Aluminum Precision Products Inc. (the “Company”) recently reached a $2 million deal to settle an ESOP suit related to allegations that the ESOP committee was overly conservative in its investment of the cash contributions and dividends the ESOP received from the Company. The case highlights the importance for ESOP fiduciaries to fully consider their duty of prudence in selecting investments held in a plan, and indicates that an ESOP’s risk tolerance may support a relatively more aggressive asset allocation strategy.
Plaintiff argued that, since ESOPs primarily invest in a single asset (i.e., employer securities), an ESOP’s risk tolerance is high and requires “an investment strategy focused on long-term capital appreciation.” First Amended Complaint (“FAC”) ¶36. As such, Plaintiff claimed that a prudent fiduciary would elect to invest a majority of an ESOP’s non-employer security assets into assets designed to achieve higher returns.
Instead, the ESOP committee directed the ESOP trustee to invest the ESOP’s available cash into a money market fund and short-term US treasury bonds. FAC ¶49. By not adopting a more aggressive strategy in its asset allocation, Plaintiff believed they were harmed due to the opportunity cost of not being invested in riskier assets with greater expected returns. Plaintiff claimed that this strategy represented a prohibited transaction as it was undertaken to benefit the Company at the expense of the ESOP. FAC ¶¶89-94.
In support of these claims, Plaintiff pointed to the allocations of other ESOPs, which held nearly all their non-employee security holdings in equities and other risky investments with de minimis holdings in cash or cash equivalents. FAC ¶62.
In response, Defendant raised two key arguments in their defense. First, that the diversification exemption provided to ESOPs under 29 U.S.C. § 1104(a)(2) should extend to the non-employer security assets held under the plan. Moran v. ESOP Comm. Of the Alum. Precision Prods., 2026 U.S. Dist. LEXIS 20459, *7 (C.D. Cal). In other words, the exemption that allows ESOPs to hold a singular asset (i.e., employer securities) also exempts the ESOP from needing to diversify its remaining assets. Defendant also argued that the decision to hold less risky assets was prudent under the law. Id. Defendant claimed that since there exists a repurchase obligation to repurchase the securities of the employee participants, it was prudent for the ESOP to hold a large cash position to satisfy this obligation. However, as the Court noted, “[i]t is not enough for a plaintiff simply to allege that the fiduciaries could have obtained better results — whether higher returns, lower risks, or reduced costs — by choosing different investments.” Id. at *11.
The U.S. District Court for the Central District of California did not appear to be swayed by either argument from the Defendant, stating that, while the diversification exemption relaxed the duty of prudence with respect to diversification, “It does not eliminate the duty of prudence wholesale.” Id. at *8. Additionally, the Court clarified that the diversification exemption applies solely to the employer securities and not to the remaining assets held in the plan. Id.
As to prudence, the Court explained that Plaintiff did not simply state that the ESOP should have pursued riskier assets, rather the Plaintiff claimed that the failure to invest in riskier assets represented a breach of the duty of prudence due to a “mismatch” between the assets held in the plan and the objectives and purpose of the plan. Id. at *12.
The Court also addressed Plaintiff’s prohibited transaction claim stating, “Plaintiff has plausibly alleged that Defendant caused the Plan to engage in affirmative investment transactions to create an allegedly excessive buffer for the employer’s benefit.” [emphasis in original] Id. at *18.
Ultimately, this matter appears as though it will settle prior to going to trial, but it highlights two notable issues. First, it’s highly important for ESOP fiduciaries to fully consider their duty of prudence in selecting investments held in a plan rather than defaulting to low risk securities. Further, since an ESOP’s primary investment is a single asset in the employer securities, an ESOP’s risk tolerance may be relatively high and therefore may support a more aggressive asset allocation strategy in its portfolio.
Author Background: David J. Neuzil, CFA, ASA, is a Director with Coherent Economics, LLC. For more than ten years, Dave has been helping business owners, attorneys, and courts understand complex issues involving valuation and damages. His expertise includes the analysis of sophisticated capital structures, ESOP transactions and valuations, derivative securities, and securities with embedded options. Dave’s litigation support has spanned numerous high-profile matters in the Delaware Court of Chancery and U.S. District Courts.
The views and opinions expressed in this content are solely those of the author and do not necessarily reflect the position or views of the firm, its partners, employees, or affiliates. The information provided is for general informational purposes only and should not be construed as professional advice.