ESOP Association Blog
Federal Appeals Court Sides With ESOP on Key Valuation Case
Second Circuit Addresses Key Pleading Requirement for Constitutional Standing in ESOP Transaction Case
The Court of Appeals for the Second Circuit affirmed the dismissal of a putative class action suit involving stock overvaluation claims against an independent trustee and several officers and directors of Tharanco Group, Inc. in connection with the purchase of employer stock during the formation of the Tharanco ESOP on constitutional standing grounds in Plutzer v. Bankers Trust Co. of S. Dakota (22-561-cv, Nov. 21, 2022). In doing so, the Second Circuit revisited pleading standards for ESOP transaction claims and set a reasonable bar that a participant-plaintiff must satisfy in pleading facts necessary to show an “injury in fact” arising from an ESOP’s purchase of employer stock.
The Plaintiff’s Claims
In a typical ESOP stock overvaluation case, plaintiffs allege that plan fiduciaries breached their fiduciary duties and engaged in transactions prohibited by the Employee Retirement Income Security Act of 1974 (“ERISA”) by causing the ESOP to pay more than fair market value for employer stock in connection with the formation of an ESOP. Plaintiffs often argue that the mere existence of an ESOP transaction is enough to survive the initial pleading stage and therefore allow the litigants to engage in costly and time consuming discovery. This is because ERISA facially prohibits such transactions absent a statutory exemption.
The Plutzer plaintiff—a participant in the ESOP seeking to represent a class of other participants and beneficiaries—brought claims that fit squarely in this category. Plaintiff alleged the trustee caused the ESOP to engage in a prohibited transaction under ERISA and breached its fiduciary duties in connection with the ESOP’s 2015 leveraged purchase of 100% of the company’s outstanding stock for $133.4 million.
In support of his claims, plaintiff pointed to the company’s equity value as reported on Form 5500s filed in the years following the transaction. Those values, which reflected the post-transaction debt incurred in connection with the ESOP’s purchase, included: a 2015 equity value of $13,250,000, a 2017 equity value of $30,800,000, a 2018 equity value of $25,200,000, and a 2019 equity value of $9,800,000. Plaintiff also claimed discovery would likely reveal errors in the valuation process for the transaction, including that the trustee relied on unreasonable financial projections and applied inappropriate valuation methodologies.
The Federal District Court’s Dismissal
On February 28, 2022, the district court dismissed the case based on constitutional standing grounds. To establish standing under Article III of the Constitution a plaintiff must demonstrate (1) an “injury-in-fact,” (2) a “causal connection” between the alleged injury and challenged conduct, and (3) that the injury is redressable by the court. The district court concluded that plaintiff failed to establish the first two of these necessary elements: injury and causation.
The district court reasoned that plaintiff failed to adequately plead an injury because, despite citing to the alleged post-transaction drop in equity value, plaintiff disavowed that those valuations reflected the company’s true value. Absent allegations of a post-transaction decline in value, plaintiff was left with only his belief that pleading the elements of his claims was enough. The district court disagreed that was sufficient, explaining in its decision that ERISA does not provide a participant constitutional standing simply because an ESOP transaction occurred.
The district court further explained that plaintiff failed to demonstrate his alleged injuries were fairly traceable (i.e. causally connected) to defendants’ conduct. With respect to plaintiff’s claims against the individual officers and directors of Tharanco, the district court reasoned the complaint lacked a factual basis from which the court could make an inference of causality. Indeed, plaintiff prefaced his allegations against those parties by noting he believed future discovery would likely provide evidentiary support. The district court rejected the notion that discovery should precede a threshold showing of constitutional standing. With respect to plaintiff’s claims against the trustee, the district court explained a post-transaction decrease in value could not create the necessary causal link because, among other things, the decreases occurred after the trustee ceased providing services to the plan. Plaintiff’s appeal followed.
The Second Circuit’s Decision
In November 2022, the Second Circuit issued a summary order affirming the district court’s decision dismissing the case for lack of standing. Focusing on Article III’s injury-in-fact requirement, the Second Circuit reasoned that plaintiff’s allegations concerning the company’s post-transaction equity values, which were net of debt used in the transaction, were insufficient. As an initial matter, plaintiff disavowed those values were accurate. That aside, as the Second Circuit explained, the company’s equity values fluctuated up and down in the years following the transaction, consistent with the fortunes of a company’s business operations going up or down based on a whole host of factors. Indeed, it was not until four years after the transaction that the equity value significantly decreased. The Second Circuit concluded that no plausible inferences could be drawn from those sets of facts of a supposed overpayment by the ESOP, much less one in plaintiff’s favor.
The Second Circuit further considered plaintiff’s allegations about the alleged errors in the trustee’s valuation process, finding them too conclusory to support standing. As the Second Circuit put it, plaintiff provided “only a generic list of potential valuation errors,” but failed “to specify what errors the company actually committed.” Implicit in this reasoning was the Second Circuit’s rejection of plaintiff’s reliance of the prospect of future discovery.
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