ESOP Participants Win Case Over Failed Diversification Implementation

A court used plain language of the ESOP plan document to show the plan administrator's failure to implement participants diversification elections was "arbitrary and capricious."

A federal court has found that an employee stock ownership plan (ESOP) document’s plain language makes the plan sponsor’s decision to not implement participants’ diversification elections in a timely manner “arbitrary and capricious.”

The Case 

Dave and Vikki Bryant were participants in Community Bankshares ESOP, when in April 2009, they met age and participation requirements to diversify a portion of employer stock in their ESOP accounts. Since Bankshares’ stock was not publicly traded, the plan also allowed them to exercise a put option to sell the shares to the company for cash. The put option was based on the preceding year’s annual stock valuation.

According to the court opinion, both Bryants elected to have their allowed portions of their ESOP accounts rolled over to an individual retirement account (IRA) and exercised put options. The previous year’s valuation was $11.00 per share. The Bryants were sent letters informing them that their elections would be completed by June 30, 2009.

However, that deadline came and went. Instead, Bankshares suspended implementation of the diversification elections until after an interim valuation revealed that in September 2009 the stock’s worth had plummeted to $2.30 per share, and Bankshares and the Federal Reserve Bank in November 2009 had entered into a written agreement that prohibited Bankshares from redeeming put options.

In November 2009, Bankshares offered to issue stock in satisfaction of the diversification elections but informed participants that it would not honor the put options. Bankshares also gave participants the option to change their 2009 diversification elections in light of this new information; however, the Bryants contend that this offer to receive the illiquid stock of a failing bank and the resultant tax liability presented no choice at all. However, they made new elections to keep the stock in the plan.

Chief U.S. District Judge W. Keith Watkins of the U.S. District Court for the District of Alabama, noted in his opinion that Bankshares deprived the Bryants of their rights under the plan to receive a distribution of shares and to exercise a put option, which would have required Bankshares to buy back the shares based upon the preceding year’s stock valuation of $11.00 per share. The stock is now worthless, at 15 cents per share.

The plan administrator defends its decision, contending that, given Bankshares’ deteriorating financial condition, it acted in the best interests of all plan participants by refusing to honor 2009 diversification elections, which under the plan would have been subject to put options at the preceding year’s stock valuation. It further contends that, in November 2009, the Bryants voluntarily submitted new diversification elections to keep their stock in the plan and that these new elections voided their April 2009 diversification elections.

NEXT: The Court’s Arguments

Watkins found that Sections 5.8 and 8.3 of the ESOP plan document work together, and he looked at the plain language of the plan. In summary, an eligible participant—one who had participated in the plan for ten years and had attained the age of at least 55 years—could make a diversification election within the 90-day period following the close of each plan year in the six-plan-year qualified election period. For the first five 90-day annual election periods, the plan gave an eligible participant the option to diversify 25% of his or her account balance that was invested in employer securities, reduced by any amounts previously diversified. During the sixth and final 90-day election period in the qualified election period, an eligible participant could diversify 50% of stock shares in his or her account balance, reduced by amounts previously diversified. The value of the account balance was its value on the Annual Valuation Date.

Because Bankshares’ stock was not publicly traded on an established market, it was bound by Section 5.8(b) of the plan document, which says when a participant received a distribution of Bankshares stock pursuant to a diversification election, the participant could exercise the put option within 60 days after the distribution of the stock or during the first 60 days of the following plan year. The price of the shares for purposes of the put option was the fair market value of the shares on the Annual Valuation Date preceding the year in which the participant exercised the put option.

Watkins found that the timeliness of the Bryants’ diversification elections is not an issue, and there is no dispute that the Bryants properly exercised their rights under the plan to make a diversification election. He also found there is no plan language in Section 5.8 of the plan document that permits Bankshares to use a date other than the Annual Valuation Date when placing a value on Bankshares’ stock for purposes of buying back the shares under a put option.

The plan administrator cited Section 8.4 of the plan which said the plan administrator had a general fiduciary obligation to exercise its authority for the benefit of all plan participants when offering its reasons for not honoring the Bryants’ elections. The court rejected them all.

Watkins found the decisions conflict with the clear, specific, and mandatory terms of the plan governing stock valuation, a participant’s right to make a diversification election, and a participant’s right to exercise a put option on distributed shares and. The decisions also construe the plan in a manner that contravenes the governing federal regulations, he said. The Internal Revenue Code requires that, if an employer’s stock is “not readily tradeable on an established market” then the company that sponsors the ESOP must provide a put option right to the participant to sell the shares of stock back to the company.

Defendants’ argument that the June 30 deadline was a self-imposed, rather than a contractual, deadline surfaced for the first time in this litigation. The court did not assign much weight to that, noting that the plan administrator’s construction of the plan to permit a special valuation in times of Bankshares’ financial crisis clearly conflicts with the plan language. “Notably, the Plan could have made an exception for an alternative valuation date or other contingency plan in unexpected times of financial stress, but it did not,” Watkins wrote. In addition, he found that the plan administrator consistently interpreted June 30 as a mandatory deadline, beginning in February 2009 and continuing through the Bryants’ administrative review process.

Watkins conceded that the fact of an oral prohibition from a federal regulatory agency would seem to be a significant reason to relay to participants to explain a plan administrator’s suspension of a put option, had that fact actually motivated the decision. However, the written agreement between the Federal Reserve Bank and Bankshares, which prohibited Bankshares from purchasing or redeeming its stock shares, did not take effect until September 16, 2009, several months after the June 30, 2009 deadline had passed.

Finally, the judge said the Bryants’ November 2009 diversification elections to keep their shares in the plan could not explain or justify Bankshares’ decision not to implement the diversifications by the June 30, 2009, deadline for the obvious reason that the November 2009 diversification elections were non-existent in June. “It was not reasonable for the Plan administrator to conclude that the Bryants’ November 2009 diversification elections amounted to waivers of their previous invocation of their rights to pension benefits,” Watkins wrote. And, he found that communications to the Bryants did not effectively give then notice that they were waiving their rights to the benefits.

NEXT: Awards to Participants

The court found that Bankshares, as the plan administrator, is liable under the Employee Retirement Income Security Act (ERISA) for the benefits that plaintiffs did not receive as a result of Bankshares’s failure to distribute the shares of stock in satisfaction of plaintiffs’ diversification elections by June 30, 2009. Those benefits encompass the put option, which would have permitted the Bryants to obtain cash in lieu of stock shares at the $11.00 share price fixed by the December 31, 2008, annual valuation. Section 8.3 of the plan entitled Mr. Bryant to diversify 50% of the employer securities in his account, which would have equaled approximately 4,599 shares of stock. Exercising the put option at $11.00 per share, Mr. Bryant would have received $50,589. Mrs. Bryant was entitled to diversify 25% of the employer securities in her account, which would have equaled approximately 220 shares of stock. Exercising the put option at $11.00 per share, Mrs. Bryant would have received $2,420.25. Accordingly, the court ruled the Bryants are entitled to an injunction ordering Bankshares to pay benefits in the foregoing amounts.

In addition, the court found plaintiffs are entitled to an award of prejudgment interest. Prejudgment interest will permit them to receive full compensation for their losses and will ensure that thepPlan administrator does not obtain “a windfall as a result of its wrongdoing.” The Bryants assert that they are entitled to an award of prejudgment interest at a rate of 1.5% per month (18% per annum), and the court found that rate appropriate.

“Accordingly, prejudgment interest will be calculated at the rate of 18% per annum for the time period during which Plaintiff was wrongfully denied benefits under the policy. To account for this delay, the court finds that the unique circumstances of this case justify an accrual of prejudgment interest from the date that the Bryants initiated the administrative claims process. That process began by letters dated March 12, 2014, in which Plaintiffs’ counsel submitted a written claim to the Plan administrator, contending that the plan administrator had breach its contractual obligation to diversify the Bryants’ accounts,” Watkins ruled.