Federal Court Dismisses Challenge to ESOP Transaction
In Lee v. Argent Trust Co., the court dismissed ERISA claims challenging an ESOP stock transaction because the plaintiff, who “fundamentally misunderstands the nature of the” ESOP transaction, did not allege that she suffered any injury. This decision is important to educate other courts about economics, particularly in cases where plaintiffs rely on little more than the post-transaction valuation as evidence of supposed overvaluation.
On August 7, 2019, a district court dismissed ERISA claims against a trustee, sponsor company and individuals because the complaint did not plead that the ESOP transaction was overvalued. The claims related to the Choate Construction Company ESOP. Choate is a privately held company that formed an ESOP in 2016. It retained Argent as the plan’s trustee, and Argent was responsible for evaluating and overseeing the initial ESOP stock purchase.
In December 2016, the ESOP bought 8 million shares, or 80% of Choate’s stock, for $198 million as part of a leveraged transaction. Like many ESOP transactions, the Choate ESOP’s stock purchase was financed with a $57 million loan that Choate borrowed from a bank and then loaned to the ESOP. To finance the remainder, the ESOP issued notes to the selling shareholders for the remaining $141 million.
The plaintiff, a former employee, filed a class action under ERISA alleging that the ESOP purchase was overvalued. The complaint relied principally on the valuation right after the transaction at year-end 2016, less than a month after the ESOP deal. The plaintiff alleged that the company, allegedly worth $198 million at the time of the transaction, was worth only $68.4 million after the transaction.
The defendants moved to dismiss for lack of subject-matter jurisdiction and for failure to state a claim. Focusing on the subject-matter jurisdiction question, the court noted that federal courts have jurisdiction only if a plaintiff suffers an injury related to the alleged misconduct. A plaintiff uninjured by alleged misconduct has no standing to sue. The court determined that the plaintiff failed to allege injury because she “fundamentally misunderstands” the nature of the leveraged ESOP transaction. The court viewed the transaction like a house purchase, giving the following example: suppose a buyer with no money for a down-payment has to borrow against a house she purchases for $198,000. After the purchase, the buyer’s equity is zero, assuming the house is actually worth $198,000. But what if the house were worth $262,000, and not $198,000? Right after the transaction, the buyer, who put up no money, now has $64,800 in equity.
The ESOP transaction was similar. The ESOP’s year-end valuation in 2016 was $64.8 million, meaning that the ESOP immediately after the transaction had $64.8 million in equity and realized “an immediate economic benefit.” This allegation undercut the plaintiff’s claims of an overvalued transaction. The plaintiff did not plead that she suffered any injury, and thus lacked Article III standing to sue.
Plaintiffs often allege that post-transaction valuations evidence an inflated price at the time of an ESOP stock transaction. This court correctly understood the economics of a leveraged ESOP transaction, namely that taking on debt reduces equity value and is not evidence of an overvaluation. This decision is important to educate other courts about these economics, particularly in cases where plaintiffs rely on little more than the post-transaction valuation as evidence of supposed overvaluation.