The Department of Labor’s national enforcement initiative for employee stock ownership plans ("ESOPs") is intended to identify and correct what the Department deems to be violations of the Employee Retirement Income Security Act ("ERISA"). As part of the initiative, the Department has been challenging the enforceability of industry-standard indemnification agreements between ESOP plan sponsors and the independent fiduciaries they retain to represent the ESOP in stock transactions. The Department’s challenge to these agreements rests on an aggressive and controversial theory unique to ESOPs. On March15, 2013, a federal court in Los Angeles rejected the Department’s theory and granted the defendants’ motions to dismiss the claim in Harris v. GreatBanc Trust Co., Sierra Aluminum Co., & Sierra Aluminum ESOP, Case No. 5:12-cv-01648-R, 2013 WL 1136558 (C.D. Cal.). Trucker Huss represents Sierra and the Sierra ESOP in the lawsuit. The ESOP Law Group serves as regular ESOP counsel to Sierra and the Sierra ESOP.
Most benefit-plan service providers require the plan’s sponsor to agree to indemnify the provider for costs and damages the provider may incur if a claim or lawsuit is filed involving the provider’s work for the plan. This is true whether the service provider serves in a fiduciary capacity or otherwise. Under ERISA section 410(a), which states that "any provision in an agreement or instrument which purports to relieve a fiduciary from responsibility or liability for any responsibility, obligation, or duty under this part shall be void as against public policy," these agreements are permissible as long as they do not indemnify fiduciaries for breaches of their ERISA duties. The Department has taken the position in regulatory guidance since 1975 that these industry-standard indemnification arrangements comply with ERISA section 410 because the agreements function essentially the same as commercial insurance, which Section 410(b) expressly allows, and that they are necessary in order for plans to obtain the services of well-qualified professionals.
Department’s ESOP Theory
In the Sierra Aluminum case, the Department argued that ERISA section 410 and the rules governing the indemnification of fiduciaries should work differently when the sponsoring company is owned in whole or in substantial part by the ESOP. Its theory is that the ESOP in those cases is the entity that really will be indemnifying the fiduciary, albeit indirectly, because the ESOP’s sole asset is the company’s stock, which the Department presumes will decline in value if the company pays indemnification costs. In support, the Department relied on a decision by the U.S. Court of Appeals for the Ninth Circuit, Johnson v. Couturier, 572F.3d 1067 (9th Cir. 2009), where the court invalidated under ERISA section 410 a company’s indemnification agreement with the ESOP’s fiduciary, based in part on the negative financial impact that indemnification would have had on the ESOP. In that case, Mr. Couturier, who was the president and a director of the company, and a fiduciary of the company’s ESOP, profited greatly when the company bought out his deferred compensation agreements for $35 million.
The Department also argued that certain language in the Sierra-GreatBanc agreement violated ERISA section 410 because it might entitle GreatBanc to indemnification for costs it incurs to settle a lawsuit alleging breach of fiduciary duty in circumstances where no final judgment of breach has been issued by the court.
Last, the Department argued that the Sierra-GreatBanc agreement violated ERISA section 410 because there was no guarantee that GreatBanc would reimburse Sierra for any advanced defense costs in the event GreatBanc ultimately were found liable for breach of fiduciary duty.
The court in the Sierra Aluminum case rejected all of the Department’s arguments, and threw out the government’s challenge to the indemnification agreement. The court agreed with the defendants that ERISA section 410 contains no special rule for ESOPs. As Sierra explained, the Department’s own plan asset regulation contradicted its position in the case. Under that regulation, when an employee benefit plan owns all of the outstanding shares in an entity, the entity’s underlying assets are treated as plan assets and therefore subject to ERISA’s fiduciary rules, unless the plan is an ESOP, in which case the company’s underlying assets are not treated as the ESOP’s assets. 29C.F.R. §2510.3-101(h)(3). The upshot of the regulation is that the Department itself treats the ESOP as separate and distinct from the assets of the sponsor company when the plan owns all of the company’s shares. In a similar vein, when a plan owns less than all of the sponsor’s shares, the company’s underlying assets are not treated as plan assets if the company is an operating company. 29C.F.R. §2510.3-101(a)(2). Sierra is both 100% owned by the ESOP and an operating company.
The court also rejected the Department’s Couturier arguments, finding that decision inapplicable for three reasons. First, the plaintiff in the case already had proven in a preliminary injunction proceeding that Mr. Couturier likely had breached his ERISA fiduciary duties. The defendants argued that the Department could not make any such showing with respect to GreatBanc. Second, the indemnification agreement at issue in Couturier, unlike the indemnification agreement in Sierra, contained no exception for breaches of ERISA fiduciary duties. This meant that Mr. Couturier would have had a right to be indemnified under the agreement even if he ultimately were held to have acted imprudently in violation of ERISA. Third, the Department’s plan asset regulation did not apply in Couturier because the company in that case, unlike Sierra, had been liquidated and no longer was an operating company. The cash proceeds were awaiting distribution to the ESOP’s participants, and any payout to Mr. Couturier would reduce dollar-for-dollar the amount available to participants.
The court also rejected the Department’s arguments based on the possibility that a settlement might be covered by the indemnification agreement. The court held that the Department failed to identify anything in the law that would support reading ERISA section 410 to preclude advancement of legal fees under an indemnity agreement simply because it was possible that the case might settle. Since this was the Department’s own lawsuit, the Department was free to refuse to settle if it truly believed that a settlement would relieve a fiduciary from liability for breach of its ERISA duties.
The court also rejected the Department’s contention that indemnification agreements violate section 410 if they do not ensure reimbursement for advanced fees, holding that the Department could ask to have GreatBanc post a bond in the amount of any advanced fees in the event the Department ultimately showed that a breach of fiduciary duty had occurred.