ESOP Valuation Court Case Questions Fiduciary's Diligence in Buy-Out of CEO's Shares

The Employment Retirement Income Security Act of 1974 (“ERISA”) permits an employer to create Employee Stock Ownership Plans (“ESOP”), which are formed to help incentivize employees by giving them ownership in the business that employs them.

ESOPs can be funded through issuing new company shares, buying existing shares with cash or borrowing money to buy shares. The ESOP trustee, or any other person or committee designated in the plan documents as responsible for making investments in company stock, is a named fiduciary of the ESOP. The ESOP fiduciary secures an independent valuation of the company stock, assures that the ESOP transactions meet the interests of the plan participants (e.g., employees) and approves all ESOP stock transactions. The Department of Labor (“DOL”) regulates the adequacy of consideration paid in ESOP transactions to help protect plan participants.

A recent ESOP court case, Pizzella v. Vinoskey[1], found that Evolve Bank and Trust (“Evolve”), the trustee for Sentry Equipment Erectors, Inc.’s (“Sentry” or the “Company”) ESOP, violated its duties of prudence and loyalty regarding the ESOP’s purchase of Sentry’s CEO’s 51,000 shares of the stock of the Company (a 52% ownership interest, at $406 per share for a total purchase price of $20.7 million) in 2010. The following main issues were identified in the case:

1. Testimony from the trustee revealed that the goal of the transaction was to be fair to both the CEO and the ESOP plan participants, instead of protecting only the interests of the ESOP plan participants – as the trustee’s duties require. The court also found that Evolve never engaged in any negotiation over the stock price in the transaction; the first offer submitted by the trustee was the final transaction price.
2. Early communications prior to the ESOP transaction indicated that a company representative shared an estimate of the transaction’s value with Evolve and the ESOP’s appraiser. It appeared that the appraiser had backed into the company representative’s estimate through the use of questionable inputs in his valuation model including, among other issues, the following:
   1. Valuing the 52% ownership interest on a controlling basis even though the CEO and his wife would still retain control of the Company’s board of directors, and remain the ESOP’s trustees, after the transaction. Based on the way the Company’s by-laws were structured, the board would ultimately be able to designate and remove ESOP trustees and the ESOP trustees would be able to control the vote of the ESOP shares in most matters. Therefore, the ESOP would not ultimately have control of the Company upon acquiring the 52% interest because the CEO would still be controlling the board and influencing its actions;
   2. No forecasts of the Company’s performance were considered while experts hired by both the plaintiff and defendant in the case each utilized a discounted cash flow model in their valuations;
   3. Adjusting Sentry’s earnings to remove a portion of health care benefits above typical industry levels even though management did not intend to discontinue this benefit. The appraiser argued that the ESOP would gain control of Sentry after the transaction and would thus be able to reduce this expense going forward, but, as discussed in 2a above, the court found that the ESOP would in fact not gain control of the Company; and
   4. Reducing the capitalization rate to 12.2% for the transaction valuation when the rates used in prior years’ valuations ranged from 15%-18%, thus significantly increasing value for the transaction valuation. In addition, the appraiser prepared another valuation one month after the transaction that utilized an 18.2% capitalization rate. The ESOP appraiser’s previous valuations of the Company, prepared between 2005 and 2009, concluded on a per share value of $215-$285 for the company’s stock, which was much lower than the transaction price of $406 per share.
3. Evolve did not perform thorough due diligence to assess the validity of the valuation. Although Evolve identified many of the issues listed in number 2) above, and discussed them with the appraiser, the issues were never resolved in the final valuation. In addition, Evolve did not question whether the appraiser had manipulated his inputs to arrive at the $21 million transaction price.

The court found that:

1. The appropriate stock price was $278.50, and according to that result, the ESOP had overpaid by $6.5 million for the CEO’s shares.
2. Evolve had violated its duties of prudence and loyalty under 29 U.S.C. § 1104(a)(1), and the CEO was jointly liable as a knowing participant in a prohibited transaction and as co-fiduciary.

Schneider Downs has significant experience assisting clients with various ESOP-related needs, including audit, tax, plan design and administration. For more information, please contact Jason Lumpkin (412.697.5472; [email protected]) of our Employee Benefits Group.

Schneider Downs also has significant experience providing business valuation services. For more information, please contact Joel Rosenthal (412.697.5387; [email protected]) or Steve Thimons (412.697.5281; [email protected]) of our Business Advisory Group.