The Seventh Circuit Court of Appeals recently ruled that a participant lawsuit challenging an employee stock ownership plan (ESOP) transaction could not be forced into arbitration. See Smith v. Bd. Of Dir. Of Triad Mfg., Inc., No. 20-2708 (7th Circ., Sept. 10, 2021). There, a former employee sued several defendants alleging that the ESOP overpaid for company stock. Certain defendants sought to compel arbitration of the disputes pursuant to an arbitration provision and class-action waiver that was added to the plan after the initial stock transaction. The district court, and then the Seventh Circuit, held that the arbitration provision was not enforceable.
The reason why, as the Seventh Circuit indicated, was “straightforward”: the arbitration clause in the ESOP plan document barred relief, monetary or otherwise, for any employee, participant, or beneficiary other than the particular plaintiff. ERISA permits certain forms of equitable relief, such as removal of fiduciaries, even for an individual plaintiff who is barred from bringing a class or collective action. The arbitration provision triggered the “effective vindication” exception to arbitration, which provides that an arbitration provision may not forbid certain statutory rights. An arbitrator must have the authority to award the same relief that a court could award, and by precluding any relief to anyone other than the plaintiff, the arbitration provision impermissibly “prohibits relief that ERISA expressly permits.”
The decision does not invalidate all arbitration and class-waiver provisions in ESOP plans, and the holding can be addressed by some careful drafting of arbitration language. But there is a broader, more pervasive problem reflected by the Seventh Circuit’s decision, specifically in the Court’s discussion of background facts that had nothing to do with the arbitration issue before the Court. The Seventh Circuit completely misunderstood the nature of a leveraged ESOP transaction and the difference between ‘equity’ value of ESOP stock and ‘enterprise’ value of the plan sponsor.
In a section of the decision discussing the plaintiff’s complaint’s allegations, the Court wrote that that the transaction occurred on December 17, 2015 at a price of $58.05 per share. The Court wrote that the “share price then dropped to $1.85 on December 31, 2015,” and “[w]hat had been valued at over $106 million plummeted in two weeks to just under $4 million.” The decision contains additional comments intimating that the post-transaction drop in stock value is evidence that the ESOP overpaid for stock at the time of the transaction.
Yet the decision also states that the transaction was financed by loans. Clearly, the Seventh Circuit did not understand the difference between the value of the company pre-transaction, on the one hand, and the post-transaction value of the ESOP stock, which accounted for the leverage. In a leveraged ESOP transaction, the post-transaction valuation of the ESOP’s stock is affected by the loans obtained to buy the stock. The company itself, as an enterprise, is not worth less; the equity value of the ESOP’s shares is what the post-transaction valuation represents.
The Smith decision provides guidance on how to draft potentially enforceable arbitration provisions, but it also underscores the need in ESOP litigation matters to fully educate judges about foundational ERISA, ESOP, and valuation principles. It is a mistake to assume that judges are familiar with any of these issues, or that judges understand these issues, especially the complex, nuanced issues involved in ESOP litigation. Defendants should employ comprehensive strategies designed to educate judges in order to correct some widespread misunderstandings about ERISA, ESOPs and valuation principles.
Faegre Drinker: Thinking ESOPs is an e-newsletter that seeks to encourage thoughtful discussion of key issues in ESOP transactions and ESOP litigation. For more information, please contact one of our ESOP team members: Rick Pearl, Jeremy Pelphrey, Jason Luter, Philip Gutwein.