Illinois ERISA Lawyer Blog

Employees of Chicago companies who participate in a 401(k) holding employer stock or an Employee Stock Ownership Plan are often attracted to owning stock in their employer because of the significant upside for the staff doing a good job for the employer. You are there at work every day, and you see how the business operates. So you can see how your (and your colleagues') efforts will pay off. But holding employer stock in your retirement plan does not come without its risks. For example, one might say you have all your eggs in one basket. If your employer goes bankrupt, you not only are out of a job, but your retirement savings could be decimated. Fiduciaries of an ERISA retirement plan owe a duty of prudence with respect to the investments in the plan, and failing to take employer stock out of the retirement plan can be a breach of your employer's, or some individuals who make such decisions, fiduciary duties.

Many employer plans "hard wire" the holding of employer stock into the terms of the plan. This means the plan document states one of the purposes of the plan is to hold employer stock. In such cases, the fiduciaries are given a broader deference in their decision over when they should make the decision to stop including employer stock in the plan, a so called presumption in favor of the retention of employer stock being reasonable. The seminal case on that point is Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995). Recently, the Second Circuit Court of Appeals (a significant court that sits in New York City) adopted that rule in Gearren v. McGraw-Hill Cos., 660 F.3d 605 (2d Cir. Oct. 19, 2011). Plaintiffs in that case alleged it was a breach of fiduciary duty for fiduciaries of the McGraw-Hill 401(k) plan to not remove employer stock from the plan when the stock dropped 64% in value following the subprime mortgage crisis. The Second Circuit held that this presumption applies at the pleading stage, meaning it can cause a case to be dismissed if the proper facts are not pled.

Where the plan is subject to the Moench presumption, a plaintiff will generally have to allege that the employer stock faced a dire situation that was foreseeable to the fiduciaries. This is, of course, pretty vague language, and what it means can only be discovered through the case-by-case examples. If you have questions about your retirement plan including your employer's stock, consult an ERISA lawyer.

Employees of privately held companies in Chicago and the Midwest have tremendous opportunities and risks ahead, as the baby-boomers who own those companies get set to retire. Generally, an owners of a privately held business has two choices when it comes time to retire: pass the business on to a family member, or sell it. Passing the business on to a family members is often not feasible. Many of these baby-boomers built the sort of business that required a lot of elbow grease. Meanwhile, they sent their children to the best schools and encouraged them to pursue other sorts of careers: accounting, finance, medicine, law, etc. Therefore, the boomers will look to sell those businesses. But as there likely will be more boomers retiring in the next decade than entrepreneurs looking to buy the businesses, selling the business to the employees via an Employee Share Ownership Plan (ESOP) will likely become more commonplace. If you are an employee in such a company, that sounds great so far, right?

The answer depends. ESOPs usually get billed as tokens of generosity: a means for a benevolent owner to pass the legacy on to employees. But often the true purpose is one of corporate finance: a means for the owner to liquidate a holding in the company. Danger lurks in ESOPs where the outgoing owner sets up the ESOP and also serves as a trustee of the plan at the time the ESOP will decide what price to pay for the stock to that very same owner. Not surprisingly, many such business owners have been caught doing just that before.

The Department of Labor just obtained several consent judgments against ESOP trustees in a case where the DOL alleged the trustees paid over $60 million for company stock only worth about $18 million. See Solis v. Mattingly, No. 2:09-cv-00207-WOB (E.D. Ky).

This particular ESOP affected over 5,000 employee participants, causing them losses, but similar transactions will become more likely on a smaller scale, and they have been alleged in larger scales as well (e.g., the lawsuit against the famed real estate mogul turned Chicago Tribune owner, Sam Zell). For instance, the business with 20 employees, 50 employees, maybe even 100 employees could easily become the next plan sponsor of an ESOP that pays inflated prices for company stock. If you are on of the participants in a company that recently set up an ESOP, you should ask several questions. Are the individuals who are selling the stock also running the ESOP? Who performed the valuation of the company stock? How did the valuator arrive at that number? Privately held companies are more difficult to value than publicly held companies, because there are no shares traded on securities exchanges.

Because of the potential for such abuse, the IRS has even issued guidance recently with respect to S Corporations sponsoring ESOPs. If you are a participant in an ESOP, and you think the plan may have paid too much for employer stock, speak to an ERISA lawyer today.

Executives, managers and employees of closely held businesses in Chicago and all over the country may soon become more likely to own part of their employers. On March 29, 2011 several Congressmen, both Democratic and Republican, introduced H.R. 1244, the Promotion and Expansion of Private Employee Ownership Act of 2011. On April 15, 2011, the bill was referred to the Education and Workforce Committee, the first step on the process before a vote. There is a similar bill pending in the Senate Finance Committee, the Employee Stock Ownership Plan Promotion and Improvement Act of 2011, S. 101. The bills effectively give incentives to owners of closely held businesses formed as a Subchapter S corporation to transfer ownership of the company to an Employee Stock Ownership Plan ("ESOP"), and incentives to lenders who loan the corporation money to purchase the stock from the owner.

Many small businesses structured as Subchapter S corporations have already created ESOPs. But if enacted, the House Bill would make forming an ESOP by an S corporation even more attractive. The bill would allow owners of an S corporation to defer the gain realized on the sale of stock to the ESOP in the same way as currently allowed for owners of C corporations by amending I.R.C. § 1042(c)(1) to define qualifying securities as including those of S corporations, not just C corporations. Moreover, the bill would allow lenders that loan money to an S corporation for the purposes of purchasing the corporation's stock for the ESOP to deduct half the interest received, thereby incenting lenders to participate in these leveraged ESOPs.

Congress appears to have two things on its mind. First, as expressly noted in its findings, "40 percent of working Americans have no formal retirement account at all". Second, with a Baby-Boomer population at or nearing retirement, many owners of small to medium-size are succession planning. There would likely be an abnormally large number of businesses for sale. This may give those business owners increased incentive to pass the businesses along to their employees rather than sell the business on the open market, and incurring immediate tax liability.

We are excitedly monitoring the progression of this bill. With all change comes opportunity, for the better and worse. There will always be a few bad apples in the bunch, With increased benefits to owners for selling their stock to an ESOP, there will undoubtedly increased number of attempts to sell the stock to the employee benefit plan for an inflated price. Luckily, with the pending changes to the DOL's definition of fiduciary, as covered in an earlier post, to possibly encompass valuation experts, this may be mitigated. If you have questions about your employer creating and ESOP, call an ERISA lawyer.