ESOP trustees are increasingly becoming targets


There are a number of very good reasons for an employer to have an Employee Stock Ownership Plan (ESOP):

  • There is overwhelming evidence that ESOP companies are more profitable and more productive than their peers.
  • They provide sustainable jobs, while allowing ESOP participants to accumulate more benefits for retirement.
  • The ESOP itself also provides a mechanism for owners to sell their stock to their employees in a very tax favored manner.

It is impossible to have an ESOP without a trustee – but ESOP trustees are being aggressively targeted by the Department of Labor (DOL) and the plaintiff’s bar. ESOP trustees and ESOP transactions are being attacked on multiple fronts. 

  • The DOL and plaintiff’s bar are closely examining the amount that ESOP trustees agree to pay to buy the stock from the selling shareholders, and are filing suit claiming that the ESOP trustees paid too much.
  • The DOL and plaintiff’s bar have objected to the indemnity agreements that are commonly used by ESOP companies to indemnify ESOP trustees. 

These two things, in combination, are making trustees reexamine their potential exposure and revisit their decision to accept the role of ESOP trustee. 

While not downplaying the risk involved, there are steps that can be taken and protocols developed that can help ESOP trustees. Companies and trustees can still establish and maintain strong and productive ESOPs, while protecting ESOP trustees from litigation risks, if they take certain precautionary steps. 

How to protect ESOP trustees from litigation risks

Stock Value

First, companies can help ESOP trustees avoid claims that they paid too much to shareholders for their stock by providing accurate and reliable information about the company.

Under the Employee Retirement Income Security Act of 1974 (ERISA), which governs ESOPS, ESOP trustees are “fiduciaries” of the ESOP. As such, they have a duty to: 

  1. Act solely in the interest of ESOP participants and beneficiaries.
  2. Act for the exclusive purpose of providing benefits to ESOP participants and their beneficiaries and defraying reasonable expenses in administering the ESOP.
  3. Exercise the same care, skill, prudence and diligence that a prudent person acting in a like capacity and familiar with such matters would exercise in the conduct of an enterprise of a like character and with like aims. 

Furthermore, under ERISA, the sale of employer securities between the owner of a company and the company’s ERISA plan is prohibited unless the sale is for “adequate consideration.”

Much of the litigation against ESOP trustees claims that the trustees breached their fiduciary duties of prudence and loyalty to the ESOP and engaged in prohibited transactions by paying too much for the company stock. In making their case, the DOL and plaintiffs bar point to problems with the valuation upon which the ESOP relied to determine the purchase price.

In 2014, the DOL laid out a procedural road map that ESOP trustees can use to help them demonstrate that they utilized an appropriate process for determining the purchase price and hopefully minimizing the risk of litigation. In that year, the DOL entered into a settlement agreement with GreatBanc Trust Company. The agreement arose out of litigation brought by the DOL regarding GreatBanc’s handling of the purchase of Sierra Aluminum Company stock by the ESOP. 

In the past year, this procedural roadmap has been modified by four additional settlement agreements with other ESOP trustees, including one issued in early May. While these agreements have subtle differences that apply in particular situations, and although these settlements technically only apply to the parties to the agreements, all of them generally provide procedural guidance that companies and ESOP trustees should use for obtaining and evaluating a company valuation upon which the trustee will be relying to determine the stock purchase price. They provide, in part, the following: 

  • Selection of a valuation advisor. ESOP trustees must carefully consider their selection of the valuation advisor. ESOP trustees should considering questions like:
          – Is the appraiser independent?
          – What are the appraiser’s qualifications?
          – Is the ESOP trustee undertaking a prudent process in selecting the appraiser?
  • Oversight of the valuation process. ESOP trustees also have an obligation to monitor and oversee the valuation process. For example, they must question the reasonableness of the company projections, including whether anyone creating those projections has a conflict of interest. They also must consider the projections in light of things like the company’s historical performance and the performance of any comparable public companies. Companies looking to implement an ESOP should closely scrutinize the projections they provide to the ESOP trustee’s valuation advisor and ensure that they are reasonable under the circumstances.
  • Financial statements. The ESOP trustee should ensure it receives audited, unqualified financial statements or assess whether it is nonetheless prudent to rely on unaudited or qualified financial statements. Companies looking to implement an ESOP should make sure that their financials are in good shape and can reasonably be relied upon by the trustee’s valuation advisor.
  • Fiduciary review. The ESOP trustee must take reasonable steps necessary to determine the prudence of relying on the ESOP sponsor’s financial statements. The ESOP trustee must also ensure that valuation advisor receives specific information pertaining to prior valuations, etc. The ESOP trustee must also consider things like marketability discounts.
  • Control. The ESOP trustee must consider the appropriateness of control premiums, including its ability to vote its shares. If the ESOP pays a control premium, the trustee must document why it believes the ESOP is obtaining voting control and control in fact, and identify any limitations on such control, as well as the specific amount of consideration the ESOP received for such limitation(s).
  • Consideration of claw back. The ESOP trustee should consider whether it is appropriate to request a claw-back arrangement or other purchase price adjustment in the event of a significant corporate event or changed circumstances or other purchase price adjustment(s).

The ESOP trustee should carefully document its decision making process each step of the way. 

While the parties’ natural inclination may be to think of the stock purchase as simply another corporate transaction and act accordingly, due to the scrutiny these transactions receive, the parties should adhere to the above “best practice” approach, and be prepared to explain any variances therefrom, in order to lessen the likelihood of litigation over the price the ESOP pays for the stock.

Indemnification Agreements

In light of the litigation risk, it is not surprising that ESOP trustees often seek indemnification agreements from ESOP sponsors, and ESOP sponsors are typically willing to provide them. Nonetheless, the DOL and plaintiff’s bar have attacked the enforceability of such agreements. 

A typical indemnification agreement will provide that the ESOP sponsor will indemnify the trustee against losses, costs, etc. related to the trustee’s performance of services unless the loss is held by a court of competent jurisdiction (in a final judgment from which no appeal can be taken) to have resulted from the trustee’s gross negligence or willful misconduct or from the violation or breach of any fiduciary duty imposed under ERISA. These agreements typically also provide that the ESOP company may pay litigation costs up front, but the trustee must reimburse the company if it is determined that the indemnification should not apply.

The DOL and plaintiff’s bar have attacked indemnification agreements on the basis that they violate Section 410(a) of ERISA, which provides that "any provision in an agreement or instrument which purports to relieve a fiduciary from responsibility or liability for any responsibility, obligation, or duty under this part shall be void as against public policy.” So the question becomes:

Can an ESOP sponsor indemnify ESOP fiduciaries without violating Section 410(a) of ERISA? 

In 1975, the DOL issued an interpretive bulletin that suggests it can. The DOL interpreted Section 410(a) to permit indemnification agreements that do not relieve a fiduciary of fiduciary responsibility or liability. The DOL determined that indemnification provisions which leave the fiduciary fully responsible and liable, but merely permit another party to satisfy any liability incurred by the fiduciary in the same manner as insurance, are not void.

Johnson v. Couturier

Despite its seeming acceptance of agreements in which the ESOP sponsor indemnifies the ESOP trustee, the DOL and the plaintiff’s bar have consistently sought to have such agreements nullified. For example, in Johnson v. Couturier, the United States Court of Appeals for the Ninth Circuit disallowed the ESOP trustees’ indemnification agreements. In that case, the company agreed to advance litigation costs, which the ESOP trustee would reimburse if it was found that the litigation involve the trustee’s “deliberate wrongful acts” or “gross negligence.” In enjoining the advancement of litigation costs, the court noted that the indemnification agreements provided complete indemnity so long as the challenged acts or omissions did not involve deliberate wrongful acts or gross negligence. Thus, the indemnification agreements effectively limited the trustees’ liability under ERISA because, so long as they did not engage in deliberate wrongful acts or gross negligence, the trustees would be indemnified, even if they had violated their ERISA fiduciary duties. The court noted that, although ERISA does not bar the purchase of fiduciary liability insurance, the DOL has interpreted section 410 to permit indemnification of fiduciaries only so long as the agreement “do[es] not relieve a fiduciary of responsibility or liability.” 

It’s important to note that the Couturier court relied, in part, on the fact ERISA does not allow an ERISA plan to indemnify a plan fiduciary. In its 1975 interpretive bulletin, the DOL interpreted section 410(a) as rendering void any arrangement for indemnification of a fiduciary by the plan on the basis that such an arrangement would essentiality relieve the fiduciary of responsibility and liability to the plan by abrogating the plan’s right to recovery from the fiduciary. Although the trustees in Couturier argued that this provision did not apply because the advancement would be made from corporation and not the plan assets, the court nonetheless found it applicable. That is because, in this case, the ESOP sponsor was being liquidated, and its plan of liquidation provided for payment of all remaining equity to ESOP participants as shareholders. As a result, any proceeds taken from ESOP sponsor’s remaining funds to pay the trustee’s defense costs resulted in a dollar for dollar reduction in the funds available for distribution to ESOP participants.

Greatbanc v. Harris

In Greatbanc v. Harris, the United States District Court for the Central District of California relied, in part, on this distinguishing fact in allowing the indemnification agreement in its case to stand. In Harris, the indemnification agreement expressly prohibited indemnification if a court entered a final judgment from which no appeal could be taken finding the trustee liable for breach of its fiduciary duties under ERISA. As a result, the court found that the indemnification agreement did not run afoul of ERISA 410(a). The court distinguished this agreement from the one in Couturier, noting the rather unique circumstances present in the Couturier case. Were it not for those facts, the court held, under the law, the assets of the ESOP sponsor would not have been treated as assets of the ESOP and there would be no basis under ERISA for concluding that the indemnification agreement would harm the ESOP. 

One important thing to note in Harris was that the DOL argued that indemnification should be precluded in part because, in the event of a settlement, GreatBanc could obtain the benefit of defense and indemnification from ESOP sponsor even if GreatBanc admitted it breached its fiduciary duties under ERISA. (Remember that the indemnification applied unless a final judgment from which no appeal could be taken found the trustee liable for breach of its fiduciary duties under ERISA. Thus on its face, the indemnification would apply to settlements.) The DOL also argued that the indemnification agreement should be precluded because it did not specify how GreatBanc would reimburse the ESOP sponsor for advanced defense costs if a court ultimately determined that GreatBanc breached its duties under ERISA. The court rejected these arguments noting that the DOL was free to condition its consent to any settlement on any terms it believes are appropriate. For example, if the DOL was concerned about GreatBanc's ability to reimburse advanced defense costs, the DOL could seek a bond.

Pfeifer v. Wawa, Inc

While the DOL’s and plaintiff’s bar’s motives for attacking indemnity agreements can’t actually be known, its easy to see how if ESOP trustee have to pay their own defense costs upfront, they may be more motivated to settle claims. For example, in October 2016, in Pfeifer v. Wawa, Inc., the Eastern District of Pennsylvania followed the “majority” view in Couturier, that indemnification by an ESOP sponsor functionally equates to an impermissible indemnification by the ESOP itself, and thus found that the plaintiffs has standing to challenge Wawa, Inc.’s indemnification of the ESOP trustees. The ESOP trustees settled that case a little more than a year later for $25 million.

Fortunately, with careful planning, ESOP companies should still be able to indemnify ESOP trustees against most claims and outcomes. Indemnification agreements between the trustees and the company may still be enforced if they are carefully crafted to avoid the ERISA section 410 pitfalls. Furthermore, under ERISA, an ESOP may purchase fiduciary insurance for its fiduciaries if such insurance permits recourse by the insurer against the fiduciary in the case of a breach of a fiduciary duty. Similarly, an employer can purchase fiduciary insurance to cover ESOP fiduciaries. Thus, because there may be circumstances in which ESOP fiduciaries are not be able to rely on an indemnification from the employer sponsoring the ESOP, ESOP fiduciaries or trustees, whether inside or outside trustees, should ensure that they have sufficient fiduciary insurance coverage. This can be paid for by the employer sponsoring the ESOP or the trustee (with or without reimbursement by the ESOP company).

Don't abandon your ESOP plans

Despite the attacks coming from the DOL and the plaintiff’s bar, companies looking to implement an ESOP should not abandon their plans. If done correctly, an ESOP can have significant benefits for the ESOP company, the selling shareholders and the employees, while mitigating some of the risk for the trustee and the company. However, it almost does not need to be said, but due to the risks involved, companies and trustees need to surround themselves in any ESOP situation with professionals who are knowledgeable and experienced in the world of ESOPs.


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