HADDONFIELD, N.J. (DTN) -- The Department of Labor's recent lawsuit against Amarillo, Texas-based Cactus Feeders Inc., the nation's largest privately owned cattle feeding operator, sends a warning for anyone with an employee stock ownership plan. If the government proves its allegation that the Cactus ESOP overpaid when it bought outstanding company stock for $100 million in 2010, fiduciaries could be forced to repay tens of millions of dollars to the employees who are part of the ESOP.
The administrative rules of ESOPs are so complex and require so much annual compliance, legal authorities like Roger McEowen, a Washburn University law school professor, liken them to a "toxic situation."
"Many cattle feeders and farmers adopted these plans as an employee benefit," McEowen said. "They were heavily pushed throughout the Midwest in the 1980s. Now we're seeing the fallout after 20 or more years of management."
Paul Engler, Cactus Feeder's legendary founder, considered the ESOP part of his company's core values.
"Cattle feeders are a special breed. Caring for cattle takes a person who understands that we are not building cars or making widgets; that cattle feeding is a biological process. At Cactus, our Employee Stock Ownership Plan makes each employee an owner of the company," Engler said in a statement on the company's website. "Now, people ask 'why go to all the time and trouble to give away part of the company to the employees? What do you get in return?' The reward is when those employees drive through that gate in the morning, they're thinking, 'I am an owner.'"
PAPERWORK AND PENALTIES
McEowen understands that sentiment, but cautions that federal rules for ESOPs are rigorous.
"You have to babysit these plans. You have to have competent tax and legal advice, and it almost never happens," McEowen added. "The Department of Labor just salivates for owners to make a misstep, and unfortunately, they're winning a lot of cases."
Unlike McEowen, Tom Peebles, a Salina, Kansas-based attorney and head of the consulting firm K-Coe Isom's tax department, doesn't hate ESOPs, but he remains cautious about their use.
Peebles talks entrepreneurs like farmers out of the arrangement, saying independent-minded owners won't like the restrictions on their operation.
"With an ESOP, you have a responsibility to run the plan to benefit plan participants," Peebles said. "The administrative burdens and fiduciary concerns are more like running a public company."
The Department of Labor's complaint against the cattle feeder alleges that the Cactus trustee, Lubbock National Bank, violated its legal obligations when it caused the ESOP to overpay for company stock in 2010. Additionally, the complaint contends the company's ESOP committee members and board of directors -- including Engler -- knew of those breaches of duty but did nothing to stop them.
At the time, many Engler family members were selling stock in the closely-held company. Paul Engler retired as chairman of the board in 2011. The ESOP, which already owned 30% of the company stock, was purchasing the remaining company stock for $100 million. The Labor Department charges the purchase price failed to account for:
-- Dilutions to the ESOP's 100% ownership. After the sale, Cactus had additional outstanding warrants and stock options to key employees and company officers that, when exercised, would dilute the ESOP's equity from 100% to 55%.
-- Adjustment for lack of marketability. Cactus Feeders is a closely held company in a niche industry. Stock in companies that are not publicly traded, and where ownership is restricted, are typically discounted 5% to 15%, Peebles said.
-- Any value adjustment for an investors' rights agreement. That provision was part of the agreement of sale and effectively gave selling shareholders control over the company for 15 years even though they were no longer owners.
The Department of Labor's complaint asks a U.S. District Court to issue a court order requiring the fiduciaries to repay all losses incurred by the ESOP, which could amount to tens of millions of dollars, McEowen said. If it imposes penalties and interest, the tab could escalate.
"I've seen ESOPs in other businesses run well over the years. Some of them have outperformed the stock market since the 1990s," Peebles said. "But it's very important to document stock valuations and cross all the T's. If the allegations are true, it seems on the serious side."
In response to DTN questions about the suit, Cactus Feeders said it has over 25 years of experience as a successful employee-owned company. "The company, the Board of Directors, and the ESOP Trustee strongly disagree with the position that the Department of Labor is now taking, more than five years after a 2010 transaction, and look forward to discussions with the DOL to demonstrate that the transaction was fair and the lawsuit should be dismissed. This lawsuit is not expected to have any material adverse effect on the company's operations, financial performance, or the company's employees and ESOP participants."
The U.S. District Court in the Northern District of Texas has yet to take action on the case.
Marcia Taylor can be reached at email@example.com
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