Whither Employer Stock Drop Litigation?

August 2014
Philip J. Koehler, Esq.

Professor Kingsfield, the fictional Harvard Law professor in the classic movie “The Paper Chase,” each year famously greeted the first year law students in his Contracts class with the words:

 “You teach yourselves the law, but I train your minds. You come in here with a skull full of mush; you leave thinking like a lawyer.” 

Turns out, as Justice Breyer strongly suggests in writing the unanimous opinion for the Court in Fifth Third Bancorp v. Dudenhoeffer, No. 12-751, 2014 BL 175777, 58 EBC 1405 (U.S. June 25, 2014), a law degree is no inoculation against mushy thinking.

In the seminal case of Moench v. Robertson, 62 F. 3d 553 (3rd Cir. 1995), the Third Circuit held that “an ESOP fiduciary who invests the [ESOP's] assets in employer stock is entitled to a presumption that it acted consistently with ERISA” and that, in the absence of alleging the employer was in dire financial condition, a claim for breach of the fiduciary duty of prudence cannot survive a motion to dismiss.  Over the ensuing twenty years, a majority of Circuit Courts followed the Third Circuit, allowing the so-called “Moensch Presumption” to become a standard defense tactic that nipped dozens of employer stock drop fiduciary breach claims at the pleadings stage and undoubtedly deterred the filing of many more.

With thinly veiled, almost Kingsfield-like, sarcasm, Justice Breyer tossed the Moensch Presumption into the dustbin of judicial history based on a review of the text of ERISA as it has existed since it was amended by the Tax Reform Act of 1976.   Unanimously telling the lower courts that followed Moensch that they had been improvidently granting motions to dismiss for up to 20 years, while they marched up a yellow brick road to “presumptive prudence,” because they didn’t read the statute with sufficient care, is about as shrill as the Court gets in admonishing them about mushy thinking. 

Some proponents of the Moensch Presumption argued that, because ERISA’s ”Prudent man standard of care” requires a fiduciary to follow the documents and governing instruments of the plan (the “Documents Rule”), the Court should balance the various competing legislative interests by reading into ERISA’s duty of prudence an exemption that distinguishes between so-called “hard wired plans,” which mandate investment in employer stock, and those in which the investment is at the discretion of the fiduciaries.  In the Court’s view this argument whiffed because, as Justice Breyer pointed out, ERISA’s Documents Rule clearly states that it applies only “insofar as such documents and instruments are consistent with [other provisions of ERISA],” which includes the duty of prudence, where we find an exception for ESOP fiduciaries “insofar as [prudence] requires diversification.”

Applying standard rules of statutory construction, Justice Breyer furthermore observed that Congress has distinguished between ESOPs (“hard wired” or discretionary) and other plans by providing ESOP fiduciaries with a statutory exemption from the duty to diversify plan assets, both as a free standing fiduciary duty and as an exception under its sister duty of prudence, but that’s it.  Having roundly criticized the lower courts for mushy thinking in concocting the Moensch Presumption, none of the nine Supreme Court Justices seemed inclined to find the requisite “penumbra” under the “Prudent man standard of care” to divine unstated exceptions to the duty of prudence.  It should be settled that, post Dudenhoeffer, ERISA’s duty of prudence (as limited for ESOP fiduciaries regarding diversification) trumps the Documents Rule.  ESOP fiduciaries should be on notice that the “Sergeant Shultz defense” (“I was only following orders”) is unavailing in defending an imprudence claim that is not based on a failure to diversify plan assets.

Justice Breyer acknowledged that, compared to other ERISA fiduciaries, ESOP fiduciaries are exposed to a heightened vulnerability in a stock drop case, given the inherent volatility of the price of a single stock, and have an understandable desire to avoid costly and intrusive discovery orders in confronting frivolous law suits.  However, as an argument in support of the Moensch Presumption, this too was unpersuasive.

“[W]e do not believe that the presumption at issue here is an appropriate way to weed out meritless lawsuits or to provide the requisite “balancing.”  The proposed presumption makes it impossible for a plaintiff to state a duty-of-prudence claim, no matter how meritorious, unless the employer is in very bad economic circumstances. Such a rule does not readily divide the plausible sheep from the meritless goats. That important task can be better accomplished through careful, context-sensitive scrutiny of a complaint’s allegations.”


“Thus aside from the fact that ESOP fiduciaries are not liable for losses that result from a failure to diversify, they are subject to the same duty of prudence like other ERISA fiduciaries.”

On remand the Court instructed the Sixth Circuit to reconsider whether the complaint states a claim for breach of the duty of prudence by applying the “plausibility” standards developed in two earlier non-ERISA Supreme Court cases:  Ashcroft v. Iqbal, 556 U.S. 662 (2009) and Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007).  To summarize Iqbal and Twombly:

  • A claim that a decision not to sell employer stock that is publicly traded was imprudent based on allegations that a fiduciary should have recognized, on the basis of publicly available information, that the market was overvaluing or undervaluing the stock are generally implausible, barring special circumstances, and thus is insufficient to state a claim; and
  • A claim that a decision to continue to acquire shares of employer stock that is publicly traded was imprudent based on allegations that a fiduciary was in possession of material, nonpublic information about the employer, must plausibly allege an alternative action that the fiduciaries could have taken that (1) would have been legal, and (2) a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the plan than to help it.  Specifically, the Court said that where the complaint alleges imprudence based on a fiduciary’s failure to act on the basis of inside information, the trial court should apply the following analysis in considering a motion to dismiss:
    • ERISA’s duty of prudence never requires a fiduciary to break the law, including the insider trading laws;
    • The court must consider the extent to which imposing an ERISA-based obligation to either refrain from scheduled future purchases or the public disclosure of such information would conflict with complex insider trading and corporate disclosure requirements of federal securities laws or their objectives; and
    • Whether a prudent fiduciary in the defendant’s position could not have concluded that either refraining from future purchases or the disclosure of inside information would do more harm than good by causing the share price to drop further or at an accelerated rate with a concomitant drop in the value of shares already held by the plan.

While the Moensch Presumption is no more, the Fifth Third Bancorp 401(k) plan fiduciaries can take heart that the Iqbal/Twombly plausibility standards that have now replaced it are a daunting set of hurdles for the plaintiffs.  Since their complaint was not prepared in anticipation of this new pleading requirement, it’s unlikely that, following a “careful, context-sensitive scrutiny,” the allegations merit a reversal by the Sixth Circuit of the lower court’s original dismissal.

Going Forward.

The sudden demise of the Moensch Presumption leaves behind a jurisprudential vacuum for motions to dismiss in employer stock drop cases. Trial courts may revert to their general distaste for denying plaintiffs a chance at their day in court, especially where damages are potentially very large.  In opposing a fiduciary’s motion to dismiss, post Dudenhoeffer, plaintiffs will probably argue that the Supreme Court did not intend that the Iqbal/Twombly plausibility standards be so strictly applied that they become a classic “Catch 22″ and, by operation, a surrogate for the discredited Moensch Presumption.  In many cases plan participants cannot, absent reasonably targeted discovery, chart plausible alternative courses of action, navigating intricate securities laws, or make sufficiently informed allegations regarding complex factual issues, especially if they concern inside information.  One approach a court may consider is to split the baby by taking the fiduciary’s motion to dismiss under advisement, while allowing the plaintiffs to amend their complaint after issuing highly restricted discovery orders.

The Supreme Court all but held that imprudence claims based on a fiduciary’s failure to sell publicly traded shares without considering public information in assessing whether the market price fairly stated their value are per se implausible, but not quite.  It did leave the door slightly open for such allegations to survive a motion to dismiss.  The Court said that, while the classic Modern Portfolio Theory generally supports a fiduciary’s reliance on the market valuation of employer stock, there may yet be a “special circumstance affecting the reliability of the market price as an unbiased assessment of the security’s value in light of all public information.”  The Court left it to the lower courts to explain further what it meant by such a “special circumstance.”

Fiduciaries of plans holding nonpublic stock should take note that the Iqbal/Twombly plausibility standards appear to be inapplicable as a pleading requirement in that context.  Therefore, motions to dismiss by the fiduciaries of such plans will presumably be denied with greater regularity.   About the only takeaway for them is the demise of the Moensch Presumption and the troubling notion that they “are subject to the same duty of prudence like other ERISA fiduciaries.”  We can expect fiduciary breach complaints regarding nonpublicly traded employer stock to recite those words from Justice Breyer’s opinion like a mantra.

What’s next? 

On July 15, 2014, the Fifth Circuit vacated the dismissal of a similar complaint by the Federal District Court for the Central District of Texas because the basis for dismissal was the lower court’s reliance on Moensch.  Whitley v. BP, PLC (No. 12-20670). Remanded back to the trail court, the plaintiffs will presumably amend their complaint to take into account the Iqbal/Twombly plausibility standards and, for the first time, we will see how a trial court comes to grips with these issues shorn of the fanciful notion of “presumptive prudence.”

In Whitley the plaintiffs are participants in plans maintained by BP North America, Inc., a subsidiary of the UK company, British Petroleum.  One of the investment options available under each plan is the “BP Stock Fund,” which consists mainly of publicly traded BP American Depository Shares (‘BP Shares”).  BP Shares comprised about one-third of the assets of each plan.  After the Deepwater Horizon oil spill disaster in the Gulf of Mexico in 2010, the value of BP Shares dropped precipitously and the plans sustained major losses.   Plaintiffs claim that the plan fiduciaries breached their duty of prudence by failing to take appropriate steps based on information in their possession and by engaging in misrepresentations and omissions of material information they possessed in their capacity as ERISA fiduciaries.  If these allegations cannot survive a “careful, context-sensitive scrutiny,” then what sorts of allegations ever would?  Will the court find the “special circumstance” discussed by Justice Breyer that limits the reliability of the market price of BP shares?  Stay tuned. 

Independent Fiduciaries.

By definition, bona fide independent fiduciaries are not insiders of the plan sponsor.  Consequently, they would rarely, if ever, be in possession of material nonpublic information about the plan sponsor’s financial condition.  As a practical matter, in the context of plans holding publicly traded employer stock, imprudence claims against independent fiduciaries, whether for failure to sell shares held by the plan (based on public information) or for failure to suspend future purchases (based on the fiduciary’s possession of material nonpublic information), are the least likely to survive motions to dismiss.  Adopting a plan governance posture with the lowest risk of subjecting the plan sponsor to intrusive and expensive discovery is one more reason that delegation of ESOP management responsibilities to independent fiduciaries will make sense.  Given the uncertainty surrounding even the most objective valuations of nonpublicly traded stock, such a posture may be the only hope a private company has that a court will dismiss imprudence claims.