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Litigation in ESOPs and Related Plans

In a litigious society, it's natural to worry about lawsuits when making any significant business decisions. Out of the 14,000 or so qualified employee ownership plans, fewer than one percent have landed in court, and many of these were for egregious practices. Still, it makes sense to understand where lawsuits can originate and how prevalent they are.

Shareholder Suits

Shareholders can sue over the creation or terms of an employee ownership plan under state law. For instance, shareholders have sued companies over stock option plans, especially when they think their terms are too generous. Shareholders can also sue if they believe a company's actions in setting up a plan improperly dilute their ownership interests or that the company underpaid or overpaid for the shares. These suits have been very rare in qualified employee ownership plans (ESOPs, profit sharing, stock bonus, and 401(k) plans), perhaps because most of the plans that own substantial amounts of stock are ESOPs, and ESOPs require outside appraisals. In one case, however, a shareholder blocked the completion of an ESOP transaction for two years, even though the company had both an appraisal and a fairness opinion.

A more common shareholder suit is over the creation of an ESOP as part of an anti-takeover defense. Often initiated by would-be hostile acquirers, these lawsuits could fall under state corporate law (over the decision to set up the plan) or ERISA (for decisions made by the plan fiduciary). In general, being able to show the ESOP had already been contemplated, was "shareholder neutral" (that is, paid for by changes in compensation), and good for the company's human resource strategy have been effective defenses against this kind of suit.

Employee Lawsuits

Participants in qualified plans can sue anyone who acts as a plan fiduciary over a number of issues. Fiduciaries are not just trustees, but anyone making a decision causing the plan to take an action (such as the company's board or management might do). Participants commonly sue over the denial of personal benefits, improper valuations, failure to abide by the rules of the plan (such as not distributing shares at the required time), the conversion of profit sharing assets into an ESOP that subsequently did poorly, a cutback in promised benefits, and takeover issues. All of these issues have to do specifically with the operation of the plan or decisions made by fiduciaries with respect to plan assets. Holders of stock options can sue under the contractual terms of the option; their rights are not a matter of ERISA or other benefit law.

The situation is murkier for employees wanting to sue as shareholders. The ESOP trustee is the legal shareholder, and the legal rights pertaining to shareholders apply to the trustee. Participants have to sue the trustee, and/or whoever directs the trustee, for failure to exercise these rights in a manner that is consistent with the interests of plan participants. In some cases, such as providing information for employees voting on a proposed sale, this line of attack is likely to succeed because employees also have voting rights as part of ERISA. In others, such as challenging a business decision (such as an acquisition or granting options to executives), there appears to be much less chance that employees could sustain a lawsuit. In one case initiated by the Department of Labor, however, this theory did prevail, as discussed below.

Government Lawsuits

Both the Department of Labor and the IRS can initiate legal action against plans. The IRS gets involved when plan actions result in taxes not being paid. Recent prominent cases have included improper valuations, excessive dividend payments to an ESOP, and challenges to whether dividend payments are subject to the Alternative Minimum Tax. The IRS can also disqualify plans, leading to sometimes costly penalties and the recapture of taxes, but these disqualifications would rarely end up in court.

The Department of Labor (DOL) can sue under any issue regarding ERISA. Consequently, it can sue for all the same issues participants in qualified plans can sue. It usually does so on larger cases or cases in which important policy issues arise. The DOL has been particularly active in cases involving valuations, takeovers, and conversions of profit sharing plan assets. In a recent case, Martin v. Feilin, the Department successfully argued that it could also challenge plan fiduciaries for a failure to pursue their rights as shareholders in business decisions. In this case, the company gave non-ESOP owners an option to buy company stock at a very low price. The DOL successfully argued the fiduciaries should have challenged the transaction, although the court decided the offer was a corporate one not involving the investment of plan assets that generally would qualify a suit.

The DOL has issued policy guidelines saying plan fiduciaries have an obligation to pursue their shareholder rights to insure the sound operation of a company. This does not mean active day-to-day involvement, but it does mean reviewing broad corporate policy. Technically, this could suggest that plan fiduciaries who are also company managers should challenge their own decisions; practically, it means the DOL could pursue a range of issues not heretofore pursued.

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