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(Article from Securities Law Alert, May/June 2019) 

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In Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. 409 (2014), the Supreme Court held that in order “[t]o state a claim for breach of the duty of prudence” against the fiduciaries of an employee stock ownership plan (“ESOP”) “on the basis of inside information, a plaintiff 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.”[1] On June 3, 2019, the Supreme Court granted certiorari to decide whether Fifth Third’s “‘more harm than good’ pleading standard can be satisfied by generalized allegations that the harm of an inevitable disclosure of an alleged fraud generally increases over time.” Ret. Plans Comm. of IBM v. Jander, No. 18-1165.

In Jander v. Retirement Plans Committee of IBM, 910 F.3d 620 (2d Cir. 2018), the Second Circuit held that Fifth Third’s “more harm than good” pleading standard was met where plaintiffs alleged that the disclosure of the overvaluation of one of the company’s business divisions was “inevitable, because [the company] was likely to sell the business and would be unable to hide its overvaluation from the public at that point.” The Second Circuit reasoned that “[i]n the normal case, when the prudent fiduciary asks whether disclosure would do more harm than good, the fiduciary is making a comparison only to the status quo of non-disclosure.” In the case before it, “however, the prudent fiduciary would have to compare the benefits and costs of earlier disclosure to those of later disclosure—non-disclosure is no longer a realistic point of comparison.”

The Second Circuit found plaintiffs adequately alleged that “the eventual disclosure of a purported fraud causes reputational damage that increases the longer the fraud goes on.” The court explained that “[a] reasonable business executive could plausibly foresee that the inevitable disclosure of longstanding corporate fraud would reflect badly on the company and undermine faith in its future pronouncements.” Moreover, the court found it significant that plaintiffs cited economic analyses in support of this proposition. The court noted that “[w]hile these economic analyses will usually not be enough on their own to plead a duty-of-prudence violation, they may be considered as part of the overall picture.” The Second Circuit concluded that “when a drop in the value of the stock already held by the fund is inevitable, it is far more plausible that a prudent fiduciary would prefer to limit the effects of the stock’s artificial inflation on the ESOP’s beneficiaries through prompt disclosure.”

In contrast to the Second Circuit, the Fifth and Sixth Circuits have held that plaintiffs cannot satisfy Fifth Third’s “more harm than good” standard by alleging that delaying disclosure always results in greater stock price harm. In Martone v. Robb, 902 F.3d 519 (5th Cir. 2018), the Fifth Circuit found insufficient allegations that “the longer a fraud goes on, the more damage it does to investors.” The Fifth Circuit agreed with the district court that such a “generalized allegation” that arguably “applies in virtually every fraud case” does not meet Fifth Third’s pleading standard under governing circuit precedent. In Graham v. Fearon, 721 F. App’x. 429 (6th Cir. 2018), the Sixth Circuit reached the same conclusion with respect to nearly identical allegations. The court observed that the United States made the same argument in its amicus brief in Fifth Third. The United States contended that “[i]t better serves the interests of the plan participants if the fiduciaries take immediate actions to  . . . disclos[e] the material nonpublic information” since a “greater drop might well occur if correction of the misrepresentations were delayed.” The Sixth Circuit found that the Fifth Third Court “rejected that argument, albeit implicitly.” The Sixth Circuit further reasoned that the case in favor of early disclosure of negative nonpublic information “does not account for the risk of market overreaction to such a disclosure, resulting in a decline worse than actually warranted.”

The Court will hear oral arguments and issue a decision in Jander in October Term 2019.