By Harvey M. Katz
In recent years, many sponsors and trustees had to defend investigations from the U.S. Department of Labor (DOL) in connection with transactions in which company shares were sold to an Employee Stock Ownership Plan (ESOP). In certain cases, these investigations have resulted in DOL-initiated lawsuits seeking to recover damages allegedly suffered by the ESOP participants because of, among other things, supposed “overpayments” by trustees for company stock.
A new and potentially more dangerous threat is posed by lawsuits now being filed by attorneys representing plan participants in connection with certain ESOP transactions. Although DOL-initiated litigation has changed the manner in which ESOP transactions are conducted, these participant class action lawsuits may have far more serious implications for sponsors and trustees and their business partners.
The DOL lawsuits are aimed at a relatively few specific transactions where the DOL has determined that the ESOP trustee has overpaid for the shares. However, the class action suits have a broader focus, which is to find errors in the implementation or operation of the ESOP in order to obtain the highest possible dollar recovery.
What makes this so significant is that the plaintiff’s bar obtains access to the ESOP’s books and records by claiming the loss in share value constitutes a breach in fiduciary duty. This loss, however, is a necessary part of every leveraged ESOP transaction. In essence, an ESOP transaction is a leveraged buyout of all or part of the company. Debt is placed on the company to finance the sale, as it would be in any management buyout. The debt (and the associated drop in share value) is a normal and expected part of the transaction. The company’s intrinsic value does not change; it has merely converted some of its equity into debt.
In these cases, the plaintiff’s bar asserts that the ESOP trustees have breached their fiduciary duties as a result of the loss in the stock value without action to divest the shares. These allegations are based upon a line of so-called “stock drop” cases involving public company stock held by ESOPs and other similar plans.
From a litigation perspective, factually based allegations are more problematic because these type of allegations are not easily susceptible to motions to dismiss, which are motions arguing that the plaintiff has no legal claim even if the facts he or she alleges are presumed to be true. Once a fact-based set of allegations survives a motion to dismiss, a plaintiff typically has a right to commence far-ranging discovery. When litigation has entered the discovery phase, it becomes very labor intensive and expensive to litigate. In addition, the federal discovery rules are liberally construed and open the entire operation and administration of the ESOP to examination by the plaintiff.
This poses a threat to ESOPs by creating a situation where some plaintiffs’ attorneys may feel there is an incentive to bring multiple lawsuits in the belief that ESOPs may enter into expensive settlements simply to avoid litigation costs. The ultimate result may be unaffordable fiduciary liability insurance and fewer ESOP transactions.
The situation is far from hopeless. There are multiple strategies available to ESOP sponsors and trustees that enable them to minimize or eliminate the threat. ESOP fiduciaries and the ESOP community, in general, are well advised to take this threat seriously and to move aggressively to adopt some or all of these strategies.
A full analysis of all of the options available to ESOP sponsors and fiduciaries is far beyond the scope of this alert. However, the strategies can be divided into four basic categories: 1) plan document amendments; 2) enhanced release forms; 3) pre-discovery litigation strategies; and 4) additional litigation strategies.
For example, plan document strategies might include amendments to the plan to add impediments to litigation such as contractual statutes of limitations and mandatory arbitration clauses, but other techniques aimed more directly at class action and derivative type lawsuits are also possibilities.
Another pre-litigation strategy is to potentially require releases for all participant distributions. These releases need to be specifically crafted and appropriately tailored in the hope of precluding further claims relating to fiduciary breaches as well as further claims for individual benefits.
The courts are split as to what language constitutes an effective release of claims against a fiduciary, and look at the specificity of the provision and the sophistication of the parties involved. They often reject plaintiffs’ claims of ignorance when the language is clear and unambiguous.
In the event that litigation has already commenced, it is possible, with proper planning, to defeat the litigation on a motion to dismiss if without disputing the facts presented by the plaintiff the drop in share price can be demonstrated as an expected outcome of the transaction. The ESOP community can be helpful in educating the courts about this aspect of ESOP transactions. It may also be prudent to deliver a forward-looking prospectus to all beneficiaries to put them on notice that trustees and fiduciaries need not be prescient about future stock-value movements – an idea often forgotten but repeatedly affirmed in the courts. Full disclosure to participants regarding the mechanics and the amount of an expected drop in value in the Summary Plan Description and other documents would enhance the position of any potential defendant.
Finally, in the event that the complaint survives a motion to dismiss, the defensive strategy should involve aggressively limiting discovery to issues raised in the complaint to the extent possible. More importantly, in the event of other issues with individual benefit claims, defendants should always require administrative exhaustion via the plan’s claims procedures.
Of course, the key to defending any claims is advance planning with the assistance of knowledgeable ESOP transactional and litigation counsel.
