How Useful is Indemnification for ESOP Companies?
by Chris Buch and Robert Grossman, Polisinelli, P.C.
Fiduciaries and other service providers to plans governed by ERISA, including ESOPs, have long sought protection against lawsuits and regulatory actions. The protection typically comes in the form of insurance (whether fiduciary, errors and omissions, or directors and officers coverage), indemnification, or both. The Department of Labor (DOL) and private plaintiffs are trying to significantly limit, or even completely curtail, such indemnification protections.
Section 410 of ERISA provides that any provision that purports to relieve a fiduciary from fiduciary responsibility or liability is void as against public policy. However, ERISA Section 410(b) provides that a plan, a fiduciary, or even an employer or employee organization may purchase insurance to cover fiduciary liabilities, and there is nothing in the statute that prevents an employer from defending a fiduciary and/or satisfying a fiduciary’s obligation to the plan or the plan’s participants and beneficiaries.
After ERISA was enacted, the DOL released Interpretive Bulletin 75-4 to help further explain Section 410 of ERISA. It stated that while a fiduciary cannot be indemnified by a plan itself, indemnification provisions that leave a fiduciary fully responsible and liable but merely permit another party to satisfy any liability incurred by the fiduciary in the same manner as insurance purchased under Section 410(b) of ERISA are permissible. Specifically, it provides that indemnification of a plan fiduciary by an employer or employer organization is permissible.
Over the next 30 years, the DOL released a number of advisory opinions and an information letter that slightly narrowed the scope of Section 410 of ERISA, largely concluding that indemnification could be provided unless a court determines that a fiduciary breach actually occurred, but the guidance largely left the language of the statute in place.
During the same period, case law further defined the scope of ERISA Section 410. In Donovan v. Cunningham, 541 F. Supp. 276 (S.D. Tex. 1982); Fernandez et al. v. K-M Industries Holding Co., No. C 06-7339 CW (N.D. Cal. Aug. 21, 2009); and Johnson v. Couturier (9th Cir. July 27, 2009) courts invalidated broad indemnification provisions that purport to relieve fiduciaries from all acts except for those that arose from a fiduciary’s willful misconduct. The courts reasoned that because the plan sponsor (which provided the indemnification) was owned by an ESOP, any indemnification obligation by the plan sponsor would cause a burden upon the ESOP and was void.
A few years later, courts gave plan sponsors and ESOP fiduciaries guidance regarding how to draft indemnification agreements that, until recently, had been the model that many ESOP sponsors and fiduciaries followed. In Harris v. GreatBanc Trust Co. 2013 WL 1136558 (C.D. Cal. 2013) the court stated the indemnification agreement in question provided that indemnification would not apply to the extent the loss was held to have resulted from a fiduciary’s gross negligence, willful misconduct, or a violation or breach of any fiduciary duty imposed by ERISA. Further, in order for fees to be advanced to the fiduciary, a reasonably satisfactory arrangement to return the fees was to be made if the fiduciary was ultimately found to be not entitled to indemnification. Following this court decision, many ESOP plan sponsors and fiduciaries drafted or revised indemnification agreements to largely mirror the indemnification arrangement present in the case.
In 2020, the DOL included, for the first time, a section on indemnification in one of its settlement agreements with an ESOP fiduciary (this one did not include a process agreement). It provided that this ESOP fiduciary could not enter into any agreement providing that it will be indemnified by an ESOP or by a company owned in whole or in part by an ESOP even absent a demonstrated breach of fiduciary duties. This agreement also contained a second provision that completely prevents any indemnification payment or advance for any legal fees and costs from an ESOP or ESOP-owned company related to a fiduciary breach.
The DOL’s earlier position that no advancement could be made unless an independent third party determines that such arrangement is prudent creates a practical problem in that determining whether there is a fiduciary breach is a highly fact-sensitive analysis. In essence, the standard imposed by this agreement requires a “mini-trial” to determine whether one has breached its fiduciary duties before a court ever gets involved in the matter. Because a court could override and ultimately determine whether there was a fiduciary breach, even if an independent party determined no breach has occurred, what value does the independent assessment even have?
In its most recent settlement agreement with an ESOP fiduciary, the DOL set forth surprising provisions related to its position on indemnification, arguably reversing its position taken one year earlier. The DOL now argued that, in effect, indemnification was simply not an option.
If the DOL were to adopt its most recent positions as policy, this could ultimately limit a fiduciary’s ability to realistically defend any lawsuit or claim, which significantly increases the pressure on a fiduciary to settle a lawsuit irrespective of the validity of the underlying claim. This will add costs and complexity to any ESOP transaction and possibly even tip the scales against doing any transaction.
In light of these positions, there may be heightened sensitivity to insurance or other litigation funding sources so that ESOP fiduciaries could be ensured of adequate defenses against claims brought by the DOL or private plaintiffs. This is also likely to add cost, especially as the cost of insurance continues to rise. ESOP sponsors and fiduciaries should carefully consider how to craft indemnification agreements to attempt to limit this impact.