Court: Challengers Must Prove Plan Loss for Fiduciary Breach in ESOP Merger

April 18, 2007 ( - The 3rd U.S. Circuit Court of Appeals ruled that because there was "no loss" when a company merged two employee stock ownership plans (ESOPs) following a corporate merger, executives negotiating the deal did not breach their fiduciary obligations.

Affirming a lower court’s summary judgment in favor of Herzog Heine Geduld Inc. (HHG), the three-judge appellate panel said no fiduciary breach occurred during the merger of the ESOPs because there was “no loss” to the Herzog, Heine and Geduld (HHG) plan.

HHG, a privately-held NASDAQ market maker with an ESOP, was acquired by Merrill Lynch & Co. in July 2000.

The HHG ESOP was a “leveraged ESOP” in that it had borrowed money to purchase its holdings, which consisted exclusively of HHG stock. Under the terms of the ESOP, HHG had an obligation to pay into the ESOP, which in turn used these funds to repay the loan. As the ESOP repaid its debt, it released HHG shares from a suspense account and allocated shares into participants’ accounts – any unallocated shares stayed in the plan.

In March 2000, the HHG Board appointed State Street Bank as the trustee of the ESOP, and a few months later gave State Street the sole authority to decide whether to sell the HHG shares held by the ESOP if another company made an offer to buy HHG.

Following Merrill’s tender offer for HHG shares in June, State Street decided to sell the ESOP’s 30.5% stake in HHG. Merrill eventually acquired 93% of HHG shares and in exchange for tendering all HHG shares it held, the ESOP received over 5.2 millionMerrill shares worth approximately $354 million. Allocated and unallocated HHG shares were converted into allocated and unallocated Merrill Lynch shares.

Merrill then decided in November to merge the HHG ESOP into the Merrill ESOP and said that the Merrill ESOP would allocate any future releases of Merrill shares to all participants in the Merrill ESOP, including to Merrill employees who had never worked for HHG.

This meant that unallocated Merrill shares that were previously held in the HHG ESOP were then dispersed to a wider pool of employees than if the merger had not occurred, essentially diluting the number and value of shares that would have gone to the HHG employees absent the merger, according to the district court opinion.

HHG & State Street Sued for Fiduciary Breach

The unallocated shares were the center of the lawsuit brought in the U.S. District Court for the District of New Jersey by the two HHG plaintiffs, who claimed that HHG breached its fiduciary duties under the Employee Retirement Income Security Act (ERISA) in negotiating and approving the Merrill merger without safeguarding HHG employees’ rights to the unallocated shares.

The plaintiffs also argued that trustee State Street breached its fiduciary duty by tendering the ESOP’s shares without first attempting to prepay the loan to allocate to HHG employees any HHG shares that remained unallocated.

U.S. District Judge William Martini wrote in the lower court opinion that ERISA requires that plaintiffs show a “loss to the plan” when trying to get monetary recovery for fiduciary breaches and further that the loss must be to the plan as a whole, not only to individual beneficiaries. The court said the plaintiffs proved no loss.

The appeals court agreed with the Martini’s summary judgment, ruling that the plaintiffs could not prove a loss to the plan as a result of the merger. In fact, the appeals opinion stated, HHG’s shareholders reaped a substantial gain from Merrill Lynch’s acquisition of HHG, because it allowed shareholders to exchange illiquid shares of HHG stock for Merrill stocks, which held a greater value.

The case is Fox v. Herzog Heine Geduld Inc., 3d Cir., No. 06-1333, unpublished 4/16/07.