In recent litigation involving employee stock ownership plan (ESOP)-owned companies, the US Department of Labor (DOL) has taken the position that indemnification clauses are void against public policy under Section 410 of the Employee Retirement Income Security Act of 1974, as amended (ERISA). Though lacking clear precedent, this policy has also been adopted by private plaintiff classes in recent years. As evident from the settlement in Pfeifer v. Wawa, a policy of voiding indemnity provisions can limit defense budgets, make settlements more likely and potentially create dangerous precedent for ESOPs.
ERISA sets minimum standards for employee benefit plans, like ESOPs, that are meant to protect plan participants and their beneficiaries. These protections include strict standards of duty and loyalty for the individuals responsible for the ESOP—known as the “plan’s fiduciaries”—and ready access to federal courts for ESOP participants, the DOL and other ESOP stakeholders.
ERISA Section 502(a), the “civil enforcement provision” of ERISA, allows a plan participant to sue to recover benefits owed to the participant by the ESOP, to redress violations of ERISA’s fiduciary standards, and to seek “other equitable relief.” Similarly, the DOL can, and frequently does, bring civil actions for breaches of fiduciary duties and other provisions of ERISA.
As one of the primary agencies charged with ERISA enforcement, the DOL has long maintained that Section 410 of ERISA prohibits blanket indemnification of fiduciaries by an ESOP sponsor or the ESOP itself. Specifically, Section 410 prohibits, “as a matter of public policy,” any provision in an agreement or instrument which purports to relieve a fiduciary from responsibility or liability under ERISA. Meant to prevent a plan fiduciary from shifting its own ERISA liability to a sponsoring company or plan participants or beneficiary, Section 410 expressly allows an ESOP or plan sponsor to purchase liability insurance for the ESOP’s fiduciaries. DOL regulations issued under Section 410 further permit “indemnification agreements” that function as insurance, but flat-out prohibit indemnification paid for with plan assets.
In general, indemnity is a promise by one party, the indemnitor, to provide compensation for a loss suffered by another party, the indemnitee. Indemnification can be negotiated as provision of a larger contract or can exist as a stand-alone agreement. Indemnification is the basis for many insurance contracts, but can also be used to allocate risks amongst parties to many types of contracts, including an engagement agreement between a plan sponsor and plan fiduciary. It is common for ESOP trust agreements to contain a provision that states:
Recognizing that engagements of the type contemplated in this agreement can result in government investigations, litigation, or other proceedings, the Company agrees to indemnify Trustee against and from any and all claims, damages, expenses, liabilities and losses whatsoever (including, but not limited to, any and all expenses reasonably incurred in investigating, preparing for, defending, or responding to discovery requests or other requests for information relating to, any government investigations, litigation, arbitration or other proceedings, commenced or threatened, or any claim whatsoever, whether or not resulting in any liability), to which any or all of them may become subject under any applicable federal or state law or otherwise relating to the Proposed Transaction or Trustee’s duties as Trustee (including all events that occurred prior to Trustee becoming the Trustee or after Trustee’s service as Trustee has terminated). However, the indemnification of Trustee shall not apply to any claim, damage, expense, liability or loss that is found by a court of competent jurisdiction, in a final judgment from which no appeal can be taken, to have resulted either from a breach by Trustee of its fiduciary duties under Title I of ERISA or, in non-fiduciary matters, from the bad faith, gross negligence, willful misconduct or material breach of the terms of this letter agreement by Trustee.
While DOL has no objection to those indemnification arrangements that allow a fiduciary or plan sponsor to purchase fiduciary liability insurance for those who act in fiduciary roles, it has taken the position that allowing an ESOP-owned company to pay for any amount of a settlement or award in addition to the costs of an insurance policy would cause monetary harm directly or indirectly to the ESOP and its participants and beneficiaries.
In Donovan v. Cunningham, the first major case to examine indemnity provisions, the Southern District of Texas found that ERISA 410 voided an agreement that provided for an ESOP sponsor would indemnify “each member of the Board of Directors, each member of the [plan committee], the trustee and any other person to whom any fiduciary responsibility with respect to the plan is allocated or delegated from and against any and all liabilities, costs, and expenses incurred by such persons as a result of any act or omission to act in connection with the performance of their fiduciary duties, responsibilities and obligations under the Plan and under the Act, except for liabilities and claims arising from such fiduciary's willful misconduct.” The court found that such a broad indemnification provision was, in fact, an attempt to relieve the fiduciaries from responsibilities under ERISA.
On the other hand, in Pfahler v. National Latex Products Company, a case involving a welfare benefit plan, the Sixth Circuit held that indemnification agreements are valid under ERISA 410, saying “Given that ERISA explicitly permits parties to insure against possible liability, it would be illogical to interpret the statute as prohibiting indemnification agreements, which accomplish the same thing.” In Schafer v. Multiband Corp, the Sixth Circuit noted that, while deciding the case on other grounds, the holding in Pfahler applies with equal weight to indemnification of ESOP trustees.
At least one court has held that, in the context of a 100 percent ESOP-owned company, any costs borne by the company arguably impact the value of company stock held by the ESOP. In the often-cited Johnson v. Couturier, the Ninth Circuit held that a series of fiduciary indemnification agreements that excluded only “deliberate wrongful acts” and “gross negligence,” but included breaches of fiduciary duty, were void under Section 410.
An important, but often overlooked, fact in Couturier is that the ESOP sponsor was in the process of liquidation, therefore any funds used to pay the fiduciaries’ defense costs would result in a dollar for dollar reduction in the funds available for distribution to ESOP participants. In Harris v. GreatBanc Trust Company, the Central District of California distinguished Couturier, allowing an indemnification agreement that expressly prohibited indemnification if a court entered a final judgment—from which no appeal could be filed—that found a trustee liable for breach of its fiduciary duties. Additionally, the court in GreatBanc noted that where the plan sponsor is an operating company, as opposed to a company in the process of liquidation, plan asset regulations (29 CFR Section 2510-3.101) apply, meaning the assets of the plan sponsor are not treated as assets of the ESOP.
The Settlement Thicket
The law is less clear on the limits of fiduciary indemnification, particularly as applied to settlement payments by ESOP sponsors. With the protections of indemnification provisions jeopardized, many ESOP trustees would lack the resources to defend a case through trial, increasing the incentive to settle claims and agree to terms that they otherwise would not.
As the court in Harris v. GreatBanc pointed out, even if the DOL is mistaken in its interpretation of Section 410, it is still free to demand that indemnification agreements be void as a condition of settling a case. In fact, that was precisely what the DOL did in settling the Harris case, where GreatBanc ultimately agreed to not seek or accept indemnification from the sponsoring company.
The pressure to settle can also be seen in cases between private parties. In Pfeifer v. Wawa, the Eastern District of Pennsylvania allowed the plaintiffs’ challenge to the indemnification of ESOP trustees and administrators to survive a motion to dismiss. The parties subsequently reached a settlement agreement before proceeding to trial. While not bound by the Ninth Circuit’s decision in Couturier, the court in Wawa declared Couturier the “majority view” on the validity of indemnification of fiduciaries without acknowledging its distinct facts, providing an attractively succinct, but inadequate summary of the issue for future plaintiffs to cite.
The unique circumstances of settlements, where the defendant typically doesn’t admit liability but is not technically cleared of it either, can also pose challenges when applying the terms of indemnification agreements or insurance policies. For example, if the agreement provides for indemnification of defense costs only where the fiduciary is cleared of all wrongdoing, a settlement may not meet that criteria.
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The recent trend highlights the importance of trustees seeking insurance and litigation budgets for costs that go above and beyond their coverage limit, in addition to indemnification provisions, when negotiating their engagement with the plan or plan sponsor. Adequately preparing for litigation is even more important for individual trustees, who may otherwise lack the resources to defend against prolonged litigation and feel more pressure to settle. Trustees should consult counsel when drafting indemnification language to ensure it complies with the most recent developments in ESOP case law. In addition, trustees should work with counsel to budget for potential legal claims with the understanding that indemnification provisions may not cover all costs associated with such claims.