Department of Labor Wins Important ESOP Case

Posted · Add Comment

An employee stock ownership plan (ESOP) is a retirement plan that is permitted to invest some, or all, of its assets in employer stock. ESOP plans are often sponsored by small or mid-sized, closely held firms that are not traded on any public exchange or capital market. As such, there is no way of knowing if the price paid for a share of stock is, in fact, fair market value without careful and precise review of the company’s financials and projected earnings.

A key element of implementing a successful ESOP is to structure the “sale” of the company stock held by the selling shareholders to the plan at “fair market value.” In this way, the participants in the plan that is purchasing the shares are buying them at their true market value. Obviously, to overpay for the shares would benefit the selling shareholders at the disadvantage of the plan participants.

In early April 2017, a federal judge upheld the findings of the U.S. Department of Labor (DOL) in an ESOP-related lawsuit. The Court found that First Bankers Trust Services Inc. (First Bankers) breached its duties of prudence and loyalty to the participants of an employee stock ownership plan sponsored by a New Jersey paving and building site preparation company when it caused the plan to overpay $9.4 million for shares of the company’s stock.

SJP Group Inc., the plan’s sponsor, hired First Bankers as an “independent fiduciary” to advise the company’s plan on whether – and at what price – to purchase shares of SJP Inc. from its majority shareholder and officer, Vincent DiPano.

An investigation by the DOL’s Employee Benefits Security Administration (EBSA) found violations of the Employee Retirement Income Security Act (ERISA), and the department filed suit against both First Bankers and DiPano in the U.S. District Court for the District of New Jersey, seeking to recover losses suffered by the plan participants.

“Participants’ retirement benefits depend on the plan buying and selling stock for fair market value, and the department intends to make certain that the price a plan pays for the plan sponsor’s stock reflects its true market value,” said Jonathan Kay, EBSA’s regional director in New York. “Those retained to advise a plan about the stock purchase must fulfill their fiduciary duties under ERISA and prevent those who sell their shares to a plan from receiving an unwarranted windfall.”

Following a 17-day trial in 2016, the court held that First Bankers had, indeed, breached its fiduciary duties to the plan’s participants by failing to conduct a prudent investigation into the fair market value of the shares. As a result, the participants’ purchase of 38% of the outstanding SJP Group stock from DiPano was approved  for $16 million, which was nearly $10 million more than what the stock was worth. DiPano agreed to pay $2.25 million in restitution and a penalty for failing to adequately monitor First Bankers.

The court also held that First Bankers:

  • Failed to independently and thoroughly investigate the true value of the shares – as the plan’s fiduciary, it was responsible for ensuring that the participants paid no more than fair market value for the shares
  • Relied on unrealistically optimistic projections of SJP’s future earnings

Unfortunately, a failure to respect the spirit of the ESOP laws and overvalue the shares being sold is pervasive in ESOP planning. This decision was made to send a message to plan fiduciaries that their sole obligation is to protect the interest of the plan participants regardless of the impact on the selling shareholders and the fiduciary. The 2014 GreatBanc decision also demonstrated the DOL’s aggressive enforcement of ESOP transactions that fall short of compliance with the rules designed to protect plan participants against owner/manager malfeasance.

While an ESOP structure can be an excellent vehicle for accomplishing many different planning strategies, it is most important that focus first be on the determination of fair market value and the fair treatment of the plan and the participants therein. Otherwise, the many positive benefits of an ESOP could be unwound years later in decisions such as this one and others.  Click here to read a related newsletter article.

Grossman Yanak & Ford LLP is highly experienced in all types of business valuations and has done a great deal of work with ESOPs and their Trustee Committees to assist them with meeting both their Internal Revenue Service and Department of Labor requirements under ERISA.

Should you wish to discuss your specific ESOP questions, or offer a comment, please contact Bob Grossman or Melissa Bizyak at 412-338-9300.