Fernandez et al. v. K-M Industries Holding Co., No. C 06-7339 CW (N.D. Cal. Aug. 21, 2009)
The September 15, 2009 Employee Ownership Update is online and discusses the following:
The Update discusses Fernandez et al. v. K-M Industries Holding Co., No. C 06-7339 CW (N.D. Cal. Aug. 21, 2009) and how it is the second recent case (Johnson v. Couturier (9th Cir. July 27, 2009)) that has ruled that an indemnification agreement is invalid if an ESOP would directly or indirectly bear the financial burden of indemnification:
- Pakistan Starts Wide-Scale Employee Ownership Program
- Another Court Says ESOP Trustees Cannot Be Indemnified
- Deloitte/NASPP Survey Shows Sharp Increase in Restricted Stock Plans Globally
In the second case in the last two months on this topic, a court has ruled that an ESOP trustee cannot be indemnified for breaches of fiduciary duty that involve an ESOP if the indemnification comes out of corporate assets. In Fernandez et al. v. K-M Industries Holding Co., No. C 06-7339 CW (N.D. Cal. Aug. 21, 2009), a district court concluded that an indemnification agreement between North Star Trust and K-M Industries Holding Co. (parent of Kelly-Moore Paint Co.) that indemnified North Star was void. The court found that "[I]ndemnification agreements are invalid any time an ESOP would bear the financial burden of indemnification, whether directly or indirectly."
K-M's ESOP owned 42% of the company's stock. In 2006, a group of former employees sued the plan's former fiduciaries, alleging they failed to provide complete information about asbestos litigation that drove down the value of the shares. In 2008, North Star became the successor trustee. North Star filed to dismiss the claims against it as successor trustee, arguing it was shielded from claims because it did not cause the breach. A district court denied the motion. Subsequently, a $40 million settlement was reached. North Star then argued it could not be held liable as a fiduciary because it was indemnified by the company. The court concluded that although it was the company not the ESOP indemnifying North Star, the ESOP would lose value if the company made the payment.
In Johnson v. Couturier (9th Cir. July 27, 2009), the U.S. Court of Appeals for the Ninth Circuit reached a similar decision on this issue. In that case, however, the ESOP owned 100% of the company. The court seemed to suggest that if the indemnification provided that a third party (such as a seller) or the company could make up the loss in such a way as not to cause a decline in ESOP stock value, indemnification might still be valid. For instance, a company in which the ESOP owned less than 100% of the shares might be able to put enough additional shares into the plan to offset the loss, effectively transferring the loss to other shareholders.
ESOP's Indemni-Fables also contains a detailed discussion of the two cases:
Fernandez, from a district court in Couturier's circuit, quickly piles onto the Couturier result, and is interesting in several ways. First, it's becoming clear that the courts are not messing around when it comes to this result. They really don't like indemnifications from ESOP-owned companies. Second, the facts in Fernandez are actually less conducive to looking through the company back to the ESOP shareholder than the Couturier facts, and yet the court, after clear reflection, nevertheless came to the look-through result. Third, on the other side of the ledger, I like that Fernandez in its thinking and reasoning seems more focused on indemnification than Couturier. While I think that Couturier and Fernandez are flat-out wrong altogether, at a minimum it's critical that it be narrowed to the indemnification question that consistently seems so to offend courts' sensibilities.
For example, in Fernandez, the company was minority-owned, but the court nevertheless traced indirect indemnification back to the ESOP ("The ESOP, which owns forty-two percent of KMH, would thus shoulder a large part of the burden of indemnification."). In terms of how much the plan needs to own before there's a problem, what's the Fernandez standard? Majority ownership? Material ownership? So, a PubCo plan owns 2% of PubCo and a PubCo plan fiduciary has an indemnity - the indemnity is invalid? 2% invalid? C'mon. . . .