Court Awards ESOP $6.5 Million for Overpayment, Finds That Trustee Breached Duty
Ruling Holds ESOP Trustee and Selling Shareholders Jointly and Severally Liable
- A U.S. District Court has rendered a $6.5 million judgment in favor of an employee stock ownership plan (ESOP) for the ESOP's overpayment for the founding shareholder's majority interest in the company.
- The selling shareholders and the ESOP trustee were held jointly and severally liable.
- The crux of the court's criticism focused on the process and valuation methodology and assumptions of the ESOP trustee's financial advisor.
The U.S. District Court for the Western District of Virginia has awarded the Sentry Equipment & Erectors Inc. Employee Store Ownership Plan (the ESOP) $6.5 million for the ESOP's overpayment for the founding shareholder's 52 percent interest in Sentry Equipment & Erectors Inc. (the company). The selling shareholders (Adam Vinoskey and a related trust) and ESOP trustee were held jointly and severally liable. See Patrick Pizzella, Acting Secretary of Labor, U.S. Department of Labor, v. Adam Vinoskey, et. al., Case No. 6-16-cv-00062.
The court held that the ESOP trustee had breached its duty of prudence and duty of loyalty to the ESOP and had committed a prohibited transaction by overpaying for the company stock held by Vinoskey and a related trust. It also held that Vinoskey was a knowing participant in the prohibited transaction and, thus, jointly and severally liable with the ESOP trustee.
The transaction occurred on Dec. 20, 2010, less than six weeks after the independent trustee, Evolve Bank & Trust, was first contacted about the transaction. The court concluded that the ESOP trustee's due diligence was rushed and cursory, noting that the transaction closed before the ESOP trustee received the final valuation report and without negotiation over the price to be paid for the company stock.
Process and Valuation Issues
The crux of the court's criticism focused on the process and valuation methodology and assumptions of the ESOP trustee's financial advisor. The court criticized the trustee for apparently overlooking indications that the financial advisor completed his appraisal with an eye toward reaching a predetermined value. The court was also critical that the trustee settled on a final purchase price prior to reviewing the appraiser's final appraisal.
As to the valuation itself, the court found it significant that the financial advisor used only the capitalization of earnings methodology and did not use the discounted cash flow (DCF) methodology. The advisor believed DCF analysis to be unhelpful where the company did not have a history of developing detailed financial projections. The court found it significant that the trustee had expressed concern over sole reliance on the capitalization of earnings methodology but did not urge its financial advisor to work with the company to develop projections, or insist that the company either develop its own projections or hire a third-party firm to help it do so.
In addition, the court criticized a number of assumptions used in the financial advisor's capitalization of earnings analysis: the assumption that the ESOP had acquired total control of the company where the selling shareholders were ongoing trustees of the ESOP and directors of the company; the working capital assumption, which the court found unrealistic in light of the company's historic and projected working capital requirements; the use of a three-year lookback period, instead of five to six years, in assessing the company's earning capacity; the add-back of ESOP contributions and healthcare expenses when calculating the company's cash-flow where there was no reasonable expectation that the related adjustments would actually occur; the add-back of land value and cash to company value, which had not been used in prior valuations of the company; and the use of an unusually low discount rate relative to prior and subsequent valuations of the company.
The court rejected the DOL position that a 20 percent lack of control discount should be applied and instead applied a 5 percent discount because the ESOP participants have some elements of control, including the ability to instruct the ESOP trustee on the voting of ESOP shares on important corporate issues such as mergers and asset sales.
While the court criticized the ESOP trustee and its financial advisors on the healthcare expense and ESOP contribution add-backs, it did not assign specific amounts of damages to these items because it felt that the record was underdeveloped on these issues. The court did refuse to offset Vinoskey's 2014 forgiveness of $4.6 million of ESOP debt against the amount of damages, a rather harsh result for Vinoskey, who was held jointly and severally liable and could end up paying the $4.6 million twice.
The decision highlights the following considerations that were key to the court's holding.
- Absence of evidence of a thorough and deliberate due diligence
- Failure to consider a discounted cash flow analysis, even where the company has not traditionally prepared detailed projections
- Failure of appraiser to be responsive to the trustee's concerns before closing the transaction
- Lack of a robust discussion with the appraiser on the issue of ESOP control for valuation purposes
- Lack of any evidence or record of negotiation of the ESOP purchase price
For questions about the ruling and its potential impact on your ESOP transaction, please contact the authors or another member of Holland & Knight's ESOP Group.
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