Justices to consider liability of insiders for mismanagement of pension plans that invest in employer stock

The argument next week in Retirement Plans Committee of IBM v. Jander asks the justices to apply their 2014 decision in Fifth Third Bancorp v. Dudenhoeffer. The current case may allow the justices to offer guidance on how to reconcile two dissonant themes from that decision.

The general topic is how to apply the duty of prudence that the Employee Retirement Income Security Act of 1974 imposes on the fiduciaries of pension plans that invest in employer stock (often referred to as employee stock ownership plans, or ESOPs). On the one hand, ERISA imposes a broad, vigorous and nonwaivable duty of prudence on those fiduciaries. On the other hand, Congress strongly has encouraged plans that invest in employer stock, reasoning that tying the financial returns of the firm to the pension assets of officers and employees can improve the incentives for effective operation of the firm. And if the plan is established to invest in employer stock, what, precisely, is the role of “prudence” in selecting appropriate investments?

The lower courts responded to that conundrum by adopting a strong, effectively irrebuttable presumption that a decision to invest in employer stock is prudent. One of the central challenges in those cases was how to reconcile that approach with cases in which the actual fiduciaries of the plan (often, though not always, insiders of the company) had reason to know that the employer’s stock was overvalued: Continuing purchases of the employer’s stock at a price known to be unreasonable ordinarily would be imprudent.

The Supreme Court swept that framework away in Dudenhoeffer, rejecting the notion that there is any special rule for assessing the prudence of insiders that manage ERISA plans that invest in employer stock. The Supreme Court noted the broad and unqualified nature of ERISA’s fiduciary duty and went out of its way to explain that ERISA does not permit parties to contract around that fiduciary duty by defining particular investments as prudent.

In considerable tension with that discussion, the next part of the opinion called for critical and skeptical assessment of complaints that challenge the prudence of insiders managing ESOPs. The justices explained that it should be quite difficult to persuade a court that purchasing a publicly traded security at its market price was imprudent. To be sure, insider fiduciaries might have information, not yet disclosed to the public markets, that should persuade them that the stock is overvalued, and that the stock would decline in value when the public market learned of the adverse information. The court noted the difficulty fiduciaries face in acting on that information for the benefit of the plan’s beneficiaries. Disclosure of the information, for example, might depress the value of the plan’s existing investments. To solve that dilemma, the court held that a beneficiary in such a case could prove a breach of the ERISA duty only if it could show an alternative course of action for the fiduciary so obviously appropriate that a prudent fiduciary “could not have concluded” that continued investment in the employer’s stock was warranted.

Applying that standard, the courts of appeals have dismissed almost all class actions challenging the investment decisions of ESOP fiduciaries. Given the difficulty of knowing what will happen as the markets learn of adverse information about a company, it is quite hard to show that a fiduciary “could not have concluded” that ignoring potential problems with the employer’s operations might have turned out the best for the plan’s beneficiaries. And the only case in which a court of appeals did deny a motion to dismiss such a cause of action led to a prompt summary reversal (the 2016 decision in Amgen v. Harris, from the U.S. Court of Appeals for the 9th Circuit). Those decisions might seem a reasoned application of Dudenhoeffer’s “could not have concluded” standard, but they have drained any substantive force from the part of the opinion in Dudenhoeffer that reinvigorated application of the ERISA duty of prudence.

What brought this case to the Supreme Court was a decision from the U.S. Court of Appeals for the 2nd Circuit, which accepted allegations as satisfying the “could not have concluded” standard. The specific allegations were that the harm of an eventual disclosure of insider information about fraud in the company typically increases with the duration of the fraud. Resting on that premise, the complaint contended that any fiduciary familiar with that premise necessarily would have concluded that disclosure of the fraud would be the prudent response, because it would be less harmful to beneficiaries than continued nondisclosure of the adverse information.

The strategies of the parties here are interesting. For its part, the IBM retirement plans committee suggests a bright-line rule that insider fiduciaries have no duty whatsoever under ERISA to use information acquired in their corporate capacity to manage the plan for the benefit of the plan’s beneficiaries. Taken to its logical conclusion, the argument is startling: If the managers of the plan in their status as officers of IBM had actual knowledge of information suggesting that the stock was overvalued, they would have no duty at all to consider that information as they made decisions about the plan’s investment in IBM stock. It is, though, an argument that would provide a bright-line result consistent with the skeptical discussion of ERISA class actions in the closing pages of the Dudenhoeffer opinion. To the extent the justices believe that the securities laws should manage the disclosure of insider information about public companies, a stark exception from ERISA barring actions predicated on the failure to respond to such information would make a great deal of sense. To be sure, it would essentially overrule the part of Dudenhoeffer that validated a full-fledged fiduciary duty for the ESOP’s fiduciaries, but it would flow naturally from the later part of that opinion.

More generally, the retirement plans committee argues that the allegations about the likely effects of continued nondisclosure are too vague to survive Dudenhoeffer. Essentially, their point is that judicial validation of those allegations in this case would vitiate the last part of Dudenhoeffer by making it trivially easy for plaintiffs challenging ESOP investments to survive a motion to dismiss whenever the employer’s stock has fallen. All the plaintiffs need do is include in their complaint the boilerplate allegations of Jander’s complaint in this case and they would be entitled to discovery and an opportunity for factual development on the question whether the fiduciaries acted prudently, precisely the course of action that Dudenhoeffer (at least the last part of it) castigated.

Jander’s argument on behalf of the employees is much simpler. For one thing, he points out (with considerable force) that the retirement plans committee’s cert petition did not present the broad bright-line argument barring any claims calling for use by insider fiduciaries of information they obtained in their capacity as corporate officers. In any event, Jander argues, any such approach would create just the sort of special exception from the ERISA duty that Dudenhoeffer rejected in the first place.

On the merits of the employees’ particular allegations, Jander argues that the 2nd Circuit has done nothing but take the allegations of the complaint at face value. If everything that the complaint alleges turns out to be provable, then it follows that anybody in the position of the IBM fiduciaries would have disclosed the adverse information sooner, believing that early disclosure was better for the fiduciaries than late disclosure.

Nothing in Dudenhoeffer will provide any real constraint on the Supreme Court’s decision here. The opinion in Dudenhoeffer includes strongly worded passages that, standing alone, seem to compel giving the plaintiffs an opportunity to prove their case and parallel passages that just as strongly seem to compel dismissal of the case as a fishing expedition, much like the securities class actions that have fared so poorly at the Supreme Court in recent years. The argument should give us a chance to see what tack the justices might take.

One practical topic that might be relevant to the argument, but does not feature prominently in the briefs of the parties, is the ability of firms to sidestep all of these problems by using noninsider fiduciaries to manage ESOPs. If true independent fiduciaries managed those plans, then there would no reason to fear the self-interested hiding of adverse information that motivates the torrent of litigation in this area. To the extent that some of the justices view the use of independent fiduciaries as a strategy that would both protect companies from ERISA litigation and ensure prudent investment of pension funds, they well might see that as a way out of the box in which Dudenhoeffer seems to have left the courts of appeals.

[Disclosure: The author of this post represented the plaintiffs in Fifth Third Bancorp v. Dudenhoeffer, but has played no role in Retirement Plans Committee of IBM v. Jander.]