How to Protect Your ESOP from Lawsuits Over Cash Holdings

At least four lawsuits have recently been filed against employee stock ownership plan (ESOP) fiduciaries alleging a failure to prudently invest cash held in the ESOP trust. While scrutiny of investments in company stock has long been common, the focus on cash holdings represents a significant and novel shift. These cases signal a potential trend, and ESOP fiduciaries should take steps to mitigate risk, as outlined below.

Why Are ESOP Cash Holdings Becoming Litigation Targets?

One recent case, Schultz v. Aerotech, sheds light on this issue. In this lawsuit, the plaintiffs argue that Aerotech’s ESOP held nearly 20% of its total assets in cash equivalents, yielding a return of less than 1.5% over five years. Aerotech counters that the cash-heavy approach was necessary to meet future repurchase obligations. The plaintiffs, however, claim the company could have pursued higher-yield investments while maintaining adequate liquidity.

The court reviewing Aerotech’s motion to dismiss pointed to the “vast disparity” between Aerotech’s cash-heavy approach and the practices of similar plans as raising plausible inference that the company, as a plan fiduciary, failed to meet its fiduciary obligations. While Aerotech may later demonstrate that its investment strategy was justified under the specific circumstances, the allegations of imprudence were sufficient for the case to survive a motion to dismiss and proceed to costly discovery.

What Actions Can ESOP Fiduciaries Take?

Although the courts have not yet fully addressed these claims, ESOP fiduciaries can take the following measures to reduce risk and align their actions with their fiduciary obligations:

1. Assess Cash Holdings and Prepare for Increased Scrutiny

Evaluate the rationale behind the ESOP’s cash holdings. For instance:

• Are large cash reserves an intentional strategy to buffer repurchase obligations?

• Or are they the unintended result of segregating accounts of terminated participants over extended periods (which raises other compliance issues)?

Prepare for increased scrutiny from employees, plaintiff’s lawyers, and regulators by documenting the reasoning behind your investment strategies.

2. Reevaluate Investment Strategies

Ensure the ESOP’s investment approach aligns with fiduciary duties under ERISA. Unlike investments in company stock, cash holdings and other non-stock assets do not enjoy the same protective standards. Consider whether reallocating cash into low-risk, higher-yield assets could achieve better returns without compromising liquidity. Ultimately, an ESOP is a retirement plan, and the fiduciaries responsible for investment of the plan assets need to evaluate the prudence of those investments. This is separate in certain respects to the company’s need to satisfy the repurchase obligation.

3. Engage an Investment Advisor or Investment Manager

Appointing an investment advisor or investment manager can help reduce fiduciary liability. An investment advisor could make recommendations to the plan administrator or ESOP committee on appropriate investments of cash for the ESOP. However, the ultimate fiduciary responsibility for the investment of plan assets would rest with the plan administrator or ESOP committee. The plan administrator or ESOP committee could also appoint an investment manager who would take on the primary fiduciary obligation for the management of the assets. However, the plan administrator or ESOP committee would still have to act prudently with respect to the selection and monitoring of the investment manager.

4. Invest in Fiduciary Training

Formal training on fiduciary duties, particularly on selecting and managing investments, is increasingly common for 401(k) plans and can be equally beneficial for ESOP fiduciaries. This is especially important if an investment manager is not engaged.

5. Evaluate Transferring Cash to a 401(k) Plan

One way to mitigate liability for investing cash allocated to the account of a terminated participant who no longer holds any stock is to transfer the cash out of the ESOP and into the employer’s 401(k) plan. This option is most useful when the accounts of terminated participants are segregated (i.e., the stock is exchanged for cash to maximize the investments in stock for active participants) and immediate distributions are not permitted. While there are complex pros and cons to this approach, reducing the fiduciary obligations on the ESOP fiduciaries is a clear benefit.

If you have any questions about compliance with ESOP fiduciary duties, please contact one of the attorneys in the Employee Benefits & Executive Compensation Practice Group at Bradley.