When the owner of a closely-held company sells stock to an employee stock ownership plan (ESOP), there are numerous valuation, fiduciary, and conflict of interest issues that could explode into ERISA liability. Imagine having ESOP participants recover damages equal to 33% of the amount the ESOP paid for the founder’s shares. The 5th Circuit recently upheld such an award. Its decision provides warning signs for companies with ESOPs and owners who sell shares to ESOPs – and for those performing diligence before they buy or invest in companies that sponsor ESOPs.
Based on fiduciary abuses that occurred in the 5th Circuit case (Perez v. Bruister), here are a few key points to consider:
- Were (or are) company owners or executives acting as ESOP fiduciaries with respect to any purchase or sale transactions in which the owners had a direct or indirect personal interest?
- In the Perez case, the owner was one of three ESOP trustees, but abstained from decisions involving the ESOP’s purchase of his shares.
- The owner was nevertheless held to be a functional ESOP fiduciary because he influenced the underlying valuation decisions by –
- firing one appraiser and the ESOP’s independent legal counsel,
- seeking “tweaks” to influence the valuation generated by the successor appraiser,
- changing the assumptions and financial figures that the ESOP appraiser factored into his valuation analysis, and
- actively participating in ESOP trustee meetings during which the ESOP’s purchase from him was discussed.
- Note that one of the defendants held liable in the Perez case was a family LLC that the owner created and funded with shares of his that the ESOP later purchased from the LLC.
- Were the ESOP trustees justified in relying on the ESOP appraisal they received when buying company shares, or selling them?
- ESOP trustees generally are liable under ERISA if they cause the ESOP either to overpay when buying company stock, or to sell company stock for less than its fair market value.
- In Perez, the 5th Circuit found that the ESOP overpaid for company stock, and that its fiduciaries violated ERISA’s prudence requirement by unreasonably relying on the appraiser’s ESOP valuation. The Perez decision rested on findings that the ESOP trustees –
“(1) conducted insufficient investigation into [the appraiser’s] background and qualifications;
(2) overlooked communications in which ‘[the appraiser] and [the owner’s personal lawyer] were obviously working together to increase the value,’;
(3) failed to inform [the appraiser] of significant information and risk factors for the company that should have influenced his valuation;
(4) and failed to doublecheck or significantly review [the appraiser’s] ultimate conclusions."
- ESOP trustees (and those diligencing their past conduct) should be keen to each of the four items noted above when they review ESOP appraisals and make valuation decisions.
Overall, ESOPs have a long history of creating ERISA litigation risks. The Perez case may seem extreme, but closely-held companies often stumble not only when creating ESOPs but when maintaining and terminating them. Extra diligence is consequently warranted, with special attention on employer stock valuations and the potential conflicts of interest when owner-employees serve as ESOP trustees.