You Misunderstood the Valuation: Court Rejects ESOP Fiduciary Breach Suit

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A federal trial court has dismissed a lawsuit brought by a participant in an employee stock ownership plan (ESOP) claiming that fiduciaries of the ESOP caused it to overpay for stock of the company in a leveraged transaction. The court concluded that, based on a fundamental misunderstanding of the valuations of the company stock, the plaintiff’s belief that she had suffered an injury was erroneous and that she lacked standing to bring the suit.

In Lee v. Argent Trust Company, Choate Construction Company created an ESOP and engaged Argent Trust Company (Argent) to serve as the ESOP’s trustee. The ESOP, the company, and the shareholders of the company then entered into a transaction in which the ESOP purchased 8 million shares of company stock representing 80% of the value of the company. The remaining 2 million shares were redeemed by the company from the shareholders. The ESOP paid $198 million for the 8 million shares, which amount was funded through a combination of bank financing and seller notes. As trustee for the ESOP, Argent was responsible for retaining the independent appraiser who valued the company stock at $198 million as of the date of the transaction.

Less than one month after the transaction was completed, the company stock was valued, in the aggregate, at $64.8 million—$133.2 million less than what the ESOP paid for the stock. Based on this reduction, the plaintiff brought suit against company personnel, Argent, and the shareholders claiming that they caused the ESOP to significantly overpay for the company stock to the detriment of herself and her fellow participants.

The defendants filed a motion to dismiss the plaintiff’s claims for a lack of standing, and the court agreed. The court found that the plaintiff “fundamentally” misunderstood the nature of the transaction that created the ESOP and the subsequent valuation. To demonstrate the misunderstanding, the court analogized the complex leveraged ESOP transaction to the more common transaction of purchasing a home with the proceeds of a mortgage. The court’s example supposed that a fictitious homebuyer purchased an asset (a home) with 100% financing. The home was worth $198,000, and the homebuyer paid for the home by taking a $198,000 loan. After the purchase, the homebuyer’s interest in the home was worth $0 ($198,000 asset minus $198,000 liability). Of course, the home itself was still worth $198,000.

Applying this simple example to the ESOP, the court explained that, if the fair market value of the company stock when it was purchased by the ESOP with 100% financing was $198 million, then one would expect the value of the ESOP’s interest soon after the transaction to be $0. In other words, the subsequent valuation necessarily took the debt into consideration. However, unlike the homebuyer, the value subsequently placed on the company stock was not $0; it was $64.8 million. The court reasoned that this must have resulted from the company appreciating 33% in less than a month or the ESOP paying $198 million for stock actually worth closer to $262.8 million. With this explanation, the court concluded that the plaintiff realized a clear benefit as opposed to suffering any injury that would provide her with standing and agreed to dismiss the suit.

The facts in this case provide a timely illustration of the continued scrutiny that is being placed on leveraged ESOP transactions by plaintiffs’ attorneys. That is, fiduciaries involved in such transactions should be prepared to defend and explain their actions regardless of how beneficial the transaction may actually be to participants. As illustrated here, a fundamental misunderstanding in providing a valuable benefit to employees could become the basis for costly and unnecessary litigation.

For more information on the Lee decision or ESOP transactions in general, please contact one of the attorneys in the Employee Benefits and Executive Compensation Practice Group at Bradley.