A Lesson in ESOP Transactions: Do Your Diligence and Don’t Ignore Red Flags

In Pizzella v. Vinoskey, the U.S. District Court for the Western District of Virginia held that an independent fiduciary hired to represent the interests of participants in an employee stock ownership plan (the ESOP) engaged in a prohibited transaction and breached its fiduciary duties of prudence and loyalty in a $21 million transaction involving the ESOP’s purchase of stock from one of the company’s founders. The ESOP was awarded a $6.5 million judgment based on the amount that the Court determined the ESOP had overpaid for the stock. The Court held that the founder and independent fiduciary were jointly and severally liable for this judgment.

The Court focused on two issues:

  • Rushed Diligence: The Court determined that the independent fiduciary rushed through the diligence process, noting that (1) the entire diligence process took just over one month, (2) the fiduciary failed to negotiate the price to be paid for the stock, and (3) the transaction was approved before the final valuation report was delivered.
  • Valuation Report Deficiencies: The Court noted numerous deficiencies in the appraisal that the independent fiduciary failed to question, including:
    • The influence on the appraisal of a $21 million transaction price estimate provided to the appraiser
    • The flawed assumption that the transaction would result in the ESOP having a controlling interest in the company (founder would still control the board of directors and ESOP trustees following the transaction)
    • The lack of financial projections that are part of a widely used valuation methodology
    • Other flawed assumptions including, for example, working capital levels, length of look-back period, and discount rates applied to the valuation methodologies.
  • The Court also noted that even when the independent fiduciary questioned aspects of the appraiser’s methodology (such as the fact that the appraisal was based solely on the capitalization of cash flow methodology without any weight given to the discounted cash flow methodology or other methodologies), these concerns did not result in material changes to the appraisal.

Takeaways

  • DO your diligence. This case illustrates the importance of conducting thorough due diligence. Rushing through the diligence process and cutting corners can prove costly for fiduciaries.
  • DO advocate for the ESOP. Fiduciaries need to act in the sole interest of participants. In this case, the independent fiduciary testified that he wanted a fair price for both the founder and the ESOP. It is not a duty of the independent fiduciary to be fair to the founder (or seller).
  • DO NOT ignore red flags. Fiduciaries need to review the work product of third-party “experts” and ask questions when something does not make sense. It also is important that fiduciaries follow up regarding these concerns and get the experts to address the concerns in their analysis, as appropriate.