Employee stock ownership plans (“ESOPs”) are a valuable tool for businesses to create a succession plan and provide retirement benefits to employees by having employees purchase employer stock. Although self-interested transactions are generally prohibited under the Employee Retirement Income Security Act of 1974 (“ERISA”), ESOPs are encouraged under ERISA despite the fact that the plans can only invest in the employer stock through related party transactions. This Congressional encouragement has even been noted by the Supreme Court in the recent Fifth Third Bancorp v. Dudenhoeffer case when the Court reiterated that Congress has sought to “promote ESOPs” and has warned against “regulations and rulings” that “block the establishment and success of” ESOPs. In Dudenhoeffer, the Supreme Court protected the Congressional intent of promoting ESOPs by requiring plaintiffs to bear a heightened pleading standard before being able to proceed in a suit against plan fiduciaries for maintaining employer stock within the company’s retirement plan.
Despite the Congressional pronouncements to protect ESOPs, and the recognition of those pronouncements by the Supreme Court, some federal trial and appellate courts have placed burdens upon ESOP fiduciaries that exceed the obligations of the express terms of ERISA. Congress encouraged the creation of ESOPs and permitted an ESOP to purchase employer stock so long as the ESOP “pays no more than adequate consideration” for the company’s stock. 29 U.S.C. § 1108(b)(17). Due to regulatory inaction on behalf of the Department of Labor, what constitutes adequate consideration has not been well defined. This inaction has opened the door to litigation against ESOP fiduciaries to litigate ESOP transactions for over paying for company stock.
A plaintiff adequately pleading that an ESOP fiduciary paid more than adequate consideration for company stock can have critical implications for defendants. Specifically, some federal trial and appellate courts have ruled that, once a plaintiff pleads that an ESOP fiduciary paid more than adequate consideration, the burden shifts to the ESOP fiduciary to prove that the ESOP purchased the company’s stock for no more than adequate consideration – a burden shift not contained within ERISA or its implementing regulations, which runs counter to both the express indications of Congress in ERISA and the Supreme Court’s pronouncements in Dudenhoeffer and which flies in the face of traditional American jurisprudence. But, a recent case from the District Court in the Eastern District of North Carolina (Lee v. Argent Trust Company), has rejected this incorrect trend by implicitly concluding that burden shifting is improper and following the general premise of Dudenhoeffer in requiring more than bald assertions in complaints. This tension between these differing pleading standards is demonstrated by looking at the Court’s conclusion in Lee as compared to looking at the Western District of Virginia’s recent decision in Pizzella v. Vinoskey.
Lee v. Argent Trust Company (E.D.N.C.)
The Eastern District of North Carolina recently came to the conclusion that baldly asserting that an ESOP overpaid for the employer stock does not shift the obligation to the ESOP fiduciary to prove that the plan didn’t pay more than “adequate consideration.” In Lee v. Argent Trust Company, et al., the Court ruled that the plaintiff failed to state a claim for damages and dismissed the plaintiff’s complaint. Choate Construction Company Employee Stock Ownership Plan (“Choate ESOP”) purchased 80% of Choate Construction Company’s (“Choate”) shares for $198 million. Like most ESOP transactions, the ESOP did not actually finance the purchase itself. Instead, Choate obtained financing from lenders, which it used to make a loan to the ESOP, and the ESOP issued notes to the selling shareholders. Thus, the ESOP’s purchase was fully leveraged by debt incurred or guaranteed by Choate.
These obligations on Choate following the ESOP’s purchase understandably caused the first post-transaction valuation of the Choate stock held within the ESOP to recognize a per share value that was significantly less than the value paid by the ESOP a few weeks prior. Based on this apparent significant drop in stock price immediately after the close the transaction, the plaintiff brought class-wide allegations that the ESOP trustee paid more than adequate consideration, in violation of ERISA. The defendants moved to dismiss for lack of standing and for failing to state a claim upon which relief could be granted.
Recognizing the unique realities of an ESOP transaction, the Eastern District of North Carolina granted the motion to dismiss for lack of standing because the plaintiff could not show she suffered any injury. Because the plaintiff only relied on the purchase price compared to the valuation, the Court noted the plaintiff “fundamentally misunderstands the nature of the” ESOP transaction and the subsequent stock valuation. Merely looking at the drop in value ignores the fact that the ESOP did not actually own any equity in the shares at that point. Instead, much like a mortgage without a down payment, the ESOP took on debt in exchange for an equal amount of assets, but no new equity. Instead of showing a drop in value to the plaintiff, the fact that these shares had a value of $64.8 million mere weeks after closing actually showed an immediate equitable benefit to the plaintiff that plaintiff would not otherwise have seen. Without any injury, the plaintiff did not have standing.
In short, the Eastern District of North Carolina correctly recognized that a stock drop immediately post transaction does not prima face demonstrate the ESOP fiduciary paid more than adequate consideration for company shares, but is instead a reality of an ESOP transaction financed by the company itself taking on debt. Therefore, without any showing of actual injury, the plaintiff could not state a claim for relief.
Pizzella v. Vinoskey (W.D. Va.)
On the other end of the spectrum is Pizzella v. Vinoskey, the recent decision after a week-long bench trial in the Western District of Virginia. Unlike Lee, Pizzella highlights the importance of recognizing the distinction between a mere stock-drop case and one that involves allegations of valuation errors, especially as it relates to valuing control.
In Pizzella, the Court permitted the case to proceed and required the ESOP fiduciary to bear the burden of proof that it did not cause the ESOP to pay more than adequate consideration when it purchased shares of the employer’s stock. As in Brundle v. Wilmington Trust, N.A., the Court took specific issue with the fact that the valuation expert applied a control premium to the purchase price, even though it concluded that the ESOP did not have full control over the company.
As a contrast to Lee, the Court found that the allegation that the ESOP fiduciary caused the ESOP to overpay when coupled with specific arguments that the ESOP failed to “control” the company following the ESOP sale was sufficient to find the ESOP fiduciary breached its ERISA duties. Interestingly, while the Court’s conclusion that the ESOP lacked “control” to operate the company following the transaction was pivotal in concluding that the ESOP fiduciary didn’t carry its misplaced burden of proof, the lack of ESOP “control” was not an element of the complaint. Instead, the complaint rested upon the premise that the stock value dropped following the transaction and that the ESOP fiduciary didn’t take adequate steps to protect the participants as a result of that drop in value.
Despite the differing conclusions of the Courts, the complaints in Lee and Choate are largely indistinguishable – allegations of post transaction drops in value resulting from the debt taken on by the company sponsoring the ESOP to facilitate the transaction. However, because of the misplaced application of the shifting burden of proof, the results between the two matters vary widely. The differing application of the standard of proof in ESOP litigation needs to be addressed. Courts should, at the least, follow the general principles the Supreme Court announced in Dudenhoeffer and mandate a higher pleading standard for a claim against an ESOP fiduciary prior to shifting the burden to the ESOP fiduciaries. And, more readily, Courts should re-think the bench-created shifting of burden all together and revert to applying ERISA’s explicit statute and express purpose of promoting ESOPs by following the standard obligation of American jurisprudence and mandate that the plaintiffs bear the burden of proving that an ESOP fiduciary paid more than “adequate consideration.” And, if the Supreme Court grants certiorari in the Putnam Investments LLC v. Brotherston case, the chance to correct this inequity may be presented.