In Pizzella v. Vinoskey, 2019 U.S. Dist. LEXIS 129579, the US Department of Labor (DOL) brought a case against an independent transactional ESOP trustee (the trustee), but also named the seller of stock to an employee stock ownership plan (ESOP) as a defendant (the seller). The court found that the ESOP overpaid for Sentry Equipment Erectors, Inc. (the company) stock, in violation of ERISA, and that the trustee breached its duties of prudence and loyalty and engaged in a prohibited transaction by paying more than adequate consideration for shares in the ESOP transaction.
The court also found the seller jointly and severally liable for the ESOP’s losses (calculated to be around $6.5 million), both as a knowing participant in the prohibited transaction and as a co-fiduciary of the ESOP, since the seller also served as a trustee of the ESOP (but was not involved as a trustee of the ESOP transaction).
The Vinoskey case focuses on a second-stage ESOP transaction where the ESOP purchased the remaining 52% of the company’s stock from the seller in a leveraged transaction.
On November 9, 2010, the company’s attorney reached out to the trustee about the transaction and provided the trustee with an estimated value of the shares to be purchased in the transaction of $21 million. On November 18, 2010, the trustee was formally engaged by the company as an independent fiduciary for the transaction. The trustee engaged an independent valuation firm, which had conducted annual appraisals on behalf of the internal ESOP trustees before, as the valuation firm for the ESOP transaction.
The transaction closed on December 20, 2010, less than six weeks after the trustee was first contacted about the transaction.
The court held that the trustee had breached its duty of prudence and duty of loyalty to the ESOP and had committed a prohibited transaction under ERISA by overpaying for the company stock held by the seller. It also held that the seller was a knowing participant in the prohibited transaction and, thus, was jointly and severally liable with the trustee.
Based on the short time frame in which the ESOP transaction closed, as well as other extenuating factors, the court concluded that the trustee’s due diligence process was abbreviated, rushed, and cursory, noting that the parties were motivated by tax reasons to close the ESOP transaction by the end of 2010. In fact, based on testimony, the transaction closed before the trustee even received the final valuation report and without negotiation over the price to be paid for the company stock.
The court was also critical of the assumptions used by the trustee’s valuation firm, including the failure to account for the fact that the company’s business was cyclical, as well as understating certain economic risks the company faced.
In reaching its decision in favor of the DOL, the court found as follows:
- The trustee agreed to the transaction after a “rushed and cursory” review of the financial data. In reference to this, the judge noted, “A prudent fiduciary would not simply point out some flaws in a draft appraisal, leave others unaddressed, and settle on a price using an expert’s range of value without ever reviewing that expert’s final appraisal.”
- The trustee failed to engage in any back-and-forth negotiation over the stock price.
- The fact that a trustee representative testified to wanting to find a deal that was “fair to both” sides demonstrated that the trustee was not acting with an “eye single” to the ESOP participants.
On December 6, 2021, in Walsh v. Vinoskey, the US Court of Appeals for the Fourth Circuit upheld the district court’s finding that the seller was liable for causing the ESOP to overpay for company stock, but reduced the $6.5 million judgment to $1.9 million. The reduction was meant to give credit to the $4.6 million of the ESOP’s outstanding debt that the seller forgave. In reducing the judgment, the Fourth Circuit court held that the district court did not clearly err when it said the seller was liable to the ESOP, but did err by not subtracting the amount of debt forgiven.
Vinoskey highlights the importance of a thorough and deliberate (and well-documented) due diligence review by an ESOP trustee and its valuation firm, as well as the importance of being able to produce evidence or a record of meaningful negotiations between the ESOP trustee and a seller over the ESOP purchase price.
Thus, fiduciaries and their advisors, as well as sellers, will want to create a thorough written record (emails, minutes, etc.) of their respective due diligence efforts, detailing checklists, data rooms, meetings, phone calls, and other communications among the ESOP trustee, its valuation firm, seller(s), and company management. A written negotiations development chart, with dates, that tracks negotiations of the ESOP transaction price and terms is also highly recommended.
A selling shareholder also needs to consider the risk of liability related to the purchase price in an ESOP transaction, even if the selling shareholder subsequently agrees to a reduction of an ESOP note.
Moreover, where an independent trustee is appointed for the ESOP transaction, trustees who are also selling shareholders should be formally removed or resign well before the transaction process is underway in order to avoid possible co-fiduciary status and possible attendant joint and several liability under ERISA.