Highlights
- The U.S. District Court for the Western District of Arkansas recently denied a motion to dismiss a complaint that challenged an employee stock ownership plan (ESOP) releveraging transaction.
- The court concluded that at the pleading stage, the plaintiffs had plausibly alleged breaches of the duty of prudence and duty of loyalty against the company and trustee, despite expressing skepticism regarding the merits of those claims.
- The case and decision is one to be aware of when considering an ESOP releveraging transaction.
The U.S. District Court for the Western District of Arkansas issued its written decision in Shipp v. Central States Manufacturing, Inc. on July 5, 2024, declining to dismiss the case against Central States Manufacturing Inc. and the trustee of its employee stock ownership plan (ESOP) in a lawsuit asserting that a releveraging transaction breached fiduciary duties under the Employee Retirement Income Security Act (ERISA).
Background
Central States Manufacturing is an employee-owned metal roofing and siding company. The company's stock is wholly owned by the Central States Manufacturing Inc. Employee Stock Ownership Plan. Every year, Central States contributes stock shares and/or the cash equivalent to each employee's ESOP retirement account. The yearly contributions increase proportionally as employees' salaries increase and the employees achieve greater seniority.
When an employee retires or leaves the company, the company repurchases the shares in that employee's account at the fair market value as determined by the ESOP trustee and pays the employee for those shares. The repurchased shares are then removed from circulation and "retired," shrinking the available pool of shares over time.
The three named plaintiffs are employees who recently retired or left Central States. The plaintiffs brought a class-action complaint, alleging that the company, its board of directors and the ESOP trustee breached fiduciary duties owed to the ESOP and its plan participants by engaging in a releveraging transaction in 2020, which the plaintiffs assert diluted the value of their ESOP shares.
The challenged releveraging transaction occurred in two steps. During the first step, Central States took out a bank loan for $40 million. It used that loan to redeem approximately 2.2 million shares owned by ESOP participants who were retired or separating from Central States. The trustee set the stock's fair market value at $18 per share. During the second step, Central States conveyed the 2.2 million newly redeemed shares to the ESOP, and in exchange, the ESOP issued a promissory note for $40 million to Central States, to be repaid over 30 years. The ESOP kept the 2.2 million shares, securing the $40 million note in a suspense account. As the $40 million loan was repaid, the equivalent value of company shares was to be released and allocated to participant accounts.
The plaintiffs allege that this releveraging transaction violated ERISA for three primary reasons. First, the plaintiffs allege that the releveraging transaction diluted the value of Central States' shares and thus reduced the value of existing participants' accounts. Second, the plaintiffs allege that, in the second step of the transaction, the ESOP overpaid for the 2.2 million shares it acquired, because $18 per share was no longer the fair market value, considering the $40 million of additional debt saddled on Central States. Third, the plaintiffs allege that the inflated share price caused the ESOP to incur more debt that would have been necessary if the shares were valued properly.
Based on these allegations, the plaintiffs brought two claims. The first claim was against the company defendants and ESOP trustee, asserting that they breached their fiduciary duties to ESOP participants by conducting the second step of the releveraging transaction and allegedly diluting the value of existing shares in participants' accounts. The second claim was against only the company and its board and asserted that Central States engaged in an ERISA-prohibited transaction by 1) charging the ESOP too much for the 2.2 million shares it acquired and 2) causing the ESOP to take on unnecessary debt.
Defendants' Motions to Dismiss
In their defense, the defendants asserted that Central States faced a serious concern that is common among mature ESOPs, namely, that due to the longevity and success of Central States, the per-share value of its stock was increasing faster than the equity of the company, such that Central States' obligation to repurchase stock from retired accounts was becoming unsustainable.
The defendants stressed that the releveraging transaction was necessary to avert an impending cash crisis that would occur if Central States' repurchase obligation was greater than the company's total equity. The trustee and company defendants filed separate motions to dismiss asserting distinct arguments.
The trustee argued that the plaintiffs lacked standing because the plaintiffs failed to establish that the ESOP, separate from the individual plaintiffs, suffered an injury-in-fact. The trustee asserted that the releveraging transaction did not shrink the ESOP's overall "pie" of shares but instead sliced the pie up differently. The trustee additionally argued that the decision to releverage was not a fiduciary function because the decision to releverage is a corporate, non-fiduciary function outside of ERISA's purview. Finally, the trustee asserted that the plaintiffs had not alleged sufficient facts to support an inference of an imprudent process and similarly failed to allege sufficient facts to support the claim that the trustee breached its duty of loyalty.
The company defendants asserted that the plaintiffs' claims were plan-based, rooted in the text of the plan document, and thus, the plaintiffs were required to exhaust the administration remedies set forth in the plan document before bringing suit. The company defendants additionally argued that the plaintiffs failed to allege facts supporting the notion that the company defendants were acting in an ERISA fiduciary capacity at the time of the challenged transactions. The defendants alleged that the Amended Complaint contained vague and conclusory allegations of "dilution" and "overpayment" and unsupported conclusions that there were "alternatives" that the defendants failed to consider. Lastly, the company defendants argued that the plaintiffs had failed to plead sufficient facts to support a breach of the duty to monitor and failed to plead an underlying breach necessary to support a derivative claim.
Court's Opinion
Ultimately, the court found that given the early stage of the case and the liberal pleading standard afforded to plaintiffs, the claims were plausible enough to "chin the bar and survive dismissal." The court's opinion noted the defendants' characterization of these allegations as "exaggerated and incorrect" and stated that "[t]he veracity of these allegations will be tested in the course of discovery."
In line with that, the court's case management order reflects a rapid discovery schedule that allows the parties to file early motions for summary judgment. The court's order permits plaintiffs a short window to establish facts supporting their claims before summary judgment - the colloquially characterized "put up or shut up" moment in a case.
Key Takeaways
This case raises a number of considerations with respect to ESOP releveraging transactions. Notably, the plaintiffs do not assert that a releveraging transaction, by itself, violates ERISA or is otherwise impermissible; rather, the plaintiffs challenge the way this one proceeded. Whether that challenge will be upheld is yet to be seen. The court's decision did not rule on the merits of the plaintiffs' claims, but just determined that they were sufficient to get past a motion to dismiss.
Most importantly, the decision makes clear that, even in newly formed ESOPs, planning for the future is important. The decision in Shipp v. Central States Manufacturing, Inc. is one to consider when considering ESOP sustainability and a potential releveraging transaction.
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.