Fifth Circuit Decision Includes Important Holdings for ESOP Fiduciaries
- The U.S. Court of Appeals for the Fifth Circuit affirmed the holdings of the U.S. District Court for the Southern District of Mississippi on numerous issues involving the sale of closely held stock from a company's owner to the company's employee stock ownership plan (ESOP).
- The case, Perez v. Bruister, focused on whether the trustees of the ESOP breached their fiduciary duties to the ESOP by overpaying for the company stock.
- The Fifth Circuit reviewed a number of important issues, including standing, shareholder status as a fiduciary, duty of loyalty under the Employee Retirement Income Security Act (ERISA), engaging in a prohibited transaction, equitable relief and determination of losses.
The U.S. Court of Appeals for the Fifth Circuit affirmed on May 3, 2016, the holdings of the U.S. District Court for the Southern District of Mississippi on numerous issues involving the sale of closely held stock from a company's owner to the company's employee stock ownership plan (ESOP) in Perez v. Bruister, No. 14-60811 (5th Cir. 2016). Among the court's key rulings were the following:
- ESOP participants may bring claims on behalf of the ESOP without proceeding as a class action, at least in cases where the U.S. Secretary of Labor also participates.
- An ESOP trustee who is also the seller in an ESOP transaction may be found to have breached his fiduciary duties, even if he abstains from voting on the transaction.
- Whether trustees violate their Employee Retirement Income Security Act (ERISA) fiduciary responsibilities in an ESOP transaction is a function of whether they acted solely in the interest of the plan's participants; thus, a violation can occur even if the ESOP fortuitously paid no more than adequate consideration.
- The burden of proving that an ESOP stock purchase meets the requirements for exemption from the ERISA prohibited transaction rules falls squarely on the plan fiduciaries, who must show that they arrived at their conclusion of fair market value by means of prudent investigation under the circumstances then prevailing.
- Where an ESOP overpays for company stock, it is entitled to restitution for the difference between the amount paid and the stock's fair market value at the time of the transaction; the amount of restitution is not limited to the amount the ESOP has paid on its securities acquisition loan, nor is it affected by changes in value of the company stock subsequent to the transaction.
Perez v. Bruister focused on whether the trustees of the ESOP breached their fiduciary duties to the ESOP by overpaying for the company stock. The U.S. Secretary of Labor (the Secretary) and two plan participants brought separate civil actions, raising claims for 1) breach of the fiduciary duty of loyalty under Section 404(a)(1)(A) of ERISA, as amended, 2) engaging in prohibited transactions in violation of Section 406 of ERISA, 3) failing to monitor investments as required by Section 404(a)(1)(A) of ERISA and 4) co-fiduciary liability under Section 405 of ERISA. The two cases were consolidated, and the District Court conducted a 19-day bench trial, during which it ruled in favor of the Secretary and the plan participants on all claims.
On appeal, the Fifth Circuit reviewed a number of important issues, as discussed below:
Defendants argued that the District Court erred by allowing individual participants to bring a claim on behalf of the ESOP and its beneficiaries without seeking class certification or having the court provide safeguards for absent beneficiaries' interests. The Fifth Circuit found that because the private plaintiffs advanced the interests of the ESOP as a whole and did not make a claim for individual recovery, and because the Secretary had joined the case, there was no requirement that the private plaintiffs pursue their claims on a class action basis. The Fifth Circuit did note, however, that it might not have reached the same conclusion if the Secretary had not also joined the case.
Selling Shareholder Status as a Fiduciary
The Fifth Circuit recognized that there are three ways in which an individual may become a fiduciary under ERISA: 1) by being named as a fiduciary in the instrument establishing the plan, 2) by becoming a named fiduciary pursuant to a procedure specified in the plan or 3) by serving as a "functional" fiduciary pursuant to Section 3(21)(a) of ERISA.
The Fifth Circuit applied the "two hats" doctrine set forth by the U.S. Supreme Court in Pegram v. Herdrich, 530 U.S. 211, stating that an individual is subject to fiduciary duties under ERISA only to the extent that such individual performs fiduciary functions with respect to a plan. In this case, the principal defendant wore two hats: selling shareholder and ESOP trustee. In an apparent effort to avoid an impermissible conflict in his role as trustee, the defendant did not vote on any matters items related to the ESOP transaction. Despite his abstention, the Fifth Circuit found that the seller/trustee was still a functional fiduciary with respect to the transactions because he 1) fired the original ESOP appraiser, 2) hired a new ESOP appraiser, 3) influenced the outcome of the second appraiser's valuations, 4) made his personal preferences regarding the transaction known to other ESOP trustees and 5) actively participated in trustee meetings considering the transaction.
The Secretary, citing an earlier Fifth Circuit case, had argued that the seller/trustee was obligated to remove himself completely from the fiduciary decision-making process. In a footnote, the Fifth Circuit stated that while, in this case, the seller/trustee stepped over the line by taking an active role in setting the purchase price paid by the ESOP, this fact does not establish a rule of law that a conflicted fiduciary must remove himself completely from the decision-making process. The court did not, however, elaborate on what it believed the permissible scope of involvement by a conflicted fiduciary in such a situation might be.
Duty of Loyalty
The Fifth Circuit then turned to the question of whether the trustees breached their duty of loyalty to the ESOP. The trustees argued that they did not breach their duty of loyalty because the valuations prepared by the ESOP appraiser were similar to the valuations set forth by defendants' trial experts. The Fifth Circuit rejected this "all's well that ends well" argument, holding that, for liability to arise under ERISA, the critical question is whether there was a conflict of interest, and, if so, whether the conflict was avoided because the trustees' decisions were "made with an eye single to the interests of the participants and beneficiaries." Whether the ESOP paid no more than adequate consideration for the company stock is not dispositive of whether the trustees can be found to have breached their fiduciary duties under ERISA. The question of whether the ESOP actually overpaid goes to losses, not liability. The Fifth Circuit concluded that the fiduciary duty of loyalty was breached because 1) the trustees fired the ESOP's independent counsel, 2) the seller/trustee's personal lawyer influenced the appraiser's valuations to inflate the stock price, 3) valuation drafts were sent to sellers before being sent to the ESOP, 4) the ESOP's counsel was cut out of all valuation communications, 5) assumptions were adjusted to obtain a higher valuation for the seller and 6) trustees did not speak up for the ESOP participants.
While the Fifth Circuit found that the trustees breached their duty of loyalty and prudence in their conduct, the court noted that it was not approving nor relying upon an additional derivative theory of liability under ERISA Section 404(a)(1)(A). The District Court had held the seller/trustee individually liable for failing to monitor the activities of other ESOP trustees. While the Fifth Circuit ultimately found that the trustees in this case breached their duties of loyalty, it stated that this was not because of any derivative liability theory based upon a failure to monitor, a theory of which the court said it did not approve.
Engaging in a Prohibited Transaction
While a plan's purchase of company stock from a party in interest is, on its face, prohibited by ERISA, the transaction will be exempt from the prohibited transaction rules if the plan pays no more than adequate consideration (and certain other requirements are satisfied). However, the burden of showing that no more than adequate consideration was paid falls entirely on the plan fiduciaries. According to the Fifth Circuit, in order to sustain this burden, the fiduciaries must demonstrate that they had arrived at their conclusion of fair market value by way of a prudent investigation into the circumstances then prevailing. According to the appellate court, the ERISA exemption from the prohibited transaction rules is focused on the conduct of the fiduciaries, assessed in light of the overriding ERISA duty of care.
While fiduciaries may point to their use of an expert as evidence of a good faith investigation, here, the trustees 1) did not undertake a full investigation into the appraiser's background and qualifications, 2) overlooked communications that were aimed at increasing the value of the company as opposed to determining an objective fair market value, 3) failed to inform the appraiser of significant information and risk factors about the company and 4) failed to double check or review the appraiser's conclusions. The Fifth Circuit determined that the trustees did not act prudently, and therefore could not show that adequate consideration was paid so as to claim exemption from the prohibited transaction rules. Therefore, the appellate court affirmed the lower court's holding that the trustees had caused the ESOP to engage in a prohibited transaction.
Equitable Relief and Determination of Losses
In the remedies portion of its decision, the Fifth Circuit initially addressed the Secretary's contention that the District Court should have ordered that the original ESOP stock purchases be rescinded. (This would have resulted in the defendants having to return the entire purchase price to the ESOP in exchange for return of the company stock from the ESOP; however, at that point, the company stock was worthless.) The Fifth Circuit agreed that rescission might be ordered in an appropriate case (e.g., where losses cannot be fairly determined), but indicated that ordinarily the focus should be on losses incurred by the ESOP as a result of the defendants' fiduciary breaches. In that connection, the Fifth Circuit held that losses are to be calculated based on the difference between the amount the ESOP paid for the shares and the actual fair market value of the shares at the time of the transaction. In so holding, the Fifth Circuit rejected the Secretary's argument that losses should be measured as the difference between the price paid by the ESOP in the original transactions and the current value of the company stock, which, at that point, was zero.
However, the Fifth Circuit did determine that the ESOP's losses were not limited to the amount that the ESOP had actually expended in payment for the shares. A brief review of the underlying facts is helpful to an understanding of this holding. For one of the stock purchases, the ESOP agreed to pay $10.5 million for shares that the District Court determined to be worth $7.1 million at the time of the transaction. The District Court determined that this transaction resulted in a loss to the ESOP of approximately $3.4 million. The ESOP's purchase, however, was made entirely with borrowed funds, as to which the ESOP had repaid total principal and interest of approximately $762,000. The Fifth Circuit rejected the defendants' argument that the ESOP's losses could not exceed the $762,000 it actually expended in connection with the stock purchase, instead holding that the ESOP was entitled to recover the entire $3.4 million differential between the purchase price and the fair market value of the shares at the time of the transaction.
Finally, the Fifth Circuit held that a non-fiduciary party in interest entity (an affiliate of the seller/trustee) that had sold overpriced shares to the ESOP could be held liable under the prohibited transaction provisions of ERISA, even though it had no duty to the ESOP under the substantive provisions of the statute. The Fifth Circuit therefore affirmed the District Court's decision, holding the non-fiduciary party in interest jointly and severally liable with the breaching fiduciaries for the losses incurred by the ESOP.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.