On November 28, three participants in Central States Manufacturing, Inc.’s employee stock ownership plan (ESOP) filed a complaint on their own behalf and on behalf of other ESOP participants against the company, its board of directors, individual members of its board of directors, and GreatBanc Trust Company (the ESOP trustee) (the Fiduciaries).

The plaintiffs allege that the Fiduciaries breached their fiduciary duties under the Employee Retirement Income Security Act (ERISA) by causing the ESOP to engage in a re-leveraging transaction.

Allegations of Breach of Fiduciary Duties

In August 2020, the company purchased 2,222,222.22 shares from the ESOP accounts of inactive participants at a total cost of $40 million. In December of the same year, the ESOP purchased 2,222,222.22 shares of company stock at a purchase price of $40 million from the company. The purchase of the additional shares was financed through a loan from the company to the ESOP for a term of 30 years. This is because the shares would be released incrementally to the accounts of ESOP participants in accordance with the ESOP’s release formula over the 30-year loan term.

The plaintiffs allege that the re-leveraging transaction diluted the value of the existing participants’ accounts, causing them harm. They acknowledge that the $40 million loaned by the company to the ESOP to purchase additional shares did not impact the value of the company’s assets, as the company borrowed that amount from a third party and would need to pay the borrowed amount back. However, they claim that the value of the company was now divided among a greater number of shares, and, because the additional shares were not immediately allocated to the ESOP accounts of existing participants, their accounts were diluted. The plaintiffs further allege that by causing the ESOP to engage in the transaction, the Fiduciaries intended to benefit the company by reducing the per-share price of the company stock, thus reducing the company’s repurchase obligations.

The plaintiffs claim that the Fiduciaries violated their duties of loyalty and prudence under ERISA to “act solely in the interest of plan participants”^[1] and “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”^[2] They further allege that the Fiduciaries engaged in a “prohibited transaction” when they caused the ESOP to engage in the re-leveraging transaction because the Fiduciaries dealt with the assets of the ESOP in their own interests or on behalf of the company, whose interests were adverse to the interests to the ESOP and its participants.^[3]

According to the plaintiffs, the Fiduciaries:

• failed to give due consideration to the impact of the transaction on the per-share value of the company stock held by existing ESOP participants;
• failed to consider viable alternatives to the transaction that would not have minimized the dilutive effect on, and the harm to, the participants, such as share recycling, dividends, annual cash contributions, annual stock contributions, or having the ESOP itself purchase shares from the inactive participants and allocating such repurchased shares to the accounts of ESOP participants; and 
• placed the interests of the company over the interests of ESOP participants.

Balancing the Interests of Participants – Department of Labor Field Assistance Bulletin No. 2002-01 

Although the US Department of Labor (DOL) has not issued specific guidance addressing its view of re-leveraging transactions in the ESOP context, the principles outlined in Field Assistance Bulletin No. 2002-01 (FAB 2002-01) are also informative in the re-leveraging space.

An ESOP refinancing involves entering into a new loan that extends the loan repayment schedule and the period over which stock is allocated to the accounts of plan participants. This results in fewer shares being released and allocated to participant accounts than would have other been released and allocated during the period of the original underlying loan. The DOL explains that, in determining whether to cause an ESOP to engage in a refinancing, the plan fiduciary must:

• assess the costs and benefits conferred upon the ESOP by the refinancing;
• consider the consequences of a failure to refinance; and
• ensure that the transaction is “arranged primarily in the interest of participants and beneficiaries.”^[4]

The DOL does note that a refinancing may benefit the employer. However, in making its determination, the fiduciary must act with undivided loyalty to participants and beneficiaries of the ESOP. For example, the employer can offer inducements for the ESOP to engage in the refinancing, which could support the fiduciary’s conclusion that the transaction is primarily for the benefit of participants (such as through additional diversification rights or larger employer contributions). The DOL also asserts that when evaluating a proposed refinancing, fiduciaries have “a duty of impartiality to all of the plan’s participants, and may appropriately balance the interests of different classes of participants in evaluating a proposed refinancing, including the potentially varying interests of present and future participants.”

Lessons to be Learned

The complaint filed in Shipp v. Central States Manufacturing, Inc. and FAB 2002-01 provide important lessons to ESOP fiduciaries considering a proposed re-leveraging transaction. One noteworthy point is the complaint does not assert that a fiduciary’s decision to cause an ESOP to engage in a re-leveraging transaction per se violates ERISA. However, both the complaint and FAB 2002-01 serve as reminders that fiduciaries considering re-leveraging transactions must engage in due consideration of the transaction, which include:

• evaluating the impact of the transaction on the per-share value of stock held by existing ESOP participants;
• assessing the consequences of a failure to engage in the re-leveraging transaction;
• considering viable alternatives that would minimize harm to existing participants;
• assessing the costs and benefits conferred upon the ESOP (for example, through an increase in diversification rights or an increase in employer contributions); and
• prioritizing the interests of ESOP participants over those of the employer (even though the employer may also benefit from the transaction).

Although the allegations by the plaintiffs in Shipp focus on the harm to existing ESOP participants, in FAB 2002-01 the DOL explains that a fiduciary’s duty of impartiality extends to “all of the plan’s participants” and the fiduciary “may appropriately balance the interests of different classes of participants in evaluating a proposed refinancing, including the potentially varying interests of present and future participants.”

In Shipp, the company is 100% ESOP-owned, meaning all of the company’s benefits would ultimately be realized by the present and future participants of the ESOP. It is possible that, upon evaluation of the re-leveraging transaction, the Fiduciaries may have concluded that the re-leveraging transaction was in the best interests of the ESOP and current and future ESOP participants. This is because additional shares were needed to allocate to future plan participants. Without the additional purchased shares, future employees would not achieve meaningful ownership in the Company, which is necessary to drive motivation and commitment to increase the Company’s value. Therefore, although the purchase of additional shares may have had a dilutive effect of the accounts of existing participants in the near term, in the long term, both current and future participants would receive greater value.

FOOTNOTES

[1] ERISA Section 404(a).

[2] Id.

[3] ERISA Section 406(b).

[4] DOL Regulations Section 2550.408b-3(b)(2).