March 2014
By Philip J. Koehler, Esq.

Those “of a certain age” will probably recall the evening of Sunday, February 9, 1964.   “Ladies and gentlemen,” the stone-faced Ed Sullivan uncharacteristically barked over a chorus of shrieks from the teenage girls in his studio audience, “the Beatles!”  In a country of 192 million people, more than 73 million watched the live, black-and-white television images of four fresh-faced, thin young Brits in their tight Edwardian suits.  They played two five-minute sets of up-beat love songs with joyful abandon, nailing three-part harmonies while vamping their mop-heads of hair, which throttled the shrieks to higher crescendos.

The country was in the grip of a gathering gloom.  The enormity of the loss from the Kennedy assassination ten weeks earlier was painfully sinking in.  Distant drums from Viet Nam were getting louder, anger and violence were stoking racial tensions at home and the ever present threat of nuclear confrontation with the Soviet Union didn’t leave much room for optimism.  When the band smiled into the TV cameras that night and struck the first few chords on their guitars, they opened a generational rift in the fabric of the post-World War II society.  That rift would grow and deepen for a multitude of reasons and, by the time the Beatles broke up in 1971, give rise to seismic levels of societal change.

Through a glass darkly now, we (who are not so young anymore) savor our memories of this time.  It’s hard to argue that the evolution of their music was anything short of astonishing.  But, fifty years ago the Beatles were also undeniably in the right place at the right time, snatching the chance to become the pied piper to a boomer generation coming of age in the vortex of upheaval.  The band never did much touring after 1964 and, in fact, stopped altogether after 1966, mainly due to the immense logistical problems caused by its unprecedented popularity.  Without any significant stage presence, the Beatles kept intact a mystical connection to their huge international fan base by producing 12 studio albums, each one in succession a separate work of fresh and compelling songs.  Long after they had each made more money than he could spend in several life times, they exhibited a passion for what they wanted to say.  Indeed, it’s virtually impossible to ignore the band’s impact on modern culture and popular music.  Through it all they were true to the people who made them what they were and to their times.

The Beatles had a way of communicating complex ideas in simple human terms.  We all struggle with the meaning of words like “prudence.”  Imbedded in ERISA’s quartet of fiduciary standards: (1) Exclusive Purpose Rule, (2) Prudent Expert Rule, (3) Documents Rule and (4) Diversification Rule, the Prudent Expert Rule stands out from the other three more or less unambiguous notions as the illusive one. The statute only gives us the hypothetical prudent expert construct that a fiduciary is prudent in any given situation if his actions or failures to act lined up with what an expert in the field would have done in a similar situation.  Presumably, “Prudence” is as “Prudence” does.  Prudence (or the lack thereof) it seems is a judgment we make with 20/20 hindsight.  It is easy to spot when we see a “job well done” or a “mission accomplished.”  Thinking of prudence in this abstract way is of limited use.  It’s important to turn the record over and hear the B-Side, where we consider real people suffering significant damage and we want to know if there is someone, who owed them a duty of prudence, who should be accountable.

Not surprisingly, Courts often become flummoxed in applying the Prudent Expert Rule, particularly in the so-called “stock drop” ESOP/EIAP fiduciary breach cases.[i]  In Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995) Charles Moench, a participant in the ESOP of his employer (Statewide), filed a class action fiduciary breach lawsuit.  From July 1989 to May 1991 the share price of Statewide stock declined from $19.25 to $0.25.  Mr. Moench claimed that the ESOP Committee acted imprudently by continuing to acquire company stock during the price drop and failing to warn plan participants about the company’s deteriorating financial condition.

The Third Circuit consulted “the common law of trusts for guidance.”  Noting the basic principle that a “settlor’s intent” should control the interpretation of a trust’s terms, the court stated that in compelling the ESOP fiduciaries to hold employer securities the plan affords participants the “maximum opportunity to recover their losses.”  Exposing the fiduciaries to liability under the Prudent Expert Rule because they abided by this general intent of the ESOP, fails to honor this time-honored principle of the “settlor’s intent.”  However, rather than immunizing ESOP fiduciaries from fiduciary liability for their continued investment in company stock during a prolonged period of share price decline, or, on the other hand, subjecting their investment decisions to “a de novo review” (i.e. a trial on the merits after development of a full evidentiary record), the court split the baby.  The Court introduced the brand new “Moench Presumption.”  In defending stock drop fiduciary breach claims, it held, ESOP fiduciaries are entitled to a rebuttable presumption of prudence at the pleadings stage, subject to judicial review on an abuse-of-discretion standard.  P.S….Sorry Mr. Moench, while you get the dubious distinction of having a new pleading requirement named after you, you can’t get over this hurdle.

The “Moench Presumption” has crystallized into a standard defense tactic at the pleadings stage in support of its motion to dismiss plaintiffs’ claim in the hope of avoiding the trial court’s issuance of discovery orders.  The Second Circuit sanctified this reasoning by holding that “there is no reason to permit a case to proceed to discovery where the facts, even if proven true, would not establish that defendants abused their discretion in failing to divest employer stock.”  See In re Citigroup ERISA Litig at Note [ii].

Despite the U.S. Department of Labor’s consistent opposition to the “Moench Presumption,” the Second, Third, Fifth, Seventh, Ninth and Eleventh Circuits have followed a variation of Moench and added a gloss on the plaintiff’s burden to rebut the presumption that requires showing that the plan sponsor was in a “dire financial predicament” during the class period.[ii]  In one of the few cases in which the plaintiffs successfully rebutted the “Moench Presumption,” the trial court was clearly frustrated with this line-drawing exercise and looked to the totality of the alleged facts.   See In re Fannie Mae 2008 ERISA Litig., 09 CIV. 1350 PAC, 2012 WL 5198463, at *4–5 (S.D.N.Y. Oct. 22, 2012).  (“The Second Circuit’s presumption of prudence sets a very high threshold; but if FNMA’s alleged situation [noting evidence of the growing rate of foreclosures, concerns about the housing market, concerns about lessened underwriting standards, claims that there would be further deterioration of the housing market in the event of a bubble bursting, concerns about increased exposure to the subprime market, internal risk officers’ warning, and a decrease in plan assets of more than 90 percent] is not sufficiently “dire” to state a claim, it is not clear what would be sufficient.  Accordingly, the Court finds that Plaintiffs have plausibly pled that the Defendants violated their duty of prudence.”)  Fannie Mae imploded during the so-called “Great Recession,” the global contraction from December 2007 to June 2009 that resulted in the world economy shrinking for the first time since 1945.  Does it have to get that “dire” before the fiduciaries’ conduct is not “presumptively prudent?”

In 2012 the Sixth Circuit became the first appellate court to limit Moench.  It held that the plaintiff in a similar case was not required to rebut the presumption in its complaint by alleging that defendant was in a “dire financial predicament.” See Pfeil v. State Street, 671 F.3d 585 (6th Cir. 2012) cert. denied, 12-256, 2012 WL 4009309 (Dec. 3, 2012) (to rebut the presumption, plaintiff must merely demonstrate that “a prudent fiduciary acting under similar circumstances would have made a different investment decision.”)  Later in 2012 the Sixth Circuit took another swipe at MoenchSee Dudenhoefer v. Fifth Third Bancorp, 692 F.3d 410 (6th Cir. 2012), cert. granted in part, 12-751, 2013 WL 6510745 (U.S. Dec. 13, 2013) (“Today, we hold that the presumption…is not an additional pleading requirement and thus does not apply at the motion to dismiss stage….As such, a plaintiff need not plead enough facts to overcome the presumption in order to survive a motion to dismiss.”)

Both the ESOP portion of Fifth Third’s 401(k) plan and its company matching account were required to be invested “primarily” (but not “solely”) in company stock.  Additionally, participants could sell such shares and redirect any matching contributions into alternative investment options.  The Court held that since the terms of the plan did not require the ESOP portion of the plan to invest solely in Fifth Third stock and did not limit the ability of the fiduciaries to curtail the ESOP or divest its assets, the “Moench Presumption” was inapplicable at the pleadings stage.[iii]  Where the plan leaves to the discretion of the fiduciaries the extent to which the plan invests in company stock, the Court relaxed the standard of review from the very high abuse-of-discretion standard (which got Mr. Moench’s claim tossed out) to the standard of “what a prudent fiduciary would have done.”  More importantly, it removed the “Moench Presumption” altogether from the pleading stage and, thus, as a gateway to discovery.   Industry groups, lobbyists and pundits predict that this will open the proverbial floodgates of “stock drop” cases.  They argue that the high cost of defending these cases will chill the establishment and maintenance of plans with ESOP/EIAP features, thereby frustrating the goal of increasing employee ownership of employer stock.

The Supreme Court granted certiorari in the Fifth Third Bancorp case last December on the issue of the Sixth Circuit’s construction of the “Moench Presumption.”[iv]  Oral arguments are set for April and a decision should be forthcoming by the end of the Supreme Court’s current term in June.  For Fifth Third Bancorp, its prospects for avoiding a very intrusive and, no doubt expensive, round of discovery hang on how the Supreme Court resolves the split among the Circuit Courts.

Whether or not you think Moench and its progeny came out the right way, there is a significant flaw in the underlying rationale.  The Third Circuit arguably got off on the right foot by looking to Statewide’s intent in establishing the ESOP, but, in divining that intent, it treated ERISA/Code-mandated boilerplate language in the plan (investing “primarily in employer securities”) as evidence that this objective was ascendant over the plan’s raison d’etre, viz. providing retirement benefits to the participants.  Whether the “settlor’s intent” can be discerned by focusing on a few isolated sentences in a complex ESOP document that describe this subsidiary goal (because it has to), while assigning less weight to the vast bulk of the document that establishes the terms and conditions for payment of future retirement benefits in detail, seems dubious to say the least.  The Court said it was weighing these interests and striking a balance, but it failed to explain how a balancing test squares with the Exclusive Purpose Rule (requiring a fiduciary to act “solely in the interest of the participants and their beneficiaries for the exclusive purpose of (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan“).[v]

Compared to the Prudent Expert Rule, the Exclusive Purpose Rule is straightforward.  The latter bars fiduciaries from considering any interests other than those of the participants and their beneficiaries and any purposes other than providing them with the plan’s benefits or payment of the reasonable expenses of administering the plan.  If a competing interest, e.g. expanding employee equity ownership of the ESOP sponsor, can be simultaneously achieved, then the fiduciaries should be in a “no harm no foul” situation.  But, if it cannot, any judicially contrived presumption that represents a balancing of competing interests is completely disconnected from this fiduciary standard and, probably, the analogous rule in Code Section 401(a).  See Note [i].  Sometimes courts can wander so far off in trying to find meaning for an ambiguous statutory term, that they lose sight of the forest for the trees and fail to give proper weight to an unambiguous statutory term that will resolve the issue.  If prudence is indeed a judgment we make with 20/20 hindsight, then the notion that somehow one can be “presumptively prudent” is an oxymoron on its face, a fig leaf that hides the presumption’s effect of functioning as a virtual exemption from the Prudent Expert Rule itself.

The Moench Court also erred when it failed to follow normal rules of statutory construction.  Since Congress did exempt the ESOP fiduciaries from the Diversification Rule, but chose not to exempt them from either the Exclusive Purpose Rule or Prudent Expert Rule, the appropriate conclusion is that Congress did not intend to relax these standards.  It can be argued that, in the absence of express statutory exemptions that relieve the fiduciaries from both the Exclusive Purpose Rule and the Prudent Expert Rule, the retirement security objective of the plan, which naturally permeates the four corners of the Statewide ESOP documents, trumps its narrower and subsidiary goal of expanding employee ownership when the two conflict.  Unlike ESOP participants confronted with the “Moench Presumption,” the general investing public can better protect itself by selling their stock whenever they choose and seeking other legal remedies if they believed fraud was involved.

The statutory history of ESOPs, which were introduced in the 1970s, provides considerable support for the theory that aligning employee interests with those of regular shareholders is a good thing.  However, it is not at all clear that ESOPs actually do that.  First, in many ESOPs (except for narrow, age-restricted diversification rights) the participants may not freely dispose of their shares, as regular shareholders, but must generally wait until they terminate employment.  Second, many ESOP sponsors (other than companies whose stock is not readily traded on a pubic exchange) restrict the pass through of voting rights on the shares allocated to participant accounts.  Unlike regular shareholders holding voting class shares, such ESOP participants cannot participate in the full range of shareholder voting activities.  In any event, participants may only vote those shares allocated to their accounts to the extent vested.  The ESOP trustees, typically a group of corporate directors or senior management, vote all nonvested shares.  Because the proxy solicitation rules for ESOPs are so complicated, among the ESOP participants whose accounts hold vested voting class shares, the percentage who actually vote their shares is significantly less than the percentage of the company’s regular shareholders who vote their shares.  Shorn of these other valuable features of equity ownership, it’s a stretch to claim that an ESOP aligns the interests of participants with those of regular shareholders.

Furthermore, these restrictions on the ESOP participants’ shareholder rights buttress another competing, although more obscure, strain of the “settlor’s intent” in the establishment of many ESOPs, i.e. the insulation of a substantial part of the plan sponsor’s capital structure from external threats.  ESOPs can be very effective in protecting the interests of current management from the influence of pesky minority shareholders, institutional shareholder advocates like ISS, or in fending off hostile takeover bids.  An ESOP parks a large chunk (in some cases a controlling interest) of the company’s outstanding shares in the hands of ESOP trustees, who, in turn, are composed of, or controlled by, management.  This is not to infer anything nefarious is present because the ESOP serves these legitimate business interests of the settlor.  However, they bear no relationship to the plan’s purpose of providing retirement income to the participants and their beneficiaries.  They increase the fiduciaries’ exposure to real or apparent conflicts of interests and demonstrate how readily the “[ESOP] settlor’s interest” can be sliced and diced, making judicial balancing tests in the face of the Exclusive Purpose Rule an even more problematic walk in the woods.

Upholding the primacy of a retirement plan’s goal of providing retirement income does not leave employers seeking to expand employee ownership empty handed.  There is a panoply of tax-favored approaches that are not subject to ERISA’s fiduciary standards, e.g. Employee Stock Purchase Plans, grants of Restricted Stock, Incentive Stock Options and Nonqualified Stock Options and performance-based non-qualified deferred compensation arrangements.   On the other hand, there is a substantial body of opinion that seriously questions the wisdom of a policy that encourages concentrating the exposure of an employee’s future retirement security, as well as his current employment, to the same risk, i.e. the financial fortunes of his employer.  The facts of the Enron and WorldCom debacles are instructive here.

Where fiduciaries have no discretion to determine the extent to which the plan invests in company stock (so-called “hardwired plans”) the Supreme Court may well choose to reserve judgment since those are not the facts of the Fifth Third Bancorp case.   On the other hand, where fiduciaries have such discretion, the Court should adopt the view of the Sixth Circuit and discard the “Moench Presumption” as a pleading requirement.  If it wants to preserve the presumption as an evidentiary burden shifting mechanism, it should craft a more nuanced standard of review that allows a trial court to ascertain the circumstances under which continued holding and acquiring of new shares of company stock during a prolonged period of decline in the share price become sufficiently antithetical to a plan’s fundamental retirement income purpose that, under ERISA’s Prudent Expert Rule, a duty to deviate from the static terms of the trust arises.  Ideally, such an approach would:  (1) differentiate between the duty to sell shares of company stock versus a duty to impose a mere temporary suspension of future purchases, and (2) establish a sliding scale based on the total percentage of plan assets held in company stock, which prescribes less severe conditions on the duty to deviate as the percentage of plan assets held in company stock increases.

Moench was decided in 1995.  Since then how many EIAP participants, whose future retirement income security was severely damaged by losses on company stock, were told they had no case because whatever the fiduciaries did or didn’t do, absent a “dire financial predicament,” was “presumptively prudent?”  In 1964, the Beatles were singing “I want to hold your hand” and “Do you want to know a secret?”  The band evolved with its times.  Year by year, its music steadily grew more refined and innovative.  Songs like “Norwegian Wood” (1966), “A Day in the Life” (1967), “While My Guitar Gently Weeps” (1968) and “Here Comes the Sun” (1969) made its earlier music seem quaint and unsophisticated.  After 19 years, it’s time for the Supreme Court to give the lower courts a less arbitrary and more sophisticated understanding of ERISA’s Exclusive Purpose and Prudent Expert Rules. 


[i] An Eligible Individual Account Plan (“EIAP”) is an ERISA “pension benefit plan” that is a stock bonus or a profit sharing plan, e.g. a 401(k) plan, that either specifies a required percentage of plan assets that will be invested in employer securities or establishes a permissive percentage target.  An Employee Stock Ownership Plan (“ESOP”) is a special form of EIAP that, in order to maintain its tax-qualified status, is required to invest “primarily in employer securities.”  ERISA requires non-EIAP-type “pension benefit plans” to diversify their investments under the Diversification Rule and prohibits them from holding more than 10% of their assets in employer securities.  However, EIAP fiduciaries are exempt from both the Diversification Rule and the 10% cap on employer securities.  An EIAP is also a tax-qualified retirement plan, subject to the requirements of Section 401(a) et seq. of the Internal Revenue Code of 1986 (the “Code”).  Section 401(a) of the Code provides that, in order to be qualified under that section, a stock bonus, pension, or profit-sharing plan of an employer must be for the exclusive benefit of its employees or their beneficiaries.  § 1.401-1(a)(2)(i) of the Income Tax Regulations provides that a qualified retirement plan is an arrangement that is established and maintained by an employer to provide for the livelihood of employees or their beneficiaries after the retirement of the employees.

[ii] See White v. Marshall & Ilsley Corp., 714 F.3d 980, 987–97 (7th Cir. 2013) (claim failed due absence of evidence of extreme risk); Lanfear v. Home Depot, Inc., 679 F.3d 1267, 1271 (11th Cir. 2012)(short term events and market fluctuations not sufficient to show dire situation); In re Citigroup ERISA Litig., 662 F.3d 128, 134 (2d Cir. 2011), cert. denied, 133 S. Ct. 475 (2012)(no evidence plan sponsor was in a dire situation); Quan v. Computer Sciences Corp., 623 F.3d 870 (9th Cir. 2010) (employer’s viability as going concern not in doubt, nor precipitous drop in stock price); Kirschbaum v. Reliant Energy, Inc., 526 F.3d 243 (5th Cir. 2008) (no indication doubt as to going concern); and Edgar v. Avaya, Inc., 503 F.3d 340, 348 (3d Cir. 2007) (no dire situation).

[iii] Plan fiduciaries also incorporated by reference Fifth Third’s SEC filings into the summary plan description.  Plaintiffs claimed that such filings contained misstatements and omissions in breach of ERISA’s duty of loyalty.  The Court held that, since the fiduciaries “expressly incorporated by reference specifically named SEC filings into the Plan’s summary plan description,” a document ERISA requires to be sent to plan participants to provide specified information about the plan, the action was undertaken in the defendants’ role as plan administrators and, accordingly, it was an exercise of discretion on the fiduciaries’ part and actionable under ERISA.

[iv] The Supreme Court denied cert on the issue of whether the incorporation of SEC filings by reference in the plan’s SPD was a fiduciary act, leaving that portion of Sixth Circuit’s holding in support of plaintiffs in effect.

[v] Similarly, the Court spent no time considering the requirement in the Code and Income Tax Regulations that a qualified retirement plan must be established and maintained exclusively to provide for the livelihood of employees or their beneficiaries after the retirement of the employees.