Corporate Officer/ESOP Trustee Ordered to Return Excessive Compensation
September 1999On June 10, 1999, the U.S. District Court for the Western District of Pennsylvania issued a decision in Delta Star, Inc. v. Andrew W. Patton, Civil Action No. 96-2183 (WD Pa. 1999), that has profound implications for setting management compensation in ESOP companies. This case is important because it is the first of its kind to highlight the duties that an individual who serves as both a company officer and ESOP trustee owes to the company and the ESOP when determining his or her own compensation. Officers and fiduciaries should take note that the court ordered the defendant to repay over $3.3 million of excessive compensation already received by the defendant and also retroactively terminated certain deferred compensation plans that would have paid him significant amounts in his retirement years.
In this decision, the court relied on both the Employee Retirement Income Security Act of 1974, as amended (ERISA), and Delaware corporate law to hold that the defendant, in his capacities as the president and chairman of the board of Delta Star, Inc. (the "Company") and a member of the board of trustees of the Company's employee stock ownership plan (ESOP), violated his fiduciary duties under both ERISA and Delaware law when he caused the Company to pay him excessive compensation.
BackgroundThe Company was created in 1989 as a spin-off from a parent company (the "Parent"). After the spin-off, the ESOP owned 98.63% of the Company's stock, with the remaining 1.37% owned by the defendant and other management employees. Contrary to the advice of legal counsel, no outside directors were appointed to the board of directors of the new company.
Before the spin-off from the Parent, the defendant's annual base salary had been set by the Parent at $201,400. Over the years 1990 to 1994, the defendant unilaterally increased his base salary in $25,000 to $50,000 increments, until it finally reached $301,320. Over this same period, he awarded annual bonuses to himself that ranged between zero and $1,040,000. These annual bonuses averaged just over $450,000. The defendant also rewarded himself with the "usual" executive perquisites of multiple country club memberships, lawn care for his home and several company-paid luxury cars.
In 1990, the Company's board of directors adopted a benefit restoration plan (BRP) to compensate the Company's executives for reductions in their ESOP benefits resulting from limitations imposed by the Internal Revenue Code of 1986, as amended (the "Code"). In 1991, the Company's board of directors adopted a supplemental executive retirement plan (SERP) to provide additional deferred compensation benefits to the same executives. Shortly after the adoption of the SERP, the board of directors amended it twice to increase benefits significantly.
What Did the Court Determine?The court determined as a factual matter that the defendant unilaterally established his own base salary, annual bonuses, and other items of compensation without approval by, or consultation with, the other two members of the Company's board of directors and the ESOP's board of trustees. Indeed, the court found that he actively concealed the amounts of his base salary and bonuses from his fellow directors and trustees. The court also found that the defendant determined his compensation without the benefit of any compensation plan, formula, industry standard, outside compensation consultant, the Company's profitability, or any other ascertainable criteria. The court compared the defendant's compensation with the compensation of comparable executives in the Company's industry and found that the defendant's compensation was much higher than one would reasonably expect.
The court found that the BRP and the SERP were adopted (and subsequently modified) primarily to benefit the defendant and that both plans were unusually generous, in part due to the fact that benefits under these plans were based on the defendant's excessively high compensation. The board of directors did not seek advice from an outside compensation consultant regarding the suitability, design or level of benefits provided under either the BRP or the SERP.
The court determined that the Company's financial performance over the period 1989 to 1994 was consistent with the business cycle of the Company's industry as a whole and that the defendant's management skills made a minimal difference to these results. The court contrasted the defendant's compensation package with the Company's lackluster financial performance over this period and found that the Company's flat net income was primarily due to the excessive compensation paid to the defendant. The court determined that the excessive compensation paid to the defendant and the adoption of the BRP and the SERP resulted in a diminution of the value of the Company's stock, shares of which constituted the ESOP's sole asset.
How Did the Court Apply ERISA to the Facts of the Case?The court determined that the defendant breached his fiduciary duties to the ESOP (1) by placing himself in a position where his activities as an officer and director prevented him from functioning with complete loyalty to the ESOP participants and (2) by failing to recognize the conflict of interest between his duty of loyalty to the ESOP and his personal financial interest in maximizing his salary, bonuses, and deferred compensation. Interestingly, the court found that the defendant had a duty to conduct an independent investigation of his own improper activities (such as concealing material information from the other members of the ESOP's board of trustees) and then to bring suit against himself, if appropriate. In any case, the defendant should have recognized the obvious conflict of interest situation and should have placed the matter of his own compensation in the hands of other members of the ESOP's board of trustees and the Company's board of directors.
The court also found that the defendant violated ERISA's prohibition against fiduciary self-dealing by voting as a member of the ESOP's board of trustees to retain himself as a member of Company's board of directors so that he could continue to enrich himself at the expense of the Company and the ESOP.
Accordingly, the court ruled that the defendant breached his fiduciary duties as a director and ESOP trustee by paying himself unauthorized, excessive, and unreasonable salary increases and annual bonuses, and by causing the board of directors to adopt the BRP and SERP, under which he would receive excessive and unreasonable deferred compensation. The defendant was ordered to repay to the Company over $3,300,000--the difference between the annual base salary and bonuses actually paid to him and the $201,400 annual base salary originally authorized at the time of the spin-off from the Parent. The ESOP was ordered to determine the damages suffered (as a result of the defendant's wrongful acts) by individual participants who had already received benefit distributions from the ESOP. The Company was ordered to pay that amount to the ESOP, so that the ESOP could then make these individuals whole.
How Did the Court Apply Delaware Law to the Facts of the Case?The court reached virtually identical results under both ERISA and Delaware corporate law, and found that the defendant's acts of disloyalty and self-dealing as an officer and director violated Delaware corporate law.
The Court Rejected Defendant's Request for IndemnificationThe defendant asserted a counterclaim against the Company for indemnification under the terms of the ESOP plan document, which provided for indemnification of the ESOP's trustees in the absence of willful misconduct. The court rejected this claim on two grounds: first, based on its finding that the defendant did, indeed, engage in willful misconduct and, second, because the ESOP owned virtually all of the Company's stock, public policy precludes a fiduciary who has breached his duties to the ESOP to be indemnified indirectly by the ESOP.
What Does This Case Mean to ESOP Fiduciaries?Although the facts in this case are extreme, the principles that underlie the case are relevant to many closely held ESOP companies. Members of a company's senior management should not be in a position to unilaterally establish their own compensation. The defendant in this case would have been in a more defensible position had his compensation been established by a compensation committee composed of outside directors. It is advisable to have outside directors on an ESOP company's board of directors, both for purposes of approving management compensation and for acting in other situations in which inside directors may have a conflict of interest.
When it is not possible to subject management compensation to approval by outside directors, it is prudent to determine compensation pursuant to an objective compensation plan or formula, industry standards, company profitability and other ascertainable criteria. The board of directors of an ESOP company that does not have outside directors would be well-advised to retain an outside (and independent) compensation consultant to provide it with objective advice regarding appropriate levels and types of management compensation.
About the Author
Jeffrey Krenzel, now retired, was an attorney with the law firm of Ludwig Goldberg & Krenzel.