Pension & Benefits News Trustee breached fiduciary duty by causing ESOP to overpay for company stock
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Tuesday, May 7, 2019

Trustee breached fiduciary duty by causing ESOP to overpay for company stock

By Pension and Benefits Editorial Staff

An employee stock ownership plan (ESOP) trustee, appointed by a closely held company, breached its fiduciary duty by causing the ESOP to overpay for the company’s stock by over $29 million, thereby enriching the company’s owners at the expense of plan participants, according to the U.S. Court of Appeals in Richmond (CA-4). The trustee could not establish that the purchase price constituted adequate consideration for the stock or that its reliance on a purported independent valuation of the company was “reasonably justified.” In addition to awarding damages to the ESOP, the court granted attorney’s fees to the participant’s counsel under ERISA and supplemental fees from the damages under the common fund doctrine.

“Uniquely” structured ESOP. Constellis Group, Inc, the closely held parent company of a group of private security subsidiaries, contracted with an investment banking firm (CSG International) to create an ESOP that would allow the company’s owners to liquidate their shares while avoiding 23.8 percent in capital gains taxes. CSG created a “unique” ESOP that was structured to effectuate the sale while allowing the owners to retain de facto control of Constellis, even after the ESOP had purchased all of the company stock. Under the arrangement, the owners sold 90 percent of their shares to the ESOP and exchanged the remaining 10 percent for warrants. The warrants entitled the owners to buy back equity in Constellis from the ESOP at a designated price and granted the owners a majority on the company’s board of directors. In addition, the ESOP trust agreement required the trustee to vote its shares as dictated by the Constellis board, and not the ESOP.

On the recommendation of CSG, Constellis engaged Wilmington Trust to serve as trustee for the ESOP. Wilmington, in turn, hired Stout Risius Ross (SRR) to serve as the financial advisor for the ESOP’s purchase of Constellis. CSG, Wilmington and SRR had established a long-term business relationship, having worked together on more than 20 ESOP deals.

In November 2013, SRR submitted a draft report to Wilmington, valuing the Constellis stock at $3,865-$4,600 per share, for a median price per share of $4,235. Following negotiations with CSG, a share price of $4,235 was agreed upon. On December 20, 2013 the ESOP purchase of Constellis closed for a per share price of $4,235.

A former Constellis employee and ESOP participant brought suit, maintaining that Wilmington caused the ESOP to engage in an ERISA prohibited transaction by overpaying for the company stock. Although the participant sought recovery for the ESOP, the action was denied class certification, and he elected to proceed to trial individually.

A federal trial court agreed that the purchase of Constellis by the ESOP constituted a prohibited transaction. Subsequently, the court rejected the trustee’s argument that the transaction was exempt under ERISA Sec. 408(e) as being for adequate consideration. According to the court, the trustee had not demonstrated that its reliance on the SRR valuation report was reasonably justified because the trustee had not shown that it “thoroughly probed the “gaps and internal inconsistencies in that report.”

Concluding that the trustee’s breach caused the ESOP to overpay by $29,773,250 for the company’s stock, the court awarded that amount as damages to the ESOP. In addition, the court awarded attorney’s fees under ERISA Sec. 502(g) for $1,819,631 and a supplemental award of $1.5 million in fees, to be paid from the damages assessment.

The trustee appealed, challenging the trial court’s liability and damages determination. The participant also appealed, maintaining that the attorney’s fee award was inadequate. The Fourth Circuit affirmed the lower court’s rulings in all respects.

Inadequate decision-making process: Failure to scrutinize valuation. After first dismissing the trustee’s claim that it had not acted in bad faith as not determinative of liability fiduciary breach, the appeals court focused on the adequacy of the trustee’s decision-making process. The trustee maintained that it acted prudently in relying on the independent valuation provided by SRR. However, the trial court cited 4 major failures in the trustee’s decision-making process that indicated that its reliance on the SRR valuation was not reasonably justified, including: omission of a substantially lower valuation from the SRR report; disregard of red flags regarding the reliability of the company’s financial projections; failure to address the appropriateness of a 10% control premium; and neglecting to question SRR’s round up of the valuation of company stock. The appeals court found no error in the trial court’s findings or reasoning.

Subsequent sale did not validate ESOP purchase price. The trustee suggested that a subsequent sale of Constellis stock to a competing concern (seven months after the ESOP transaction) at an enterprise value of over $288 million, with $20 million going to the ESOP, indicated that the ESOP paid fair market value to the company. However, even assuming that the purchase was for fair market value, the appeals court found no error in the trial court’s conclusion that the trustee failed to prove that the share price was also the product of a determination made by the fiduciary in good faith.

Damages assessment upheld. In calculating damages, the trial court, in accordance with the requirements under ERISA Sec. 409(a), subtracted the fair market value of the stock, as determined by the court from the inflated price paid by the ESOP. Independently analyzing each of the trustee’s purported failings, the court awarded damages of $29,773,250, less than 1/3 of the $103,862,000 in damages estimated by the participant’s expert.

The trustee did not provide an alternative to the methodology used by the trial court, but argued that the damages assessment should have been offset by the $20 million “windfall” the ESOP received following the second sale. The appeals court explained, however, that because the trustee breached its fiduciary duty by overpaying for the company stock, principles of restitution entitled the ESOP and its participants to compensation for the loss of the overpayment. Any subsequent gain involving the stock, which the ESOP would have obtained regardless of the overpayment, the court stressed, had “no bearing on that loss.” For similar reasons, the court advised, analogous offsets to damages award in overpayment cases have been uniformly rejected

Attorney’s fees assessment confirmed. The trial court awarded the participant’s counsel $1,819,631 in statutory attorney’s fee and an additional $1.5 million in supplemental fees from the ESOP damages judgment. The appeals court affirmed the attorney’s fees assessment as not clearly wrong or reflecting an abuse of discretion.

The participant argued that the trial court abused its discretion by not awarding his counsel $9.9 million in fees under the attorney’s 1/3 contingency fee agreement with the participant. According to the participant, ERISA Sec. 502(a)(2), which empowers ESOP participants and beneficiaries to bring suit on behalf of an ESOP, also authorized him to enter into a legal services contract binding the ESOP. The appeals court rejected the participant’s contention, noting that neither ERISA Sec. 502(a)(2), nor any other statute, enabled the participant to bind the ESOP to a contract or other fee arrangement. Thus, the participant’s agreement with the law firm did not establish a valid fee arrangement between the firm and the ESOP.

Common fund award. Although the participant’s attorneys did not have a contractual agreement with the ESOP, the trial court did award an additional $1.5 million supplemental fee to the firms as a “common fund” award. The equitable common fund principle allows a court to award reasonable attorney’s fees from a common fund recovered by a litigant or lawyer for the benefit of other persons. The principle prevents a party who benefits from a lawsuit without contributing to its costs from being unjustly enriched at the litigant’s or attorney’s expense, a concern that the ERISA fee-shifting provision does not address.

The trustee contended that the common fund award violated ERISA’s anti-alienation and exclusive benefit provisions. The appeals court disagreed, upholding the trial court’s reasoning that, because the plan administrator did not possess the damages award, as it had not been distributed by the court, the award could not be considered a plan asset subject to the ERISA restrictions.

The trustee further argued that ERISA’s fee-shifting provision displaces the common fund doctrine. The trustee relied heavily on a case in which the Seventh Circuit ruled that the common fund approach should be limited to cases outside the scope of a fee-shifting statute (Pierce v. Visteon Corp., CA-7 (2015), 791 F. 3d 782). The appeals court rejected the Seventh Circuit view, joining the Second Circuit (Suffolk v. Long Island Lighting Co., CA-2 (1990), 907 F. 2d 1295), Eighth Circuit (McKeage v. TMBC, LLC, CA-8 (2017), 847 F. 3d 92), and Ninth Circuit (In re Bluetooth Headset Prods. Liab. Litig., CA-9 (2011), 654 F. 3d 935, and Staton v. Boeing, CA-9 (2003), CA-9 (2003), 327 F. 3d 938) in holding that a statutory fee-shifting provision (or an award of fees under such a provision) does not preclude an award of a supplemental fees under the common fund doctrine.

However, the appeals court further explained, a reasonable fee owed to plaintiff’s counsel from a common fund will not be “necessarily identical” to a reasonable fee payable to a defendant to compensate the prevailing plaintiff’s counsel under a fee shifting statute. The amount of the common fund recovery was the final issue addressed by the appeals court.

Prior to assessing the common fund award, the trial court noted that it had received letters from 59 out of 1800 ESOP participants objecting to the contingency award, primarily because they had never been informed of the status of the case, never agreed to representation by the law firm, and never authorized the fund to pay the 1/3 contingency. Accordingly, the court awarded only $1.5 million as a supplemental fee from the damages award, rather than 1/3 of the amount recovered by the ESOP.

The court advised that the attorneys could have secured fees from the class as a whole if the participant had filed suit as a class action. The participant did initially apply for class certification, but did not appeal the subsequent denial of the certification. In light of the participant’s election to forego pursuing class certification, the appeals court concluded that the trial court’s decision to limit the common fund award was not inequitable, especially given the objections of a significant number of ESOP participants. The common fund award, the appeals court explained, reflected a proper balancing by the trial court of the attorneys’ efforts (including the assumption of the contingency risk) and the objections of the ESOP participants.

SOURCE: Brundle v. Wilmington Trust, N.A. (CA-4).

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