6th Circuit Rules for Eaton Corp. in ESOP Suit

The appellate court agreed with a lower court that plaintiffs did not meet pleading standards set forth in the Supreme Court ruling in Fifth Third v. Dudenhoeffer.

The 6th U.S. Circuit Court of Appeals has upheld a district court decision to dismiss a class-action suit against Eaton Corporation fiduciaries of its employee stock ownership plan (ESOP), alleging they had made statements that artificially inflated the company stock.

The original suit said that between November 13, 2013 through July 28, 2014, plan participants purchased $40 million of Eaton stock through the ESOP, adding to the $909 million already held.

Beginning in 2008, Eaton began concentrating more on its electrical component business than on its vehicle business. In 2012, Eaton acquired Cooper Industries, an electrical product manufacturer based in Ireland, for $11.8 billion. The acquisition was done through the creation of a holding company that permitted Eaton to move its headquarters to Dublin, Ireland, and benefit from a lower corporate tax rate.

Following the acquisition, investment analysts began to question whether the acquisition would prevent Eaton from selling its vehicle business. On two investor calls and at a Goldman Sachs Industrial Conference, Eaton CEO Alexander Cutler said that the deal would not prevent the company from selling its vehicle business—but that the company had no plans to do so. As a result, one analyst said, “We believe a spin-off or sale of the [Eaton] vehicle segment is possible over the next 12-18 months and could be a positive catalyst for the stock.”

However, on an earnings call on July 29, 2014, Cutler said that Eaton was subject to a five-year restriction on tax-free spin-offs as a result of the Cooper merger. On that day, the stock fell 8.13% to $70.51 a share, and in the following months, it fell further to $61.

The plaintiffs accused Eaton of fraud and misrepresentation that “caused its stock price to trade at artificially inflated prices. Any reasonable person would be hard pressed not to believe that Eaton was at least contemplating a spin-off of its vehicle business.”

Plaintiffs said that Eaton could have issued corrective disclosures, halted new contributions to the fund or directed the fund to divert a portion of its holdings into a low-cost hedging product.

Defendants asked that the case be dismissed for failure to meet the pleading standards required of claims against ESOP fiduciaries.

Citing findings in Fifth Third Bancorp v. Dudenhoeffer and Amgen Inc. v. Harris, the appellate court concluded that “the district court properly determined the complaint does not propose an alternative course of action so clearly beneficial that a prudent fiduciary could not conclude that it would be more likely to harm the fund than to help it.”

The court said that with respect to issuing corrective disclosures, disclosing the tax consequences of the Cooper merger could have resulted in a market overreaction. Because Culter and another Eaton executive “repeatedly stated that Eaton had no plans to spin off its vehicle business, a reasonably prudent fiduciary may have determined that disclosing the tax consequences of such unplanned actions would do more harm than good,” the court said.

With respect to halting all new investments into the Eaton Stock Fund, the appeals court agreed with the district court’s finding that “halting investment in a company fund can cause the market to infer that ‘insider fiduciaries view the employer’s stock as a bad investment,’ resulting in a drop in stock price.”

Finally, the plaintiffs’ suggestion that the defendants could have directed a small portion of the fund into low-cost hedging product runs counter to ESOPs fiduciaries’ exemption from investment diversification, the appeals court said. The district court said that the plaintiffs failed to identify what alternative investments the fund should have directed inflows into “whether it was a short position in Eaton stock, an insurance product or something else.”

The appellate court said that the plaintiffs’ appeal added “no further detail to the kind of low-cost hedging product they envision.”

The 6th Circuit’s opinion is here.