United States: Court Pares Down Claims By ESOP Participants Against Company Directors, Selling Shareholders

Highlights

• A federal district court has entered summary judgment in favor of defendants who sold stock to an employee stock ownership plan (ESOP) and faced liability under the Employee Retirement Income Security Act of 1974 (ERISA).
• In Foster, et al. v. Adams and Associates, Inc., et al., the court concluded that none of the selling shareholders who were also directors of the company were liable under ERISA Section 406(b) for acting with interests adverse to the ESOP.
• The court's opinion is noteworthy for continuing to highlight the distinction that must be made between a person's various roles in a transaction (e.g., director versus selling shareholder) when analyzing potential liability under ERISA. It also highlights the importance of establishing the availability of equitable relief in order to hold non-fiduciaries liable under ERISA.

The U.S. District Court for the Northern District of California entered summary judgment on July 6, 2020, in favor of defendants who sold stock to an employee stock ownership plan (ESOP) and faced liability under the Employee Retirement Income Security Act of 1974 (ERISA). In Foster, et al. v. Adams and Associates, Inc., et al., the court concluded that there was no evidence that one of the selling shareholders, who was also a company officer and director, had sufficient knowledge that the sale of stock to the ESOP was an allegedly unlawful prohibited transaction, and dismissed the claim against her under ERISA Section 406(a). The court also concluded that none of the selling shareholders who were also directors of the company were liable under ERISA Section 406(b) for acting with interests adverse to the ESOP.

Factual Background

In Foster, plan participants filed a putative class action in connection with the Adams and Associates ESOP, arising from the ESOP's purchase of 100 percent of the outstanding stock of the company from the selling shareholders, some of whom were also officers and directors of the company. Relevant to the discussion, the complaint alleged that the selling shareholders engaged in non-exempt prohibited transactions under ERISA Sections 406(a) and 406(b) by selling their stock to the ESOP and were liable as both fiduciaries and non-fiduciaries under ERISA.

The plaintiffs' prohibited transaction claim under Section 406(a) was brought against the selling shareholders on the theory that they knew that the acquisition of the shares by the ESOP was for more than adequate consideration because the trustee was unaware of material information that certain of the selling shareholders knew, in their capacity as company directors, and which, according to the plaintiffs, would have reduced the shares' value. The plaintiffs also brought a prohibited transaction claim under ERISA Section 406(b) on the theory that the selling shareholders, who were also directors, engaged in a transaction with interests adverse to the plan.

District Court Decision

The court found that director defendants, who were also selling shareholders, were non-fiduciaries in the ESOP transaction because there was no evidence that they caused the plan to engage in the ESOP transaction. As a result, the court proceeded to evaluate the director defendants' liability on this claim as non-fiduciary parties in interest. To be liable as a non-fiduciary party in interest under Section 406(a), the non-fiduciary must have "actual or constructive knowledge" of an unlawful transaction. As to one of the selling shareholder/director defendants, the court concluded that there was no evidence that she was involved in the company's due diligence responses, which the plaintiffs claimed were misleading and, accordingly, there was no evidence that she knew of the circumstances that rendered the transaction unlawful.

As to the claim under ERISA Section 406(b) against the selling shareholders, who the plaintiffs also contended were ERISA fiduciaries based on their corporate director positions, the court concluded that the director defendants were not fiduciaries for the purpose of the ESOP transaction. Rather, the director defendants' fiduciary obligation was limited to selecting and retaining the trustee. Thus, concluded the court, they could not be liable as fiduciaries under Section 406(b) for selling their stock to the ESOP. The court also concluded that the selling shareholders were not liable as non-fiduciaries because a claim under Section 406(b) is available only against a fiduciary.

The court also addressed the selling shareholders' argument that they were entitled to judgment on the ERISA 406(a) claim because the plaintiffs failed to identify appropriate equitable relief. As claims against non-fiduciaries arise under ERISA Section 502(a)(3) for "other appropriate equitable relief," establishing the availability of equitable relief is a required element to recover. The court agreed that neither disgorgement nor surcharge, two of the equitable remedies that the plaintiffs claimed, were available. The court concluded that disgorgement was not available because the plaintiffs could not establish that selling shareholders owed a fiduciary duty. Surcharge was not available because the court concluded that it was traditionally a legal, not equitable, remedy. The court also addressed the claim for rescission, which had not been briefed by the parties, stating, in dicta, that if rescission is no longer possible because the plaintiffs have disposed of the consideration received, the "monetary equivalent" might be recoverable. Although this dicta seems to go against the black letter law of rescission, the court did not further address the issue, since the defendants did not move for summary judgment on the plaintiffs' request for rescission.

Key Considerations

The court's opinion is noteworthy for continuing to highlight the distinction that must be made between a person's various roles in a transaction (e.g., director versus selling shareholder) when analyzing potential liability under ERISA. It also highlights the importance of establishing the availability of equitable relief in order to hold non-fiduciaries liable under ERISA.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.