ESOPS, ERISA, and Employer Stock: A Litigator's Approach
Click here for documents describing a recent suit filed by CMHT challenging the purchase of overpriced employer stock by an ESOP
by Marc I. Machiz
(Mr. Machiz, formerly the Department of Labor's chief ERISA lawyer, is a partner in the Washington, D.C. law firm of Cohen, Milstein, Hausfeld & Toll, P.L.L.C. concentrating in ERISA.)
It appears we've finally reached the end of a seemingly endless economic expansion, and Americans are about to discover that their prized assets are worth less than they thought. At no time is this discovery more wrenching than when the asset in question is an equity interest in an individual's employer. Suddenly, the employee's job is lost, or at risk, and at the same time the presumed value of his employer stock is evaporating. In closely-held companies, this equity interest is often held through an employee benefit plan covered by ERISA.
In this economic environment, distressed employees and former employees may find their way to a lawyer wondering if there isn't someone who can be held accountable for the unexpected decline in their economic outlook. Your first reaction might be philosophical. After all, the risk of a downturn in economic activity threatens jobs and equity in equal measure. As explained below, a loophole in ERISA allows employees to be undiversified and over committed to employer stock in the most common types of pension plans. You may think that there is nothing you can do. Think again.
There is good reason to be suspicious of the price at which employee benefit plans purchase stock in closely-held companies. This is because ERISA, which generally prohibits the failure to diversify and self-dealing, actually invites both sorts of conduct when it comes to the purchase and sale of employer stock. The combination of these two loopholes is explosive. If you don't specialize in ERISA, this will strike you as outrageous. How could a statute designed to protect the retirement security of Americans actually encourage abusive purchases of employer stock? Here's how.
ERISA's overarching goal of retirement security was hijacked by advocates of an entirely different policy agenda, the encouragement of employee stock ownership. We leave for another day a debate over the merits of this agenda. Beyond debate is the potential for abuse created by its implementation. Once you understand it, you'll look at any investments in closely-held employer stock by a benefit plan with fresh eyes.
ERISA's prohibitions against self-dealing have no application to employer stock. Generally, ERISA does not permit a trustee or other fiduciary to purchase an asset on behalf of a pension plan from himself, an entity in which he has a financial interest, or from a broad range of statutorily defined insiders known as "parties in interest," including the employer who sponsors the plan. A statutory exemption trumps all of these prohibitions in the case of the purchase or sale of employer stock. 29 U.S.C. § 1108(e). If you have any doubt that this is outlandish, consider the following comparison. As the trustee of my company's profit-sharing plan, I cannot lend my company money from the plan, even if the loan is secured by real estate or other hard assets valued far in excess of the loan amount. This per se rule is designed to protect against the obvious conflict of interest that exists in such transactions. Nevertheless, in the case of a far riskier asset, unmarketable employer stock in a closely-held company, I can cause the plan to purchase stock from myself, or from the employer.
To qualify for the exemption in 28 U.S.C. § 1108(e), the purchase or sale must be for "adequate consideration." In the case of closely-held stock, "adequate consideration" is defined as "the fair market value determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations issued by the Secretary." 29 U.S.C. § 1002 (18). The Department of Labor has never succeeded in issuing final regulations defining "adequate consideration," but the courts have placed a gloss on this language requiring an objective test of good faith consistent with ERISA's "prudent investor" standard. See, e.g., Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983). Accordingly, in transactions of any size you will find an appraisal purporting to support the purchase or sale price. For many appraisers, employer stock valuations are a large part of their business. Not all of them are as disinterested as might appear at first blush. Even assuming the appraiser is reputable and has scruples, the employer can manipulate the appraised value by providing the appraiser with outdated, or inaccurate data. Generally, even the best appraisers will give substantial weight to management projections of income and expenses. Thus, a seemingly disinterested appraisal will be based in large part on information and projections supplied by the party dealing with the pension plan. Obviously, the potential for abuse is huge. As explained below, the opportunity to engage in substantial transactions of this sort is large as well.
ERISA's diversification requirement has virtually no application to purchases of employer stock in closely-held companies. Generally, ERISA requires fiduciaries to diversify pension plan assets to avoid the risk of large losses. Smaller employers, however, typically maintain only so-called defined contribution plans, rather than defined benefit plans for their employees. Defined contribution plans provide an account for each employee to which investment gains and losses are credited. By contrast, defined benefit plans provide a fixed benefit guaranteed by the employer. To protect defined benefit plans from employer insolvency, they are not permitted to hold more than 10 per cent of their assets in employer securities and employer real property. 29 U.S.C § 1107. Incredibly, defined contribution plans are permitted to hold up to 100 percent of their assets in employer stock. 29 U.S.C. §1107(b)(1); 29 U.S.C. 1104 (a)(2). Thus, self dealing transactions may account for an employee's entire pension benefit, and the risk of loss is borne entirely by the employee in his defined contribution account.
Further, various tax code provisions create an incentive for employers to establish a special type of defined contribution plan known as an Employee Stock Ownership Plan or ESOP. To qualify for certain tax breaks, an ESOP must be designed to invest primarily in employer stock. ESOPs are not only permitted to be undiversified, they are required by statute to not diversify.
Apart from tax breaks designed to encourage their creation, what's special about an ESOP is that it can borrow money, generally from the employer, or from a bank with a guarantee from the employer. The loan proceeds can only be used to purchase employer stock. The stock purchased is generally held in a suspense account securing the loan, and will be repaid from employer contributions to the ESOP, proceeds of the sale of the stock, and dividends on the stock in the suspense account, if any. As employer contributions are made paying off the ESOP loan, stock is released from the suspense account in proportion to the original purchase price, and allocated to each individual's account.
ESOPs are inherently good deals for employers, but they become better deals if the ESOP buys stock for more than fair market value. Because the valuation issues are complex, and because the courts have not required the disclosure of employer stock appraisals outside of litigation or government investigations, relatively few employer stock transactions have been challenged. A well organized ESOP lobby, which frequently seeks help on Capitol Hill when a transaction is challenged, has made the government cautious.
Spotting an abusive transaction is not impossible. Often, some of the employees will have a sense that things are amiss. Purchases of employer stock which immediately precede hard times, or follow failed attempts to market the stock to third parties (or sales shortly before buyouts or other value enhancing events) are danger signals. But filing suit on a wing and a prayer, or mere suspicion of wrongdoing, is risky business.
An issue known to few outside of the ERISA bar, however, may provide a basis for filing suit when the nuances of the actual valuation remain to be discovered. Most ESOP valuations are done based on the value of the stock to be purchased, disregarding the impact on the company of ESOP acquisition debt. If the stock is valued based on company financial statements which do not include the burden of this debt, the stock will generally have a greater value than it has after that debt is taken on. This will be true unless there is some offsetting factor to help pay for the cost of the ESOP or enhance the value of the stock, such as a cut in pay or other benefits, or the issuance of a special class of stock which will pay the ESOP debt with dividends. Two Court of Appeals cases, however, say that the impact of the ESOP acquisition debt must be considered in deciding what the ESOP can pay. See Eyler v. Commissioner, 88 F.3rd 445, 452, 455-456 (7th Cir. 1996); Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983).
Mandatory plan filings with the Department of Labor may tip off the existence of this issue. If the amount paid for the stock significantly exceeds the value of the stock as reported on the end of year filing, the difference in values is likely the result of recognizing the impact of the ESOP acquisition debt after the ESOP has paid an inflated price which excluded the impact of the debt. Even the ESOP consultants and appraisers acknowledge that the impact of the debt must be recognized post-transaction, because the ESOP is required to carry the stock on its books at fair market value, and the impact of debt on a company is undeniably real.
Beginning with the withdrawal of a case filed on this theory in the late 1980s, the Department of Labor has committed publicly not to assert this theory. It has never opined, however, that the effect of the ESOP acquisition debt can legally be disregarded in setting the price of employer stock. Similarly, the IRS has not pursued the theory in any reported case since Eyler.
No one reading this article should conclude that employer stock valuation cases are easy to litigate. The valuation issues invariably come down to a battle of experts who speak a language that judges find difficult to penetrate. The technical nature of these discussions creates sympathy for trustees who claim to have followed expert advice in an arcane field. One Court of Appeals has even accepted the argument that a debt-financed ESOP stock purchase cannot result in a recoverable loss to a benefit plan because, but for the agreement of the ESOP trustee to buy overvalued shares, the transaction would have been restructured, to create a smaller loan, with fewer, but correctly valued shares purchased for the ESOP. See Crawford v. Lamantia, 34 F.3d 28, 33 (1st Cir. 1994). As a practical matter, this analysis reads the "adequate consideration" requirement out of the statute, but a full refutation of this and other arguments made by proponents of ESOPs is beyond the scope of this article.
My point here is that for too long an entire class of uniquely vulnerable transactions has gone largely unchallenged. The relative dearth of litigation in this area has provided additional encouragement for abuse. The opportunity exists to take a closer look, and the faltering economy assures that the injured participants will find their way to your doorsteps. Don't turn them away just because the issues are unfamiliar.
This article was first published by the Association of Trial Lawyers of America. ATLA Commercial Litigation Section Newsletter, Volume 7, Number 3 (Spring/Summer 2001).
