District Court Upholds ESOP Stock Cash-Out Feature for Terminated Employees

Tharaldson Motels, Inc. (TMI) is a holding company that owns and operates hotels in 36 states. TMI adopted an ESOP in 1998, which, by the end of 1999, had acquired 100 percent of TMI's stock. Prior to 2005, the governing plan documents required plan participants who terminated employment to elect either an immediate cash distribution or a reinvestment of their stock balance in a stable value account; the plan did not allow participants to retain their balances in TMI stock after termination of employment. In 2005, the Plan was amended to allow Plan participants to retain their accounts in TMI stock after termination of employment but this amendment was repealed in 2006. The 2006 amendment reinstated the prior policy mandating cash out of TMI Stock upon termination of employment (the Stock Cash-out Feature).

Richard Hoffman and Dean Mantermach, former employees of TMI, brought suit against the TMI ESOP, the ESOP Committee and certain named officers and directors of TMI, on behalf of themselves and the class of similarly situated TMI employees who they contended would be forced to liquidate their stock balances upon termination of employment (a class of employees which could be as large as 3,500 or more). The plaintiffs sought to have the 2006 Amendment reinstating the Stock Cash-out Feature to the TMI ESOP invalidated, on the grounds that (i) the 2006 Amendment was not properly disclosed to Plan participants; (ii) the 2006 Amendment had the effect of depriving terminated participants of future appreciation in the value of TMI stock; and (iii) there is an inherent conflict of interest (and breach of ERISA fiduciary duty) between the ESOP Committee and plan participants as regards the Stock Cash-out Feature.

In Hoffman v. Tharaldson Motels, Inc. Employee Stock Ownership Plan, 2010 WL 749788 (D.N.D., February 26, 2010), the U.S. District Court for North Dakota reviewed the 2006 Amendment in light of the anti-cutback rule in ERISA, which prohibits amendments to a retirement plan that reduce a plan participant's accrued benefit. ERISA § 204(g) and Internal Revenue Code §411(d)(6). The Court initially found that the 2006 Amendment appeared to be an amendment which resulted in a change in the way payouts under the plan could be made, such that it was a cutback of some sort. The Court went on to note, however, the IRS safe harbor regulation which permits plans to be amended to eliminate alternative forms of payment (Treas. Reg. § 1.411 (d)-4(b)) and, in particular, Treas. Reg. § 1.411(d)-4(b)(7) which provides that [t]he right to a particular form of investment (e.g., investment in employer stock or securities or investment in certain types of securities, commercial paper or other investment media) is not a protected benefit under the anti-cutback rules.

The Court found that the 2006 Amendment is permitted by law and that the Stock Cash-out Feature for departing employees protected their accrued benefits under the plan. The Court rejected the plaintiffs' argument that there was a conflict of interest and breach of fiduciary duty between the ESOP Committee and the ESOP participants, because the decision by TMI to adopt the 2006 Amendment was a permissible settlor function and therefore did not implicate a fiduciary duty under ERISA. The Court rejected the plaintiffs' arguments that the 2006 Amendment deprived employees of future appreciation in the value of TMI stock as speculative and also rejected the Plaintiff's lack of disclosure claim.

The significance of Tharaldson is that a federal court has clearly and affirmatively recognized an employer's right to adopt a Stock Cash-out Feature for terminated employees in an ESOP. Coming as it did in the same month as IRS Technical Assistance Memo #4 (dated February 23, 2010), which sanctions Stock Cash-out Features as part of an acceptable re-shuffle of plan investments (see related article in this ESOP Report), this case is part of a one-two punch affirming the validity of this common feature in ESOPs.

Recent Development in this Case
The decision in Tharaldson addressing the Stock Cash-out Feature in the TMI ESOP, as reported above, did not end that litigation. The plaintiffs have also challenged the 1998/99 purchase of TMI stock by the TMI ESOP, contending that the price paid by the ESOP for the stock was excessive, and they seek to restore losses to the plan sustained as a result of the defendant's breach of fiduciary duty.

In the motion decided by the U.S. District Court for North Dakota on May 7, 2010, the plaintiffs sought to certify their action as a single class action under the Federal Rules of Civil Procedure (Rule 23(b)(1) and/or (b)(2)) including all of the participants, both those currently employed by TMI, and those who had previously terminated.

The gist of the underlying claim was that the Defendant, Gary Tharaldson, as the sole Director of TMI and the Trustee of the ESOP, breached his fiduciary duties of prudence and loyalty under ERISA, because the purchase price paid for the stock was in excess of fair market value in that: (i) the independent valuation upon which the ESOP Trustee relied did not include a reduction in stock value due to the existence of ESOP loans; and (ii) there was no appropriate deduction for minority discount.

At the time this Complaint was filed, there were somewhere between 3,300 and 4,100 active participants in the ESOP, and 250 to 1,100 participants who were no longer employed by TMI.

The Court noted that the interests of former employees with ESOP balances are very different from those of current employees – the former employee group no longer holds shares of TMI stock in their accounts, those shares having been converted to cash or a stable value fund by virtue of the Stock Cash-out Feature described above, whereas the current employees still have shares of TMI stock in their plan accounts which may appreciate in value. This latter group, according to the Court, is injured by continuing litigation: (1) the litigation interferes with the efficient and smooth running of the Company, reducing its value, and (2) makes a possibly lucrative sale of TMI difficult or even impossible. Consequently, the interests of the former employees and current employees are not in alignment.

The holding of the Court was to divide the participants in the litigation into two subclasses: (1) Former Employee Class, and (2) Current Employee Class, with separate legal representation for each subclass. This holding may serve to curtail this litigation in the long run – the Current Employee Class with many more members than the Former Employee Class, may have little interest in continuing the litigation, as it very likely impairs the value of their TMI stock.

The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances.


The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2017.

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