"I wonder if my pension plan is buying overvalued stock."

Court Gets Caught Up in Insider Trading

Noah Feldman is a Bloomberg View columnist. He is a professor of constitutional and international law at Harvard University and was a clerk to U.S. Supreme Court Justice David Souter. His books include “Cool War: The Future of Global Competition” and “Divided by God: America’s Church-State Problem -- and What We Should Do About It.”
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Dilemma for the day: You run the pension plan for your own company -- and as an insider, you know the company's stock is seriously overvalued. What are you supposed to do? You can't sell without violating insider-trading laws. But you're also a fiduciary of the plan, so if you don't sell, you're violating your responsibilities under the Employee Retirement Income Security Act, which is, by the way, your bible. You are, ahem, flummoxed either way.

Today, the U.S. Supreme Court tried to help out pension plan decision-makers who are also corporate insiders. Its answer was a little complicated but, in essence, the court said: "Don't break the law by selling; don't buy any more of the stock; and we'll try to cover you if you get sued." To do so, the court issued guidance to the lower courts that will have to consider employee suits against pension plan fiduciaries. The guidance directs the lower courts to look very carefully at the competing legal constraints on the fiduciaries, and encourages them to be understanding of their plight.

The issue arose in a case involving the employees' pension plan for Fifth Third Bancorp, a large financial services firm. Employees sued the firm, alleging that insiders knew its stock was overvalued but kept buying it for the pension plan. The employees argued that the plan not only should have stopped buying the stock but also should also have sold it, canceled the employee stock ownership plan altogether and, if necessary, should have publicly disclosed the insider information so the market would depress the stock price and the plan would no longer be overpaying for it.

Before getting to the plan fiduciaries' dilemma, the court had to clarify the applicable legal standard. In general, under the complex and arcane law of pension plans, decision-makers have a duty to behave prudently -- except that they aren't obligated to diversify the pension plan if there is an employee stock ownership plan in place, because one of the whole points of employee ownership is to create a greater-than-market alignment of the interests of employees and the company.

Some lower courts have addressed the situation by saying that a pension plan's fiduciaries should enjoy a special presumption of prudence. The Supreme Court rejected that idea. In some sense, this was a defeat for pension plan fiduciaries who would like to avoid being sued -- and a victory for plan beneficiaries who want to be able to use the legal process to supervise the people who control their retirement savings. This took up most of the opinion, and was legally the most important part of it -- but not the most interesting.

The most fascinating part of the opinion came toward the end, when the unanimous opinion by Justice Stephen Breyer got to the insider-trading issue. First, Breyer dispensed with the idea that ERISA requires a fiduciary to break the law and engage in insider trading to benefit the plan. There was no such requirement in ERISA, he said -- so fiduciaries had better not commit insider trading.

But things got more complicated when Breyer turned to the arguments about what else the plan's fiduciaries should do when they're in possession of insider information that the company is overvalued. Two legal options exist: not purchasing new stock, because not buying isn't ordinarily insider trading; and publicly disclosing the insider information, which wouldn't be insider trading either because the inside information becomes public.

The court never said that plan fiduciaries must adopt one of these two courses of action. Instead, it said that, if someone sues the fiduciaries for not doing these things, the courts should look closely at whether the decision not to buy stock or not to make a public disclosure might have been taken pursuant to the laws governing insider trading and corporate disclosure.

This formulation amounted to a road map for trapped plan fiduciaries. Go to your lawyers, the court was telling them, and get an opinion that says you can't refrain from making purchases or that says you are barred by relevant laws from making the insider information public. If you do, the courts will be especially solicitous of you. If you don't, you're on your own. The courts will have to consider the possibility that you were trapped between a rock and a hard place, but there are no guarantees.

Breyer had one further, important word of advice to courts that would have to hear cases against plan fiduciaries. They must consider, he wrote, the possibility that plan fiduciaries couldn't have refrained from buying stock or made public disclosures without tanking the stock price and harming the pension plan itself. This formulation was clearly meant as guidance to courts to take pity on plan fiduciaries stuck in the insider-information dilemma. Sometimes, Breyer was saying, you might just have to keep buying -- and keep on not disclosing that insider information -- to keep the stock price up.

Although Breyer didn't say so, the implication for plan decision-makers is relatively clear: Prepare an explanation of why you thought you had to keep the stock price from deflating. Say you had to buy this and if you didn't, the price would tank. Then cross your fingers and hope for the best. The Supreme Court was unwilling to give you a special presumption of prudence. But the justices feel your pain.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Feldman at nfeldman7@bloomberg.net

To contact the editor on this story:
Stacey Shick at sshick@bloomberg.net