[In]Securities Guest Blog: Driving That ESOP Trolley by Aegis Frumento Esq

January 23, 2020


Driving That ESOP Trolley

Who hasn't heard of the Trolley Problem? This chestnut of moral philosophy originated in an obscure article by Oxford philosopher Philippa Foote in 1967 and has become the starting point of many a drunken college bull session ever since. It can be stated simply enough. Imagine you're driving a train and your brakes fail. All you can do is steer it onto one track or another. Down one track are five workmen, and if you do nothing they will all be killed. Or, if you pull the switch and divert the trolley to a siding where one man is working, he will be killed. What will you do? See https://philosophynow.org/issues/116/Could_There_Be_A_Solution_To_The_Trolley_Problem 

Fortunately, you don't have to enroll in a philosophy course to get this. The best recent exploration of the Trolley Problem occurred in season two of NBC's hit comedy, The Good Place. See https://www.youtube.com/watch?v=vfIdNV22LQM. Noting that a principal problem with the Trolley Problem is that it's only a thought experiment, the show actually puts one of the characters in a trolley and forces him to choose, with somewhat messy results. https://www.youtube.com/watch?v=JWb_svTrcOg. Its better than an ethics lecture.

For a while, professional philosophers lost interest in the Trolley Problem because they thought it was too artificial a construct to be useful in real life. And yet, the Problem wouldn't go away. Different variations on the Trolley Problem yields different results. If one of the workers on the track is a friend or relative, people will tend to act so as to avoid hurting them. People will not kill one healthy stranger to harvest her organs in order to save five strangers with failing organs, even though logically it is no different than throwing the switch to kill the one workmen so as to save the five. Likewise, people will recoil against the idea of throwing a fat man off a bridge to stop the train instead of pushing a lever on the train itself. All these various permutations, and many others, have been tested on real subjects in order to obtain gut reactions as to what the "right" answer is in various situations. See, e.g., https://www.designboom.com/technology/what-is-the-self-driving-trolley-problem-31-25-2018/. More recently, studies of brain waves of subjects pondering various permutations of the Trolley Problem demonstrates something intuitively obvious. In any number of scenarios, people instinctively will choose whatever causes least injury to the party with whom they feel the closest emotional connection. https://www.theatlantic.com/technology/archive/2015/10/trolley-problem-history-psychology-morality-driverless-cars/409732/.

It turns out that Trolley Problems are not nearly as esoteric as moral philosophers thought. In fact, they occur all the time. They may not require any of us to kill anyone, and that's good. However, we are all at one time or another faced with the dilemma of causing some kind of hurt to one person or group of persons in order to benefit another. And so it was that I immediately thought of the Trolley Problem when reading the unsigned Supreme Court decision in Retirement Plans Committee of IBM v. Jander. http://brokeandbroker.com/PDF/RetirementPlansSupCtOp200114.pdf.  Driving this particular trolley is the management committee of the IBM employee stock ownership plan ("ESOP"). It turns out that this committee is also part of IBM's senior management. As the management committee of the ESOP plan, they had fiduciary obligations to the plan participants (generally past and current IBM employees) to maximize the value of the ESOP. And, as senior IBM executives, they had obligations to IBM and under the federal securities laws not to trade on the basis of inside information. Okay, you can guess what's coming. As IBM executives they became aware that (allegedly) IBM's stock was overvalued because, unbeknownst to the investing public, one of its divisions was performing badly. And, like the trolley operator, they chose not to pull any levers, but kept buying IBM stock at market prices for the ESOP as they had historically done.

The plaintiff in this case was a beneficiary of the ESOP, who saw the value of his retirement plan decline when the overpriced IBM stock inevitably tanked. He sued the committee, alleging, funnily enough, that as IBM executives they surely knew the stock was overpriced, and yet they continued to buy it. The District Court dismissed the case but the Court of Appeals for the Second Circuit reversed. Believing that the District Court was right and the Court of Appeals was wrong, the ESOP management committee asked the Supreme Court to review the matter. https://www.supremecourt.gov/DocketPDF/18/18-1165/90623/20190304194440700_18-%20Petition%20for%20Writ.pdf

The Supreme Court has struggled with this particular issue before. In 2014, it decided Fifth Third Bancorp v. Dudenhoeffer, in which it first tried to sort out the thorny conflicts inherent in having the fiduciaries of an ESOP plan be the executives of the same company sponsoring the ESOP. http://brokeandbroker.com/PDF/FifthThird.pdf. In Dudenhoeffer, Justice Breyer formulated three basic rules for suing ESOP fiduciaries. First, ESOP plan fiduciaries do not have an "obligation" to engage in illegal insider-trading for the benefit of the ESOP. That seems reasonable enough, but wait. The court also noted that an ESOP committee must still act prudently in light of that non-public information. Generally speaking, a person with inside knowledge must either disclose that knowledge or refrain from trading. The ESOP committee could disclose the information it had. However, you can see what kind of complications that would raise when the ESOP committee happens to be composed of executives of the issuer. The issuer has its own disclosure obligations under the SEC, with which the executives must also abide. Hmmm. . . . .

Finally, the Supreme Court in Dudenhoeffer said that "lower courts faced with such claims should also consider whether the complaint has plausibly alleged that a prudent fiduciary in the defendant's position could not have concluded that stopping purchases -- which the market might take as a sign that insider fiduciaries viewed the employer stock as a bad investment -- or publicly disclosing negative information would do more harm than good to the fund by causing a drop in the stock price and a concomitant drop in the value of the stock already held by the fund."

Putting aside for the moment whether that is even an English sentence, I think you get the gist. Whatever the ESOP committee does -- whether it discloses bad news or starts trading as if the news were bad -- the market will react to it by pummeling the stock. Will that be good or bad for the ESOP? According to the Supreme Court in Dudenhoeffer, ESOP beneficiaries can't sue plan fiduciaries unless they can credibly allege that the plan would surely have been better off had the fiduciaries acted, pulled the lever in some way.

In the newly decided Jander case, the Supreme Court sent the case back to the lower courts because they had not addressed that last of the Dudenhoeffer considerations. "The question presented in this case concerned what it takes to plausibly allege an alternative action 'that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.' " That question turns on timing. The essence of the case is that the ESOP committee violated its fiduciary duties by riding the market to the bottom. They could have acted sooner, still consistent with the securities laws, and saved some of the ESOP's value even if it couldn't save all of it. Or so the plaintiff alleges.

Needless to say, the business community very much wants to see the trolley hit the many ESOP beneficiaries rather than the few company executives. See SIFMA's amicus brief, https://www.supremecourt.gov/DocketPDF/18/18-1165/112241/20190813170716351_18-1165.tsac.pdf. Frankly, given how the Supreme Court has enunciated the hurdles that ESOP plan participants must overcome to file a complaint against plan fiduciaries who are also corporate executives, it seems unlikely that any such complaint could survive. Justice Kagan frankly said as much. And so, once again, corporate executives are driving that train any way they please.


Aegis J. Frumento

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters.  Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of BrokeAndBroker.com Blog.