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(Article from Securities Law Alert, October 2017) 

For more information, please visit the Securities Law Alert Resource Center

On October 4, 2017, the Southern District of New York dismissed, in its entirety, an ERISA action brought against the fiduciaries of an employee stock ownership plan (the “Plan”). John Price v. Michael Strianese and Ralph D’Ambrosio, 2017 WL 4466614 (S.D.N.Y. Oct. 4, 2017) (Caproni, J.). The action, which followed closely on the heels of a related securities fraud action, alleged that defendants had knowingly failed to protect Plan participants from a temporary drop in the company’s stock price following the company’s disclosure of alleged accounting misconduct.  The court held that plaintiffs did not adequately allege that defendants knew or should have known of the alleged fraud.  The court further ruled that plaintiffs did not satisfy the “highly exacting standard” established by the Supreme Court’s decision in Fifth Third Bancorp v. Dudenhoeffer, 134 S. Ct. 2459 (2014)[1] for pleading a breach of the duty of prudence claim based on inside information.

Plaintiffs Did Not Allege Defendants Knew Or Should Have Known of the Alleged Fraud

Plaintiffs contended that defendants “knew or should have known that [the Plan] had become an imprudent investment during the [c]lass period” because of alleged accounting improprieties involving a contract at one of the company’s operating divisions.  In a parallel securities fraud class action litigation, the Southern District of New York found plaintiffs failed to allege scienter as to the individual defendants based on substantially similar allegations.[2]

Plaintiffs attempted to rely on Jander v. International Business Machines Corp., 205 F. Supp. 3d 538 (S.D.N.Y. 2016), a case in which the court held that the Rule 8 pleading standard was satisfied in an ERISA action even though the court found plaintiffs had not adequately alleged scienter in a parallel securities fraud action. However, the Price court found Jander “distinguishable” because that case involved materially different facts: “a $2.4 billion write down associated with the sale of an entire business segment.” Here, by contrast, plaintiffs alleged a “material misstatement aris[ing] out of [allegedly] improper recognition of $17.9 million in revenue associated with a single contract in a subdivision of one of [the company’s] four business segments.” The Price court reasoned that Jander was inapposite for purposes of assessing what defendants “knew or should have known” because “a significant write down associated with the sale of a business segment necessarily requires the involvement of the company’s senior most executives, whereas the revenue recognition associated with a single contract typically does not.”

Plaintiffs Failed to Meet Fifth Third’s “More Harm Than Good” Standard for Pleading a Breach of the Duty of Prudence Claim Based on Inside Information 

The court found that even if plaintiffs had satisfied the “knew or should have known” standard, they “failed to allege an ERISA breach of duty of prudence claim” based on inside information. The court explained that, to survive a motion to dismiss under Fifth Third, plaintiffs “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.” The Price court emphasized that Fifth Third established a “highly exacting standard that is incredibly difficult to satisfy” and noted that “the vast majority of ERISA duty of prudence claims brought against [the fiduciaries of employee stock ownership plans] since Fifth Third have foundered on the pleading requirements.”

In the case before it, the court found plaintiffs’ proposed “alternative courses of action [did] not satisfy Fifth Third because [plaintiffs] . . . failed to plead facts plausibly showing that any of these alternatives was legally viable or that [d]efendants could not have concluded that they would do more harm than good.”

First, plaintiffs alleged that defendants “could have closed the [Plan] to new purchases or otherwise prevented Plan participants from purchasing [company] stock until the stock price corrected to a non-inflated value.” The court explained that “[t]his alternative . . . has been consistently rejected” because freezing purchases could have such “dire consequences” as “sending the stock into a significant price decline and weakening investor confidence in the company—particularly if the freeze is not accompanied by a disclosure explaining the reason for the freeze.”

Second, plaintiffs argued that defendants could have made an “earlier public corrective disclosure.” The Price court found that post-Fifth Third courts “have [also] consistently . . . rejected earlier public disclosure” as a viable alternative course of action. Courts have reasoned that a prudent fiduciary “could very easily conclude that such an action would do more harm than good,” especially if “the disclosure would have been made before the company had an opportunity to investigate the issue that would have been disclosed.”

The Price court observed in passing that it could “imagine a scenario in which a proposed corrective disclosure could potentially survive Fifth Third’s standard” if a complaint included “particularized allegations” that “earlier disclosure of the ‘bad fact’ would necessarily cause less damage than a later disclosure.” The court offered as an example a case in which a plan fiduciary was “aware that the company [was] a Ponzi scheme that [was] built on sand and virtually worthless.” The court noted that in such a situation, it would “seem[ ] likely that the fiduciary could not conclude that it would cause more harm than good to disclose as soon as possible.” “Unlike [this] hypothetical Ponzi scheme,” however, the court found that “a prudent fiduciary [in the case before it] could have concluded that early disclosure would do more harm than good.” The court stated that “only an extremely narrow category of . . . fiduciary duty claims based on failure to disclose nonpublic information may survive” a motion to dismiss under the framework articulated by Fifth Third.  The court opined that this is due in part to the fact that “‘ERISA and the securities laws ultimately have differing objectives pursued under entirely separate statutory schemes’” and that, as such, “alleged securities law violations do not necessarily trigger a valid ERISA claim.” 

Finally, the plaintiffs suggested that defendants could have invested in a “low-cost hedging product that would behave in a countercyclical fashion vis-à-vis [company] stock.” The court found that this “third alternative [was] also not adequately pled pursuant to Fifth Third because the description of the hedging product [was] simply too vague for the [c]ourt to conclude that it reflect[ed] a viable option.” The court further observed that that it was not clear from plaintiffs’ allegations “whether the purchase of such a product would qualify as the purchase of a security that might implicate insider trading laws.”