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There has been a lot of attention in the world of employee ownership plans to the 2014 Supreme Court Decision in Fifth Third Bancorp v. Dudenhoeffer. In that case, the Court ruled that "the law does not create a special presumption favoring ESOP (Employee Stock Ownership Plan) fiduciaries. Rather, the same standard of prudence applies to all ERISA fiduciaries, including ESOP fiduciaries, except that an ESOP fiduciary is under no duty to diversify the ESOP's holdings." This ruling overturns the so-called Moench rule that has been applied to plan fiduciaries for certain 401(k) plans investing in company stock and ESOPs. Moench gave a presumption of prudence to plan fiduciaries unless they knew or should have known the company was in dire financial circumstances.

As important as this ruling is, it actually has very little if any impact on the vast majority of ESOPs, over 95% of which are in closely held companies. The ruling is far more important for public companies with 401(k) plans or ESOPs that offer company stock as an investment choice.

First, it is important to distinguish between a statutory ESOP and what courts came, by a rather tortured logic, to call ESOPs—namely any defined contribution plan that had company stock in it. ESOPs were created as part of ERISA in 1974 and given not just the right but the requirement to invest primarily in employer securities. ESOPs were specifically created to encourage employers to share ownership with employees, and over the years Congress has given these plans a number of special tax benefits. Because fiduciaries are required to invest primarily in employer stock, standard fiduciary obligations concerning diversification in retirement plans would be impractical. The Moench presumption was created in a case involving a statutory ESOP.

The large majority of "stock drop" cases, however, have not involved statutory ESOPs, but 401(k) plans that either allowed employees to invest in company stock and/or matched in company stock. Some of these plans required fiduciaries to offer company stock; others made it optional. Defense attorneys argued that these plans were actually "ESOPs" too and were subject to the Moench presumption. Most district and circuit courts bought that argument, although some applied it only when company stock was required. That, I think, was unfortunate and inappropriate. 401(k) plans were never meant to be vehicles for sharing corporate ownership. They are intended to be safe, cost-effective retirement plans. ESOPs are a specific statutory creation with a specific set of rules and purposes.

When reading the Supreme Court decision, as well as the arguments made before the Court, it is also clear that the justices were thinking entirely of public companies. There is virtually no discussion of ESOPs in closely held companies, and the key tests that the Court now requires plaintiffs to meet in stock drop cases largely do not apply to privately held companies. Since the original Moench decision in 1995, we at the National Center for Employee Ownership have only found two cases in closely held companies that were decided even in part based on that presumption.

The Court's decision in the Fifth Third case laid out three key hurdles for plaintiffs to overcome to prevail. The first states that it is insufficient to argue that fiduciaries should be able to outguess the market based on publicly available information. The second issue is whether decisions to sell company stock in light of inside information could be prudently taken in light of their potential impact on the prices of company stock. Fiduciaries are also not obligated to violate securities laws. Finally, the Court said plaintiffs must allege a reasonable alternative course of action.

In ESOPs in closely held companies, fiduciaries have few options that could form the basis for plaintiffs arguing a plausible course of action. First, the law requires that ESOPs be primarily invested in company stock. Second, the only liquidity options are a company buy-back of shares, which is probably impractical if the company is already in financial distress, or a sale of the company. But a fire sale like that would mean an even lower price for plan participants. As noted in more detail below, none of the presumption of prudence cases has concerned closely held companies, probably because of these issues. Also note that Dudenhoeffer distinguished between relying on inside information to sell company stock (which it classified as illegal insider trading and thus not required by the duty of prudence) and refraining from buying more company stock (which might be a fiduciary violation). The purchase of shares by an ESOP is already subject to substantial statutory and case law requirements, and this decision is unlikely to change the way these cases are contested.

As a result of all this, the prudence presumption has so far not been an issue for closely held ESOP companies in court, and it is likely to continue not to be as plaintiffs would have a hard time indicating what fiduciaries should have done. Instead, cases will continue to focus, as they have been before where there are alleged problems, on the initial sale price of the shares of the ESOP, which is determined by the trustee and relies on an outside appraiser. It is possible that the Dudenhoeffer decision may embolden the plaintiffs' bar to initiate more lawsuits, but we would expect that to continue to be primarily in public companies.
Beyond Fifth Third—ESOPs Law for the 97%

The 97% of ESOP companies that are closely held will not be much affected by the Supreme Court decision, but the last 25 years of litigation on ESOPs reveals some important trends that should be considered.

In an analysis by the NCEO of the 224 decisions courts have made on ESOPs in closely held companies between 1990 and 2014, we found that many of the suits involved plan management issues, such as failing to make distributions. The most significant issues, however, concerned valuation, indemnification, and fiduciary duties.

The valuation decisions are mixed. Courts have focused more on process than outcome. Some processes are clearly unacceptable, such as not hiring an independent appraiser or influencing an appraiser's report. Several key best practices have emerged. A recent settlement between the Department of Labor and GreatBanc Trust in a valuation case (Perez v. GreatBanc Trust Co., 5:12-cv-01648-R-DTB (C.D. Cal., proposed settlement agreement filed June 2, 2014) set out terms for GreatBanc to follow in future engagements that does a good job of summarizing the trends in the courts.

Key points in the settlement included:

Trustees must be able to show that they vetted the independence and qualifications of appraisers carefully.

Trustees must show that they have assessed the reasonableness of financial projections given to the appraiser. Some valuation advisors include disclaimers in their engagement agreements that the DOL reads as too broad, in that read literally the valuation advisor can rely on any information it receives from the plan sponsor company without inquiring as to its reasonableness, no matter how unreasonable the information. The use of these disclaimers will not absolve the trustee of responsibility and the trustee should document how the appraisal firm has analyzed just how reliable projections are.

The trustee should consider how plan provisions, such as those relating to puts, diversification, and distribution policies, might affect the plan sponsor's repurchase obligation.

The trustee should consider the company's ability to service the debt if projections are not met.

Documentation should be detailed. While documentation of the valuation analysis may appear to be burdensome, making the effort to document the valuation review process at the time of the transaction can only benefit the valuation advisor and the trustee in later years.


The other significant legal development for closely held company ESOPs in recent years concerns indemnification, ironically also in the case involving Sierra Aluminum and GrratBanc. In Harris v. GreatBanc Trust Co., Sierra Aluminum Co., & Sierra Aluminum ESOP, No. 5:12-cv-01648-R (C.D. Cal. Mar. 15, 2013), a district court ruled that GreatBanc could be indemnified for its role as the ESOP fiduciary. The decision is significant in that it occurred in the one circuit (the Ninth) that has taken the position that indemnification should not be allowed, especially in a 100% ESOP. In Johnson v. Couturier, 572 F.3d 1067 (9th Cir. 2009), the court ruled that ESOP plan assets were not distinguishable from company assets. If plaintiffs prevailed but the company's indemnification had paid out millions in legal fees to defendants (as was the case here), the plaintiffs would have a very hollow victory. In that same circuit, in Fernandez et al. v. K-M Industries Holding Co., No. C 06-7339 CW (N.D. Cal. Aug. 21, 2009), a court that an indemnification agreement did not apply in the case of a 42% ESOP because if alleged ERISA violations concerning an improper valuation were sustained, the indemnification would harm the value of participant stock.

These decisions seemed to make indemnification largely moot, but in the GreatBanc case the court ruled that regulations (29 C.F.R. § 2510.3-101(h)(3)) of ERISA Section 410 state that in the case of an ESOP, the plan's assets and the company assets are treated as separate. In Couturier, the Harris court said, the company had already been liquidated and was thus no longer an operating company. The court also distinguished this case from Couturier in that in Couturier, plaintiffs had already shown likelihood to prevail on fiduciary charges, something that could not be said of this case. Finally, the Couturier case involved no exceptions for breaches of fiduciary duty, as was the case here, but only for "gross negligence" and "willful misconduct."

Other courts in other circuits have not weighed in on this issue. Certainly a good argument can be made that if indemnification means that plaintiffs will lose a substantial amount of a settlement agreement because there is no money to pay, it seems compelling indemnification should not apply. That would not be the case if the company had other available assets. In any event, ESOP advisors now caution clients that indemnification may have limited value and that they should rely primarily on adequate fiduciary insurance.

In recent years, the Department of Labor has been more aggressive in pursuing what it perceives as valuation abuses in ESOP companies. While there have been a few more court cases and settlements per year than normal, a typical year finds only a handful of these out of the 6,500 or so ESOPs in closely held companies. A comprehensive study by the NCEO found that the default rate on leveraged ESOPs (those that borrow money to buy stock, which most do) is just .2% per year, way below other LBOs. If valuations really were routinely excessive, this number would be higher as the debt burden would be unrealistic.

Other ESOP litigation has been relatively mundane, focusing either on administrative errors or the occasional fraudulent behavior. Indemnification could become a more important issue, but companies can (and should) resolve that with proper fiduciary insurance.

The future for company stock in public company retirement plans, mostly 401(k) plan, is far less certain. There has been a steady decline in how many companies offer this and how much those that do rely on it. Even for advocates of employee ownership, however, this is not necessarily a bad thing. Good ESOP companies have secondary diversified retirement plans—in fact, ESOP companies are more likely to have a diversified retirement plan than other companies are to have any plan. That is a best practice we strongly encourage.

Article By:  Corey Rosen

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