Investigation of Purchase and Sale of Employer Stock To and From ESOPs

Status Investigation

Practice area Employee Benefits / ERISA


Summary of the Investigation

Cohen Milstein is investigating (and has previously litigated) various issues involving Employee Stock Ownership Plans (“ESOPs”) sponsored by closely held companies in connection with potential  violations of the federal pension law (ERISA).  Many of these issues concern the valuation of the employer stock that is held by the ESOP.

What is an ESOP?

An Employee Stock Ownership Plan (or ESOP) is a pension plan (or a retirement plan) that is invested primarily in employer stock.  The ESOP owns shares of stock in the employer; the employee who participates in the ESOP has a beneficial interest in the stock through his/her participation in the ESOP, but does not have any direct ownership or control (even though ESOP employers often tell employees that they are “employee owners”).  ESOPs are governed by the federal pension law (ERISA) and subject to regulations issued by the Department of Labor and the IRS.  (They should not be confused with stock option plans, which are frequently not retirement plans.).  ESOPs are defined contribution or individual account plans, which means that each employee has an account that is assigned shares and the employee’s account rises and falls with the value of the stock.

What are some Potential Issues with ESOPs?

One issue is the price at which the ESOP purchases the stock, either at the ESOP’s initial formation or as part of “second stage” transaction.  One common scenario is the ESOP purchases stock at or near the initial formation of the ESOP at more than fair market value, and as a result also incurs excessive or unnecessary debt which substantially burdens (and sometimes threatens the viability of the company).  As the effects of an abusive ESOP transaction may not become apparent for some time, it may be wise to have an attorney examine the transaction shortly after it occurs.

A second issue involves the sale of company stock held by the ESOP and the price at which the ESOP stock is sold.  A fiduciary of an ESOP probably has a duty to obtain the highest price that a prudent and loyal fiduciary can obtain on behalf of the ESOP, and certainly sell at no less than fair market value.  This may not happen if the fiduciary has a conflict of interest, such as selling to corporate insiders.  Additionally, a sale may also trigger voting rights by the participants in the ESOP.

A third issue involves the price at which the ESOP repurchases or redeems the stock after the employees terminate employment.  This issue is most likely to arise in a leveraged ESOP – an ESOP that is still paying off debt used to finance the original purchase of the stock.  The problem is related to whether the ESOP is properly accounting for the debt when cashing out the shares.

A fourth issue concerns ESOPs that are retroactively amended or changed.  A common scenario involves an amendment of the plan to change the time or method of valuing the shares in order to liquidate the shares and distribute the proceeds (i.e. cash employees out of the ESOP) after former employees terminate.

What Are the Source of these Issues?

ERISA was designed to assure the security of private retirement plans by requiring diversification of pension investments and outlawing self-dealing by the officials who run the plans.  But ERISA contains an exception for ESOPs dealing. ESOPs are allowed to invest up to 100% of their assets in employer stock.  Not only can the assets of the ESOPs be undiversified, but there is little effective oversight.  The same person can be the trustee of the ESOP, and also the CEO and Chairman of the Board (or the Board), and also own shares separate from or sell his/her shares to the ESOP.  Even where the trustee is “independent” of the corporate officers, the trustee is usually hired by the corporate insiders, and may be shills or otherwise beholden to the insiders.  At the same time, the employees have few rights:  they have access to few documents, they are usually not provided a say in management or a right to vote, they cannot remove the fiduciaries, and they may not even be told who the fiduciaries are.

These abuses are particularly apparent in the purchase or sale of stock by the ESOP.  The decision to buy and sell employer stock may be made by or involve corporate insiders who stand to benefit directly from the transaction.  For example, the CEO and principal owner of a closely held corporation may serve as the ESOP’s trustee and cause the ESOP to purchase shares in the corporation from himself or the employer, without necessarily violating the law.  To be legal, these transactions must occur at a price that is prudently determined to be fair market value.  But there are no safeguards to assure that this takes place, and it can be very difficult for employees to obtain enough information to determine whether the ESOP has been treated fairly.

Whom to Contact for More Information

If you are concerned about the management of your ESOP, including as a result of any of the situations described above, we are willing to conduct an initial review at no charge.  Our goal would be to evaluate potential litigation that would restore losses to current and former employees of the ESOPs.  If you have information which might assist us in the investigation of such allegations, please contact one of the following persons:

Michelle C. Yau,
Norma Cana Mejia, Paralegal –
Cohen Milstein Sellers & Toll PLLC
1100 New York Avenue, N.W., Suite 500
Washington, D.C. 20005
Telephone: 888-240-0775 or 202-408-4600