Apr 3 2014, 3:22pm CDT | by Forbes
Justices wrestled with a difficult question at the U.S. Supreme Court today: If the executives in charge of a retirement plan that invests in company stock learn something bad about the company, should they sell?
That would fit the classic definition of insider trading, of course. And it could hardly be good public policy to encourage executives to help their own employees front-run the rest of the market by selling stock at an inflated price to saps who don’t know as much as they do.
Yet the Obama administration came perilously close to that position in arguments today in Fifth Third Bancorp v. Dudenhoeffer. When pressed by the justices on what a trustee of an employee stock plan should do when in possession of material, non-public information suggesting the stock is overvalued, Deputy Solicitor General Edwin S. Kneedler said “it would ordinarily be the right thing to do to sell.”
Justice Samuel Alito asked if Kneedler could possibly mean what he just said.
“No, he can’t — he can’t sell on the basis of inside information,” Kneedler backpedaled. “He could — I’m sorry, he could stop purchasing, which is –”
“But the market will see through that in about two seconds,” Justice Stephen Breyer snapped.
At issue in this case is whether plaintiff lawyers who pounce whenever a company’s stock price falls can make it past the initial motion for summary judgment, with claims that trustees of employee stock ownership plans should have dumped those shares because they knew they were overvalued. Congress carved out an exception for ESOPs from rules requiring retirement plans to diversify their holdings, under the theory that company stock ownership is a good thing and employees are free to put their retirement savings in other investments if they wish. (Despite silly articles like we’ve seen lately that confuse pension plans with self-directed 401(ks).)
The justices struggled with how to apply centuries-old standards of fiduciary duties to the peculiar situation of trusts that invest in only one stock, overseen by company executives who may possess inside information.ESOPs hold over $1 trillion in assets and how the Supreme Court rules in this case could have broad implications for how they are run and whether companies take the risk of offering them at all.
For plaintiff lawyers, it’s simple: They should sell when the stock is “overvalued.” Or at the very least, put the fund in the hands of independent directors who don’t have inside information — and charge lots of money to oversee an investment which every employee knows is his or her own company’s stock.
Do you sell? In which case the beneficiaries’ holdings go way down and they sue you, or do you not sell? In which casse when the information comes out, the beneficiaries sue you because their value goes down. What are you supposed to do?
Alito added a wrinkle to that. What if the inside information is an unproven allegation that a company executive had engaged in illegal behavior? That would definitely make the stock go down if news got out. Should the ESOP release the news to the public, serving as a second conduit for company information even when that information is unconfirmed?
Kneedler didn’t have an answer for that. “Stop buying might be the right approach,” he said.
Robert A. Long of Covington & Burling, arguing for Fifth Third, urged the court to follow every appeals court that has considered the question so far and give the “ESOP fiduciary some leeway.” Because, as he noted, plaintiff lawyers could have sued Fifth Third’s ESOP if they had dumped all the bank’s stock after it plunged to $2 on concerns about its subprime lending practices. The price has since surged past $23.
“In this case, if the fiduciaries had shut down the ESOP, they would certainly have been sued because they would have violated the plan terms, and the — the plan has done very well,” he said. Ah, well, logic has never been the hallmark of securities class-action litigation.
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