ESOP fiduciaries remain subject to suit for failure to drop inflated company stock from investment menu

ESOP participants will be allowed the opportunity to prove in court that plan fiduciaries acted imprudently in continuing to offer company stock as an investment option when they knew or should have known that the stock price was artificially inflated, according to the U.S. Court of Appeals in San Francisco (CA-9). The participants will also be permitted to rely on documents incorporated by reference in plan summary plan descriptions to establish a breach by the plan fiduciaries of their duty to provide the participants with material information related to the investment in company stock.

Note: The case is one of the first to be adjudicated in the wake of the invalidation by the U.S. Supreme Court of the presumption of prudence. However, it is important to note that the Ninth Circuit’s decision only allows the participants to continue to pursue their action. The decision is not a determination that the fiduciaries actually violated their ERISA duties.

Application of presumption of prudence

The facts and lengthy procedural history of the case are complex. Essentially the Ninth Circuit was revisiting its earlier holding applying the presumption of prudence to reflect the Supreme Court’s ruling in Fifth Third Bancorp v. Dudenhoeffer, invalidating the presumption of prudence.

Violation of duty of care

In affirming its earlier holding that the fiduciaries violated the duty of care owed under ERISA, the Ninth Circuit was required to revisit and address the defenses previously advanced by the fiduciaries in the prior action.

The fiduciaries initially maintained that, even absent the presumption of prudence, their actions in retaining the company stock investment option were prudent. In determining whether the fiduciaries actually complied with the applicable standard of prudence, the court focused on whether the fiduciaries, at the time they engaged in the challenged actions, utilized appropriate methods to investigate the merits of the investment and to structure the investment.

The fiduciaries argued that the investments in company stock during the class period were not imprudent because the company was not experiencing financial difficulty during the class period and remains a strong and profitable company. The court, noting that the company’s financial difficulties were hidden by its allegedly deceitful actions, stressed that the company’s viability did not negate the fact that the company’s stock may have been artificially inflated during the class period.

The fiduciaries further averred that the decline in the price of the stock did not establish that the stock was an imprudent investment. The court stressed, however, that the prudence of an investment is a function less of the result of the investment than whether appropriate methods were used to investigate the merits of the investment. In addition, the court explained that the trial court’s determination, in a separate action, that the alleged misrepresentations and omissions, scienter, and the resulting decline in the stock price were sufficient to state a SEC 10(b) claim, also indicated that the allegations were sufficient to state an ERISA claim that the investment was imprudent.

The fiduciaries next contended that they were in the untenable position of having to retain the company stock investment option while risking suit by selling a stock that could eventually rebound. The court dismissed the argument, noting that the plan did not require an investment in company stock. In addition, the fiduciaries knew or should have known that the stock was artificially inflated as a result of actions by company officers.

The fiduciaries, alternatively, argued that removing the company stock fund as an investment option, based on nonpublic information about the company would have adversely affected plan participants and investors by causing a decline in the stock price. The court reasoned, however, that removing the company stock fund from the list of investment options would not have caused the liquidation of the fund, but would have just prevented the plan participants from continuing to invest in artificially inflated stock. Moreover, the court stressed that, irrespective of the impact on the share price, the fiduciaries’ obligation to remove the fund was triggered as soon as they knew or should have known that the share price was artificially inflated.

The fiduciaries countered that the removal of the company stock option based on insider information would have been illegal under securities law. In rejecting the argument, the court noted that compliance with ERISA would have actually allowed the fiduciaries to further comply with their obligations under federal securities law. Moreover, simply prohibiting further investment in the fund while the company stock was artificially inflated would not have violated the insider trading prohibition, as such a violation requires the purchase or sale of stock.

The fiduciaries maintained on remand, for the first time, that the Supreme Court in Fifth Third, imposed new, more specific pleading requirements in cases alleging a breach of the duty of prudence. The Ninth Circuit rejected the suggestion that Fifth Third imposed a higher pleading standard of particularity or plausibility or articulated a new standard of liability. In Fifth Third, the Supreme Court advised that, in order to state a claim for fiduciary breach on the basis of inside information, a claimant must plausibly allege an alternative action that the fiduciary could have taken that would have been “consistent with securities laws,” and that a prudent fiduciary in the same circumstance would not have viewed “as more likely to harm the fund than to help it.” The Ninth Circuit acknowledged Fifth Third, but explained that it adhered to the proffered standard in its earlier ruling.

Note: Although the Ninth Circuit concluded that plan participants sufficiently alleged that fiduciaries violated the duty of care owed under ERISA, the eventual liability of the fiduciaries for the failure to discontinue the company stock option will depend on a fact-based determination of the likely effect of the alternative actions available to the fiduciaries. The following considerations will apply.

Under Fifth Third, when a complaint faults a fiduciary for failing to decide, based on negative inside information, to refrain from making additional stock purchases or failing to disclose that information to the public so that the stock would no longer be overvalued, courts need to consider the extent to which an ERISA-based obligation to either (a) refrain from making planned trade or (b) disclose inside information to the public could conflate with the complex insider trading and corporate disclosure requirements stated in the federal securities laws or with the objectives of those laws. Thus, a fiduciary may be required to discontinue investment in employer stock or to disclose certain information if securities law would not be violated in the process.

In addition, the Supreme Court has advised, lower courts faced with such claims should consider whether the complaint has plausibly alleged that a prudent fiduciary in the same position could not have concluded that discontinuing purchases of employer stock or publicly disclosing negative information could do more harm than good to the fund by causing a drop in the stock price and a concomitant drop in the value of the stock already held by the fund.

On remand, a district court, informed by expert opinion, will be required to weigh the effect of the alternative actions available to the fiduciaries as well as other variables. The fact that the court has been unreceptive to the participants’ claims, however, does not portend a swift resolution to the case.

Source: Harris v. Amgen, Inc. (CA-9).

Visit our News Library to read more news stories.