Unusual Facts Help Preserve Stock Drop Claim Based on Nonpublic Information

The Second Circuit Court of Appeals has declined to dismiss a lawsuit alleging that the fiduciaries of a retirement plan acted imprudently after they learned that shares in a company stock fund were overpriced. In their complaint, plan participants claimed that the fiduciaries should have disclosed accounting errors that hid losses by the company’s microelectronics business, or stopped investments in the plan’s company stock fund. The case was dismissed by the trial court on the grounds that the participants’ complaint did not satisfy a pleading requirement imposed by the U.S. Supreme Court’s Dudenhoeffer decision (see our Checkpoint article). On appeal, the parties disagreed about the nature of that requirement: the participants argued that their claims should be sufficient if an average prudent fiduciary would not have concluded that intervention would do more harm than good, and the fiduciaries argued for dismissal if any prudent fiduciary could have concluded that the intervention would be more harmful.

The Second Circuit noted the conflicting interpretations of Dudenhoeffer, but concluded that it did not need to decide which standard was correct because the participants’ complaint satisfied the more stringent “any prudent fiduciary” standard. Rejecting the trial court’s assertion that the participants’ claim “rests on hindsight” and that economic studies of market experience were merely “theoretical,” the Second Circuit found that economic analyses connecting delayed disclosure to greater stock price drops could help support the claim that any prudent fiduciary would have known delayed disclosure would be more harmful. The Second Circuit also deemed plausible the participants’ argument that there was no need for fiduciaries to fear a more harmful market overreaction because the company’s stock was traded in an efficient market. Particularly important to the court, however, was the participants’ allegation that disclosure was inevitable because the business that suffered the undisclosed losses was to be sold. If the fiduciaries knew the losses would be disclosed, that made it “far more plausible” a prudent fiduciary would have disclosed the losses promptly to limit the adverse effects of the inflated stock price. For these reasons, and drawing all inferences in the participants’ favor, the court concluded that the participants had sufficiently pleaded that no prudent fiduciary would have delayed disclosure, and remanded the case to the trial court.

EBIA Comment: The unusual facts of this case make its impact uncertain. Plan fiduciaries in stock drop cases involving nonpublic information often successfully argue that disclosure could have done more harm than good, making nondisclosure a plausible option (for example, see our Checkpoint article), but here the participants could plausibly argue that disclosure was inevitable because the buyer of the business would surely have discovered the issues during due diligence. Participants in other cases may have difficulty constructing a similar argument. And this case adds little clarity to the controversy about what standard the Supreme Court actually meant to impose in Dudenhoeffer. Still, this decision may have some lasting consequences in the way it adds to the list of allegations that participants may employ to overcome a motion to dismiss. If the existence of a breach depends on the fiduciary’s reasonable expectation of future harm, this case suggests that economic data showing the likelihood of future harm in analogous situations may be relevant. And if the expected future harm is a market overreaction, this case suggests that trading in an efficient market might neutralize that concern. These arguments seem likely to reappear in future litigation. For more information, see EBIA’s 401(k) Plans manual at Section XXV.H.6 (“Potential Fiduciary Liability for Investments in Employer Stock”).

Contributing Editors: EBIA Staff.