circuit affirmed the dismissal of claims brought by former employees who participated in the Lehman Brothers Savings Plan against members of Lehman’s Employee Benefit Plans Committee and the individual directors who appointed them.  The thrust of the plaintiffs’ claims was that the defendants failed to divest the plan’s holdings in Lehman securities despite signs of Lehman’s impending demise, beginning with the fall and subsequent fire sale of Bear Stearns in March 2008.

Under the terms of the plan, an employee could elect to allocate as much as 20% of his or her contributions to a Lehman Stock Fund.  Plan fiduciaries were authorized “to eliminate or curtail investments in Lehman Stock . . . if and to the extent that [they] determine[d] that such action [was] required in order to comply with [their fiduciary duty rules of ERISA].” The plaintiffs contended that “by no later than the collapse of Bear Stearns, Defendants knew or should have known that the Plan’s heavy investment in [Lehman] Stock was imprudent” given several red flags, including Lehman’s alleged leveraged ratio of 30:1; its questionable accounting practices; and its potential losses from trading in subprime mortgage-backed derivatives.  The plaintiffs further argued that, given plan fiduciaries’ position within the Lehman organizational framework, they were or should have been privy to non-public information portending the imminent downfall of Lehman and, as a result, should have reduced participants’ holdings in the Lehman Stock Fund.

The Second Circuit rejected these arguments, reasoning that plan fiduciaries “are under no obligation to either seek out or act upon inside information in the course of fulfilling their duties under ERISA.”  The court noted that none of the information publicly available to plan fiduciaries during the class period — the forced sale of Bear Stearns, the “general climate for financial firms in 2008,” public articles and reports, Lehman’s financial disclosures and its declining (but positive) stock price — demonstrated that their decision to remain invested in Lehman stock was imprudent.

The Second Circuit also rejected the plaintiffs’ argument that the plan’s provision of a “right” to “eliminate or curtail investments in Lehman Stock” “equate[d] to [the] ‘discretion’ to divest from the” Lehman Stock Fund.  That provision required plan fiduciaries to divest the plan’s investment in Lehman Stock only when necessary to comply with their duties under ERISA.  Because the plaintiffs had failed to plead the requisite “dire situation” auguring the employer’s collapse, the Moench presumption still applied.

Further Developments in the Presumption of Prudence

By Stephen A. Fogdall

The case law on ERISA’s “presumption of prudence” continues to develop. Previously, we reported on decisions by the Second and Ninth Circuits that refused to give plan fiduciaries the protection of the presumption where plan documents provided only that the plans “may” offer an investment option in company stock.

As we discussed there, courts are much more willing to apply the presumption if a plan provides that an employer stock fund “shall” be an available investment option, although Schnader has successfully argued that the presumption can apply even if this word is not used in plan documents (see here).

In the most recent decision in this area, Kopp v. Klein, the Fifth Circuit upheld application of the presumption where plan documents mandated a company-stock fund option using the word “shall.” The plaintiff in Kopp alleged that plan fiduciaries should have liquidated the company-stock fund because they allegedly knew that the company’s accounts receivable were overstated and the company was facing a liquidity crisis. Rejecting that argument, the court explained that plan fiduciaries could not violate the securities laws by selling the stock in the fund based on insider information.

To rebut the presumption of prudence, the plaintiff was required to plead publicly known facts that would show that plan fiduciaries were aware that “the viability of the employer was threatened or the employer’s stock was in real danger of becoming worthless.” The plaintiff could not do this. Indeed, because the company allegedly had “misrepresented its financial health in financial disclosures, the public did not have reason to be concerned that [the company’s] stock would become essentially worthless.” Thus, there were no public facts that could rebut the presumption of prudence.

The court also rejected the plaintiff’s argument that, short of liquidating the fund, the fiduciaries should not have allowed further investments in it. The court rejected this argument as well because the mere allegation that “fiduciaries were aware an employer was engaged in unscrupulous conduct or facing financial difficulties does not alone suffice to prove the fiduciaries were aware the employer was in a dire situation.”

For more information regarding this or other financial services issues, please contact Stephen Fogdall of Schnader’s Financial Services Team. 

The materials posted on and are prepared for informational purposes only and should not be considered as providing legal advice or creating an attorney-client relationship. Please see our disclaimer page for a full explanation.

New Developments in the Presumption of Prudence Under ERISA: A Dramatic Increase in Liability Exposure Hangs on the Difference Between “Shall” and “May”

Schnader Alert by Stephen A. Fogdall:

Recent decisions out of the Second and Ninth Circuits have increased the liability exposure of plan fiduciaries under the Employee Retirement Income Security Act (ERISA) where the retirement plan gives employees an option to invest in the employer’s stock. If the plan permits, but does not require, that this investment option be available, plan fiduciaries can be held liable if they fail to withdraw the option once they become aware, or should be aware, that the value of the employer’s stock may be artificially inflated.

Please click here to read the full Alert.

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