By Pension and Benefits Editorial Staff
Actions that plan fiduciaries could have taken as an alternative to continued investment in an artificially inflated company stock fund were not sufficient to state a fiduciary breach claim under ERISA, according to the U.S. Court of Appeals in New Orleans (CA-5), because the actions would be viewed by a prudent fiduciary as more likely to harm the fund than to help it. Applying a pleading standard that effectively goes beyond the Dudenhoeffer test articulated by the Supreme Court, the Fifth Circuit panel concluded that proposed alternative actions, such as freezing investments in the company stock fund, corrective public disclosures, and the diversion of the fund holdings into a low-cost hedging products were not so clearly beneficial that a prudent fiduciary could not conclude that they would be more likely to harm the fund by lowering the company’s stock price.
Alleged overpricing scheme causes drop in company stock held in ESOP. Whole Foods Market, Inc., maintains a 401(k) plan that allows participants to invest in a Company Stock Fund that was structured as an employee stock ownership plan (ESOP). While plan participants invested in the Fund, Whole Foods was subject to separate investigations in 2014 and 2015 by state officials in California and New York over allegations that it operated a widespread and systematic scheme to overcharge customers by overstating the weight of its pre-packaged products. Whole Foods eventually settled the claims and agreed to pay substantial monetary penalties.
During the period in which it was under investigation, Whole Foods continued to report growth in revenue and make representations about its integrity and reputation, which were designed to convince investors (including plan participants) of the company’s commitment to consumer value and corporate responsibility. However, in July 2015, Whole Foods filed a Form 8-K, reporting financial and operating results which fell below expectations. As a consequence, Whole Foods stock, which had peaked $63 per share in October 2013 and stabilized at $40 per share in June 2015, declined to $36.08 per share on July 30, 2015 following public disclosure of the New York investigation.
In October 2015, a plan participant filed suit against company officers serving as plan fiduciaries, alleging that they breached their duty under ERISA to protect plan participants from the foreseeable injury resulting from Whole Foods’ undisclosed misrepresentations and fraud. According to the participants, the fiduciaries knew or should have known that the company stock price was artificially inflated by the fraudulent scheme.
A federal trial court dismissed the participant’s claims without prejudice. In August 2017, the court subsequently dismissed the amended complaint, concluding that the participant failed to state a claim for fiduciary breach. The appeals court, applying the pleading standard articulated by the United States Supreme Court and further narrowed by the Fifth Circuit, affirmed.
Alternatives to continued investment rejected as risking loss to plan from lower stock price. In addressing the fiduciary breach claim, the appeals court explained that, in order to state a claim for breach of the duty of prudence by an ESOP fiduciary on the basis of public or inside information, a party must allege an alternate action that the fiduciary could have taken that would have been consistent with securities law and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it (Fifth Third Bancorp v. Dudenhoeffer, U.S. Sup Ct (2014), 134 S. Ct 2459). According to the Supreme Court, a complaint must allege that a prudent fiduciary in the same position could not have concluded that the alternative action would do more harm than good (Amgen, Inc. v. Harris, U.S. Sup Ct (2016), 136 S. Ct. 758). The Fifth Circuit has applied the Supreme Court precedents to further require a plaintiff to propose an alternative course of action “so clearly beneficial that a prudent fiduciary could not conclude that it would be more likely to harm the fund than to help it” (Whitley v. BP, PLC, CA-5 (2016), 838 F. 3d 523).
In order to meet the applicable pleading standards, the participant suggested that the fiduciaries should have: (1) temporarily closed or frozen the company stock fund until Whole Foods became a prudent investment, or (2) effectuated corrective, public disclosures to cure the fraud, thereby making Whole Foods stock an accurately priced, prudent investment again. The trial court rejected the alternative actions, reasoning that, because they would make the stock price drop, a prudent fiduciary could easily conclude that the proposal would do more harm than good.
In the amended complaint, the participant attempted to further buttress the proposed alternative actions by maintaining that the fiduciaries knew or should have known that allowing a fraud to persist will result in greater damage to investors. Accordingly, the participant argued, the fiduciaries should have disclosed the alleged fraudulent conduct earlier to reduce the damage, including the “reputational penalty” impressed upon the company following disclosure of the fraud.
The appeals court agreed with the trial court that the generic allegations were not sufficient to satisfy the Whitley standard. Even assuming the validity of the general principle, the Fifth Circuit has forcefully held that prudent fiduciary could easily conclude that taking any action that might expose fraudulent conduct might do more harm than good to the plan.
The participant further argued that the fiduciaries should have factored into their analysis of whether earlier disclosures would have done more harm than good to the plan the fact that the plan was a net buyer of the Whole Foods stock. Because the plan was a net purchaser of the stock, the participant averred, any potential benefit to the seller of the stock would have been outweighed by harm to the purchaser.
Bound by Whitley, the trial court ruled that it would be difficult to conclude that “any” alternative action that indisputably lowers the company’s stock price would be “so clearly beneficial” that a prudent fiduciary could determine that it would be more likely to harm the Fund than to help it. The appeals court agreed, noting that even if a prudent fiduciary could have predicted that the plan would become a net purchaser of the company stock over time, that fact alone would not show that an earlier disclosure would be “so clearly beneficial” that no prudent fiduciary would consider it more likely to harm than help the plan. A prudent fiduciary could conclude, the court stressed, that the risk to a company’s stock price of an unusually timed disclosure outweighed the potential benefits of an early disclosure, regardless of the plan’s status as a net purchaser.
Diversion of company stock to low-cost hedging product. In the amended complaint, the participant further suggested that the fiduciary should have diverted some of the Company Stock Fund’s holding into a low-cost hedging product that would function in a countercyclical manner with respect to the Whole Foods stock. The hedging product would be structured as an irrevocable trust and pool funds together from financially healthy and diverse companies for a fixed period of time. The pooled funds would be conservatively invested (e.g., in U.S. Treasury Securities). After the conclusion of the fixed period, the trust would restore any losses caused by a decline in the price of the company stock.
The participant further claimed that, because such hedging products are not derivatives, the purchase of them by the ESOP would not be a disclosable event under federal securities law. The trial court, however, questioned why a reallocation of the Fund’s assets from an investment solely in company stock to an investment in a hedging product would not be a “qualified change in investment options,” which must be disclosed under ERISA Sec. 404(c)(4)(b)(i). Accordingly, the trial court found that a prudent fiduciary could conclude that utilizing the hedging fund product would require disclosure to plan participants, thereby risking a drop in the stock price.
The appeals court, similarly recognizing that the required disclosure of the hedging product was an unsettled question, reasoned that a prudent fiduciary could conclude that such a product would risk a disclosure, thus, rendering it more likely to harm the fund that to help it. Therefore, the hedging product was not a plausible alternative to continued investment in Whole Foods stock sufficient to satisfy the governing pleading standards.
Source: Martone v. Robb (CA-5).
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