Court may unwind owner sale of company to ESOP because price too high

Company is a Hawaii architectural firm. On April 27, 2018, the U.S. Department of Labor filed a lawsuit in a Hawaii federal district court alleging that ESOP Trustee and Owners caused the Company’s ESOP to purchase the Company’s shares from Owners for more than they were worth.

The Department of Labor alleged that Owners met with an attorney in the summer of 2012 to discuss the creation of an ESOP to divest themselves of their ownership interests in the Company.  In the fall of 2012, Owners provided information about the Company to Valuation Firm.  Valuation Firm produced a valuation report and a fairness opinion, both valuing the Company at $40 million.  The Department of Labor alleged that the valuation report was flawed in several respects. For example, the reports applied a 30% control premium even though there would be no change in control of the Company (because Owners as officers and directors, maintained control), and the valuation report used unreasonable revenue projections that went far beyond the Company’s historical average.

In the meantime, Owners told ESOP Trustee, a lawyer with a California law firm specializing in ESOP fiduciary services, that they wanted him to serve as the trustee of the ESOP. The Department of Labor alleged that, at the outset of ESOP Trustee’s involvement with the transaction, Owners stated that the purchase price was $40 million.

According to the Department of Labor, on December 10, 2012, Owners offered to sell their Company shares to the ESOP for $41 million, payable over 20 years at 10% interest. This offer to the ESOP was communicated to ESOP Trustee. After negotiating for a day, ESOP Trustee and Owners allegedly agreed that the ESOP would purchase the Company’s shares for $40 million payable, over 25 years at 7% interest. On December 11, 2012, the ESOP was formed with a retroactive date of January 1, 2012, and ESOP Trustee was named as its trustee. On December 14, 2012, ESOP Trustee and Owners allegedly caused the ESOP to purchase the Company’s shares for $40 million dollars pursuant to the terms and conditions of an ESOP stock purchase agreement.

The Department of Labor alleged that ESOP Trustee and Owners did not carry out a meaningful review of the Valuation Firm valuation report, which the Department of Labor claimed was obviously defective and significantly overvalued the shares of the Company, and that Owners and ESOP Trustee knew or should have known that the reports should not have been relied upon to justify the ESOP transaction. Owners allegedly provided unreasonable and inflated Company revenue projections to Valuation Firm, knowing that such projections were inaccurate, and allegedly failed to monitor ESOP Trustee to assure that he acted in the best interests of the ESOP’s participants and beneficiaries; that is Company’s employees.

Relying on these allegations, the Department of Labor asserted that Owners and ESOP Trustee breached their fiduciary duties under ERISA, the applicable federal law, and asked the court to essentially unwind the transaction.

Owners filed a motion to dismiss the lawsuit on June 12, 2018. Owners essentially said that if the ESOP overpaid for their stock that it was the legal responsibility of ESOP Trustee alone, and not Owners, who owed no fiduciary duty to the ESOP.

The court disagreed and refused to let Owners out of the lawsuit. First Owners, as the primary decision-makers as owners of the Company and the sole members of its board of directors, had authority and control under the law and documents, over the ESOP, and thus owed fiduciary duties to their employees as ESOP participants, to abide by standards of conduct, responsibility, and obligation to protect the Company employees’ ESOP retirement assets. These standards included the duties of loyalty and care and a prohibition against self-dealing.

The court said that the Department of Labor’s allegations if true were enough to establish that Owners breached their duty to monitor ESOP Trustee’s performance by permitting ESOP Trustee to accept a $40 million purchase price for Owners stock which was allegedly much higher than its actual value due to the inaccurate, overly aggressive and optimistic Company projections and the inappropriate use of a 30% control premium.

This case is referred to Acosta v. Saakvitne, Civ. No. 18-00155 SOM-RLP, United States District Court, D. Hawaii, (January 18, 2019).

Comment. Selling your company to an ESOP can be an attractive exit strategy. However, if you are going to do it you must do it right.

With 20/20 hindsight, Owners should have hired a lawyer who is highly regarded in the ESOP community (part of the ESOP mafia) who has extensive experience in doing ESOP transactions. This lawyer would have told Owners that the purchase price must be fair, and the Company projections must be reasonable.

This ESOP lawyer would also tell Owners to select a highly respected trustee for the ESOP that would skeptically review the valuation and purchase price.

These actions would probably have resulted in a reasonable purchase price and would probably not risk the deal being unwound.

By John McCauley: I help people start, grow, buy and sell their businesses.



Telephone:      714 273-6291

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