Today, The Legal Intelligencer -- America's oldest daily law journal and the most trusted source of Pennsylvania legal news -- published an article that Mr. LeVan authored entitled "New Standards Announced for ERISA Company Stock Case." A copy of the article can be viewed here.
How Winning a Case Can Destroy Your Practice (aka Supreme Court Throws Out ERISA "Presumption of Prudence" And Then Guts an Entire Area of the Law Through Unsupported and Flawed Guidance)
If my children ever ask me to define the phrase "Pyrrhic victory," I now have a ready answer: Go read Fifth Third Bancorp v. Dudenhoeffer, an ERISA opinion the Supreme Court issued last week.
In Fifth Third, a unanimous Court held that fiduciaries of employee stock ownership plans (ESOPs) are not entitled to a defense-friendly presumption that continuing to invest in employer stock is prudent; instead, ESOP fiduciaries must comply with the same stringent requirement of prudence (except to the extent that it would require diversification of plan assets) that ERISA imposes on all plan fiduciaries. In so ruling, the Supreme Court disagreed with every Court of Appeals that had addressed the issue.
Score one for the ERISA plaintiffs' bar, right? Not so fast.
In a stunning move, the Supreme Court, under the guise of providing guidance to lower courts, then proceeded to eviscerate an entire category of active ERISA cases with almost no legal analysis and with little, if any, acknowledgement of the broad-ranging effects of its ruling. More troublingly, the Court's extemporaneous foray into the plausibility of ERISA employer stock allegations (1) improperly focused on stock price while ignoring issues of investment risk, (2) employed grossly flawed logic -- for instance, suggesting that an ERISA fiduciary with material non-public information may lawfully continue purchasing artificially-inflated stock to prop up the stock price (securities fraud, anyone?), and (3) ventured well beyond the scope of the only question properly before it, addressing complicated legal and economic issues without the benefit of substantive briefing or critical input from stakeholders. The extent of errors the Court made in the second half of its opinion is breathtaking.
Before we jump to the details, one important disclosure: While at my prior firm, I argued this case on behalf of plaintiff Dudenhoeffer in the United States Court of Appeals for the Sixth Circuit immediately below (i.e., the decision on appeal). At my prior firm, I also acted as lead counsel in numerous ERISA company stock cases filed against some of the largest corporations in the world. Although I left that firm well in advance of the Fifth Third briefing before the Supreme Court, I likely carry a predisposition towards the legal validity of such claims. With that said, I also bring significant experience and knowledge of the subject matter area at issue. The numerous infirmities of the opinion lead me to question whether those involved in drafting Fifth Third can make the same claim.
Now to the details: Prior to Fifth Third, federal courts around the country had held that ESOP fiduciaries were entitled to a "presumption of prudence" when their decision to buy or hold company stock was challenged by a plan participant as imprudent. Those courts reasoned that a presumption was appropriate given the unique nature of an ESOP, which is a plan designed to invest primarily or exclusively in employer stock. In light of an ESOP's singular purpose, the courts found that its fiduciaries should be presumed to have acted prudently when continuing to purchase and hold employer stock but that a plaintiff could rebut the presumption by showing that the fiduciary had "abused its discretion" -- or, put another way, by showing that the fiduciary could not have reasonably believed that continuing to purchase or hold the stock was in keeping with the settlor's expectation of how a prudent fiduciary would act. See, e.g., Moench v. Robertson, 62 F.3d 553, 571 (3d Cir. 1995). This defense-friendly presumption had the effect of cloaking ESOP fiduciaries with a level of protection from liability under most circumstances.
Although the lower courts generally agreed that a "presumption of prudence" was available to ESOP fiduciaries, they differed substantially on when in the litigation fiduciaries could invoke the protection. In Moench, the first federal appellate decision to adopt the theory, the court applied the presumption to a developed factual record on summary judgment. Over time, however, other courts had ruled that the doctrine applied from the start of a case and that, in order to plausibly state a cognizable claim, ERISA plaintiffs must plead facts in their complaint sufficient to overcome the presumption. See, e.g., In re Citigroup ERISA Litig., 662 F.3d 128, 139-40 (2d Cir. 2011) (presumption of prudence applies at pleadings stage and requires plaintiff to allege that company was in "dire [financial] situation" unforeseen by settlor). Such rulings were troublesome to ERISA plaintiffs because their cases were subject to dismissal unless they were capable of proving their case before discovery even began.
Enter Fifth Third: At the district court level, the trial judge dismissed the complaint, concluding that the "presumption of prudence" applied on the pleadings and that plaintiffs had failed to sufficiently plead around the presumption. Dudenhoeffer v. Fifth Third Bancorp, 757 F. Supp. 2d 753 (S.D. Ohio 2010). On appeal, the Sixth Circuit reversed, holding that the "presumption of prudence" is an evidentiary presumption that does not apply until plaintiffs have had the ability to develop a full evidentiary record -- usually on summary judgment or at trial. Dudenhoeffer v. Fifth Third Bancorp, 692 F.3d 410 (2012).
Fifth Third filed a petition for writ of certiorari and the Supreme Court granted the petition limited to a single question: "Whether the Sixth Circuit erred by holding that Respondents were not required to plausibly allege in their complaint that the fiduciaries of an employee stock ownership plan ("ESOP") abused their discretion by remaining invested in employer stock, in order to overcome the presumption that their decision to invest in employer stock was reasonable, as required by the Employee Retirement Income Security Act of 1974, 29 U.S.C. ss 1101, et seq. ("ERISA"), and every circuit to address the issue." See Fifth Third Bancorp v. Dudenhoeffer, 2013 U.S. Lexis 9024 (Dec. 13, 2013) (granting petition for writ of certiorari limited to question 1 presented by petition); Fifth Third's Petition for Writ of Certiorari at i (Question 1).
Writing for a unanimous Court, Justice Breyer quickly disposed of the only issue before it. Notwithstanding the lower courts' near-universal recognition of the "presumption of prudence," the Supreme Court held that "the law does not create a special presumption favoring ESOP fiduciaries[;] [r]ather, the same standard of prudence applies to all ERISA fiduciaries, including ESOP fiduciaries, except that an ESOP fiduciary is under no duty to diversify the ESOP's holdings." Slip op., at 8. The Court reasoned that nothing in ERISA supported the existence of a special presumption for ESOP fiduciaries and that none of the arguments Fifth Third advanced -- concerning the special purpose of ESOPs, the avoidance of insider trading prohibitions, or the purported need to weed out meritless suits -- could trump the plain language of the statute. Id. at 8-15. ERISA imposes stringent obligations, including the duty of prudence, on all fiduciaries, the Court reasoned, and nothing about the special nature of ESOPs modified or reduced the extent of those legal obligations. Id.
Had the Court stopped there, I would have nothing but praise for the decision. The first part of the opinion is straight-forward, logical and well-supported by appropriate legal authority. ERISA defendants may not like elimination of the presumption but it's hard to argue with the Court's reasoning: The plain language of the statute imposes certain duties on ERISA fiduciaries, nothing in the statute authorizes a reduced set of duties for ESOP fiduciaries (other than elimination of the duty to diversify), and the policy arguments advanced by Fifth Third, even if accepted, do not authorize courts to graft a reduced standard of care for ESOP fiduciaries onto unambiguous statutory language.
The Court, however, lost its way when it failed to remand the case for further consideration in light of the ruling. Both the district court and the Sixth Circuit had ruled on the sufficiency of the complaint assuming the existence of the presumption (albeit differing on when that presumption should apply). Having rejected the presumption in its entirety, the Supreme Court should have remanded the case for reconsideration of the sufficiency of the complaint under the traditional pleading standards of Twombly and Iqbal and ended the opinion there. The only question before the Court was whether ESOP fiduciaries were entitled to a "presumption of prudence" on the pleadings; the general sufficiency of ERISA breach of fiduciary duty allegations involving employer stock was not at issue -- and, at a minimum, it had not been adequately briefed by the parties or the subject of expert consideration. Unfortunately, the Court paid no mind to this limitation and, rather than merely remanding the case, strayed far afield by offering ill-considered and unsupported guidance to lower courts about the sufficiency of allegations in ERISA employer stock cases. Slip op. at 16-20.
With respect to allegations that employer stock was imprudent based upon publicly available information, the Court stated that "where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances." Id. at 16. The Court reasoned that a fiduciary, like any other investor, should not be liable for failing to "out guess" the general market. Id. at 16-17. Regarding allegations that employer stock was imprudent based upon non-public material (or inside) information, the Court suggested that "[t]o state a claim for breach of the duty of prudence on the basis of inside information, a plaintiff must plausibly allege an alternative action that the defendant 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." Id. at 18. In that vein, the Court made three additional points: (1) fiduciaries cannot be compelled to violate the law (including the securities laws), (2) these issues implicate complex insider trading prohibitions and corporate disclosure requirements and (3) some actions that plaintiffs allege the fiduciaries should have taken, such as refraining from purchasing additional employer stock, may "do more harm than good to the fund by causing a drop in the stock price and a concomitant drop in the value of the stock already held by the fund." Id. at 19-20.
Wow, where to begin.
Okay, let's start with this: In providing this purported guidance to lower courts, the Court engaged in almost no legal analysis of any relevant issues -- it simply announced its views of plausibility without any tether to supporting authority. Unlike the first half of the opinion, which is rife with citations to statutory and legal precedents supporting its holding, the "guidance" portion of the opinion reads more like extemporaneous musings that are bereft of cogent reasoning or precedential authority. There is no true analysis. There is little development or explanation of the rationale behind the guidelines. And the few decisions the Court references are cited for unassailable legal principles, such as ERISA fiduciaries are not compelled to violate federal securities laws, rather than as direct (or even indirect) support for its views on the plausibility of allegations in ERISA employer stock cases. See, e.g., slip op. at 18-19. In essence, the Court's guidance consists of "it's this way because we say so."
Second, by focusing exclusively on stock price, the Court ignored the critical issue of investment risk, which more often than price may lead an investment option in an ESOP or 401(k) plan to be, or become, imprudent. Yes, it is clearly imprudent for a fiduciary to allow investment in a stock that he knows is trading at an artificially inflated price, but errors in stock prices are not the only -- or even the most likely -- reason an investment option may be imprudent. Even stocks trading at "correct" prices may be imprudent to offer in an ESOP or 401(k) plan if, for instance, the security is too speculative, risky or inappropriate for the purposes of the plan. Shares in Grandma's thimble collection may be appropriately priced but nonetheless remain an imprudent option for one's retirement savings. The Court, however, focused its consideration solely on stock price, giving the erroneous impression that imprudence is limited to those unique situations where a stock is not trading at its true value.
Third, some of the "logic" the Court employs in describing its "guidance" is patently wrong. At one point, the Court appears to suggest that ERISA fiduciaries may engage in securities fraud in order to prop up the price of employer stock. How? The Court states that where plaintiffs allege an ERISA fiduciary should have stopped making additional purchases of employer stock, courts should "consider whether the complaint has plausibly alleged that a prudent fiduciary in the defendant’s position could not have concluded that stopping purchases — which the market might take as a sign that insider fiduciaries viewed the employer’s stock as a bad investment — or publicly disclosing negative information would do more harm than good to the fund by causing a drop in the stock price and a concomitant drop in the value of the stock already held by the fund." Id. at 20. A necessary implication of that statement is that, in at least some circumstances, an ERISA fiduciary in possession of non-public material information may continue to make purchases of employer stock that it knows is artificially inflated for purposes of propping up the stock price. Isn't that securities fraud? See, e.g., FindWhat Investor Group v. FindWhat.com, 658 F.3d 1282, 1317 (11th Cir. 2011) ("Defendants whose fraud prevents preexisting inflation in a stock price from dissipating are just as liable as defendants whose fraud introduces inflation into the stock price in the first instance."). And didn't the Court just get through saying that ERISA fiduciaries must comply with federal securities laws? Don't waste time trying to understand the Court's "logic;" it's intellectual nonsense.
The final problem with the Court's attempt at providing guidance in ERISA employer stock cases perhaps best explains the fundamental flaws in its unsupported dicta: the Court ventured into a subject matter area that was not properly before it, that had not been adequately briefed by the parties and amici, and for which it was not adequately prepared. As the Court expressly recognized (slip op. at 19), determining the sufficiency of allegations in an ERISA company stock case involves the intersection of ERISA's fiduciary obligations, insider trading prohibitions and corporate disclosure requirements -- areas of law that are incredibly complex on their own and in combination push intellectual limits to the brink. The parties and amici in Fifth Third understandably focused their briefing on differing applications of the "presumption of prudence" -- not on the general sufficiency of allegations in ERISA employer stock cases with no such presumption. The Court also lacked the informed views of interested federal agencies that should be considered in reaching any decision on these complicated issues. See, e.g., slip op. at 20 ("The U.S. Securities and Exchange Commission has not advised us of its views on these matters, and we believe those views may well be relevant.") Why, then, jump ill-prepared and head-first into this thicket under the guise of providing guidance? No good answer. As Justice Frankfurter once stated: "Deliberate dicta, I had supposed, should be deliberately avoided. Especially should we avoid passing gratuitously on an important issue of public law where due consideration of it has been crowded out by complicated and elaborate issues that have to be decided." United States v. United States Gypsum Co., 333 U.S. 364, 402 (1948) (Frankfurter, J., concurring). The current Justices should have heeded that warning.
In the end, the Court "leaves it to the courts below to apply" its reasoning to the complaint. Slip op. at 20. Good luck. If applied uncritically, the flawed logic and unsupported dicta of the opinion will be hard for most ERISA plaintiffs to overcome. It will take many years, if ever, before the unfortunate impact of Fifth Third can be fully undone. In the meantime, ERISA employer stock cases will be that much more difficult to sustain, all because the Court ventured into a complicated subject matter area that was not properly before it without the benefit of well-supported briefs or input from appropriate stakeholders.
Better the devil you know. Can we bring back the "presumption of prudence" now?
The Securities Bar Heaves a Huge Sigh of Relief (aka The Supreme Court Reaffirms the Fraud-on-the-Market Theory of Reliance But Allows Defendants to Challenge Price Impact at Class Certification)
If you heard a large whooshing sound last Monday, it was probably the collective sigh of relief issued by the plaintiffs' securities bar after reading the Supreme Court's decision in Halliburton Co. v. Erica P. John Fund, Inc. Of course, the securities defense bar, which makes its living from the existence of securities class actions, may also have been cheering (albeit outside the hearing of their corporate clients). Why?
At issue in Halliburton was nothing less than the continuing viability of securities fraud class actions as we know them. If the Supreme Court had overruled the fraud-on-the-market theory of reliance, a step that the defendant and numerous amici had urged the Court to take, public corporations and issuers of securities would effectively be immunized against class actions of investors alleging most forms of securities fraud. Such a decision would have eviscerated an entire substantive area of the law -- not to mention a robust legal industry -- in a single blow.
First, some background: In order to establish a violation of Section 10(b) of the Securities Exchange Act of 1934, a plaintiff must prove “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.” Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, 568 U.S. ___, ___ (2013) (slip op., at 3–4) (internal quotations omitted). Boiled down to plain English, this means that a securities fraud plaintiff must establish that the defendant made a misstatement of fact or failed to disclose a fact; that the misstatement or omission was material, meaning that a typical investor would consider that information meaningful; that the defendant did so intentionally or with knowledge; that the plaintiff relied on the misstatement or omission in purchasing or selling a security; and that the misstatement or omission caused the plaintiff to suffer a loss. (An extended discussion of the many additional nuances of these elements is not necessary for an understanding of the following discussion.)
In 1988, the Supreme Court addressed the element of reliance in Basic Inc. v. Levinson, 485 U.S. 224 (1988). What does it mean for an investor to have relied upon a misstatement in purchasing or selling a security? In recognition that the securities markets were no longer conducted through the face-to-face transactions at issue in earlier fraud cases but, instead, now involved the trading of millions of shares daily through impersonal trading systems, the Court held that an investor could satisfy the requirement of reliance by invoking a presumption that the price of an efficiently-traded stock necessarily incorporated and reflected all public material information, such that an investor's reliance on the stock price was reliance upon the misrepresentation or omission itself (the so-called "fraud-on-the-market" theory). Thus, reliance on the stock price equates to reliance upon the challenged statement. The Basic Court further held that this presumption was rebuttable and could be overcome by "[a]ny showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price." Thus, if the defendant could show that the investor would have invested anyway, or that the alleged misrepresentation or omission had no effect on the stock price (among other things), it could defeat the reliance presumption.
The impact of Basic on securities law was significant and wide-ranging: Not only could individual investors recover for securities fraud without having relied on -- or, indeed, even having been aware of -- a specific material misstatement or omission, but the necessary element of reliance could now be presumed for an entire group or class, rather than proven individually, leading to a boon to securities class actions. (In the absence of the fraud-on-the-market theory, most securities fraud cases could not proceed as class actions due to individualized issues of reliance by each class member.) Moreover, given that litigation costs would dwarf the potential for recovery in securities fraud cases brought by most individual investors, rejection of the fraud-on-the-market theory would have largely immunized securities issuers from such suits in all but the most egregious of circumstances. Armed with the Basic presumption, however, the plaintiffs' securities bar could aggregate the claims of thousands of investors against the issuer and certify a large class without concern for issues over individual reliance.
Not surprisingly, the business community began challenging the fraud-on-the-market presumption from the very issuance of Basic, arguing that it wrongfully eliminates the requirement for reliance long-established in fraud jurisprudence and that it helps create economic incentives for filing large-scale strike suits, often of questionable merit, in order to extract settlement funds from securities issuers. In the years since Basic, the business community successfully limited certain aspects of the theory but, despite its best efforts, had not succeeded in eliminating application of the theory altogether.
Enter Halliburton, in which the Supreme Court expressly took up the question of whether the fraud-on-the-market presumption of Basic should be overruled or modified. In an opinion that gave something to each side, the Court reaffirmed the holding of Basic and held that fraud-on-the-market continues to be a viable theory for presumptively proving reliance in a securities fraud case. Writing for the six-Justice majority, Chief Justice Roberts reasoned that Halliburton had failed to establish the "special justification" necessary for overturning the long-established precedent of Basic. He noted that the doctrine of stare decisis applies with "special force" in situations where the Court engaged in statutory interpretation (given Congress' ability to alter the result through subsequent legislation) and concluded that Halliburton's challenges to the fraud-on-the-market theory consisted of policy arguments that the Basic Court had already rejected and of irrelevant market theory critiques that in no way "refuted the modest premise underlying the presumption of reliance." The majority found no compelling basis for overturning Basic and thus held that the fraud-on-the-market theory of reliance continues to apply.
The news was not all good for plaintiffs however: In addition to reaffirming that a defendant can rebut the presumption by showing, among other things, the absence of "price impact" (i.e., that the alleged misrepresentation did not affect the stock price), the majority ruled that a defendant has the right to make such a showing at the class certification stage of the case -- which often occurs long before the merits are decided. Thus, efforts to certify a class, which in recent years have already become raging battles, will now lead to all-out war between the parties. Further, Justices Scalia, Thomas and Alito would overrule Basic entirely, giving hope to Corporate America that a differently constituted future Court may reach a contrary conclusion.
But for all the media hoopla over the importance of the decision, here's the rub as far as I'm concerned: Neither group of Justices asserted a logically coherent and justifiable basis for its position. As Professor Korsmo of Case Western Reserve University School of Law recently blogged, the Halliburton decision is not "particularly coherent" and "renders an already confused area of the law even more convoluted."
How? Well, let's start with the majority. I have no issue -- and, in fact, agree -- with the majority's reaffirmation of Basic. Eliminating the fraud-on-the-market theory of reliance in today's electronic trading world would effectively immunize issuers from the vast majority of individual securities fraud actions and nearly all class actions. Because federal and state regulators lack sufficient resources to monitor all securities offerings and public disclosures, the private securities bar provides an important check against unscrupulous or fraudulent behavior. I understand why issuers believe that the fraud-on-the-market theory operates as an end-run around the requirement of causation but in light of the decades-old precent of Basic, as well as the absence of an alternative effective enforcement scheme, I believe the status quo should remain.
However, the majority's decision to allow defendants to challenge "price impact" at the class certification stage seems hopelessly inconsistent with the Court's Amgen decision issued just last year. In Amgen, the Court ruled that a securities defendant is precluded from rebutting the fraud-on-the-market presumption by challenging the materiality of the alleged misrepresentation or omission at the class certification stage. The Amgen majority reasoned that any issue over materiality, while important for merits, was wholly irrelevant for class certification purposes: The challenged statements were either material or immaterial for the class at large; thus, there was no reason to allow defendants to contest materiality at the class certification stage when they adequately could do so later on the merits. Shouldn't the same be true for challenges to "price impact"? As with questions of materiality, the issue of whether a challenged misrepresentation or omission caused the stock price to change (i.e., caused a "price impact") would be the same for the class at large and thus, under the logic of Amgen, is best left to a subsequent resolution on the merits. Why is "price impact" any different? Amazingly, the majority never cogently explains it. After acknowledging the obvious similarity of issues, see slip op., at 21 ("EPJ Fund argues that much of the foregoing could be said of price impact as well. Fair enough."), Chief Justice Roberts labors to distinguish Amgen on the purported ground that the existence of "price impact" was "Basic's fundamental premise," which somehow is already at issue in all class certification proceedings in a way that the materiality element is not. Huh? Aren't related elements of materiality and "price impact" inexorably tied together? A material misrepresentation will generally have a "price impact" and an immaterial one will not; they are two sides of the same coin. You can read the passage and draw your own conclusions (slip op, at 21-23) but I view it as results-driven labyrinthine "logic" that fails to convince. Let's call it for what it is: the effective overruling of Amgen. Having exalted the doctrine of stare decisis to uphold Basic, the majority was intellectually precluded from turning around and promptly overruling Amgen. But it accomplished the same result.
The concurrence in judgment (and dissent in all else) authored by Justice Thomas and joined by Justices Scalia and Alito fares little better. In contending that Basic should be overruled, the concurrence spends the majority of its time making irrelevant arguments about the strength of the efficient capital markets hypothesis and the existence of investors who ignore stock prices -- neither of which, even if accepted, would be a basis for rejecting the fraud-on-the-market theory. Issues over the level of efficiency in a particular market make little difference to the Basic presumption. Whether the correlation is high or weak, if the stock price is affected by the challenged statement in any respect, reliance by the investor on the stock price can be a proxy for reliance upon the statement itself. And for those situations where there is a complete lack of correlation, defendants have the ability to rebut the presumption. Because the fraud-on-the-market theory does not require a purely efficient market to function, academic issues over the level of efficiency of a particular market provide no basis for scrapping the theory altogether. Similarly, the concurrence's argument that not all investors rely upon stock price is equally immaterial. Basic never stated, and is not reliant upon the view, that all investors rely upon stock price. If there are investors who did not rely upon the stock price in making their purchase or sale decision, defendants have the ability to disprove reliance. Again, the fact that there may be a limited number of investors who completely disregard stock price is no reason for rejecting the common-sense notion that most investors at some level rely "on the security’s market price as an unbiased assessment of the security’s value in light of all public information."
So what does all of this mean? More litigation. Halliburton ensures that securities fraud class actions will be alive and well for the foreseeable future. In fact, the decision will provide fodder for an ever-increasing amount of legal work as plaintiffs and defendants alike struggle to interpret and apply the troubled logic that each side invoked. It also makes certain that, from now on, defendants will attempt to attack both "price impact" and "materiality" (under the guise of "price impact" evidence) at class certification, notwithstanding Amgen.
For the securities bar, Christmas came in June this year.
An accomplished trial and appellate lawyer, Tad muses on the modern day practice of law, reflects upon interesting cases, and offers his thoughts on the new normal for the legal community.