In a recent court ruling, the US Department of Labor (DOL) prevailed against corporate directors and shareholders for claims related to an Employee Stock Ownership Plan (ESOP) transaction. Most ESOPs are established through arm's length transactions that comply with the Employment Retirement Income Security Act’s(ERISA) fiduciary standards, ultimately benefiting both owners and employees. ESOP deals that go awry are atypical, but can serve as important reminders of the necessity to be cautious at the beginning of an ESOP transaction to reduce the risk of DOL scrutiny later.
The company involved sold 100% of its stock to the ESOP, but the directors retained complete control, leaving the trustee without the power to remove them or gain a seat on the board despite the purchase price being designated as “controlling interest value.” As a result, the valuation significantly exceeded the fair market value of the company, with the defendant executives fully aware of their retained control. In addition, the trustee had an ongoing relationship with the consulting firm and appraiser such that none were willing to challenge the other and which led to rushed decision making. The trustee agreed to an abbreviated timeline solely to secure tax benefits, negotiated the deal without adequate information affecting the company’s value, and failed to fully engage in the valuation or negotiate terms beyond the total price. For these violations, the trustee ultimately agreed to a settlement of $22.5 million with the DOL.
The facts of this case emphasize that board members responsible for appointing and removing ESOP trustees are themselves bound by fiduciary duties related to trustee selection and oversight. An ESOP trustee has a duty to act for the exclusive purpose of providing benefits to participants and with the care, skill, and diligence that a prudent man would use in similar circumstances. After establishing that the trustee did not meet its duties, the court found that the defendants had not adequately monitored the trustee's performance or ensured compliance with the ESOP’s terms.
When navigating an ESOP transaction, it’s crucial to be vigilant for potential red flags that could signal trouble down the line. Deals that appear too good to be true often are; this includes advisers who guarantee inflated sale prices and advisers lacking independence. Additionally, aggressive transaction structures may lead to outcomes that are detrimental to plan participants and attract heightened scrutiny from the DOL. While engaging outside advisers, trustees, and consultants can help mitigate risks and reduce liability, it’s important to remember that such measures do not absolve the company of its fiduciary responsibilities to the ESOP. Ensuring transparency and adherence to best practices from the beginning can safeguard both the integrity of the transaction and the interests of all stakeholders involved.
If you are thinking about implementing an ESOP or you currently sponsor an ESOP and have questions on fiduciary obligations to the plan, please do not hesitate to contact any member of Bricker Graydon’s Employee Benefits team.
