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ESOP's Fable

By now the story of the 2018 failure of the flight stabilization program of the Boeing 737 MAX is well known. The result was two fatal crashes and 346 deaths. After a cover up of a defect in the program, amid charges of fraud, the company has already paid out over $2.5 billion in penalties and compensation. Boeing is still dealing with the aftermath.

Some Boeing employees also believe they are victims of the company’s conduct connected with the 737 MAX. They are participants in the Boeing employee stock ownership plan (“ESOP”), which has a stake in the company worth around $11 billion. The employees filed what is commonly known as a “stock drop” case, a lawsuit predicated on a steep drop in the price of a company’s shares.

The Boeing ESOP participants allege that, soon after the retrieval of the flight data recorder of the plane involved in the first of the crashes, that of a Lion Air aircraft in October 2018, Boeing knew, or should have known, that the 737 MAX was unsafe. Boeing, the employees claim, was then bound to issue a corrective public disclosure acknowledging the danger. As a result of what they charged was a campaign of concealment, the plan continued to hold and acquire Boeing shares at artificially inflated prices.

The employees sued under the Employee Retirement Income Security Act (“ERISA”), a federal law designed to protect participants in employee benefit programs and their beneficiaries. Among ERISA’s many requirements is that the fiduciaries of such plans act prudently and solely in the interest of the plans’ participants in managing plan assets.[i]

The employees’ theory of liability is that Boeing insiders responsible for administration of the ESOP, and the Company itself, had access to non-public information about the safety issues in connection with the 737 MAX, which the administrators failed to disclose to Newport Trust Company, the firm to which they delegated their fiduciary responsibility under the plan, and the investing public. That failure, the employees argue, rendered Newport incapable of performing its fiduciary duty and, what is more, breached a broader duty of loyalty, which cannot be delegated.

But before a court could consider the merits of their claims, the ESOP participants had to scale a pretty high bar due to Boeing’s offloading its fiduciary responsibility to Newport and the nature of the information that they claimed the company was obliged to disclose to Newport.

Boeing erected the first hurdle by simply delegating to Newport “the exclusive fiduciary responsibility” over the plan in an Independent Fiduciary Agreement. In an August 1, 2022 decision,[ii] the United States Court of Appeals for the Seventh Circuit, which heard the employees’ appeal from a lower court decision dismissing their complaint, found that the Boeing insiders were neither named nor functional fiduciaries and therefore did not owe a duty of prudence under ERISA to plan participants. Newport, which did not know of the dangers posed by 737 MAX flight stabilization program before members of the public, was the sole fiduciary. Theoretically, Boeing could be liable for failure to monitor the activities of Newport, but there could be no plausible claim that the company acted inappropriately in that way or that the honesty and competence of Newport were in question. Boeing, the court held, was entitled to delegate the entirety of its fiduciary power over investment decisions for its ESOP to a third party.

As to the second impediment, the Supreme Court had adopted a demanding standard for claims involving fiduciaries of benefit plans invested in employer stock. A plaintiff in such a case must “plausibly allege an alternative action that the defendant could have taken that would have been consistent with the securities law and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.”[iii] This test has come to be known as the “more harm than good” standard. (Seriously).

The claim of the Boeing employees was effectively that the plan administrator, and Boeing, had a duty to disclose insider information—that is, non-public facts about a publicly-traded company which could provide an advantage to investors in the company. They contended that there was an ERISA-based duty to disclose material non-public information to third-party plan fiduciaries. However, the Court of Appeals found no basis to say that ERISA imposes a duty on company insiders to do what the securities laws forbid: publicly disclose non-public material information.

Boeing argued, and the Court of Appeals agreed, that a prudent fiduciary could have reasonably concluded that real time disclosure of the problems connected with the 737 MAX would have done more harm than good to the ESOP in the light of the many investigations that were under way in November 2018.

Corporate fiduciaries may well find themselves in a bind—caught between a claim by a plan participant that the duty of loyalty requires that they disclose what may be non-public information and navigating the complexity of the securities laws. The evident lesson in this case is that the optimal way to relieve this tension is to hire a third-party manager to act as fiduciary. By appointing Newport, Boeing extricated itself from the bind.

Apart from all of this, the role of ESOP fiduciary is subject to conflicts of its own. The Supreme Court has recognized the “tension” between the ERISA-imposed duty of prudence and offering non-diversified, high-risk ESOPs.[iv] ERISA is itself conflicted about ESOPs. While requiring fiduciaries to control risk by diversifying plan investments, the law specifically authorizes including ESOPs in an investment program.[v]

Maybe, there’s a different way to do this—not offering the option to invest retirement funds in the company’s stock. It wouldn’t be the worst decision you could make as a fiduciary. Advisors caution against the under-diversification that results when your assets are heavily invested in your employer. (Remember Enron and Lehman Brothers?)

This is not to say ESOPs aren’t beneficial. They can provide employees with a sense of ownership and a stake in the success of the company that employs them and the company with a source of capital growth. So, they’re not going away soon, and companies will continue to face the challenge of reconciling ERISA and federal securities laws.

ESOPs have no doubt worked out well for some employees who chose to bet on their company’s future. But as we see every time there is a market downturn or a non-systemic company failure, diversification is the investor’s best friend long term. Just ask Boeing’s ESOP participants. As much as there is a pretty clear lesson for companies in all of this—to hire a third-party fiduciary—there is a lesson for employees: Keep the bulk of your investable assets somewhere other than an ESOP.

[i] 29 U.S.C. §1104(a)(1)(B). [ii] Burke v. Boeing Co., Docket No. 20-3389 (7th Cir. Aug. 1, 2022). [iii] Fifth Third Bancorp. v. Dudenhoeffer, 573 U.S. 409, 424 (2014). [iv] Amgen v. Harris, 577 U.S. 308 (2016). [v] Compare 29 U.S.C. §1104(a)(1)(B) with 29 U.S.C. §1104(a)(2).


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