By Pension and Benefits Editorial Staff
Employee stock ownership plan (ESOP) participants plausibly pled that plan fiduciaries breached their duty of prudence under ERISA by failing to disclose the financial condition of a company subdivision, thereby allowing for the overvaluation of the company stock prior to a decline in value, according to the U.S. Court of Appeals in New York (CA-2). In reversing the trial court, the court concluded that no prudent fiduciary in the position of the plan officials could have concluded that early corrective disclosure would do more harm than good.
Stock drop following investment in inflated stock. IBM sponsored a defined contribution plan that, among other investment options, allowed participants to invest in an ESOP that primarily invested in IBM stock (the “Fund"). Plan participants brought suit following a 7.11% drop in the value of company stock, precipitated by the company’s divestiture, at a cost of $1.5 billion, of a microelectronics subsidiary and $4.7 billion pre-tax charge. The participants maintained that IBM and plan fiduciaries misrepresented and concealed the financial status of the subsidiary, allowing the plan to continue to invest in artificially inflated stock, which subsequently declined in value when the status of the subsidiary was revealed.
A U.S. district court in New York dismissed the participants’ fiduciary breach claim in September 2016, for failure to plead facts giving rise to an inference that the fiduciaries could not have concluded that public disclosure or discontinuing the purchase of IBM stock would more likely harm than help the fund (Jander v. Retirement Plans Committee of IBM). However, the court allowed the participants to re-plead their claim with greater specificity, in order to comply with the pleading requirements stipulated by the United States Supreme Court in Fifth Third Bancorp v. Dudenhoefer and Amgen v. Harris.
In disposing of the second amended complaint, the trial court determined that the failure of the plan fiduciaries to mitigate the effects of a foreseeable drop in a company’s stock price by failing to disclose the financial status of a subsidiary prior to divestiture, discontinue trading in company stock, or purchase a hedging product were not actionable fiduciary breaches under ERISA because the plan participants failed to establish the inference that a reasonable fiduciary would not have concluded that the proposed corrective actions would had done more harm than good to the plan (Jander v. Retirement Plans Committee of IBM.
Early corrective disclosure. On appeal, the participants focused on the proposed alternative action of early corrective disclosure. At the trial court level, the participants, noting that the fund purchased $111 million in IBM stock in 2014, charged that the fiduciaries could have ended the artificial inflation in the company’s stock price by making an earlier disclosure of the financial status of the subsidiary and the attendant fraud and misrepresentations.
The trial court dismissed the premise of the participants’ corrective disclosure argument as theoretical and untested. The participants, the court concluded, failed to articulate any numeric or comparative basis from which a prudent fiduciary could not conclude that early disclosure would do more harm than good.
Second Circuit finds plausible breach in failure to disclose. In reversing, the Second Circuit dismantled the reasons underlying the trial court’s concern that the early corrective disclosures would “spook” the market.
Initially, the appeals court dismissed the concern that an unusual disclosure outside the securities’ laws normal reporting regime would cause a more significant drop in the IBM stock price than if the disclosures were made though the customary procedures. The participants plausibly alleged, the court stressed, that the disclosures could have been included within IBM’s quarterly SEC filings and disclosed to the ESOP beneficiaries at the same time in the plan officials’ fiduciary capacity.
The appeals court next reasoned that a reasonable business executive could plausibly foresee that the inevitable disclosure of longstanding corporate fraud would reflect badly on the company and undermine faith in its future pronouncements. Thus, in advocating early disclosure, the participants’ focus on the “reputational damage” of the perpetuated fraud could not be dismissed as merely an argument based on hindsight.
The trial court rejected the suggestion that early disclosure would have minimized the eventual stock correction as not sufficiently “particular to the facts” of the case. By contrast, the appeals court noted that assertions grounded in economic studies of general market experience cannot be dismissed as merely theoretical. While the economic analyses would usually not be enough on its own to plead a duty of prudence violation, they needed to be considered by a court in determining whether early disclosure would have been dangerous (i.e. done more harm than good).
The trial court expressed concern over market reaction to the disclosure of fraud. However, the appeals court agreed with the participants’ argument that, as IBM stock traded in an efficient market, the correction of the company’s fraud would reduce the company’s stock price by only the amount by which it was artificially inflated. Accordingly, the court found that the participants plausibly alleged that a prudent fiduciary would not need to fear an irrational overreaction to disclosure of the fraud.
In further dismissing the trial court’s concern that disclosure would spook potential buyers of the troubled subdivision, the appeals court noted that the disclosure of the truth regarding the actual financial condition of the division was inevitable, as IBM could not hide the overvaluation from the public following the sale of the unit. Under such circumstances, the court advised, a prudent fiduciary could plausibly prefer to limit the effects of the stock’s artificial inflation on plan beneficiaries through prompt disclosure. A potential buyer of the overvalued business would not be spooked by public disclosure of what the buyer would have discovered through its own due diligence.
Finally, the appeals court rejected the trial court’s ruling that the participants’ corrective disclosure theory did not sufficiently account for the effect of disclosure on the value of the stock already held by the fund. Reemphasizing that nondisclosure of IBM’s financial troubles was no longer a realistic option, the appeals court reasoned that a stock drop following early disclosure would not have been more harmful than the inevitable stock drop that would occur following a later disclosure.
Drawing all reasonable inferences in their favor, the appeals court concluded that the participants had sufficiently pleaded that no prudent fiduciary in the IBM defendants’ position could have concluded that earlier disclosure would have done more harm than good. Accordingly, the participants adequately stated a claim for breach of the ERISA’s duty of prudence, which would be litigated on remand.
SOURCE: Jander v. Retirement Plans Committee of IBM (CA-2).
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