Lysengen v. Argent Trust Co.

This proposed ESOP class action featured familiar claims against the trustee and several individual defendants. In her complaint, the plaintiff alleged the trustee violated ERISA by allowing the plan to overpay for company stock and by breaching its fiduciary duties. The complaint also claimed the individual defendants, i.e., selling shareholders, knowingly participated in, and benefitted from wrongdoing by accepting a price that exceeded fair market value. The defendants asked the court to dismiss the case. The court denied the motion. It rejected the defendants’ argument that it was bad policy to allow lawsuits whenever there was a “prohibited transaction.” Also, the court found it was inappropriate to consider itself and the plaintiff bound by an earlier, related, state court proceeding that declared the transaction fair. The plaintiff’s case may go forward, the court concluded.

Allegations

The company was Morton Buildings Inc. The plaintiff was an employee and participant in the company’s employee stock ownership plan (ESOP) that was formed in 2017. The defendants were the ESOP trustee and two majority shareholders who sold their stock to the ESOP.

Earlier, in 2015, minority shareholders filed a lawsuit in state court that aimed to stop the formation of the ESOP. The minority shareholders claimed the defendants (the company and three individuals) had breached various fiduciary duties. The state court case went to trial and the court determined the contested transaction was fair; the stock price was appropriate. The state court allowed the transaction to move forward.

The instant transaction, which forms the basis of the plaintiff’s lawsuit, took place in May 2017. The transaction was in part financed with a loan from the company and the selling shareholders. One of the plaintiff’s claims was that the per-share price dropped twice after the sale. The transaction price was $75.25 per share. Five months later, in December 2017, it was $33.78 per share. One year later, in December 2018, it was $29.48 per share.

Further, the plaintiff said, the stock price “strangely rose before the sale.” The defendants were able to explain that the “strange” increase was due to a mistake in pricing that the company later corrected. However, the plaintiff countered that the price correction did not occur until a year and a half after the contested ESOP transaction. Therefore, it was plausible that the company corrected “to justify the value paid by the ESOP in May 2017.” The plaintiff sought discovery on this point.

She also contended that the ESOP transaction allowed the sellers to “unload their interests in Morton above fair market value and saddle the Plan with tens of millions of dollars of debt over a 30-year period.”

The complaint alleged the trustee that oversaw the ESOP transaction: (1) engaged in a prohibited transaction under ERISA and caused the plan to overpay; (2) violated its fiduciary duties to the plan to act solely in the interest of the plan; (3) the trustee’s indemnification agreement with the company improperly relieved the trustee from liability for an ERISA violation and should be invalidated; and (4) the selling shareholders had actual and constructive knowledge that the transaction was improper and that they were receiving the benefit of that wrongful conduct.

State court ruling not binding

In their pretrial motion to dismiss, the defendants argued the federal court presiding over the instant case should adopt the state court’s ruling that the ESOP transaction was fair. The plaintiff here already had the benefit of all the publicly available information related to the state court action and should not be allowed to “file a complaint that on its face demands discovery despite the readily available information that shows the claims are doomed from the start.” In other words, the federal court should take judicial notice of the facts and conclusions of the state court proceedings.

The federal court declined to do so. Judicial notice, the court explained, required “indisputability” of a fact. Judicial notice “substitutes the acceptance of a universal truth for the conventional method of introducing evidence.”

The court explained that, while it may take judicial notice of the fact that there was a state court proceeding, “the heart of this dispute is disagreement over whether the transaction was fair. It is not appropriate for this Court to take judicial notice of any of the state court’s factual findings or legal conclusions.” The state court finding that the transaction was fair was not a fact and was disputed, the instant court observed.

It also pointed out that the instant case involved different parties and was brought under different laws and years after the initial decision. The plaintiffs in the state court proceeding had other interests, motives, and claims that did not align with those of the plaintiff in the instant action. The plaintiff here has not yet had a chance to investigate and present her own version of the facts and her own witnesses and she cannot be bound by prior litigation in which she had no part, the court stated.

Enough facts to argue prohibited transaction

The defendants contended most of the plaintiff’s claims turned on the theory that the ESOP overpaid for the company’s stock. What the plaintiff called facts were legal conclusions, the defendants said. Also, the stock fluctuations the plaintiff described in the complaint were not what they seemed.

The court recognized that the defendants had made a price correction. But the court also noted the plaintiff’s allegation that the correction occurred nearly two years after the “purported stock valuation error.” At this stage in the proceeding, the correction “does not conclusively determine that the price did not strangely rise [before the sale to the ESOP],” the court said. It also noted that the per-share price dropped not once but twice. Even if a drop due to the loan was expected, the plaintiff claimed, “that does not explain why after the 2017 drop, the price was yet still lower in December 2018.” The plaintiff “plausibly alleged that the stock price movement is suspicious and suggests the ESOP overpaid,” the court said.

The court also found the plaintiff alleged sufficient facts to support her claim that the trustee caused the plan to engage in a prohibited transaction (i.e., a transaction between the plan and a party in interest).

The court allowed that the acquisition of employer stock is permissible if it is for “adequate consideration” (one of the section 408 exemptions). However, under the controlling 7th Circuit law, “an ERISA plaintiff need not plead the absence of exemptions to prohibited transactions” Rather, the burden is on the defendant to show the section 408 exemption applies, the court pointed out (citing Allen v. GreatBanc Trust Co., 835 F.3d 670 (7th Cir. 2016)).

The court cited the 7th Circuit (Allen) in rejecting the defendants’ argument that, since the statute authorizes ESOPs, “it simply cannot be the case that every time an ESOP is created a plaintiff can sue.” The 7th Circuit, in Allen, considered this “flood” argument “overwrought” and was more concerned that plaintiffs would have to “plead around all the exemptions to a prohibited transaction when plaintiffs generally lack access to information about the plan’s dealings,” the court here noted. It concluded that just because ESOPs are legally permitted “does not bar Plaintiff’s claim for a prohibited transaction when she has reason to believe the plan overpaid.”

The court further found the plaintiff offered sufficient facts to support her claim that the trustee breached its fiduciary duty under ERISA. The complaint raised “serious questions” as to whether the plan, as represented by the trustee, paid a fair price, and adequately considered the drop in stock price, the court said. It declared itself “satisfied” that the plaintiff’s allegations were enough to “nudge her claim ‘across the line from conceivable to plausible.’”

The plaintiff contended an indemnification agreement in the trustee’s engagement contract was improper as it sought to relieve the trustee from liability for a violation of ERISA’s prohibited transaction rules. Under the applicable regulations, indemnification agreements that function as insurance are allowed, but indemnification must not come from the plan. The Department of Labor has noted such an agreement would in effect “relieve the fiduciary of responsibility and liability to the plan by abrogating the plan’s right to recovery from the fiduciary for breaches of fiduciary obligations.”

The defendants argued the indemnification agreement here did not apply to claims or liability related to the trustee’s breach of fiduciary duty under ERISA and that the agreement functioned essentially as insurance, which was permissible. The court noted that many courts considered indemnification by an ESOP sponsor the functional equivalent of an impermissible indemnification by the plan itself. “Here, the company is entirely owned by the ESOP. Accordingly, the Court agrees that the indemnification would indirectly place the indemnification burden on the ESOP, which is impermissible under ERISA.”

Finally, the court found the plaintiff’s complaint alleged sufficient facts that the selling shareholders benefited from the alleged ERISA violation by the trustee, “when they received a payment above fair market value for their stocks.”

Denying the defendants’ motion to dismiss, the court asked the plaintiff to file a motion for conditional class certification.