Re-Thinking Company Stock

by Michael Barry

October 20, 2014

We've had a couple of major company stock cases in the last year—the Supreme Court's decision in Fifth Third Bancorp et al. v. Dudenhoeffer and the Fourth Circuit's in Tatum v. R.J. Reynolds Tobacco Company. Fifth Third represented a much-needed re-thinking of the analysis of company stock issues; Tatum, in my view, represents a step backwards from that re-thinking.

In this article, I'm first going to review the new analytical framework established in Fifth Third and how that framework is different from the old framework rejected by the Court. I'm then going to review Tatum and explain why, I think, the Fourth Circuit (and based on the response to Fifth Third, and a lot of others) just didn't get what the Supreme Court was saying. Finally, I'm going to take a step back and consider how company stock does/does not fit within ERISA's framework for fiduciary regulation. Along the way I'm also going to make a couple of detours—one into ESOP history, in the hope of making sense of the current situation we're in, and one a brief comment (a.k.a. rant) on courts' (very much excepting the Supreme Court) and lawyers' inadequate understanding of basic market economics.

Fifth Third

The Court summarizes the design of the Fifth Third plan as follows --

Petitioner Fifth Third Bancorp, a large financial services firm, maintains for its employees a defined contribution retirement savings plan. Employees may choose to contribute a portion of their compensation to the Plan as retirement savings, and Fifth Third provides matching contributions of up to 4% of an employee's compensation. The Plan's assets are invested in 20 separate funds, including mutual funds and an ESOP. Plan participants can allocate their contributions among the funds however they like; Fifth Third's matching contributions, on the other hand, are always invested initially in the ESOP, though the participant can then choose to move them to another fund.

The 401(k) "ESOP"

I want to pause here for a moment to consider why the Fifth Third plan was designed this way. This is not an old-school leveraged ESOP being used to buy out a company. Indeed, it's probably not what the ideologues of the ESOP "movement" had in mind in 1974 when they inserted the ESOP design into ERISA. Their idea was—more or less—that an ESOP would be a way for employees to borrow money to buy all or (a big) part of a company.

The initial impulse behind the kind of "ESOP" in Fifth Third -- where employer contributions are "invested initially" in an "ESOP" (really, just a company stock fund in a 401(k) plan)—came from the Deficit Reduction Act of 1984, which included a provision allowing banks, for tax purposes, to exclude from income 50% of the interest received on an ESOP "securities acquisition loan." Banks and sponsors quickly figured out that it was possible to create below-market financing by moving a loan into a 401(k) plan and using it to buy stock that would then be allocated out as matching contributions to plan participants over the life of the loan. Very soon, every large company's 401(k) plan had a company contribution fund made up of company stock, called an "ESOP."

The door was (more or less) closed on this particular tax artifice by the Omnibus Budget Reconciliation Act of 1989, which limited the tax-subsidized financing of these transactions to ones in which, after the transaction, the ESOP owned at least 50% of the company. But there were still, left over, a lot of companies with pre-1989 "leveraged ESOPs" that were just 401(k) plan company stock funds installed to take advantage of the tax subsidized discount financing.

As those pre-1989 ESOPs wound down, the ESOP lobby came up with another inducement to CFOs to continue maintaining ESOPs: the Economic Growth And Tax Relief Reconciliation Act of 2001 (EGTRRA) allowed sponsors a deduction on dividends paid on 401(k) "ESOP" stock. To this day, that tax benefit is pretty much the main financial incentive for companies to, as Fifth Third did, make 401(k) matching contributions that are invested in the company stock fund (a.k.a. the "ESOP").

Through all of this, what sort of plan could be called an "ESOP"—and reap tax benefits or a special fiduciary deal—remained a very flexible concept. Wikipedia has a fascinating timeline of ESOP history. The ESOP concept was developed by Louis Kelso and Mortimer Adler, who published a book in 1958 called The Capitalist Manifesto. The concept seems then to have been freighted with what now seems (in my humble opinion at least) irrelevant and naïve romance. Quoting Wiki: "The book presents the economic and moral case for employee ownership, arguing that a) wealth disparity is a negative force in society; b) most workers are excluded from ownership and prosperity, as they can only rely on their paychecks and have no way to acquire capital; c) with technological advances, capital will continue to become more productive, labor will find itself at an ever-greater disadvantage, and inequality will continually increase; and d) the working class can acquire an ownership stake in the economy with borrowed capital."

Russell Long, Senator from Louisiana, the son of Huey Long, and the Chairman of the Senate Finance Committee when ERISA was being passed, latched on to this idea and added provisions to ERISA and the Tax Code making leveraged ESOPs possible.

What has happened since is a cautionary tale. Leveraged ESOPs were, indeed, used by workers to buy companies, usually in distress. Some of those deals were successful. Some were disasters. But over time the leveraged ESOP evolved into, first, "shark repellent"—an anti-takeover device—and then into a tax-subsidized financing device and finally into what it is today—a way for companies to get a deduction on stock dividends. So much for the dreams of Mssrs. Kelso, Adler and Long.

The Stock Drops

Back to Fifth Third. What happened in this case is what happens in every stock drop case: "the market crashed, and Fifth Third's stock price fell by 74% between July 2007 and September 2009." Participants investing in the plan's company stock fund lost a lot of money. And they sued Fifth Third.

The Supreme Court summarizes the plaintiffs' complaint as follows:

[B]y July 2007, the fiduciaries knew or should have known that Fifth Third's stock was overvalued and excessively risky for two separate reasons. First, publicly available information such as newspaper articles provided early warning signs that subprime lending, which formed a large part of Fifth Third's business, would soon leave creditors high and dry as the housing market collapsed and subprime borrowers became unable to pay off their mortgages. Second, nonpublic information (which petitioners knew because they were Fifth Third insiders) indicated that Fifth Third officers had deceived the market by making material misstatements about the company's financial prospects. Those misstatements led the market to overvalue Fifth Third stock—the ESOP's primary investment -- and so petitioners, using the participants' money, were consequently paying more for that stock than it was worth.

The complaint further alleges that a prudent fiduciary in [the Fifth Third fiduciaries'] position would have responded to this information in one or more of the following ways: (1) by selling the ESOP's holdings of Fifth Third stock before the value of those holdings declined, (2) by refraining from purchasing any more Fifth Third stock, (3) by canceling the Plan's ESOP option, and (4) by disclosing the inside information so that the market would adjust its valuation of Fifth Third stock downward and the ESOP would no longer be overpaying for it.

All of that—a 401(k) plan with a company stock fund, a "crash" in the value of the stock, participants who lose a lot of money, a complaint claiming that based on public and non-public information the plan fiduciaries should have sold all the stock (and/or stopped buying it)—is your basic stock drop case.

The Presumption of Prudence

Until Fifth Third, most courts began their analysis of this sort of case with the notion that "ESOPs are different." The main difference, as they saw it, was that an "ESOP" (at least if it's drafted properly) requires investment in company stock. Because of this, several Courts of Appeal have, as the Supreme Court said, "[given] ESOP fiduciaries a 'presumption of prudence' when their decisions to hold or buy employer stock are challenged as imprudent."

Indeed, when the Supreme Court took Fifth Third, there was a split in the Circuits not about whether there was a "presumption of prudence" but when that presumption applied. While some Courts of Appeal have granted (to defendant fiduciaries) a motion to dismiss based on the presumption of prudence, the Sixth Circuit in its decision in the Fifth Third litigation held that "this presumption is an evidentiary rule that does not apply at the pleading stage" -- letting the plaintiffs proceed to discovery and pile on litigation costs.

Fiduciaries and their lawyers generally liked the presumption of prudence standard—it gave them an edge in stock drop litigation.

... Or Not

In its Fifth Third decision, the Supreme Court, in what was in my humble opinion an important breakthrough in stock drop case jurisprudence, unequivocally rejected the presumption of prudence doctrine. It stated:

In our view, the law does not create a special presumption favoring ESOP fiduciaries. Rather, 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.

Instead, as this quote indicates, the Court focused on a provision of ERISA that does clearly apply, not just to ESOPs but to investments in company stock generally—the exemption for such investments from ERISA's diversification requirements.

This move, from according special status to ESOP fiduciaries to focusing on the consequences of the diversification exemption, was a theoretical breakthrough. What the Supreme Court said—in so many words—is that absent a requirement for diversification, with certain limited exceptions, the only test for whether an investment is prudent under ERISA is whether the price paid for it was prudent, and with respect to a publicly traded stock that prudence is determined by the market and not by mystical notions of what a stock's "real" value is.

Implicit in this analysis was a rejection of the notion that the stock of a company "on the brink of collapse" was an inherently imprudent investment. Indeed, the idea that you would know (other than with hindsight) whether a company was "on the brink of collapse" implies that you can see into the future. The implicit attribution to fiduciaries of this clairvoyance has been a fundamental part of all stock drop cases.

Here is the Court at its most robust:

In our view, 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. * * * The [Sixth Circuit]'s decision to deny dismissal therefore appears to have been based on an erroneous understanding of the prudence of relying on market prices. [Emphasis added.]

I read Fifth Third as holding:

1. A plaintiff cannot sue a fiduciary on the premise that the fiduciary should know, based on public information, that a publicly traded stock is overvalued, absent special circumstances.
2. A plaintiff cannot state a claim that a fiduciary should have sold stock in a fund, based on private (a.k.a. "inside") information that the stock was overvalued, because to do so would violate insider trading laws.
3. With respect to a decision to continue to buy stock or not publicly disclose insider information in such circumstances, it's probably better to consider the conduct of company officials under the securities laws.
4. In any case, in considering a motion to dismiss ("whether the complaint has plausibly alleged" a breach of ERISA's prudence rule), a court should consider whether the proposed action (stopping buying stock and/or disclosing non-public information) would do more harm than good.

A Brief Rant

I'd like to pause for a moment for a comment: How ignorant of the basic economics of markets do you have to be to not understand "the prudence of relying on market prices"? To argue that, notwithstanding that hundreds or thousands of investors trade a stock at, say, $10, that based on public information the stock is "really" and "prudently" worth $9? And yet this seems to be the intellectual condition of most lawyers and most judges who have considered stock drop (and, as we'll see, reverse stock drop) cases.

Further in this regard, let's consider the proposal that fiduciary access to non-public ("inside") information that a stock is overvalued can somehow be the basis of an ERISA prudence claim. I would say that this claim presents an even more stark example of lawyers not understanding the basic economics of markets. What is the theory here? That the fiduciary should exploit the inside information to bail participants out of company stock investments before telling the market about the inside information? Uh ... that would be obviously illegal.

But if plan fiduciaries tell the market about the inside information, there will then be no inside information, the stock price will go down, and the participants will lose at least as much money as they did in the first place.

In Fifth Third plaintiffs claimed that the fiduciaries should have gone to the securities regulators. But shouldn't such a claim be brought under the securities laws, rather than under ERISA? (One is tempted to add: "!!!")

Why this sort of claim isn't dismissed out of hand as utterly incoherent is a mystery to me.

Special Circumstances

As I understand it, after reading the Fifth Third opinion, plaintiffs' lawyers were celebrating the inclusion of the exception for "special circumstances" in the Court's sweeping holding that public information can never be a basis for a claim that a publicly traded stock's publicly traded price is "wrong." Given (as we'll see) the Fourth Circuit's utter misunderstanding of Fifth Third, this response is not surprising. And unless either the Supreme Court straightens everyone out or the lower courts all of sudden "get it," the plaintiffs' lawyers may be right.

For what it's worth, here's what I think might constitute special circumstances: public information that would lead a prudent person (not ignorant of the economics of markets) to believe a public price was wrong. For instance, with respect to a thinly traded stock, public information that the stock price was being manipulated.

But where, as with Fifth Third, there's broad trading and copious public information—you have to be kidding. The price is the price.

Tatum v. R. J. Reynolds Tobacco Company

Tatum v. R. J. Reynolds Tobacco Company, decided by the Fourth Circuit after Fifth Third, is interesting in several respects. It's a reverse stock drop case—here the claim is that the fiduciaries shouldn't have sold the stock because it later went up in value. It involves (as reverse stock drop cases often do) non-company stock—here, the stock of Nabisco which, after a spinoff of Nabisco, continued for a time to be held in the RJR plan. And it involves a discussion of the notion of "objective prudence"—that a fiduciary can do a very bad procedural job in reaching a particular conclusion (here, to sell Nabisco stock) but still not be liable for a breach because a fiduciary who had done a good procedural job would have reached the same conclusion.

The facts are classic reverse-stock-drop-case facts: the fiduciaries sold the Nabisco stock out of the RJR plan; the plaintiffs claim that it was imprudent to have sold the stock because it was undervalued; shortly after the sale, Carl Icahn made a tender offer for Nabisco, and Nabisco stock dramatically increased in value.

The Fourth Circuit reversed a lower court holding that the RJR fiduciaries had been "objectively prudent" in selling out the Nabisco stock. Oversimplifying somewhat, the Fourth Circuit held that, instead of asking could a prudent fiduciary have decided to sell the Nabisco stock, the lower court should have asked would a prudent fiduciary have done so? In analyzing this question, the Fourth Circuit instructed the lower court to consider:

[A]ll relevant evidence, including the timing of the divestment, as part of a totality-of-the-circumstances inquiry. * * * Perhaps, after weighing all of the evidence, the district court will conclude that a prudent fiduciary would have sold employees' existing investments at the time and in the manner RJR did because of the Funds' high-risk nature, recent decline in value, and RJR's interest in diversification. Or perhaps the court will instead conclude that a prudent fiduciary would not have done so, because freezing the Funds had already mitigated the risk and because divesting shares after they declined in value would amount to "selling low" despite Nabisco's strong fundamentals and positive market outlook.

And thus, the Fourth Circuit, or at least the two judge-majority of this panel, demonstrated a total ignorance of the basic economics of markets. Or, as the Supreme Court put it (in characterizing a similar ignorance on the part of the Sixth Circuit), "an erroneous understanding of the prudence of relying on market prices."

Just think about it: the Fourth Circuit is saying that it is more prudent to rely on notions of "Nabisco's strong fundamentals and positive market outlook" (presumably derived from some broker's report), instead of relying on the market price. I'm sorry, but if there's anyone out there that thinks that is rational, I have a bridge you might be interested in.

What the Heck is Going On with Company Stock?

It's no surprise that 401(k) company stock investments frequently give rise to litigation. They are inherently volatile—compared with an investment that is adequately diversified. Lucky investors in this risky trade pocket their winnings. The losers look for a lawyer and someone to sue.

According to modern portfolio theory, an un-diversified investment in a single stock is imprudent because the volatility inherent in it can be diversified away at no cost. Thus, the single stock investment carries an un-compensated risk.

This element of modern portfolio theory is enshrined in ERISA's diversification rule. But company stock investments get a pass on that rule. In effect, ERISA allows (what in the view of Modern Portfolio Theory is) inherent imprudence in the special case of company stock.

As I discussed above, a lot of the ESOP rules found their way into ERISA because of notions about employee ownership that few people nowadays would share. Most would argue that, as a retirement savings investment, company stock is even worse than non-company stock, because of the not-inconceivable possibility that you might lose your job just when the stock loses all value—think of the Enron-employee company stock investors.

So why is this special treatment of company stock allowed at all? Partly just because of inertia. Partly because there are some participants who, regardless of the un-wisdom of doing so, really like being able to invest their retirement assets in their company and who complain loudly when some policymaker proposes taking away that "right." And, perhaps, because policymakers believe that participants may actually know something (that everyone else doesn't) about the "true value" of their company.

In my humble opinion, I think company stock as a retirement savings investment is a bad idea. And I think the courts probably agree, which explains why, even though investment of 401(k) savings in company stock is "legal," they continue to allow lawsuits based on the premise that fiduciaries should have prevented participants from (voluntarily) investing in it.

In a way, company stock litigation is kind of like the tobacco litigation. If the courts were thinking rationally, given the statutory scheme, they would throw every single one of these cases out at the earliest opportunity and stop wasting everyone's time. But we all know investing in a single stock is bad for you, kind of the way cigarettes are bad for you. Thus, the courts have sympathy for plaintiffs who were lured into this game by plan fiduciaries and became "addicted" to their company stock investment. So—even though the product is "legal"—the courts are going to let the victims sue you.

Kind of a good reason to wind up your company stock fund.

Stock as an Incentive

Let me conclude by emphasizing that I think company stock can be an important incentive and can, in some circumstances, increase an employee's identification with his or her employer and with employer performance. I am all for stock options and stock purchase plans and other stock-based compensation strategies. I just don't think company stock makes much sense as a retirement plan investment—the negatives (in increased risk) outweigh any positives (in increased incentives). And, frankly, I don't think—in the sort of "ESOP" involved in Fifth Third and Tatum—that those incentives are really much in play.

And a final comment: Fifth Third was a unanimous decision by the Supreme Court. There are grounds for hope that the federal judiciary as a whole, and not just the nine Justices of the Supreme Court, may at some point get it and stop allowing these cases. Alternatively, perhaps Congress will (as is very possible) repeal the deductibility of ESOP dividends. Even better, perhaps companies will (as indeed many have) on their own accord wean their participants from company stock investments. All things to hope for.

Copyright 2014, Michael Barry

Michael Barry is president of the Plan Advisory Services Group, a consulting group that helps financial services corporations with the regulatory issues facing their plan sponsor clients. He has 38 years' experience in the benefits field, in law and consulting firms. He blogs at moneyvstime.com.

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