Duty of loyalty in stock drop cases

The United States District Court for the District of Minnesota has, for a second time, dismissed claims by participants in the Wells Fargo 401(k) plan that plan fiduciaries violated ERISA’s fiduciary rules by “failing to disclose Wells Fargo’s unethical sales practices prior to September 2016.” Plaintiffs alleged that, if such a disclosure had been made, losses they sustained on stock in their 401(k) accounts would not have been as great.

This second decision focused on the issue of the fiduciary duty of loyalty, the court’s discussion of which is thorough and interesting both in its specific application to stock drop cases and to fiduciary litigation more generally.

In this article we discuss the court’s opinion in detail.

Background – duty of prudence claims post-Dudenhoeffer

This case – In re Wells Fargo ERISA 401(k) Litigation– is a classic insider information-based stock drop case. The general theory of these sorts of cases is that the plan fiduciaries had inside information on the basis of which they knew or should have known that the market price for the sponsor’s stock was “inflated” and that therefore the plan fiduciaries, under ERISA, were required to take some sort of action, e.g., disclosure of the inside information.

The rules for consideration of these sorts of cases were laid down by the Supreme Court in Fifth Third Bancorp v. Dudenhoeffer (2014). In Dudenhoeffer, the Supreme Court stated that a court’s review of this sort of claim should be informed by the following:

First, ERISA’s duty of prudence never requires a fiduciary to break the law, and so a fiduciary cannot be imprudent for failing to buy or sell stock in violation of the insider trading laws.Second, where a complaint faults fiduciaries for failing to decide, based on negative inside information, to refrain from making additional stock purchases or for failing to publicly disclose that information so that the stock would no longer be overvalued, courts should consider the extent to which imposing an ERISA-based obligation either to refrain from making a planned trade or to disclose inside information to the public could conflict with the complex insider trading and corporate disclosure requirements set forth by the federal securities laws or with the objectives of those laws.

Third, courts confronted with such claims should consider whether the complaint has plausibly alleged that a prudent fiduciary in the defendant’s position could not have concluded that stopping purchases 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.

Wells Fargo prudence claim

In September 2017, the _Wells Fargo_court dismissed plaintiffs’ prudence claim, holding that they had not satisfied _Dudenhoeffer’s_requirement “that they plausibly allege that ‘a prudent fiduciary in the defendant’s position could not have concluded that . . . 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.’”

As the district court explained, the more-harm-than good standard is “very tough” and “plaintiffs will only rarely be able to plausibly allege that a prudent fiduciary ‘could not’ have concluded that a later disclosure of negative inside information would have less of an impact on the stock’s price than an earlier disclosure.”

(We discuss the September 2017 Wells Fargo_decision in detail in our article Minnesota district court sides with defendant-fiduciaries in stock drop case_.)

Duty of loyalty claim

In its September 2017 decision, the court found that plaintiffs’ complaint did not “clearly separate” the breach of duty of loyalty from the breach of duty of prudence claim and therefore dismissed the loyalty claim, giving plaintiffs leave to replead it. In this second case, the court considered plaintiffs’ (repled) breach of ERISA duty of loyalty claim in detail, holding that plaintiffs’ allegations were insufficient.

In reaching that conclusion, the court provided a fully-reasoned explanation of how (in its view) duty of loyalty claims should be evaluated post-Dudenhoeffer.

Dudenhoeffer’s underlying theory

As the court observed (and as defendants conceded), the decision in _Dudenhoeffer_was limited to stock drop claims based on a breach of the ERISA duty of prudence. But, in stock drop cases in which plaintiffs allege that “the defendant received negative inside information about the company … turning a prudence claim into a loyalty claim requires nothing more than adding the allegation that, in failing to disclose or otherwise act upon the inside information, the defendant was motivated by a desire to protect his position as a corporate insider.”

In this context, the court observed, “the Supreme Court would have as much concern about these loyalty claims as it had about the prudence claims in Dudenhoeffer.” That concern derives from the policy implemented by the Private Securities Litigation Reform Act of 1995 (PSLRA), which “sought to reduce the volume of abusive federal securities litigation by erecting procedural barriers … such as heightened pleading standards.”

In the view of the Wells Fargo_court, ERISA-based stock drop cases represent an attempt by the plaintiffs bar to get around those heightened pleading standards under the securities laws: a strategy that involves “tak[ing] what is essentially a securities-fraud action and plead[ing] it as an ERISA action.” (Citing _Wright v. Medtronic, Inc.(2010).)

Thus, the Supreme Court’s underlying approach in _Dudenhoeffer_was to develop a “mechanism for weeding out meritless claims” in ERISA stock drop cases.

Prudence is an objective standard, loyalty is a subjective standard

As noted, however, Dudenhoeffer involved an ERISA prudence claim, and the court in this second _Wells Fargo_decision was considering an ERISA _loyalty_claim.

The standards to be applied with respect to a prudence claim are objective, e.g., “could a prudent fiduciary in the defendant’s position not have concluded that publicly disclosing negative information would do more harm than good.”

The standards to be applied with respect to a loyalty claim are, however, subjective– did the fiduciary act out of a conflicting motive? The court provided the following (simple and useful) illustration of this distinction:

Suppose that two corporate officers serve as fiduciaries of an ERISA plan that exclusively holds their company’s stock. Both fiduciaries receive inside information that one of the company’s key products is defective and will likely have to be recalled. Both fiduciaries also know that when this information is ultimately disclosed, the price of the company’s stock will plummet. Both fiduciaries decide to delay the disclosure of the defect to the public. The first fiduciary delays disclosure because he sincerely believes that a later disclosure will result in less of an impact on the price of the company’s stock—and thus less of an impact on plan participants—because the company will be able to pair the announcement of the defect with an announcement of a specific plan to remedy the problem. The second fiduciary delays disclosure because he is scheduled to receive a bonus of 100,000 shares of company stock at the end of the year, and he does not want the price of the company’s stock to drop until he gets and sells those shares.

In this hypothetical, a plaintiff bringing a prudence claim against the two fiduciaries would have to plead and prove that a prudent person would not have delayed disclosure of the defect. If the plaintiff did so, both fiduciaries could be found to have breached the duty of prudence; if the plaintiff failed to do so, neither fiduciary could be found to have breached the duty of prudence. The good intentions of the first fiduciary—and the bad intentions of the second fiduciary—would be irrelevant.

By contrast, a plaintiff bringing a loyalty claim against the two fiduciaries would have to plead and prove that the reason that a particular fiduciary delayed disclosure of the defect was to further his own interests, rather than the interests of the fund participants. Because the first fiduciary acted in subjective good faith, he could not be found to have breached the duty of loyalty. But because the second fiduciary did not act in subjective good faith, he could be found to have breached the duty of loyalty. See Tussey v. ABB, Inc., 850 F.3d 951, 958 (8th Cir. 2017) (“A fiduciary can abuse its discretion and breach its duties by acting on improper motives, even if one acting for the right reasons might have ended up in the same place.”).

Proving disloyalty in a stock drop case

Because Dudenhoeffer_dealt only with a prudence claim, the specific (objective) standards the Supreme Court developed in that case (e.g., the more-harm-than-good test) do not apply with respect to a duty of loyalty claim. But the _Wells Fargo_court found that the broader policy of “weeding out meritless claims” from which _Dudenhoeffer developed those specific standards should also be applied to loyalty claims: “This means identifying the elements that the plaintiff must prove to recover on the particular claim and ensuring that, with respect to each of those elements, … the complaint pleads ‘enough facts’ so that it ‘state[s] a claim to relief that is plausible on its face.’”

In this regard, plaintiffs alleged that defendants, as Wells Fargo employees, were “incentivized to avoid doing or saying anything that would harm the image or reputation of Wells Fargo.” The court found that this allegation (the mere existence of conflicting loyalties) was insufficient to survive a motion to dismiss, citing cases holding that “the mere fact that a fiduciary had an adverse interest does not by itself state a claim for relief” and that “[p]ersons who serve as fiduciaries may also act in other capacities, even capacities that conflict with the individual’s fiduciary duties.”

With respect to plaintiffs’ argument that defendants’ failure to disclose “material information” about ongoing misconduct violated ERISA, the court held that “ERISA and the securities laws should be confined to their respective spheres” and that the ERISA fiduciary’s duty is to “disclose plan- and benefit-specific information that is of interest to plan participants but not to investors generally.” Plaintiffs’ allegation, because it related to “investor-specific” information rather than plan-specific information, therefore did not state a valid claim under ERISA.

Takeaways for plan sponsors

It’s likely that in future stock drop cases, particularly those claiming that plan fiduciaries had inside information, plaintiffs will include a breach of ERISA duty of loyalty claim in addition to a breach of ERISA duty of prudence claim.

Following the Supreme Court’s decision in Fifth Third Bancorp v. Dudenhoeffer, courts have, for the most part, sided with sponsor fiduciaries in stock drop cases, suggesting that its standard for, e.g., proving imprudence in a case based on inside information is “very tough” and that plaintiffs will “only rarely” be able to meet it.

Courts that follow the _Wells Fargo_decision will, in evaluating duty of loyalty claims, generally apply a subjective standard but will require specific allegations that support a conclusion that a fiduciary acted against plan and participant interests because of a conflicting/adverse interest.

Whether other courts may take a more relaxed view of plaintiffs’ pleadings and allow these sorts of cases to proceed remains to be seen. But the Minnesota district court makes a persuasive case (at the beginning of its opinion) that _Dudenhoeffer_and those cases following it are in fact implementing these pleading standards as “an appropriate way to weed out meritless lawsuits.”

For those with fiduciary responsibilities, and those supervising them, it’s worth considering under what circumstances a fiduciary might be plausibly accused of disloyalty, and how such an accusation might be refuted. Unlike prudence – where the best defense is the ability to demonstrate a prudent process – the subjective nature of the disloyalty standard presents a more complicated challenge. In this regard, two observations:

As this court (and many other courts) have emphasized, ERISA permits a fiduciary to wear two hats. “What ERISA requires is that the fiduciary with two hats wear only one [hat] at a time, and wear the fiduciary hat when making fiduciary decisions.” That is, just because a fiduciary has two_general_loyalties – one to the company and one to the plan and its participants – does not mean that she cannot serve both.

On the other hand, a fiduciary concerned about a _specific_conflict, e.g., a fiduciary like the one in the court’s example “scheduled to receive a bonus of 100,000 shares of company stock,” might consider “recusing” himself from certain decisions that might affect the value of the stock.

There are likely to be nuances to stock drop litigation still to be developed. For instance, what exactly should a court do with a credible claim of disloyalty (e.g., the example given by the court of a fiduciary scheduled to receive a bonus of 100,000 shares of company stock), where the remedy proposed – e.g., disclosure of inside information – is in fact likely to do more harm than good?

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We will continue to follow this issue.