There is potential for peril whenever employers encourage employees to invest their retirement savings in employer stock. From a purely practical viewpoint, an employee who works for a paycheck and also chooses to invest his or her retirement savings in the same employer can hardly be said to have diversified risk. But with a privately-held company selling its own shares to employees, the risk that may come from accounting fraud, improper valuation and other forms of self-dealing is greatly increased.
TBM Consulting ESOP – “T” is for trouble
TBM established the ESOP in 2003. In August 2011, TBM retained Lubbock to serve as the trustee of the ESOP. Very shortly thereafter Anand Sharma, TBM’s then-CEO, offered to sell 62,239.26 of his TBM shares to the ESOP for $10,500,000.
As trustee, Lubbock had fiduciary responsibilities under ERISA section 404(A)(1)(b) to ensure that the price paid by the ESOP was reasonable. TBM Consulting, however, is a privately held company. Unlike publicly traded stock where value is established by the market and listed on stock exchanges, privately held shares can be difficult to value.
In Remy v. Lubbock National Bank, the plaintiffs, TBM Consulting and four named executives, argue that the $10,500,000 price was greater than the fair market value. Further, Lubbock knew or should have known that the financial projections used by the financial advisor it retained to value the shares were unreliable and had been heavily influenced by Sharma. Sharma was, of course, interested in maximizing the amount paid by the ESOP.
ERISA Section 3(21) defines a fiduciary as someone who exercises discretionary authority or control regarding the management of an employee benefit plan or the disposition of its assets. Those assets must be managed for the sole benefit of plan participants and beneficiaries. They must also be managed with the skill and expertise that could be expected of an expert.
A plan trustee is clearly a fiduciary. In order to execute specialized functions, fiduciaries may hire individuals or organizations with needed expertise. The fiduciary retains the fiduciary obligation to oversee and evaluate the work contracted out. Generally, although the tasks may be delegated, the legal responsibility under ERISA may not. In the case of the TBM Consulting ESOP, the trustees delegated the task of stock valuation to a financial advisor. However, they retained the ERISA obligation to evaluate the financial advisor’s work. This is, allegedly, where things went wrong.
Much of the first several years of this lawsuit were dedicated to motion practice focused on defining or restricting Lubbock’s responsibility for the over valuation.
ERISA prohibited transaction rules
But the fundamental issue is whether the seller, Sharma, played both sides of the fence. He had an interest in maximizing his profits; he was apparently also a key player in determining the value of the stock; and as CEO he had a decision-making role within the company. It’s a situation ripe for a conflict of interest and quacks like a conflict of interest …..
Insider transactions like this are so risky that they are classified as “prohibited transactions” under ERISA. The prohibited transaction rules are very complicated and technically complex. In brief, ERISA prohibits a fiduciary from allowing a plan to engage in a transaction if the fiduciary knows or should know that the transaction constitutes a direct or indirect sale, exchange or lease of any property between the plan and a related party.
There is, however, an exception when there is an independent valuation of the insider’s shares. The central question in Remy is whether the valuation was, in fact, independent. With the settlement, should the court approve it, that question will remain unresolved.
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The recent spate of ERISA lawsuits that focus specifically on ESOP fiduciary failures gives plenty of reason for suspicion. Lubbock National Bank has also been specifically involved in other Department of Labor settlement agreements concerning overpriced employer stock sold to an ESOP.
When Congress defined the rules governing ESOPS in 1974, the policy goals seemed laudable enough. The intention was to both:
- provide tax incentives for owners of privately held companies to sell their companies; and
- provide ownership opportunities and retirement assets for working-class Americans.