Pension & Benefits News ESOP fiduciaries not required under duty of prudence to disclose inside knowledge of information artificially inflating company stock
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Wednesday, October 10, 2018

ESOP fiduciaries not required under duty of prudence to disclose inside knowledge of information artificially inflating company stock

By Pension and Benefits Editorial Staff

Employee stock ownership plan (ESOP) fiduciaries did not breach their duty of prudence under ERISA by continuing to offer company stock as an investment option despite insider knowledge that the stock was artificially inflated and an imprudent investment option, according to a federal trial court in Kentucky. Alternative actions suggested by the participants, such as early disclosure of the information, were not sufficient to state a claim under the Dudenhoeffer pleading standard because a similarly situated prudent fiduciary could view the actions as more likely to harm than help the plan.

Stock drop following disclosure of criminal actions by company employees.  General Cable maintains an ESOP that allows plan participants to invest in company stock. During the period 2014-2016, the company publicly disclosed that employees of its foreign subsidiaries had violated the Foreign Corrupt Practices Act (FCPA) by paying bribes to foreign government officials. The public disclosure caused a significant drop in the value of the company’s stock, resulting in significant losses for participants invested in the stock.

Plan participants subsequently brought suit, alleging that, prior to the public disclosure, the fiduciaries breached their duties under ERISA by continuing to offer the company stock as an investment option even though they knew or should have known, based on insider knowledge, that the stock was being artificially inflated because the violations had not yet been reported. By continuing to offer what they knew was an imprudent investment, the participants averred, the fiduciaries violated their duties of prudence and loyalty.

The participants further charged that, in order to protect plan participants from harm, the fiduciaries should have: made early and candid disclosures of the FCPA violations; frozen further purchases of company stock and held contributions in cash or some other short-term investment; sought guidance from the DOL or SEC; resigned as plan fiduciaries to the extent they could not act loyally and prudently; and retained outside experts to serve as advisors or independent fiduciaries for the plan.

The trial court agreed with the fiduciaries that the participants’ complaint failed to state a claim for breach of the duty of prudence, and dismissed the action. The participants’ claims that the fiduciaries also breached the duty of loyalty and the duty to monitor were viewed as derivative of the breach of the duty of prudence claim, and similarly dismissed, without leave to amend.

Failure to respond to inside information did not constitute breach of duty of prudence.  The participants alleged that the plan fiduciaries breached the duty of prudence by failing to act in response to non-public insider information (i.e., knowledge of the FCPA violation by the company employees). Initially, the trial court explained that, under the pleading standard articulated by the United States Supreme Court in Fifth Third Bancorp v. Dudenhoeffer (134 S. Ct 2459 (2014)), a party looking to state a claim for breach of the duty of prudence on the basis of inside information must plausibly allege an “alternative action that the fiduciaries could have taken that would have been consistent with the securities laws and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.”

Alternative actions more likely to hurt than help plan. The participants charged that the fiduciaries should have made early and candid disclosures of the FCPA violations because the “longer the concealment continued, the more of the Plan’s good money went into a bad investment.” However, the court noted that the Sixth Circuit and other courts have expressly rejected the participants’ argument, generally holding that a reasonable fiduciary could believe that disclosing negative information about a company would do more harm than good to the fund’s investment.

The court also found the participants’ contention that the fiduciaries should have (a) held participants’ contributions in cash or other short-term investments or (b) frozen further purchases to fall short of the Dudenhoeffer pleading standard. The court cited opinions from the Sixth Circuit that freezing purchases of company stock could do more harm than good by sending a negative signal to the market, causing a drop in the value of the stock. The participants’ belief that it was “extremely unlikely” that a stock purchase freeze would have an appreciable adverse impact on the price of the stock the court stressed, did not satisfy the requirement that no prudent fiduciary could have concluded that the proposed action would do more harm.

Similarly, the court noted that the Sixth Circuit has dismissed the cash-buffer alternative because a reasonable fiduciary could have concluded that adopting such an action would cause more harm than good. According to the Sixth Circuit, the cash-buffer alternative would cause an investment drag, under which the return on the cash stored in the buffer is less than the cash invested in stock.

Source: Eley v. General Cable Corp. (DC KY).

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