Court backs efficient market

The U.S. Supreme Court made the right decision when it rejected a presumption of prudence as a defense in company stock-drop cases, replacing it with a presumption of market efficiency.

Still, the ruling leaves plan participants just as vulnerable to risks of company stock in defined contribution plans, and places a new, tough obstacle to surmount to prevail in litigation.

Corporate plan fiduciaries should not subject participants to the risk of an undiversified investment in company stock. Companies can end the needless tensions in company stock between achieving corporate and participant objectives by eliminating it from defined contribution investment choices as well as by making matching contributions in cash instead of company stock.

The Supreme Court's 9-0 ruling June 25 invalidated the presumption defense long used by defined contribution plan sponsors in cases where participants sued over large losses resulting from declines in the price of company stock in their accounts.

The decision removes an obstacle plan participants have faced in prevailing in lawsuits over breaches of fiduciary duty under the Employee Retirement Income Security Act.

The Supreme Court's ruling raised the issue of the efficient market, embracing it in a way that could undermine participant efforts to win in litigation against fiduciaries who fail to sell company stock when its price is falling.

In the opinion for the court in Fifth Third Bancorp et al. vs. Dudenhoeffer et al., Associate Justice Stephen Breyer, quoting another decision, wrote, “A fiduciary's "fail(ure) to outsmart a presumptively efficient market ... is ... not a sound basis for imposing liability'.”

To prevail against the efficient-market defense, participants would have to show active management can triumph over market averages, a tough proposition to prove, as academic research has found.

Congress created a tension by not reconciling conflicting goals set out between ERISA's requirement for fiduciaries to act in the sole interest of participants and to diversify investments, and legislation encouraging employee ownership in a sponsoring company's stock.

Corporations face another potential conflict to reconcile — between the fiduciary duty to participants and the fiduciary duty to shareholders.

For financially challenged companies, eliminating the stock contribution might end matches altogether. But companies that match in shares must allow employees to trade in them immediately to enable them to diversify into other investment options. Even trading is not an optimal solution because of participant inertia.

Fifth Third objected to invalidating the presumption of prudence, claiming it would make defined contribution sponsors more vulnerable to lawsuits.

But the ruling could result in fiduciaries shifting their defense to market efficiency from presumption of prudence, making plaintiff success in defined contribution company stock-drop lawsuits just as challenging.

Fifth Third, which maintained a defined contribution plan that included an employee stock ownership plan among 20 investment options, used the special presumption defense in objecting to the class action by participants, who sued over the 74% fall in the company's stock price during the financial market crisis.

But “fiduciaries are not entitled to any special presumption of prudence” in their oversight of company stock in defined contribution plans, Mr. Breyer wrote.

“Rather, the same standard of prudence applies to all ERISA fiduciaries, including ESOP fiduciaries, except that an ESOP fiduciary is under no duty to diversify the ESOP's holdings.”

In the Fifth Third case, participants in the 401(k) plan alleged that as the financial market crisis developed, plan fiduciaries “knew or should have known in light of publicly available information ... that continuing to hold and purchase Fifth Third stock was imprudent,” Mr. Breyer wrote.”

The court declined to embrace that view.

As Mr. Breyer wrote in the decision, “In our view, where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances.”

Quoting another decision, Mr. Breyer said: “Many investors take the view that "they have little hope of outperforming the market in the long run based solely on their analysis of publicly available information,' and accordingly they "rely on the security's market price as an unbiased assessment of the security's value in light of all public information'.

“ERISA fiduciaries, who likewise could reasonably see "little hope of outperforming the market ... based solely on their analysis of publicly available information,' ... may, as a general matter, likewise prudently rely on the market price.

“In other words, a fiduciary usually "is not imprudent to assume that a major stock market ... provides the best estimate of the value of the stocks traded on it'.”

“'Fiduciaries are not expected to predict the future of the company stock's performance.'”

Based on the efficient-market idea, fiduciaries are just as at risk to legal challenges over opportunity losses to participants for selling company stock prematurely before a rebound as they are for not selling as it plunges, causing losses to defined contribution account balances.

Having raised the issue of market efficiency in taking account of public information, the Supreme Court decision also rejected participants' contention that Fifth Third fiduciaries “behaved imprudently by failing to act on the basis of non-public information that was available to them because they were Fifth Third insiders.”

The participants' complaint alleges the fiduciaries “had inside information indicating that the market was overvaluing Fifth Third stock and that they could have used this information to prevent losses” to the fund's holdings of Fifth Third stock.

Mr. Breyer wrote in the ruling, “The duty of prudence, under ERISA as under the common law of trusts, does not require a fiduciary to break” federal securities lawprohibiting trading on insider information.

Some corporations have resolved the tensions by not offering company stock as an investment option, or limiting the amount participants can hold. But the issue still looms large.

In all, 36% of participants in 2012 were in plans that offered company stock as an investment option, according to an Employee Benefit Research Institute report last December. Among these participants, 27.1% held between 1% and 30% of their assets in company stock and 8.1% held 70% or more.

Corporate sponsors, which must make fiduciary duty to participants the priority, should eliminate company stock from their defined contribution plans, where participants bear all the investment risk. ERISA limits company stock to a 10% allocation in defined benefit plans, where participants bear no investment risk. Corporations should end the sources of tensions and the risks of potential litigation that take away resources that could be used to enhance plans. A better focus would help participants achieve better outcomes. n

This article originally appeared in the July 7, 2014 print issue as, "Court backs efficient market".