September 20, 2016

Seventh Circuit Rejects Dudenhoeffer Applicability to Privately Held Stock

Decision Clarifies Burden to Plead ERISA Section 406 Violation in ESOP Transaction
Holland & Knight Alert
Chelsea Ashbrook McCarthy


  • The U.S. Court of Appeals for the Seventh Circuit rejected the applicability of Fifth Third Bancorp v. Dudenhoeffer's "special circumstances" pleading requirement to private stock.
  • The Court found the lack of outside funding in an employee stock ownership plan (ESOP) transaction, plus a stock drop following the transaction, sufficient to support an inference that the trustee breached its fiduciary duty.
  • To state a claim against a trustee for engaging in a Section 406 prohibited transaction, the Court held that a plaintiff does not have to plead facts negating the Section 408 exemptions.

The U.S. Court of Appeals for the Seventh Circuit's Aug. 25, 2016, decision in Allen v. GreatBanc Trust Co., No. 15-3569, made it the first court in a published opinion to expressly reject Fifth Third Bancorp v. Dudenhoeffer's application to plan investments in privately held stock. The Court revived the claims of participants in an employee stock ownership plan (ESOP) against the trustee. In reversing the trial court's grant of the trustee's motion to dismiss, the Seventh Circuit rejected Dudenhoeffer's application to private stock transactions and clarified a plaintiff's burden to plead a prohibited transaction claim under ERISA Section 406. The decision ruled only on what a plaintiff must plead in order to state a claim. It made no determination on the merits of plaintiffs' claims.

Employees of Personal-Touch, a home healthcare company, filed suit against the trustee of Personal-Touch's employee stock ownership plan (the Plan). The lawsuit arises out of 2010 transaction in which the Plan purchased stock from Personal-Touch's shareholders for $60 million. The purchase was financed by a loan from the selling shareholders. Outside funding was not used. Shortly after the stock acquisition, Personal-Touch's share price dropped more than 20 percent, and within a year, the price had dropped almost 50 percent. Plaintiffs challenged both the stock purchase and terms of the seller-provided financing for the transaction.

The lawsuit alleged two claims against the trustee: 1) breach of fiduciary duty and 2) violation of Section 406 by engaging in the prohibited transactions of purchasing stock from the selling shareholders and participating in the shareholders' loan to the Plan. The trial court granted the trustee's motion to dismiss both claims. The Seventh Circuit reversed.

Breach of Fiduciary Duty Claim

In concluding that plaintiffs sufficiently pleaded a breach of fiduciary duty, the Seventh Circuit rejected the applicability of Fifth Third Bancorp v. Dudenhoeffer, 134 S. Ct. 2459 (2014) to private stock transactions. In Dudenhoeffer, the Supreme Court held that in order to state a claim of breach of fiduciary duty, a plaintiff must allege "special circumstances" that would have made the trustee aware that the market was over- or under-valuing the company's publicly traded stock.

The Seventh Circuit flatly rejected Dudenhoeffer's application in the private stock context. The Court reasoned that "there is no market price to explain away, and so no reason to apply any 'special circumstances.'" The Court also reasoned that Dudenhoeffer's concern about protecting fiduciaries from running afoul of insider trading laws simply did not apply in a private stock transaction.

Also of note are the allegations that the Seventh Circuit found sufficient to state a claim for breach of duty. Plaintiffs alleged that the stock dropped significantly after the ESOP transaction closed, that the loan to finance the transaction came from the selling shareholders and not an outside lender, and that the interest rate on seller's note was uncommonly high. These claims, held the Seventh Circuit, were sufficient to get plaintiffs past the pleading stage.

Section 406 "Prohibited Transactions" Claim

In reviving the plaintiffs' Section 406 claim, the Seventh Circuit clarified that a plaintiff need not allege the absence of an exemption to a prohibited transaction in order to state a claim. ERISA Section 406 sets forth a list of transactions in which a fiduciary may not engage. This list of prohibited transactions includes the acquisition of any employer security on behalf of the plan and the lending of money between the plan and a party in interest. In other words, on its face, Section 406 prohibits all ESOP transactions. However, Section 408 provides a number of exemptions to an otherwise prohibited transaction. One exception includes the purchase of employer stock for "adequate consideration." Another exempts a loan to a plan if the loan is primarily for the benefit of plan participants and is at a reasonable rate of interest.

The Seventh Circuit clarified that the exemptions under Section 408 are affirmative defenses on which a defendant bears the burden of proof. Because they are affirmative defenses, a plaintiff need not allege their absence in order to state a claim. As applied to the Personal-Touch transaction, the Court held that the plaintiffs were not required to allege that the Plan paid an unfair price for the stock or that the interest rate on the seller loan was unreasonable. The Court reasoned that requiring a plaintiff to negate all Section 408 exemptions would prematurely defeat claims in which plaintiffs lacked access to the relevant information.

The Court rejected the trustee's concerns that its ruling would open the floodgates to baseless litigation. It reasoned that a plan beneficiary would sue only if there was a reason to and that the good faith requirements of Federal Rule of Civil Procedure 11 would act as an additional deterrent to "obviously exempt prohibited-transaction claims."

Key Takeaways

The Seventh Circuit's holding that Dudenhoeffer is limited to the publicly traded stock context is not entirely surprising. In Dudenhoeffer, the Supreme Court relied on factors unique to public stock – the nature of market prices and the interplay between ERISA and the securities laws. However, the Seventh Circuit's express holding that Dudenhoeffer does not apply to private stock certainly takes away one more argument that a trustee can make in challenging a claim that it breached its fiduciary duty. Whether the Seventh Circuit's holding will result in an increase in lawsuits, or whether it will increase the number of lawsuits that survive a motion to dismiss, is yet to be seen.

Another notable takeaway from the Allen v. GreatBanc decision is the Court's reference to the lack of third-party financing and a stock drop as supporting an inference that the trustee might have breached its fiduciary duty. Stock drops immediately following the close of a leveraged ESOP transaction are almost universal since the plan sponsor company takes on debt to finance the transaction. Likewise, seller financing is commonplace, especially in 100 percent ESOP buyouts. The suggestion that these common features in an ESOP transaction may be sufficient to plead a claim for breach of fiduciary duty against a trustee may be of concern to practitioners (although, as noted below, the Court's holding was a ruling only about the sufficiency of the pleadings, not a ruling on the merits of the claim).

The Court's ruling that a complaint need not negate all Section 408 exemptions, at first blush, seems to remove all barriers to lawsuits challenging an ESOP transaction. ESOP transactions, by definition, are prohibited transactions – they involve the plan's purchase of employer stock. It is the existence of adequate consideration, an exception under Section 408, that permits them. The Court addressed this concern by reasoning that no party would bring a claim for an obviously exempt prohibited transaction.

Lastly, it is worth noting that pleading a claim for a prohibited transaction or breach of fiduciary duty is different from being able to establish on the merits that a violation actually occurred. The Allen decision is limited to the conclusion that the plaintiffs alleged facts that were sufficient to get them past the initial pleading stage of the lawsuit. It does not relieve them of the burden to prove their assertions at trial, and the Allen Court made no determination on the actual merit of any of the plaintiffs' claims. However, the Court's ruling could spur an uptick in lawsuits by plaintiffs hoping to reach an early settlement with trustees who may wish to avoid the time and expense of litigation.

For more information on this decision or strategies to avoid potential liability as an ERISA fiduciary, contact the authors or a member of Holland & Knight's ESOP Team.   


Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.

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