The Supreme Court’s Decision in Dudenhoeffer: If You Offer a Company Stock Fund Investment Option in Your 401(k) Plan, You Will be Sued, Eventually

© 2014 Winston & Strawn LLP

August 14, 2014

The Supreme Court’s Decision in Dudenhoeffer: If You Offer a Company Stock Fund Investment Option in Your 401(k) Plan

or ESOP, You Will be Sued, Eventually


Today’s eLunch Presenters

Mike Melbinger Partner, Chair

Employee Benefits and Executive Compensation

Chicago

[email protected]

Joe Torres Partner, Hiring Committee Chair

Labor & Employment Chicago

[email protected]

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Overview

• Stock drop litigation origins

• Consequences and pre-Dudenhoeffer strategies for proactive fiduciaries

• Stock drop litigation – Part II

• Dudenhoeffer – Key holdings and takeaways

• What’s likely to happen next?

• Post-Dudenhoeffer strategies

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Stock Drop Litigation Origins

• Historically, company stock price drop = lawsuits against company, officers, and directors

• Around 2002, federal securities law claims repackaged as ERISA violations

• Plan fiduciaries likely included officers and directors

• Plan participants were/are a ready-made class

• Bad facts made bad law (see Enron)

• Statutory attorneys’ fees

• Typical claim - Fiduciaries knew/should have known stock was overvalued, or about to decline in value

• Given fiduciary’s duty to act solely in the interests of plan participants, information should have been shared or acted upon (even if it was material non-public information)

• Fiduciary breached ERISA’s duties of prudence and loyalty by failing to act

• Or, fiduciary failed to monitor activities of others charged with plan oversight

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Stock Drop Litigation Origins (cont’d)

• Common fiduciary responses: • The Board member, officer, etc., was not a fiduciary

• Disclosure of material non-public information would violate federal securities laws

• ERISA creates fiduciary exception for Company stock funds

• Decision to offer a Company stock fund was settlor, not fiduciary, function

• Many courts adopt Moench presumption • Is Company stock fund mandated by the plan documents?

• If so, plan fiduciaries continuing purchases of [or failure to divest] company stock was presumed to be prudent

• “Procedural prudence” may also provide some protection • Fiduciaries need not be clairvoyant

• However, they must carefully follow all proper procedures (akin to business judgment rule)

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Who is at Risk in a Stock Drop Suit?

• ERISA broadly defines “fiduciary” to include any person who: • Exercises discretionary authority over plan or its assets

• Controls or oversees plan administration, or management of plan assets

• Covers individuals designated in plan • Named fiduciary

• Plan trustees

• Plan administrator

• Investment managers

• Also can cover de facto fiduciary, regardless of plan terms • Key to finding fiduciary status is function, not job title

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What is at Risk in a Stock Drop Litigation?

• Either participants or the DOL may sue • DOL can seek forfeiture of fiduciary plan account balance or benefit

• Fiduciaries can be personally liable for violations • “Personal” really means “personal” – your house, your assets

• Check D&O coverage

• Civil and criminal penalties also may apply • May also carry significant tax implications

• Personal liability may exist even if claim is failure to monitor, versus failure to directly act

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What’s a Fiduciary To Do?

• Understand the basics of ERISA and fiduciary statutory obligations

• Operate under well-drafted and thorough governing documents • Plan or trust

• SPD

• Board or fiduciary committee charter

• Adhere to well-designed and well-documented practices and procedures

• Participate in periodic fiduciary training

• Other protective measures • Proper, accurate, and well-documented fiduciary actions and delegations

• ERISA § 404(c)

• Prompt and accurate participant communications

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Other Stock Drop Proactive Strategies

• Appoint an independent fiduciary for the plan’s Company stock investment • Still valid post-Dudenhoeffer

• Plaintiffs’ bar has sued in-house plan fiduciaries nonetheless – and announced its intention to continue doing so

• Insert protective language into plan documents • At a minimum, hard-wire in the requirement that the plan offer a Company stock fund

investment option

• Closely review plan, policies, and procedures to: • Ensure proper governance documentation and compliance

• Correct any inconsistencies or operational deficiencies

• Update plan practices

• Review and update operating charters of relevant BOD committees

• Clarify employee communications, if necessary

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Stock Drop Litigation – Part II

• More bad facts made more bad law • The 2008-09 financial crisis and the resulting market crash = more suits

• Unanticipated corporate crisis (e.g., BP oil rig) = even more suits

• Nature of triggering events makes it likely that history will repeat itself • Bad things, unfortunately, will inevitably happen to some good companies

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Dudenhoeffer – Background and Allegations

• Followed the financial crisis

• Fiduciaries should have known, based on public and inside information, that Fifth Third stock was overpriced and excessively risky

• Public information = e.g., discussions regarding risks of subprime lending

• Non-public information = inside information that Fifth Third officers had deceived market by making material misstatements about the company’s financial prospects

• A prudent fiduciary would have responded to this information by:

• Selling off the plan’s holdings of Fifth Third stock,

• Refraining from purchasing more Fifth Third stock, or

• Disclosing the inside information so market could correct the stock’s price downward

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Dudenhoeffer – Lower Court Holdings

• Trial court dismissed the complaint for failure to state a claim • Applies Moench presumption

• Appellate court found trial court’s dismissal was erroneous • Agreed that ESOP fiduciaries are entitled to a presumption of prudence

• However, presumption cannot bar suit from proceeding at all

• Presumption only applies at trial as evidentiary presumption

• At the “pleading” stage, only question is whether suit reasonably identifies claimed harm

• Supreme Court agrees to consider nature of the presumption of prudence applicable to ESOP fiduciaries

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Dudenhoeffer – Supreme Court’s Holding

• ERISA contains no special presumption in favor of ESOP fiduciaries • Same prudence standard applies to all fiduciaries

• Only difference is that ESOP fiduciaries have no duty to diversify

• Hence, plaintiffs need not allege employer was on “brink of collapse,” “under extraordinary circumstances,” etc., to state a claim

• Presumption is also not supported by the common law trust rule that a settlor can reduce or waive the prudent man standard in plan document • Unlike common law, ERISA does not permit plan documents to excuse fiduciaries from

their statutory duties

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Dudenhoeffer – Supreme Court’s Holding (cont’d)

• “Special purpose” served by ESOP does not allow for atextual presumption • ERISA duty of prudence refers generally to trustees’ management of investments

• ERISA does not set a separate standard for ESOP management

• Fiduciaries can only follow plan terms if they are consistent with ERISA • Rule would make no sense if the duty of prudence was defined by plan (because duty

of prudence would never conflict with plan document)

• ESOP statutory exemption for diversification would be unnecessary if the duty of prudence was altered by purposes underlying ESOP • Congress’ promotion of ESOPs does not mean it allowed addition of an atextual

presumption

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Dudenhoeffer – Supreme Court’s Holding (cont’d)

• Concern of conflict between duty of prudence and prohibition on insider training is legitimate concern • However, ESOP-specific presumption is an ill-fitting means of addressing concern

• Non-ESOP fiduciaries face this same potential conflict with securities law

• ESOP fiduciaries face this conflict whether or not they need to address a financial emergency

• Concern litigation threat will deter offering ESOPs cannot bar all such claims • Presumption is not proper way to weed out meritless claims

• Presumption makes it impossible for plaintiff to state a claim, no matter how meritorious, unless company is in dire economic circumstances

• Presumption does not allow courts to discern plausible claims from meritless cases

• Better approach is to review complaint allegations carefully, and in context

• Court offers guidance to lower court for assessing claims at pleading stage

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Dudenhoeffer – Guidance for Evaluating Claims

• Claims based on public information • Allegations a fiduciary should have recognized from public information alone that the

market was overvaluing or undervaluing stock are implausible as a general rule

• At least in the absence of “special circumstances”

• Thus, fiduciary is usually not imprudent in assuming a major stock market provides estimate of the value of the stocks traded on it • Plaintiffs’ allegations that fiduciaries should have known of risks due to participation in subprime

lending market do not constitute special circumstances

• Claims based on non-public information • Plaintiffs must plausibly allege alternative action that defendants could have taken that:

• Would have been consistent with securities laws; and

• That prudent fiduciary in same circumstances would not have viewed as more likely to harm the fund than to help it

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Dudenhoeffer – Guidance for Evaluating Claims

• Three additional points: • Duty of prudence does not require a fiduciary to break the law

• Therefore, alleging fiduciaries should have divested stock based on insider information cannot state a claim

• If plaintiff alleges fiduciary should have refrained from additional stock purchases or disclosing information to the public, court should consider extent to which obligation to disclose or refrain would conflict with insider trading and corporate disclosure requirements • Court invites SEC’s views on this point

• Courts should also consider whether complaint has plausibly alleged that prudent fiduciary could have taken above actions without doing more harm than good by causing a drop in stock price and stock value

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Key Takeaways

• ERISA means what it says, nothing more

• Courts should not bolt on atextual presumptions to Congress’ carefully crafted statute • Courts also should reject attempt to degrade standards based on Congress’ general

statements of policy

• Fiduciaries cannot hide behind plan language that purports to diminish the obligations imposed by ERISA’s statutory language • No tolerance for the tail wagging the dog

• However, do not forsake this language yet

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Key Takeaways (cont’d)

• Companies and fiduciaries retain the ability to secure dismissal of some claims at pleading stage

• Allegations based on publicly available information will fail, absent “special circumstances” that reasonably challenge reliability of market price, in light of all publicly available information • Allegations “that Fifth Third engaged in lending practices that were equivalent to participation in

the subprime lending market, that Defendants were aware of the risks of such investments by the start of the class period, and that such risks made Fifth Third stock an imprudent investment,” are not sufficient to constitute “special circumstances….”

• Allegations based on “inside information” need to contend with: (a) applicable securities and corporate disclosure law; and (b) “do no more harm” guidance

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What’s Next?

• Fiduciaries may not avoid litigation beyond pleading stage based on: • Presumptions

• Plan documentation purporting to codify presumption of fiduciaries’ actions

• Getting beyond pleading stage still remains a challenge for plaintiffs: • Claims based on public information – Must overcome “special circumstances” hurdle

• Claims based on non-public information – Must overcome insider trading prohibitions and “do no greater” harm standard

• Courts may revive previously dismissed claims • E.g., in the wake of Dudenhoeffer, Fifth Circuit revives stock drop claim against BP

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What’s Next? (cont’d)

• Many stock drop lawsuits will still falter at the pleading

• However, such claims will persist and some will get to discovery: • Plaintiffs’ bar will argue that duty to disclose/refrain can exist regardless of insider

trading concerns

• Class action lawsuits remain attractive, given the leverage points noted above

• It will take time for all courts have to weighed in on application of the pleading standard • Some are sure to be more lenient than others

• DOL remains aggressive in its views: • “The position that we have taken in a number of briefs is that an SEC communication in

and of itself is not an ERISA communication. But when they are incorporated into plan documents like an SPD and a statement is made telling participants to look at the plan documents, that incorporation is a fiduciary act and the duty to be truthful to participants applies to the documents included by reference as much as it does to the SPD”

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What’s Next? (cont’d) • Securities Law Requirements

• File Form 11-K annually

• Ensure that the number of shares registered for sale under the plan on Form S-8 is sufficient

• Prepare and deliver the 10(a) Prospectus

• Consider monitoring selling by company insiders

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Steps in Light of Dudenhoeffer

• Assess the risk and the benefit of maintaining a Company stock fund option

• If you keep option, consider appointing independent fiduciary and delegate the duty to monitor the plan’s investment in Company stock • Does not eliminate risk to other potential fiduciaries

• Brings additional costs/administrative considerations

• Consider use of investment manager

• Evaluate composition of fiduciary committee • Consider removing Section 16 officers and other individuals with “significant” or “too

much” inside information from any fiduciary committee or roles

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Steps in Light of Dudenhoeffer (cont’d)

• Audit/confirm your design, drafting, and administration strategies • Hard-wire requirements that Company offer stock fund option

• Ensure that governance, oversight and practices: • Are consistent with intended/actual practices

• Vest and/or delegate authority in/to the intended entities/individuals

• Do not inadvertently vest responsibility in unintended entities/individuals

• Work with counsel to consider stock fund guidelines unique to your organization • Procedures for evaluating adverse public and non-public information

• E.g., government investigation, public scandal, product or safety recall, financial calamity

• What might constitute “special circumstances,” given the possible scenarios

• How/when inside information might come to fiduciaries’ attention

• How to evaluate inside information and public disclosure obligations, given your company’s individual circumstances

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Questions?


Thank You.

Mike Melbinger Partner, Chair

Employee Benefits and Executive Compensation

Chicago

[email protected]

Joe Torres Partner, Hiring Committee Chair

Labor & Employment Chicago

[email protected]

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