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ESOP Trustees and Administrators: Draft Your Plans Strategically

October 29, 2018Articles For Your Benefit

One challenge faced by ESOP trustees and administrators in recent years are challenges from the plaintiff’s bar in the form of class action lawsuits frequently filed by attorneys representing purported classes of participants in connection with certain ESOP transactions. In light of a recent decision by the Ninth Circuit Court of Appeals, these participant class action lawsuits may pose a more serious threat to plan sponsors, trustees and their business partners.

In a typical scenario, the plaintiff asserts that the ESOP trustees have breached their fiduciary duties as a result of the loss in the stock value without action to divest the shares. These allegations are based upon a line of so-called “stock drop” cases involving public company stock held by ESOPs and other similar plans. This loss, however, is a necessary part of every leveraged ESOP transaction. In essence, an ESOP transaction is a leveraged buyout of all or part of the company. Debt is placed on the company to finance the sale, as it would be in any management buyout. The debt (and the associated drop in share value) is a normal and expected part of the transaction. The company’s intrinsic value does not change – it has merely converted some of its equity into debt.

In many cases however, a successful stock drop claim is not the objective. Rather, the goal is to obtain access to the ESOP’s books and records by claiming the loss in share value constitutes a breach in fiduciary duty. From a litigation perspective, factually based allegations are more problematic because these type of allegations are not easily susceptible to motions to dismiss, which are motions arguing that the plaintiff has no legal claim even if the facts he or she alleges are presumed to be true. Once a fact-based set of allegations survives a motion to dismiss, a plaintiff typically has a right to commence far-ranging discovery. Because the federal discovery rules are liberally construed, it opens the entire operation of the ESOP to examination by the plaintiff, in a very expensive and time-consuming process.

The threat posed to ESOP community is creation of an incentive for the plaintiff’s bar to bring multiple lawsuits in the belief that ESOPs may enter into expensive settlements simply to avoid litigation costs. The ESOP community has responded by adding arbitration clauses to ESOP documents, requiring participants to arbitrate disputes with ESOPs. At minimum, such arbitration language will have a chilling effect on the ability of participant’s ability bring a successful challenge to the ESOP transaction. However, these arbitration clauses must be carefully drawn to serve as an effective bar to the litigation threat.

This point was underscored by a decision recently issued in the U.S. Ninth Circuit Court of Appeals entitled Munro v. Univ. of Southern California, No. 17-55550 (9th Cir., July 24, 2018). While Munro did not involve an ESOP, the fiduciary breach claims at issue parallel those that arise in the plaintiff’s lawsuits under ERISA. The arbitration agreements signed by the Munro participants did not prevent those participants from bringing their fiduciary breach claims in Federal Court, thereby bypassing the arbitration process.

At issue are the two types of participant lawsuits permitted under ERISA. The first is an individual claim for benefits under Section 502(a) (1)(B); and the second is a claim for fiduciary breach under Section 502(a)(2) of ERISA on behalf of the plan. This second type of suit has been analogized to a shareholder’s derivative suit, where an individual shareholder brings a suit on behalf of

the corporation (and its shareholders) to remedy a wrong committed by management. The critical distinction is that the ERISA 502(a)(2) action, like a shareholders derivative suit, is not an individual action, but rather brought in a representative capacity on behalf of the plan or the corporation, as the case may be.

In Munro, the participants signed individual arbitration agreements as a condition of participation in the plan. However, their lawsuit, sought financial and equitable remedies specifically on behalf of the plan and all affected participants. The plan moved to compel arbitration, relying on the arbitration agreements. However, both the trial court and the Ninth Circuit declined to enforce the arbitration agreements under the facts presented. While noting the general policy to liberally enforce arbitration agreements, the Court held that arbitration cannot be compelled by the arbitration agreement if its scope is insufficiently broad for the claim at issue.

The Court examined the language of the arbitration agreements and found them to be lacking in this regard. In doing so, it focused on the distinction between individual and representative-based lawsuits such as those authorized under ERISA section 502(a)(2). In focusing upon the fundamental distinction between these actions the Court drew another analogy: between ERISA 502(a)(2) claims and so-called qui tam claims brought under the False Claims Act. In essence, qui tam actions are brought by an individual on behalf of the U.S. government to recover damages in cases where the government has been overcharged by contractors. It cited a recent case where a substantively similar arbitration agreement was rejected as a bar to a qui tam action.

The Munro holding has broad implications for ESOPs if their trustees cannot compel 502(a)(2) plaintiffs to arbitrate their claims. However, we do not read Munro so broadly as to impose a blanket prohibition on arbitration agreements involving 502(a)(2) claims. The holding is based upon the limited scope of the arbitration agreement at issue. The decision clearly left the door open to establishing a more targeted arbitration agreement. The lesson to be learned is that arbitration agreements for all ERISA plans, but particularly with respect to ESOPs, must be drafted with extreme care and with an understanding of the available participant causes of action under ERISA.