Dudenhoeffer Standard Thwarts Imprudence Claims, But Doesn’t Apply to Disloyalty Claims

Two recent stock drop cases offer new evidence of the extent to which breach of fiduciary duty claims based on nonpublic information are being limited by the pleading standard established in the U.S. Supreme Court’s Dudenhoeffer decision (see our Checkpoint article). That pleading standard requires claims for breach of the fiduciary duty of prudence that are based on nonpublic information to be dismissed unless the claimant can “plausibly allege” an alternative course of action that a prudent fiduciary in the same circumstances would not have viewed “as more likely to harm the fund than to help it.”

Applying that standard to a claim that plan fiduciaries should have protected participants from losses caused by disclosure of their employer’s practice of systematically overcharging customers, the Fifth Circuit in Martone has rejected three arguments meant to show that a prudent fiduciary could not have concluded that alternative actions to protect participants would do more harm than good. First, the court refused to accept that earlier disclosure of the fraud would necessarily have mitigated participants’ losses, noting that if this were a widely known and generally applicable principle, it would have applied to an earlier Fifth Circuit case (see our Checkpoint article). Second, the court rejected the idea that a prudent fiduciary would have known the plan would be a net purchaser of the stock, and thus clearly better off by not making purchases at an inflated value. And, the court noted, even if any prudent fiduciary would have seen the plan as a net purchaser, a fiduciary could still have reasonably feared an “outsized stock drop” triggered by an ill-timed disclosure of the employer’s actions. Finally, in response to the suggestion that the fiduciaries could have diverted some fund assets into a low-cost, counter-cyclical hedging product that would protect the fund if the stock dropped, the court concluded that it was at least possible that the hedging transaction would need to be disclosed, so a prudent fiduciary might reasonably fear that disclosure of the hedging transaction would trigger a stock drop. As no alternatives were presented that a prudent fiduciary could not have viewed as more likely to harm than to help, the claim was dismissed.

In the Wells Fargo case, participants in a different 401(k) plan claimed that they were harmed when plan fiduciaries failed to disclose unethical sales practices that, when revealed, triggered a sharp drop in the price of their employer’s stock. After their imprudence claims were dismissed for failing to meet the Dudenhoeffer pleading standard, the participants amended their complaint to include a clearly separate claim for breach of the fiduciaries’ duty of loyalty. The fiduciaries responded that the disloyalty claim should also be subject to the Dudenhoeffer pleading standard and dismissed like the imprudence claims. The court disagreed, however, noting that breach of loyalty claims do not consider what a prudent fiduciary would have done, only whether the fiduciary acted for the exclusive purpose of benefiting plan participants and beneficiaries. To impose the Dudenhoeffer standard would require plaintiffs to plead facts they are not required to prove. Applying the correct pleading standard for loyalty claims, however, the court found the claims insufficient, observing that the mere existence of a conflict does not indicate disloyalty; ERISA imposes no affirmative duty to disclose corporate information; and the misrepresentations alleged were—for various reasons—otherwise insufficient to support the claim.

EBIA Comment: The Dudenhoeffer pleading standard replaced a presumption of prudence for employer stock investments that tended to insulate plan fiduciaries from claims of imprudence. The Supreme Court characterized the new standard (and the Court’s guidance regarding overpricing claims based on public information) as a better way to weed out meritless lawsuits using a “careful, context-sensitive scrutiny of a complaint’s allegations.” In practice, however, the requirement that proposed alternative actions be so clearly beneficial that no prudent fiduciary could conclude they would do more harm than good, coupled with judicial speculation that any negative disclosure might produce a more harmful overreaction in the market, have made the pleading standard a nearly insurmountable obstacle. Reading these cases, one wonders whether any alternative available to a fiduciary with damaging inside information could be undertaken without risking greater harm by “spooking the market.” Martone implies that proposed alternative actions might survive the pleading standard if they were entirely invisible to the market, but it is hard to imagine what those actions might be. Given the barrier presented by Dudenhoeffer, it is not surprising that plaintiffs would start looking for new angles, like breach of loyalty claims, that will not be dismissed simply because a court can imagine a market overreaction. For more information, see EBIA’s 401(k) Plans manual at Section XXV.H.6 (“Potential Fiduciary Liability for Investments in Employer Stock”).

Contribution Editors: EBIA Staff.