Pension & Benefits News Failure of fiduciaries to disclose non-public information prior to stock drop did not breach duties of prudence or loyalty
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Friday, December 11, 2020

Failure of fiduciaries to disclose non-public information prior to stock drop did not breach duties of prudence or loyalty

By Pension and Benefits Editorial Staff

Plan fiduciaries, who failed to disclose non-public information regarding the unethical sales practices of the plan sponsor prior to a drop in the value of the company’s stock, did not breach their duties of prudence or loyalty, according to U.S. Court of Appeals in St. Louis (CA-8). Rejecting a standard affirmed by the Second Circuit, the court stated that a prudent fiduciary, with knowledge that disclosure is inevitable, and that early disclosure would ameliorate harm to the stock price, may still conclude that disclosure, prior to the completion of a government investigation, would do more harm than good to the plan and its participants.

Undisclosed unethical sales practices lead to severe stock drop. Well Fargo sponsors a 401(k) plan that allows eligible employees to contribute to individual accounts. Two of the plan’s investment funds consist primarily of Wells Fargo stock. In addition, all matching contributions made by Wells Fargo are invested automatically in company stock. Accordingly, at any given time, a large portion of the plan’s assets (an estimated 34%) is invested in Wells Fargo company stock.

In September 2016, following the disclosure by the federal government of widespread fraud and unethical sale practices at Wells Fargo (allegedly dating back to 2004) the value of the company stock declined substantially (a loss in market capitalization of $18 billion between September 7, 2016 and September 15, 2016). Participants in the 401(k) plan, who experienced losses, brought suit against plan fiduciaries, who were also corporate insiders, alleging that they breached their duty of prudence under ERISA by failing to disclose their knowledge of the improper sales practices prior to 2016. According to the participants, if the fiduciaries had disclosed the inside information prior to September 2016, the value of the Wells Fargo stock in their individual plan accounts would not have declined as much as it did following the disclosure. An earlier disclosure, the participants maintained, would not only have mitigated the impact of the disclosure on the Wells Fargo stock price, but allowed the plan to discontinue purchasing the stock at an inflated price. The fiduciaries moved to dismiss the claim.

A federal trial court ruled that the failure of plan fiduciaries to disclose inside knowledge of a company’s unethical sales practices before the revelation adversely affected the value of the company’s stock did not breach the applicable duty of prudence (In re: Wells Fargo ERISA 401(k) Litigation). Subsequently, the court also rejected the participants’ breach of the duty of loyalty claim. The court declined to apply the Dudenhoeffer pleading standard to the loyalty claim, but it determined that the participants failed to plead sufficient facts to state a claim for relief that was plausible on its face (In re: Wells Fargo Litigation).

Breach of duty of prudence. On appeal, challenging the dismissal of the breach of the duty of prudence claim, the participants argued that the fiduciaries should have: (1) publicly disclosed the unethical sales practices, and (2) frozen purchases in the Wells Fargo Stock Funds. However, because the fiduciaries could not have implemented a stock purchase without disclosing the unethical sales practices, the appeals court focused its analysis on whether the fiduciaries were required to publicly disclose the non-public information.

Initially, the Eighth Circuit noted that most appellate courts that have considered breach of the duty of prudence claims based on inside information have rejected the argument that public disclosure of inside information is a plausible alternative action. The participants stressed, however, that the fiduciaries should have known that public disclosure of the fraud was inevitable. Accordingly, the participants reasoned, the fiduciaries should have known, pursuant to general economic principles, that continuing to conceal the fraud would result in in greater harm to company’s reputation and the stock price.

The appeals court first cited the Fifth Circuit (Martone v. Robb) and the Ninth Circuit (Laffen v. Hewlett-Packard Co., CA-9 (2018), 721 F. App’x 642) as having rejected the argument that a prudent fiduciary could not plausibly conclude that early disclosure of negative inside information would do more harm than good. However, the court also acknowledged that the Second Circuit has accepted the participants’ argument, concluding that where disclosure of a fraud (and the concomitant stock drop) is inevitable, it is plausible that a prudent fiduciary would prefer to limit the effects of the stock’s artificial inflation on plan beneficiaries through prompt disclosure (Jander v. Retirement Plans Committee of IBM).

Partcipants’ allegation, based on the general economic principle that the longer a fraud is concealed the greater the harm to a company’s reputation and stock price, to be “too generic” to meet the requisite pleading standard. Noting that the fiduciaries knew that government regulators were investigating the company’s sales practices, the court further reasoned that a prudent fiduciary, including one who knows disclosure is inevitable and that earlier disclosure would ameliorate some harm to the company’s stock price and reputation, could readily conclude that it would do more harm than good to disclose information about the company’s sales practices prior to the completion of the government’s investigation. Thus, the court agreed with the Sixth Circuit that, while earlier disclosure may have ameliorated some of the harm sustained by the stock funds, that course of action was not so clearly beneficial that a prudent fiduciary could not determine that it would be more likely to harm the fund than to help it (Graham v. Fearon, CA-6 (2018), 721 F. App’x 429).

Breach of the duty of loyalty. The participants further charged on appeal that the fiduciaries breached their duty of loyalty by failing to disclose to plan participants material information about Wells Fargo’s unethical and illegal sales practices. The Eighth Circuit, in rejecting the argument, stressed that the duty of loyalty does not require disclosure of non-public information about the company that might impact plan participants. The court agreed with the Eleventh Circuit that imposing an affirmative duty on plan fiduciaries to disclose non-public information that would have an impact on company stock would transform the fiduciaries into investment advisors (Lanfear v. Home Depot, Inc).

Alternatively, the participants argued that the fiduciaries breached the duty of loyal because of conflicts of interest. Specifically, the participants charged that the fiduciaries elected not to disclose the unethical sales practices so as not to jeopardize their executive positions within the company. The court found the participants’ argument to be conclusory and unsupported by any specific facts, beyond an understanding, dismissed by the court, that a high-ranking position within a company is sufficient to create a plausible inference of disloyal conduct due to a conflict of interest.

The participants, as a final point, suggested that the fiduciaries acted disloyally in selling their Wells Fargo stock at discounted prices. However, noting that company officers are allowed to sell stock periodically, the court found insufficient evidence, beyond the stock sale, to give rise to a plausible inference of a breach of the duty of loyalty.

Source: Allen v. Wells Fargo & Company (CA-8).

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