ESOP Fiduciaries Face New Legal Landscape

The jury’s still out on whether ESOP fiduciaries will face more stock-drop lawsuits.

By Eric Krell Sep 23, 2014


1014-Cover.jpg"Unfavorable yet Favorable.” “Supreme Court Giveth and Taketh Away.” “Disappointing Mishmash.”

The U.S. Supreme Court’s June 25, 2014, decision regarding employee stock ownership plans (ESOPs) inspired a wave of headlines and legal briefs that attempted to crystallize the contradictory nature of the court’s ruling.

The most important aspect of the decision in Fifth Third Bancorp v. Dudenhoeffer relates to the overturning of the so-called Moench presumption, which protected employers that sponsor employee stock ownership plans, a type of defined contribution plan. The Moench presumption basically held that a plan fiduciary’s decision to acquire and hold employer stock in an employee stock ownership plan was prudent—in other words, companies were given the benefit of the doubt that they were fulfilling their fiduciary duty in a prudent and responsible manner.

Many lower courts relied on the Moench presumption to determine whether ESOP-related stock-drop lawsuits should proceed. Current and former employees typically file the claims in response to steep drops in the value of company shares that the employees accumulated through the ESOP. The standard, also referred to as a “presumption of prudence,” was largely seen as a buffer that protected companies with ESOPs against suits filed by employee plaintiffs, who in many cases lost retirement savings.

Implications Unclear

About 13.5 million U.S. employees currently have ESOPs, according to the National Center for Employee Ownership. The Dudenhoeffer decision and the legal analysis it sparked raises questions for sponsors of those plans:

  • Will the decision stimulate more stock-drop lawsuits?
  • What are the legal duties of ESOP sponsors?
  • What should companies with ESOPs and their HR professionals do to limit the likelihood of stock-drop claims?

The answer to most of these post-Dudenhoeffer questions, according to many legal experts, will become clear during the next three to five years as case law expands with new ESOP decisions from the lower courts.

“Some law firms that specialize in bringing class-action suits tend to talk about the decision as a game changer,” says J. Michael Keeling, president of The ESOP Association in Washington, D.C., an employer-sponsored ESOP advocacy organization. “I’m a little skeptical of that message … and I call [the decision] something of a mishmash.”

The legal consensus seems to be wait and see. “Time will tell as to how high a bar the lower courts will set” for plaintiffs to bring stock-drop cases, says James Masella, a partner in the litigation department of New York City-based law firm Patterson Belknap Webb & Tyler LLP.

Until then, HR professionals should keep in mind that, although the presumption of prudence is gone, it pays to be as prudent as ever when administering an ESOP.

The Million-Dollar Question

Will the Dudenhoeffer decision give rise to more stock-drop cases? Maybe, maybe not.

The Moench presumption made it very difficult for plaintiffs to rebut the presumption of prudence, Masella explains. The Supreme Court indicated that companies with ESOPs are no longer entitled to that special presumption of prudence but instead are subject to essentially the same duty of prudence as other plan fiduciaries, such as 401(k) plan fiduciaries, under the Employee Retirement Income Security Act (ERISA).

Some legal experts, including those who represent plaintiffs in stock-drop cases, expect the decision to generate many more stock-drop claims.

However, the Supreme Court also imposed several “significant hurdles for plaintiffs to jump over before they will succeed with a stock-drop claim,” according to Masella. For example, ESOP plaintiffs now need to show the existence of “special circumstances” that make a publicly listed ESOP company’s reliance on publicly quoted stock prices imprudent.

Anatomy of a Stock-Drop Claim

Stock-drop cases generally boil down to two substantive claims, says Deborah Davidson, a partner in the law firm of Morgan, Lewis & Bockius LLP.

The first, a prudence claim, alleges that employer stock became an imprudent investment because of circumstances adversely affecting the company.

The second, a misrepresentation claim, alleges that the plan fiduciaries knew or should have known about the circumstances adversely affecting the company and that they breached their fiduciary duties by affirmatively misleading or failing to warn participants about the risks.

So, while the decision can be said to have stripped a key protection against stock-drop claims, it also added new safeguards.

Deborah Davidson believes the decision may lead to an increase in stock-drop complaints, at least in the short term. Davidson is an ERISA litigation partner in the Chicago office of Morgan, Lewis & Bockius LLP and a member of the law firm’s ESOP group. However, she—like Masella and Keeling—is quick to point to the new framework for determining what is required to establish a breach of an ESOP sponsor’s fiduciary duty. This framework poses hurdles that may not be as formidable as the Moench presumption but that seem likely to prevent a flood of new cases.

The Moench presumption forced plaintiffs to demonstrate early in the lawsuit that the ESOP fiduciary faced an employer in a “dire situation” or “on the brink of collapse.” As a result, most of these claims “were destined to fail from the start,” Masella says of the pre-Dudenhoeffer cases. “It is possible that plaintiffs will now feel re-energized in pursuing prudence claims in employer stock-drop cases, and will test out the new boundaries established by the Supreme Court.”

However, despite “the significant sea change caused by the elimination of the Moench presumption,” Masella says, the new conditions plaintiffs must meet to proceed with stock-drop claims may prove to be as effective as the Moench presumption was in enabling plan fiduciaries to defeat the claims.

Legal Duties Unchanged

What are the duties of ESOP sponsors? While the Supreme Court changed the way stock-drop claims are evaluated by courts, it did not alter the ERISA fiduciary duties of ESOP sponsors. These duties apply only to the individuals or entities that perform fiduciary functions, such as managing plan assets or administering the plan, Davidson notes. They generally include:

  • Running the plan solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses.
  • Acting prudently.
  • Following the terms of plan documents to the extent that the plan terms are consistent with ERISA.
  • Avoiding conflicts of interest.

ERISA also identifies diversification of plan assets as a fiduciary duty, but only for non-ESOPs; ESOPs exclusively include company stock.

Dudenhoeffer doesn’t change the duties that apply to ESOP plan fiduciaries, Davidson explains. “It just changes the legal framework courts use to evaluate those duties,” she says.

Stay Prudent

It may sound contradictory, but the most common legal advice for plan sponsors following the Supreme Court’s elimination of the presumption of prudence is to “prudently” fund and manage ESOPs. That means HR professionals and their colleagues should “prudently consider the value of company stock when forming and funding the plan,” Masella says. “Fiduciaries should also ensure that plan documents have clear terms that are consistent with ERISA and that seek to maximize and protect plan participant retirement income—by including financially healthy stock and buying, holding or selling where necessary.”

Masella, Keeling and Davidson identify several actions ESOP sponsors should now consider, including the following:

  •     Review the plan’s fiduciary governance and committee structures and consider inserting more checks and balances to ensure independence of those in charge of the fund from the employer’s internal structure.
  •     Adopt additional policies and procedures to closely monitor company stock and evaluate whether there are circumstances that may pose a risk of harm to the interests of ESOP fiduciaries.
  •     Review and update plan documents and participant disclosures, perhaps to place limits on participant investments in employer stock or otherwise guard against the risk of imprudently overinvesting in shaky employer stock.
  •     Document all decision-making regarding ESOPs, including why shares were acquired or sold and how their prices were determined.
  •     Obtain advice as appropriate from the plan’s advisor and, as applicable, from independent fiduciaries to support the ongoing prudence of employer stock investments and fiduciary decision-making.
  •     Be prepared for an audit, since stock-drop cases are not the only risks to ESOP fiduciaries. ESOP audits conducted by the U.S. Department of Labor can last up to three years and consume significant time. Over the course of 20 years, ESOP sponsors can expect to receive two to three Labor Department audits, Keeling says. The IRS also conducts ESOP audits.

For ESOP sponsors, prudence is no longer assumed, but it remains required.

Eric Krell is a business writer based in Austin, Texas, who covers human resource, finance and social marketing issues.


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