The 2nd U.S. Circuit Court of Appeals has ruled in favor of the plaintiffs in a now-revived Employee Retirement Income Security Act (ERISA) lawsuit alleging imprudence in IBM’s management of the firm’s employee stock ownership plan (ESOP).

The plaintiffs/appellants are participants in IBM’s retirement plan, whose arguments will now be reevaluated by the U.S. District Court for the Southern District of New York. According to case documents, the plaintiffs invested in the IBM Company Stock Fund, which is an ESOP governed by ERISA. The defendants/appellees include the retirement plan committee at IBM, along with several individually named fiduciary officers charged with overseeing the retirement plan’s management.

The plot of the “stock-drop” allegations echo previous ESOP-focused lawsuits. Plaintiffs allege that IBM began trying to find buyers for its microelectronics business in 2013, “at which time that business was on track to incur annual losses of $700 million.” Plaintiffs say IBM failed to publicly disclose these losses and continued to value the business at approximately $2 billion. Plaintiffs further allege that the plan defendants knew or should have known about these undisclosed issues with the microelectronics business.

As recounted in case documents, on October 20, 2014, IBM announced the sale of the microelectronics business to GlobalFoundries Inc. The announcement “revealed that IBM would pay $1.5 billion to GlobalFoundries to take the business off IBM’s hands and supply it with semiconductors, and that IBM would take a $4.7 billion pre‐tax charge, reflecting in part an impairment in the stated value of the microelectronics business.” Thereafter, IBM’s stock price declined by more than $12.00 per share.

At the core, the ERISA lawsuit argues defendants continued to invest the ESOP’s funds in IBM common stock despite the plan defendants’ knowledge of undisclosed troubles relating to IBM’s microelectronics business. In doing so, plaintiffs allege, the plan defendants violated their fiduciary duty of prudence to the plaintiffs under ERISA. The plaintiffs also pleaded that “once defendants learned that IBM’s stock price was artificially inflated, defendants should have either disclosed the truth about microelectronics’ value or issued new investment guidelines that would temporarily freeze further investments in IBM stock.”

In its initial ruling on these arguments, the district court determined that the plaintiffs did not plausibly plead a violation of ERISA’s duty of prudence, because a prudent fiduciary could have concluded that earlier corrective disclosure would have done more harm than good. This ruling mirrors many stock drop decisions handed down after the U.S. Supreme Court’s consequential decision in a case known as Fifth-Third vs. Dudenhoeffer.

On appeal, the plaintiffs/appellants assert that the standard expressed by the district court is actually stricter than the one set out in Dudenhoeffer and that the district court and others have applied this stricter standard in a manner that makes it functionally impossible to plead a duty‐of‐prudence violation. Taking up the appeal, the 2nd Circuit appears quite sympathetic to plaintiffs.  

The text of the appellate decision offers a detailed analysis of Dudenhoeffer and applies the pleading standards set therein to the case at hand. According to the appellate court, the Supreme Court first set out a test that asked whether “a prudent fiduciary in the same circumstances would not have viewed an alternative action as more likely to harm the fund than to help it.” This formulation, the appellate court says, suggests that lower courts must ask “what an average prudent fiduciary might have thought.”

“But then, only a short while later in the same decision, the [Supreme Court] required judges to assess whether a prudent fiduciary ‘could not have concluded’ that the action would do more harm than good by dropping the stock price,” the appellate decision explains. “This latter formulation appears to ask, not whether the average prudent fiduciary would have thought the alternative action would do more harm than good, but rather whether any prudent fiduciary could have considered the action to be more harmful than helpful.”

The appellate court says it is “not clear which of these tests determine whether a plaintiff has plausibly alleged that the actions a defendant took were imprudent in light of available alternatives.”

In the IBM case at hand, the plan defendants urge the appellate court to view Dudenhoeffer (and a related case known as Amgen) as setting out a restrictive test, noting that at least two other circuits have adopted that interpretation. Against this argument, the plaintiffs/appellants note that no duty‐of‐prudence claim against an ESOP fiduciary has passed the motion‐to‐dismiss stage since Amgen, and they therefore assert that the courts—and the plan defendants—have misread that decision.

According to plaintiffs, imposing such a heavy burden at the motion‐to‐dismiss stage runs contrary to the Supreme Court’s stated desire in Fifth Third vs. Dudenhoeffer to lower the barrier set by the presumption of prudence.

“Our sole precedential post‐Amgen duty‐of‐prudence opinion does not explicitly take a side in this dispute,” the 2nd Circuit decision states. “See Rinehart v. Lehman Bros. Holdings Inc. We need not here decide which of the two standards the parties champion is correct, however, because we find that plaintiffs plausibly plead a duty‐of‐ prudence claim even under the more restrictive ‘could not have concluded’ test.”

According to the appellate decision, the district court inappropriately held that plaintiffs failed to state a duty‐of‐prudence claim under ERISA “because a prudent fiduciary could have concluded that the three alternative actions proposed in the complaint—disclosure, halting trades of IBM stock, or purchasing a hedging product—would do more harm than good to the fund.”

“We respectfully disagree,” the appellate decision states. “Plaintiffs have limited the proposed alternative actions on appeal to just one: early corrective disclosure of the microelectronics division’s impairment, conducted alongside the regular SEC reporting process. Several allegations in the amended complaint, considered in combination and drawing all reasonable inferences in plaintiff’s favor, plausibly establish that a prudent fiduciary in the plan defendants’ position could not have concluded that corrective disclosure would do more harm than good.”

The full text of the new decision, which also includes detailed discussion of the way the circuit court views the interaction of ESOP fiduciary duties and securities law, is available for download here.