As we have explained in prior ESOP blogs, the Department of Labor (DOL) remains acutely concerned with private company employee stock ownership plan (ESOP) valuations in the formation of ESOPs. In particular, trustees who approve an ESOP trust’s purchase of shares from a seller must demonstrate that they have satisfied ERISA’s fiduciary duties with respect to the share purchase price. Specifically, trustees (whether independent or internal) need to demonstrate the due diligence and valuation procedures they undertook prior to authorizing the share purchase by the ESOP were thorough and resulted in payment of no more than fair market value (“adequate consideration” in ERISA terminology) for the shares of stock of the company. Otherwise, the DOL (as well as private plaintiffs) may hold trustees liable for making the ESOP trust whole in the event of overpayment to the seller. This focus on trustees often leads selling business owners to wonder if they are immune from liability and thus not expected to be engaged in the due diligence process. The answer is that they are not immune.
A recent federal District Court case decided in the DOL’s favor demonstrates that even selling owners in an ESOP transaction need to be engaged in the process and alert to whether the price they are being offered for their shares is well above fair market value (i.e., more than adequate consideration such that the transaction would rise to the level of a prohibited transaction under ERISA). In this case, which was brought by the DOL against the ESOP trustee and the selling owner, the court held the ESOP trustee and the selling owner in an ESOP transaction to be jointly and severally liable for over $6.5 million in damages, which was the amount that the court adjudged that that ESOP overpaid for the purchase of its shares of stock from the selling owner. The case, Pizzella v. Vinoskey out of the Western District of Virginia, could yet be appealed, but the District Court’s holding still provides valuable lessons to selling owners in an ESOP transaction, most notably the following:
The due diligence process cannot be rushed.
The due diligence process itself is vitally important in an environment where a selling owner often wants a transaction to close as quickly as possible, in part to get paid as quickly as possible, but also to keep the leadership succession plan in progress. The court in Vinoskey provides a cautionary tale about rushing the process. The judge concluded that due diligence was “rushed and cursory…” explaining that fewer than 2 ½ months elapsed between the time the independent ESOP trustee was engaged and the ESOP transaction’s closing date. The judge felt that such a quick turnaround time contributed to a lack of due diligence (and a lack of negotiations between the ESOP trustee and the appraiser) that otherwise might have produced a purchase price for the shares that was lower (and closer to a reasonable fair market value). A quick turn-around on an ESOP transaction is not absolutely a red flag, but when a deal moves quickly it is even more important to document the due diligence process in detail to demonstrate that fiduciary duties were not sacrificed for speed in closing the transaction.
Multiple valuation methods, especially including discounted cash flow, should be considered to calculate fair market value of a company.
In the ESOP transaction in Vinoskey, only one valuation method was used by the appraiser, and it was not the widely-accepted discounted cash flow method. Typically, independent appraisers apply more than one valuation method and use the varying results to calculate fair market value for a company. The appraiser in this transaction used only one method, and further, did not sufficiently justify use of this method alone over other generally accepted methods.
Ask questions if the purchase price offered exceeds the fair market value calculated under prior appraisals.
The company in Vinoskey had received annual appraisals each year for its stock because it had been a minority ESOP-owned company prior to the transaction that became subject to the suit. Those appraisals (which were done by the same appraiser retained for the subject transaction) had ranged between $215-$285 per share over the preceding five years. The price that the ESOP trust paid per share upon assuming 100% of the shares was $406. While the District Court did not expect the seller to know the details of the appraisal methods and ERISA fiduciary duties, it surmised that he and the ESOP trustee should have at least asked questions after seeing such a large premium in comparison to prior appraisal amounts, and, in the case of the ESOP trustee, pushed harder for answers from the appraiser. The difference in valuation amounts year-to-year, coupled with the speed to close the transaction, indicated to the court that sufficient due diligence was not performed to ensure that the ESOP paid only adequate consideration for the shares, resulting in a prohibited transaction to the tune of $6,5 million.
Corporate governance protections should be included in the transaction documents.
The court explained that in the transaction at issue, the sellers and the ESOP trust had a “gentleman’s agreement” to add independent or non-interested individuals to the ESOP’s board of directors, and to have those independent directors determine executive compensation, so as to effectuate the ESOP’s post-transaction controlling interest. Yet, these terms, in addition to other items, were not included in the covenants in the stock purchase agreement itself, and the court used this to find that the ESOP did not stand to gain actual control via the transaction even though it acquired 100% of the shares of the company. A seller might argue that it is not his or her responsibility to include such terms when a trustee, represented by legal counsel, does not push to include such a term in the documents. As a party-in-interest to the transaction though, such a seller must pay attention to the operative terms of the transaction. The District Court judge in Vinoskey assessed liability here, in part, for a failure to do so.
Engaging an independent trustee after the transaction may provide more protection against fiduciary liability than being an insider trustee.
After selling to an ESOP in a standard transaction, the sellers have to decide whether to have an outside independent trustee (either an individual or financial institution) be the trustee of the ESOP going forward, or whether to appoint a corporate insider to be the trustee. Insider trustees are less expensive than independent third-party trustees, but they raise inherent fiduciary concerns about whether they are serving the best interests of ESOP participants in that role, or other corporate interests. The judge in this case expressed this very concern. In this transaction, the company hired an independent fiduciary to negotiate the ESOP transaction. After the transaction, however, corporate insiders continued to comprise two of the three trustees for the ESOP. These same individuals also comprised a majority of the company’s board of directors. Because of those facts, the court concluded that the insiders, and not the ESOP, retained control of the company. As such, the court held that the ESOP’s payment of a “control premium” for acquiring 100% of the shares was unreasonable and inconsistent with ERISA’s fiduciary duties.
Post-transaction debt forgiveness related to seller financing did not cure a fiduciary breach or reduce damages.
The court held that the ESOP trust’s loss was equal to the inflated purchase price that it paid for the shares minus the stock’s fair market value on the date of the transaction—as determined by the court. The court concluded that the fair market value on the date of the transaction was $278.50 per share, which resulted in the ESOP trust overpaying by $6,502,500.
The defendants argued that these damages should be reduced because four years after the transaction, the seller forgave a large portion of the debt that the trust owed to him. Further, defendants argued that the participants in the ESOP had a higher value per share after the transaction than they had before the transaction. The court held that those factors were irrelevant to the question at hand – whether the ESOP overpaid for the purchase of the shares at time of purchase. The debt incurred at the transaction prevented the ESOP from making other investments, and so the damages were to be calculated based on the facts on the transaction date, not on subsequent events.
There is no doubt that the facts in this case could be explained away as an example of bad facts making bad law, but that gives short shrift to a very valid underlying point – that the selling owner in an ESOP transaction also has a vested interest in ensuring proper due diligence in the valuation process, and could be held jointly and severally liable where an ESOP’s shares are overvalued to the benefit of the selling shareholder. It will be interesting to see if this decision is appealed, and, if so, what happens on appeal. In the meantime, sellers should be mindful of the fact that they too, need to be engaged in the due diligence and valuation aspects of ESOP transactions.