One of the questions I’ve been asked repeatedly by the media, my clients, and industry practitioners is: what does this decision actually mean for ESOP fiduciaries and participants?
We published our immediate reactions in our first blog post on the decision. (See Supreme Court Rejects the Moench Presumption – Vacates and Remands Fifth Third Case) We discussed the idea that the Supreme Court felt uncomfortable finding a justification for a “presumption of prudence” in the statutory language of ERISA. The Court also rejected any plan document based arguments as unconvincing. As a result, the Supreme Court made clear that there are no “coach class trustees,” citing the phrase Justice Kennedy used at oral argument.
We also discussed the idea that the Court was sympathetic to the plight of ESOP fiduciaries who would otherwise be subject to an avalanche of stock drop litigation every other week as stock prices go up and go down. Out of their toolbox they pulled the Iqbal and Twombly doctrines which generally have made it more difficult for plaintiffs with less information about their claims than the defendant by adding a heightened plausibility standard. The doctrines are a relatively new development in federal jurisprudence with the Twombly case being decided in 2007. If the doctrines were available in 1995, I would bet a dollar that the Moench Presumption might never have existed.
All that being said, what must a plaintiff plead now to get past the motion to dismiss stage? Said another way, what I am supposed to advise my ESOP fiduciary clients to do when the price of the stock drops?
This Is All About the Allocation of Risk
In this post, I’m going to focus on claims based on public information, which arguably is equally available to both ESOP fiduciaries and ESOP participants. (At some point later I may post about the insider information portion) Let’s be clear: both before and after this decision ESOPs are risky. There are very few investments out there more risky than a single security. In the simplest terms, this case is all about allocating risk between the ESOP fiduciaries and the ESOP participants.
Under the Moench Presumption, the ESOP fiduciary with a falling stock price would have been protected unless it was clear the company was effectively headed for bankruptcy or total failure (think Enron, Worldcom, etc…). If you imagine a line graph where the price starts to go down, the risk related to any drop in price was shifted to the ESOP participants until, for argument’s sake, the price of the stock was maybe 10% or less of what it was at it’s height.
The Supreme Court rejected this allocation by rejecting Fifth Third’s statutory and plan document arguments. Nonetheless, what the Supreme Court clearly did not appreciate was the argument that the ESOP fiduciaries are supposed to be clairvoyant and know the stock price is overvalued when the entirety of the investing public did not or has yet to adjust. In the same vein, the Supreme Court did not appreciate the idea that the ESOP fiduciary was supposed to use insider information, again, presumably, when the stock price was at its highest.
Let’s be real about what that argument actually meant. The plaintiffs wanted the damages period to start at the highest price point of the stock. Not when the price starts slipping but instead when the maximum damages will be the greatest difference between the highest stock price and the lowest stock price. A chart showing that allocation of risk would look like this:
Are There Plausible Claims Not Covered by Part B of the Decision?
In finding that ESOP fiduciaries are not supposed to clairvoyant, the Supreme Court introduced the idea that if “special circumstances” were present, then you could possibly bring a plausible claim that the ESOP fiduciaries should have known of the overvaluation. What “special circumstances” means will be decided by the lower courts. But obviously, we will see complaints arguing special circumstances. That is an obvious point.
But after a few days of thinking about the decision, one thing that struck me is whether a more modest plaintiff who brings a complaint saying that an ESOP fiduciary violated the duty of prudence only after the stock dropped in price 10 or 20% and the market is starting to figure out what is happening and other institutional investors are selling the stock, would be subject to this portion of the Supreme Court’s decision at all. If the claim does not involve clairvoyance, then no special circumstances may be necessary. The allocation of risk under this scenario might look something like this:
How the risk is allocated (where the red and green meet in my chart) will be decided by the lower courts and may be slightly different (or dramatically different) in different factual circumstances. What I mean by this is that with 100 different ESOPs, there will be 100 different factual scenarios regarding available public information, circumstances of the stock price drop, and to what extent there is inside information.
Ultimately, I think it is important to understand that risk has not been created or destroyed by this decision. The risk was always present. Under Moench, ESOP participants bore most of the risk. But under this decision, ESOP fiduciaries will not bear most of the risk either. Instead, this case was all about shifting a portion of the risk back to ESOP fiduciaries rather than ESOP participants, but leaving it somewhere in the middle. The Goldilocks of ERISA decisions if you will.
So, Again, Now What?
Now that Moench is no more, it appears to me that plaintiffs will argue that the company stock investment is subject to the exact same investing standards as any other core option in a plan. If the price starts to tank and other investors are dumping it, then the ESOP fiduciary will be criticized (read: found liable) if they don’t do the same thing they would do with a mutual fund on their watch list (i.e. freeze or sell).
So while we all wait for the next year or two or nineteen (1995-2014) for the lower courts to figure this out, ESOP fiduciaries should consider treating their company stock investment with the same exacting fiduciary standards they are treating the plan’s other investments. The sun is rising and it’s going to be 130 degrees by Noon. The ESOP fiduciary needs shelter. Here are items they should consider:
- If they have an IPS, consider including the company stock investment or drafting an entirely separate IPS.
- If they have a watch-list procedure, consider having it cover the company stock investment.
- If they receive the services of an investment professional for the plan’s other investments but not the company stock, consider adding it or seeking a capable investment professional.
- Consider the use of an independent fiduciary who can take over all fiduciary risk but the narrow responsibility to monitor the independent fiduciary.
- Consider a review of your ERISA fiduciary liability policy to ensure that it covers losses related to the ESOP.
- And last, but not least, document every fiduciary decision related to the ESOP. Just because a presumption of prudence is gone, does not mean that the ESOP fiduciary should not engage in actual procedural prudence. Having a robust process has gotten more than one fiduciary a favorable result in a courtroom.