Pension & Benefits News ESOP trustee and founding shareholder jointly liable for $6.5 million in damages stemming from overpayment for company stock
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Wednesday, October 30, 2019

ESOP trustee and founding shareholder jointly liable for $6.5 million in damages stemming from overpayment for company stock

By Pension and Benefits Editorial Staff

An independent ESOP trustee was liable for causing a prohibited transaction and violating its duties of prudence and loyalty under ERISA by allowing the ESOP to substantially overpay for the stock of the company’s founder and controlling shareholder, according to a federal trial court in Virginia. The trustee not only failed to properly review the value of the shareholder’s stock and the terms of the transaction, but allowed the sale to close on an accelerated timeline in order to enable the owner to realize tax benefits. The founding shareholder, as a knowing participant in the prohibited transaction and a co-fiduciary of the ESOP, was also jointly and severally liable with the trustee for the $6.5 million damages assessment.

Sale of founding owner’s stock to ESOP. In 2010, in anticipation of retirement, the founder and controlling shareholder of Sentry Equipment, Adam Vinoskey, began exploring the sale of his company stock (representing 52% of the company) to the company’s ESOP. An attorney that had previously worked for the ESOP recommended that an independent fiduciary, Evolve Bank and Trust, be retained to represent the ESOP in the proposed sales transaction. The attorney contacted Evolve in November 2010, suggesting a purchase price for the owner’s shares of $21 million.

On November 12, 2010, Evolve agreed to serve as the independent fiduciary for the ESOP, responsible for reviewing the proposed sale of the owner’s stock and ensuring the proposed transaction was prudent, did not exceed adequate consideration, and was fair to the ESOP and its participants. On November 29, 2010, Evolve retained Capital Analysts Inc. (CAI), a company that had previously conducted annual appraisals of the company stock, to serve as the independent appraiser and financial advisor for purposes of the transaction.

The president of CAI, Brian Napier (appraiser), had, as recently as 2009, valued the company’s stock at $285 per share. However, on December 9, 2010, ten days after Evolve engaged CAI, Napier issued a draft appraisal, valuing the company’s shares at $405.73 per share, which would equate to an overall transaction price of $20,692,230 for Vinoskey’s 51,000 shares. The price was “strikingly close” to the $21 million transaction value suggested by the company’s attorney, of which Napier had been apprised 12 days prior to Evolve formally engaging CAI to appraise the transaction.

The appraiser’s valuation was in large measure due to the mistaken assumption that the ESOP would gain control of the company after the transaction (i.e., controlling interest basis). The company’s corporate structure and the fact that Vinoskey would remain an ESOP trustee, effectively precluded the ESOP from controlling the corporation after the transaction. However, the erroneous assumption had the effect of increasing the value of the owner’s stock.

The appraiser also made normalization adjustments, adding back the health care costs of the company’s employees. The add-back effectively increased the stock price by $50 per share. The add-back was contrary to the owner’s expressed intention not to curtail health care coverage, but was based on the appraiser’s erroneous assumption that the ESOP would gain control of the company after the transaction.

The appraiser made numerous other discretionary assumptions regarding capital rates, cash-flow, the company’s risk exposure, growth rate, applicable look-back period for evaluating earnings potential, working capital, and discount rate, that supported its valuation. However, the appraiser did not include or draw on projections or forecasts of the company’s future performance.

In reviewing the draft appraisal, Evolve noted that the report included no forecasts of the company’s performance and cited concerns with the use of cash-flow methodology, as well as valuation assumptions, such as the low capitalization rate, the add-back of the health care costs, and the understanding that the ESOP would retain control of the company after the transaction. Evolve raised its concerns with Napier, but those concerns were not reflected in the appraiser’s final report.

On December 14, 2010, one day after Evolve conducted phone calls with the appraiser expressing its concerns, and prior to the appraiser sending an updated appraisal addressing the concerns, the company’s board of directors drafted a resolution authorizing purchase of the owner’s shares for $406 per share, at an aggregate price not in excess of $20,706,000. The transaction would be financed by a $1,900,080 loan for the company to the ESOP, a $10,305,904 loan from the owner to the ESOP, and $8,500,016 in cash from the ESOP.

Evolve did not negotiate the $406 per share price. Further, it extended the offer to the owner before the appraiser had updated or finalized the appraisal and without ever reviewing the updated or final report to determine whether the appraiser had addressed its express concerns (including the company’s post-transaction governance structure). The appraiser was still finalizing the report when Vinoskey agreed to the $406 per share price.

Incident to extending the offer, the trustee on December 15, 2010 (without reviewing the final appraisal) drafted a resolution, stating that the “negotiated” purchase price” of $406 per share did not exceed fair market value and that the transaction was in the best interests of the plan and its participants.

Following the transaction, the ESOP owned 100 percent of the company stock, allowing ESOP participants to gain more shares and experience an increase in their individual account balances. However, while the company had over $8 million in cash, the ESOP owed Vinoskey $10.3 million. Subsequently, Vinoskey forgave $4.6 million of the ESOP’s debt, and interest rates associated with the loan were reduced to 3 percent.

The Department of Labor brought suit alleging that the independent trustee, Evolve, and the founding shareholder (Vinoskey) violated ERISA by approving the stock purchase by the ESOP at an inflated price, resulting in an alleged overpayment of $11,526,000. The DOL specifically charged that the Evolve violated its duties of prudence and loyalty and that Vinoskey was jointly liable for the ESOP’s losses as a knowing participant in a prohibited transaction and a co-fiduciary of the ESOP.

Trustee caused prohibited transaction. In determining whether the trustee met its burden under ERISA Sec. 408(e) to establish that the stock sale was for adequate consideration, the court focused on whether the process used by the trustee in determining fair market value was consistent with its obligations under ERISA to act prudently and solely in the best interests of the ESOP participants. ESOP trustees may rely on experts in assessing fair market value, but, the court cautioned, the trustee must be certain that the reliance on an expert’s advice was reasonably justified under the circumstances.

Evolve claimed its reliance on the appraiser’s report was reasonably justified. However, the court concluded that Evolve failed to establish that its reliance on the CAI appraisal was reasonably justified, under the circumstances prevailing at the time.

Evolve failed to notice and investigate several concerning features of the appraisal, most prominently the erroneous assumption that the ESOP would control the company after the transaction without a change in the corporation’s governance structure. The erroneous assumptions, the court stressed, further influenced other discretionary valuation choices (regarding risk, growth percentages, and add-backs for the company’s ESOP contributions and health care costs) and significantly increased the share price. Moreover, the trustee did not thoroughly examine or follow through to determine whether the issues it did raise (e.g., lack of earnings projections, rejection of discounted cash flow (DCF) analysis, and the health care cost add-back) were addressed in the final report. Such failures, combined with the “rushed” and “lackluster” nature of the trustee’s due diligence and its failure to investigate whether the appraiser had manipulated the assumptions to reach the predetermined $21 million transaction, indicated, the court ruled, that the trustee unreasonably relied on the appraisal and did not exercise the required level of prudence.

The trustee averred that it complied with its duty of prudence and reasonably relied on the appraisal because it read the initial valuation report, understood the report, and questioned it. However, the court explained, a fiduciary must “significantly review” an expert’s conclusion and actually review the expert’s final appraisal. The trustee’s failure to follow through on its concerns or review the final appraisal indicated that the trustee’s reliance on the appraisal was not reasonable.

The evidence further indicated, the court strongly noted, that Napier completed the appraisal “with an eye toward reaching the predetermined $21 million estimated transaction price.” A prudent fiduciary would have noted the similarity between the estimated cost and the appraisal and “closely and rigorously” analyzed the appraisal to determine whether discretionary choices had been made to reach to reach the predetermined price.

Evolve, alternatively, argued that even if it did not engage in a prudent investigation of the transaction, it could not be liable for fiduciary breach because a hypothetical prudent fiduciary would have approved the transaction. In rejecting the argument, the court first noted that, while a fiduciary can avoid liability under ERISA Sec. 404 for fiduciary breach if a prudent fiduciary would have made the same decision, that standard does not apply to claims under ERISA’s prohibition of party in interest transactions ( ERISA Sec. 406(a)(1)(A)). A violation of ERISA Sec. 406(a)(1)(A), the court explained is a per se violation of ERISA, notwithstanding the price a reasonable hypothetical fiduciary would have paid for the stock. Where a fiduciary does not engage in a good faith determination of the fair market value of the stock, the court stressed, ERISA’s definition of adequate consideration is not satisfied and the price that would have been paid by a hypothetical reasonable fiduciary is irrelevant.

The court further noted that, although proximate causation was not necessary to establish liability, evidence of Evolve’s imprudent process (especially its failure to question the assumption of ESOP control of the company after the stock sale) actually caused the ESOP to overpay for the stock and caused a loss to the ESOP.

Breach of duty of loyalty. The reasons underlying the court’s finding that Evolve breached its duty of prudence largely informed its conclusion that the trustee also breached its duty of loyalty to the ESOP. An Evolve representative testified at trial that the trustee’s role was to secure a deal that was fair to both the founding shareholder and the ESOP. The court cited this testimony as indication that Evolve had divided loyalties and failed to comply with its obligations under ERISA to act “solely” in the interest of the ESOPs and its participants. Moreover, the court stressed that: Evolve failed to question discretionary choices made by Napier that favored the seller, failed to follow through on its concerns, approved the transaction without reviewing an updated or final appraisal, and did not engage in negotiations with Vinoskey.

Liability of owner as knowing participant in prohibited transaction and co-fiduciary. The court agreed with the DOL that Vinoskey was liable as knowing participant in the prohibited transaction, as he had actual knowledge that the proffered price for his shares was in excess of fair market value. Vinoskey reviewed Napier’s appraisal and the company’s financials before agreeing to the $406 share price; knew that the proferred price was in excess of valuations from the 2004-2009 period; reviewed the company’s financials on a regular basis, and knew that he was not actually relinquishing control of the company by selling all his shares to the ESOP.

Co-fiduciary liability. The court also found the owner jointly liable as a co-fiduciary for Evolve’s breach of fiduciary duty. Vinoskey had actual knowledge that the $406 share price exceeded fair market value and actual knowledge that Evolve breached its fiduciary duty by approving a prohibited transaction for more than adequate consideration. In addition, Vinoskey made no effort to remedy the breach (e.g., by rejecting the $406 share price).

Note: In a footnote, the court further dismissed Vinoskey’s argument that he could not be subject to liability because he had recused himself as trustee and delegated the fiduciary duty for determining the transaction price to Evolve. Even the proper delegation of authority, the court stressed, does not shield a fiduciary from liability for a breach of which it has knowledge.

$6.5 million in damages. In calculating loss and compensating the ESOP for a fiduciary breach, courts typically subtract the stock fair market value, as determined by the court, from the inflated price paid by the ESOP. The court calculated a per-share value of $252.42 and a total damages amount of $7,832,500. After making an additional adjustment (5% lack of control discount) the court reached a per-share value of $278.50 and a total damage amount of $6,502,500.

Damages not offset by post-transaction debt forgiveness. The court rejected the argument that the damages assessment be reduced by the $4.6 million in debt that Vinoskey forgave in 2014. ERISA, the court stressed, expressly requires a fiduciary to make good to an ESOP any loss resulting from a fiduciary breach. Courts generally reject the contention that the proper measure of recovery excludes the debt that is later forgiven. The assumption of the debt, courts have explained, has immediate consequences, primarily in terms of the opportunity cost of deferred alternative investments.

Note: While the court felt constrained by judicial precedent disfavoring any reduction of damages by the amount of subsequent debt forgiveness, the court cryptically noted in a footnote that, absent such authority, it would have been “disposed” to allow a reduction in damages.

SOURCE: Pizzella v. Vinoskey (DC VA).

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