The DOL has filed a brief with the U.S. Supreme Court in the Dudenhoeffer v. Fifth Third Bank employee stock ownership plan (“ESOP”) dispute that made me think about Boundaries, a book about the importance of establishing boundaries, and compelling respect for those boundaries. In designing ERISA, Congress forged a delicate balance between protecting benefit plans and encouraging employers to provide those benefit plans. The U.S. Supreme Court reminded us in CIGNA v. Amara that this delicate balance includes carefully distinguishing the roles of plan sponsors and fiduciaries, even when one entity (e.g., the employer) wears both hats. The Court ruled that CIGNA, while acting as plan fiduciary, did not have authority to change the terms of the plan as written by CIGNA, acting as plan sponsor.
ERISA sets forth provisions that allow an employer to establish a qualified plan that is an ESOP, with favorable benefits. The plan sponsor can write a plan so that the entire plan is in an ESOP, or so that one portion of the plan is the ESOP. An ESOP is a plan design component: it must be written to invest primarily in employer securities, and is exempted from certain other requirements, most notably the diversification requirement. An ESOP can even be written so that the ESOP owns all of the stock of an S Corporation, effectively paying no corporate income tax. The plan document requirements are so extensive that ESOP sponsors had to wait about four years to receive their most recent favorable determination letters from the IRS. Thus, many believe that selling off employer stock (terminating the ESOP) would require a plan sponsor amendment. The concept that the ESOP exists and invests in employer securities as a matter of plan design rather than fiduciary discretion is referred to as “hardwiring.”
But some participants have argued that an ESOP invests in employer stock via fiduciary discretion, and that the fiduciary must continuously consider whether the employer stock remains a prudent investment. These arguments have arisen in “stock drop” cases, where an employer’s stock price has fallen. Courts have addressed this plan sponsor / fiduciary boundary dispute by applying a presumption of prudence of investment (e.g., Moench presumption), absent certain circumstances such as dire financial straits. The details and application of the presumption vary by circuit. Most ERISA stock drop cases have been dismissed an early stage, based on the presumption of prudence. In Dudenhoeffer v. Fifth Third Bank, however, the Sixth Circuit Court of Appeals caused a circuit split by ruling that this presumption does not apply at the initial stage of a case. At the invitation of the U.S. Supreme Court, the DOL filed a brief as amicus curiae. The DOL argues not only that the Supreme Court needs to hear this case, but that it should reframe the questions, rule that an ESOP is an investment that is subject to divestment and prudence review in the same manner as other investments, rule that the presumption does not exist at the initial state, and rule that the presumption of prudence does not exist, at all.
There is a secondary issue in Dudenhoeffer, regarding whether a misstatement in an SEC filing results in an ERISA breach of fiduciary duty because the summary plan description (“SPD”) incorporates the SEC filing by reference. The DOL argues that it does, and that this is so clear that the Court need not consider the issue. The reason for this incorporation relates to Securities Act requirements for prospectuses, including a provision that allows an SEC registrant to rely on documents such as the SPD to serve as the prospectus, provided that it incorporates by reference the SEC filings. So an SPD may serve as the prospectus and incorporates by reference the company’s other securities filings. The argument is that this incorporation by reference make all SEC filings fiduciary communications. We would call this another boundary dispute regarding the role of the employer for SEC purposes, versus the role of the employer as a fiduciary, and question whether the answer is clear.
Whether the U.S. Supreme Court takes this case, and how it rules, is very important to employees who participate in ESOPs, and to their employers, for the following reasons.
- Liquidating an ESOP is not like liquidating any other investment fund and replacing it with another; it can be the equivalent of hitting the nuclear button in terms of its consequences for the company, and for the shareholders, both inside and outside the ESOP.
- Many ESOPs are structured in a manner that allows participants to choose how much or how little of an interest to hold in the ESOP. Litigation may be brought by participants who failed to diversify their investments, and failed to watch performance. If a fiduciary decides to liquidate because of this risk, the ESOP participants who wanted to remain invested will not have any opportunity to recover their losses if the stock price begins to recover. In other words, treating the employer stock as an investment that the fiduciary can elect to liquidate at any moment creates adversity among the participants’ interests and the likelihood of litigation when the stock price declines, regardless of whether the stock is held or sold.
- Many ERISA stock drop claims are based on business judgment and securities fraud claims (boundaries). Plaintiffs rarely succeed with these claims, but this litigation is expensive. Employers have to ask whether the risk is worth offering the employer stock, and who will pay for the litigation (e.g., the employer, or the plan participants, where appropriate).
If the U.S. Supreme Court decides to take this case, it could reject the DOL’s arguments on the same basis that it rejected the DOL’s arguments in CIGNA v. Amara: the plan fiduciary must respect the boundaries of the plan document, and cannot change the plan terms as written by the sponsor. In this case that means the plan sponsor drafted the ESOP to be designed to invest primarily in employer securities, and the plan fiduciary must respect that boundary. Or the Court could rule that a presumption of prudence applies, and reverse the Sixth Circuit’s determination that the presumption does not apply at the initial stage. Either ruling would maintain the status quo for ESOPs.
A U.S. Supreme Court ruling that the presumption of prudence does not apply at the initial stage, or a ruling that the presumption does not apply at all, would seemingly eviscerate the statutory boundaries that favor ESOPs, and likely have a significant chilling effect. Employers would have to consider whether the ESOP model remains viable and is worth the risk. For publicly traded companies, such a decision could cause a precipitous sell-off of employer stock that drives down the stock price. This would harm all the stockholders, and most acutely harm the ESOP participants who would no longer be able to benefit from a rebounding of the stock price. For privately held companies, such a decision would put the employer in a constant quandary about whether their business model and ownership structure are viable, especially if the ESOP owns 100% of the stock. Do you focus on the business, or potential purchasers of the business, and will your business decisions result in ERISA fiduciary breach claims?
If you are an employer who maintains an ESOP, an investor in a company that maintains an ESOP, or a participant in an ESOP, you need to be aware that this boundary dispute poses risk to you, and stay tuned….