Dudenhoeffer Focuses on Public Companies; Attorneys Mull Application to Private ESOPs

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By Jacklyn Wille

Sept. 8 — The U.S. Supreme Court's decision in Fifth Third Bancorp v. Dudenhoeffer changed the legal landscape for employee stock ownership plans of public companies—but what about the ESOPs of private companies?

According to Corey Rosen, senior staff member and cofounder of the National Center for Employee Ownership in Oakland, Calif., 95 percent of the ESOPs in existence are affiliated with privately held companies.

The Dudenhoeffer ruling was largely limited to the world of public ESOPs, with very little consideration of the particular challenges facing fiduciaries of private ESOPs, attorneys told Bloomberg BNA in a series of recent interviews.

Dudenhoeffer, which was handed down in June, invalidated the pro-fiduciary presumption that some courts had used to shield ESOP fiduciaries from liability for declining share price, while at the same time articulating a number of new obstacles for participants challenging fiduciaries' actions in the face of such declines (134 S.Ct. 2459, 58 EBC 1405 (U.S. 6/25/14).

Stock-Drop Claims

One possible explanation for Dudenhoeffer's strict public ESOP focus is the fact that stock-drop claims—in which plan participants sue fiduciaries for failing to dump employer stock that has declined in value—haven't been a big issue in the private ESOP world, Rosen said.

That's because fiduciaries of private ESOPs have fewer options when faced with declining stock price, Rosen said. Unlike fiduciaries of public ESOPs, they can't sell company stock on an established market. Instead, they would have to “go try and shop for buyers,” he said.

Larry Goldberg, a partner with ESOP Law Group LLP in San Francisco, echoed this sentiment, saying that “there's no obvious market where you could as a fiduciary sell these shares.”

Instead of calling a broker with instructions to sell stock on an open market, Goldberg said that a private ESOP fiduciary likely would have to hire an investment banker and auction off the shares to a private buyer, which takes considerably more time and effort.

“It's a lot more onerous,” Goldberg said.

“For a private company to sell stock, you're really contemplating a situation where the board of directors might have to consider putting the company up for auction, and that's a very time-consuming and comprehensive process that diverts management from the day-to-day operation of the business,” Mark I. Bogart, a shareholder with Vedder Price's Chicago office, said.

This typically constitutes a “multi-month process” that involves considerable due diligence, including valuations by independent appraisers, Bogart said.

‘Fire Sale' Considerations 

Not only is this option of selling declining stock impractical for a private ESOP fiduciary, it's also likely to be seen as a “fire sale” that would drive the stock value down even further, which Rosen said would cause fiduciaries “almost by definition” to have breached the duty of prudence.

“The market hears ‘fire sale,' and that could have negative repercussions on the whole company,” Goldberg said.

In that situation, “people could rightly point the finger at the trustee that caused the failure,” Goldberg added.

Other considerations arise when poor financial conditions cause fiduciaries of private ESOPs to shop for buyers.

For example, Rosen noted that fiduciaries on this situation must disclose the company's troubles to any potential buyers. Otherwise, “you've committed fraud, so you're in trouble in a different way,” Rosen said.

Bogart added that investments in private ESOPs are intended to be long-term investments in a company, rather than investments that should be unloaded the moment something goes wrong.

“I don't think anyone really expects that, if the price of the stock goes down in a private company or if a private company enters into a period of business uncertainty, that the fiduciaries have an option other than holding the stock,” Bogart said. “If the market conditions are really going down, you might be able to find someone to buy the company, but it wouldn't be at a very good price.”

“Of course, the fact that options are more limited for fiduciaries of ESOPs sponsored by private companies is not to suggest that they may remain passive in these situations, and they would at a minimum have to be satisfied that the board of directors and management are on the right track,” Bogart added.

Private ESOP Questions

Although stock-drop claims in the private ESOP world are rare, an analogous situation is possible, Rosen said.

Specifically, he brought up the question of whether private ESOP fiduciaries can face liability for rejecting an offer to buy company stock that comes when the company's financial position is strong.

Moreover, Rosen questioned whether an argument could be made that private ESOP fiduciaries have an obligation to “shop for buyers” when the company is performing well, “on the theory that maybe you could get a good price for it.”

While these questions can arise, the bigger liability issue facing private ESOPs involves valuations and appraisals, Rosen said.

In particular, Goldberg said that the Department of Labor has “been big on challenging valuations” over the past three years.

For example, the Department recently filed two lawsuits accusing PBI Bank Inc., as ESOP trustee, of allowing two ESOPs to purchase stock at inflated values (Perez v. PBI Bank Inc.,N.D. Ind., No. 3:13-cv-01400-PPS-CAN, complaint filed 12/26/13; Perez v. PBI Bank, Inc.,S.D. Ind., No. 1:14-cv-01429-SEB-MJD, complaint filed 8/29/14).

Litigation Jumpstart?

In Rosen's view, it still may be too early to know whether the Dudenhoeffer ruling will jumpstart new litigation in the world of private ESOPs.

“It's really too early to tell whether the plaintiffs' bar is going to see this as an opportunity,” he said.

However, he expressed doubt that a significant wave of stock-drop litigation would hit the private ESOP world, because “they have other established ways to contest ESOPs if they want to.”

Further, Rosen said he expected that plaintiffs' attorneys would first “test the waters in public companies” before turning attention to private companies.

This trend nevertheless may take some time to heat up, Rosen said, because stock-drop lawsuits tend to flourish in poorer economies, such as the one following the 2008 financial crisis.

Elimination of Presumption

The Dudenhoeffer ruling hasn't caused Goldberg to change the advice he gives to clients, but he said he “expects that'll happen soon.”

Goldberg also said that Dudenhoeffer's elimination of the presumption of prudence might make ESOP fiduciaries more likely to sell stock when faced with an attractive offer.

That's because, when the presumption was in play, an ESOP fiduciary who received an offer to buy shares may have been less inclined to sell, because he had a legal presumption in his favor if he bought or held stock, but not if he sold, Goldberg said. In a post-presumption world, that same fiduciary may be more inclined to sell, he said.

To contact the reporter on this story: Jacklyn Wille in Washington at jwille@bna.com

To contact the editor responsible for this story: Jo-el J. Meyer at jmeyer@bna.com

Text of the Dudenhoeffer ruling is at http://www.bloomberglaw.com/public/document/Fifth_Third_Bancorp_v_Dudenhoeffer_No_12751_2014_BL_175777_US_Jun.