Tax Law and Business Organization Strategy

Ninth Circuit rules that ESOP Trustees' Payment of Excessive Executive Compensation Could be Breach of Fiduciary Duty

The Ninth Circuit has ruled that, where one of an ESOP's trustees was also the company's president, and on its board of directors, the trustees' “business decisions” leading to the payment of excessive executive compensation to the company president could constitute a breach of ERISA fiduciary responsibility to the ESOP. Johnson v. Couturier, (2009, CA9) 572 F.3d 1067. The court also ruled that ERISA preempted the indemnification agreements provided by the company to the president as a director and ESOP trustee.

In 2001, Noll, a closely held corporation, became fully owned by its ESOP. Clair R. Couturier, Jr., president of Noll, was designated as the sole trustee for the ESOP as of April 24, 2001. By the end of 2001, Noll's sole directors were Couturier and attorney David R. Johanson, who had previously represented the ESOP in connection with a leveraged purchase of all remaining Noll stock.

Before 2001, under a compensation continuation agreement (CCA), retired Noll executives were entitled to continue receiving 75% of their base salary, with an adjustment made every three years. In 2001, however, Johanson drafted three documents, which Noll, tying deferred executive compensation to company value:

  1. an equity incentive plan establishing an incentive stock option plan for key management personnel;
  2. an incentive stock option agreement granting Couturier 80,000 shares; and
  3. a value enhancement incentive plan creating additional synthetic equity.

Sweetening the pot for Couturier, additional incentive agreements were enacted in February 2002, which included allowing for the issuance of up to 93,500 shares to Couturier, and an increase in Couturier's monthly CCA stipend by about 33%.

In 2003, Couturier's compensation expanded even further. That year, Couturier and Johanson approved a retroactive annual cash bonus to Couturier equal to 10% of the dollar amount of external debt repaid on certain loans. Noll then purchased a $5.5 million home (the Palm Desert home), and a $325,000 private golf club membership, for Couturier's personal use.

After unsuccessful negotiations for the acquisition of Noll, during which the value of Couturier's interest in the company became a point of contention, Couturier and Johanson appointed Couturier's financial advisor, Robert E. Eddy, as special trustee to the ESOP. Eddy's role was to evaluate proposed transactions involving Noll and the ESOP, including monetization of Couturier's financial interest in Noll. Couturier and Johanson ultimately opted to merge Noll into “The Employee Ownership Holding Company” (TEOHC), which Johanson had incorporated in Delaware on December 15, 2003. As the incorporator, Johanson appointed himself, Couturier, Eddy, and accountant James Roorda as directors. Under a new plan, the ESOP was now to be administered by trustees appointed by the TEOHC board. The board members appointed themselves as trustees.

On July 20, 2004, under the merger transaction, Couturier received over $26 million in cash, title to the Palm Desert home, a Bentley car valued at $200,000, and various other benefits in exchange for his deferred compensation interests. The parties valued this buy-out package at $34.8 million. Accordingly, Couturier's overall compensation package equaled about 65% of TEOHC's assets as of June 2004, and about 80% of Noll's assets as of each of the prior two years. The package was also more than two times Noll's 2002 stock market value.

On October 11, 2005, several former and current Noll employees, all ESOP participants, sued Couturier, Johanson, and Eddy (collectively, the defendants), seeking relief from the defendants' alleged breach of fiduciary duties under ERISA. In essence, the participants' claim was that Couturier was so overcompensated that it amounted to a breach of the defendants' fiduciary duty as trustees of the ESOP.

The defendants entered into indemnification agreements with Noll and TEOHC between 2001 and 2005. These agreements generally indemnified the defendants for any liabilities incurred as directors, and as ESOP trustees, as long as any such liability did not involve “deliberate wrongful acts” or “gross negligence.” At issue here were provisions within the indemnification agreements requiring TEOHC to advance defense costs. Seeking advancement as promised in the indemnification agreements, the defendants executed an undertaking to repay TEOHC for any expenses paid by it on their behalf in advance of the final disposition of the lawsuit, if it was ultimately determined that they were not entitled to be indemnified by TEOHC under Delaware law. Responding to this, the ESOP participants got the district court to issue a preliminary injunction prohibiting the advancement of defense costs. The defendants appealed this injunction.

The defendants made three separate arguments to avoid invalidation of the indemnification agreements under ERISA:

  1. that they were not ERISA fiduciaries;
  2. that the setting of executive compensation was a business decision not subject to ERISA; and
  3. that whether TEOHC was obligated to advance their defense costs was purely a matter of state contract law.

The Ninth Circuit rejected each of these arguments.

Defendants were all ERISA fiduciaries. All of the Couturier defendants served as ESOP trustees, each was an ERISA fiduciary subject to the duties of loyalty and care, and to the prohibition against self-dealing, held the court. Couturier served as the sole trustee of the Noll ESOP beginning on April 24, 2001. Eddy was appointed special trustee to the ESOP in 2003. After Noll merged into TEOHC in 2004, all three defendants were appointed to the ESOP board of trustees. Further, all of the defendants were on the TEOHC board, which had the power to appoint the ESOP trustees.

ERISA applies to the executive compensation decisions here. ERISA confers upon federal district courts exclusive jurisdiction over any civil action brought by a plan participant or beneficiary for equitable relief from a trustee's breach of fiduciary duty. Johanson argued that the district court lacked subject matter jurisdiction over this case because the actions challenged by the participants, which resulted in Couturier's allegedly excessive compensation, were business decisions not subject to ERISA.

Decisions relating to corporate salaries generally do not fall within ERISA's purview, opined the Ninth Circuit. But, where plan assets include the employer's stock, the value of those assets depends on the employer's equity. Employee compensation levels are, of course, one of the many business expenditures reducing the value of the overall equity of any company. On the other hand, virtually all of an employer's significant business decisions affect the value of its stock, and thus the benefits that ESOP plan participants will ultimately receive. The court noted that taken to its logical conclusion, this line of thinking would, in the case of an ESOP, extend the application of ERISA to a corporation's annual expenditures on office supplies—clearly an absurd result.

On this basis, the Eighth Circuit has limited an ERISA fiduciary's duties to transactions that involve investing the ESOP's assets or administering the plan. (Martin v. Feilen, (1992, CA8) 965 F2d 660) Noting that setting executive compensation levels does not obviously fall into these categories, the Ninth Circuit, nonetheless, concluded that applying ERISA here did not risk encompassing within its confines any and all day-to-day corporate decisions shielded by the business judgment rule. Where, as here, an ESOP fiduciary also served as a corporate director or officer, imposing ERISA duties on business decisions from which that individual could directly profit did not seem to the court to be an unworkable rule. In fact, the court felt that to hold otherwise would protect the defendants here from ERISA liability for obvious self-dealing, which was detrimental to the plan beneficiaries.

ERISA preempts application of state law to the indemnification agreements. Defendants argued that whether TEOHC was obligated to advance their defense costs was purely a matter of state contract law, and that ERISA simply did not apply. However, the Ninth Circuit opined that ERISA contains a broad preemption clause, such that with only limited exceptions, ERISA supersedes any and all state laws that conflict with the provisions of ERISA or operate to frustrate its objects.

Here, the court found that the indemnification agreements provided complete indemnity as long as the challenged acts or omissions did not involve deliberate wrongful acts or gross negligence. ERISA § 404(a)(1)(B), by contrast, requires that a fiduciary act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. Since the defendants here would have been indemnified under the agreements even if they violated the ERISA prudent man standard of care, the court held that the application of state law here was preempted. Decision. Accordingly, the Ninth Circuit upheld the district court's preliminary injunction prohibiting TEOHC from advancing defense costs to the defendants, and remanded the case to the district court with instructions.

Source:  Pension & Benefits Updates on Checkpoint Newsstand, 8/23/09



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