Difficult times for the ESOP community. In a much-anticipated opinion in the Vinoskey ESOP case, the trial court recently ruled in favor of the Department of Labor on all remaining claims, finding the defendant trustee and company’s owner caused the ESOP to overpay for company stock by $6.5 million. This ruling comes close on the heels of the 4th Circuit’s Brundle decision, which upheld the trial court’s liability and damages findings against the trustee.

Suspect ‘discretionary choices’: The flashpoint was a 2010 transaction in which the owners of a successful Virginia company sold the remaining 52% of company stock to an ESOP for $406 per share. A 2009 appraisal valued the stock at $285 per share. The DOL argued the $406-per-share price exceeded fair market value (FMV). The trustee breached its fiduciary duties to the plan by failing to scrutinize the underlying appraisal, and the owner/seller was liable for accepting a price he knew exceeded FMV.

The trial court agreed. Its analysis was guided by the Brundle decisions, in which the 4th Circuit stressed that the ESOP trustee had to act “solely in the interests” of the plan participants. In the instant case, the trustee failed on multiple fronts, the court found. It pointed to testimony from the trustee’s key representative that the goal was a deal that was fair to both the seller and the ESOP. This and similar comments signaled “divided loyalties,” the court found. It also observed that the trustee never engaged in any negotiation at all over the price. Rather, the trustee’s first offer to buy was $406 per share, i.e., the final price. As the court saw it, the trustee “had significant leverage to make a lower initial offer, since [the owner/seller] was plainly eager to close the deal before the agreed-upon closing date.”

The court focused on a “guesstimate” that a company representative had emailed to the trustee and ESOP appraiser early in the process, which put the value of the planned transaction at about $21 million. The court noted that many of the ESOP appraiser’s “discretionary choices were geared toward” developing an appraisal that matched the estimate. For example, the appraiser, in his capitalization of cash flow analysis, used an “unusually low discount rate,” an inexplicably low cap rate, and a working capital assumption that did not align with the historical rate, the court found. It also questioned the appraiser’s decision to add back certain costs based, to some extent, on the appraiser’s assumption that, by owning 100% of company stock, the ESOP would in fact have control over the company. This assumption was mistaken, the court found. It noted that the company’s existing corporate structure and leadership rules, explained in ESOP plan documents and corporate bylaws (which the trustee reviewed), made it impossible for the ESOP to have complete control. The court noted that the final transaction documents did not provide for a change to the existing rules. The trustee did not press for the changes. The court found a discount for lack of control was justified.

The court acknowledged that representatives of the trustee did in fact review a draft appraisal and raise a number of concerns. However, the trustee did not “follow through” on whether the appraiser dealt with the issues in his final report, the court said. It called the diligence process “rushed and cursory.” The trustee had the burden of showing that the ESOP did not pay more than “adequate consideration” for the stock and it failed to do so, the court concluded.

Despite criticism from the ESOP community, the Department of Labor is not abandoning its litigation-prone approach toward ESOPs, as a recently filed lawsuit makes clear. Following its playbook, the DOL, in its complaint with the Southern District of New York, alleges the ESOP trustee violated its fiduciary duties to the plan by causing the ESOP to overpay for the company stock. The trustee failed to negotiate in good faith as to the price and terms and scrutinize the valuation underlying the transaction, the DOL says.

Conflicted appraiser? The contested transaction involved Stargate Apparel and a sister company, Rivstar Apparel, private companies that produce denim jeans and swimwear for the junior market. Stargate’s founder and CEO owned essentially 100% of the two companies.

According to the DOL complaint, in the latter half of 2010, the owner hired CSG Partners, an investment bank specializing in ESOPs, to advise him on a possible ESOP transaction. On CSG’s recommendation, the owner engaged an appraisal firm to produce an initial valuation of the companies. The DOL claims that, before any valuation was done, CSG communicated to the appraiser what kind of offer the owner was prepared to make. The appraisal firm then produced a draft valuation that was in line with the offer.

CSG then proposed Wilmington Trust as ESOP trustee. Wilmington hired as ESOP appraiser the very firm that had done the initial valuation for the owner/seller, on recommendation of CSG. The DOL contends Wilmington either failed to investigate the ESOP appraiser’s prior relationship with the owner and CSG or Wilmington hired the ESOP appraiser knowing that the latter had earlier worked for the owner “in connection with the same proposed transaction.” Either way, Wilmington failed to hire an independent appraiser, the DOL claims.

The complaint also says Wilmington was remiss in its duty to “thoroughly review, analyze, and question any valuation report on which it relied.” The valuation report here was “rife with red flags,” the DOL says. It points to projections concerning the companies’ future revenue and earnings “that far outstripped the Companies’ historical performance” and that had operating expenses that “were far more modest than the Companies’ historical spending.” Also, Wilmington was aware of a third-party lawsuit against Rivstar in which the plaintiff alleged accounting irregularities, which Wilmington’s counsel called “rather serious.” Regardless, Wilmington “accepted at face value the Companies’ internally prepared financial statements for 2010,” which “showed a dramatic increase in earnings and unexplained efficiency gains over the previous years,” the complaint says.

The complaint makes other allegations. The DOL asks the court to order Wilmington to restore all losses to the ESOP and return to the ESOP all fees earned from the contested transaction and subsequent work as ongoing ESOP trustee.

 Stay tuned for more commentary on this litigation as it unfolds. The case is Acosta v. Wilmington Trust, U.S. District Court for the Southern District of New York, Civil Action No. 19-2793 [Complaint filed 3/28/19].