Owners of closely held companies with employee stock ownership plans (ESOPs) may be desperately seeking exit strategies these days, but if you want a “textbook” case on how not to conduct a management buyout by leveraging plan assets, consider these facts:
- First, a company that specialized in “flipping” ESOP companies purchased a firm in the steel storage business for $24 million in 2002. It merged the firm’s ESOP plan into its own and gave stock interests to management insiders on both sides of the deal.
- Five years later—as real estate markets crumbled, taking the storage industry with it—the “flipping” firm structured an ESOP-leveraged buyout for $44 million, without telling the management-buyers about a third-party deal that had just fallen through at $38 million.
- A week before closing, the “flipping” firm dissolved the board of directors of the “flipped” firm, reconstituting it with two insiders who held substantial interests in the deal. The board then created an ESOP for the to-be-formed company, appointing the same management insiders as trustees.
- At the 11th hour, the trustees realized they faced a conflict of interest and retained an “independent” appraisal firm as fiduciary, but forbade the firm from conducting its own valuation, forcing it to rely on an abbreviated valuation conducted by another firm—the same one, in fact, that had annually appraised the ESOP on behalf of the “flipping” firm.
- A fairness opinion provider also did not conduct its own appraisal and applied a $1.9 million “tax shield” to the final value, when—as expert testimony later revealed—there was “no consensus among the valuation community” to do so.
- In conducting its “final” appraisal, the firm that had appraised the ESOP holdings in prior years changed its treatment of cash-on-hand and applied marketability discounts unevenly.
- None of the appraisers were ever told about the failed third-party bid.
Within 18 months, the storage company folded under its debt load and its ESOP participants sued for multiple breaches of the trustees’ ERISA duties. Based on the facts, the federal district court upheld most of the claims and set the trial for damages. Importantly: The trustees’ appointment in this case did not qualify the independent appraisal firm as an ERISA fiduciary. We’ll have the complete digest of Chesemore v. Alliance Holdings, Inc., 2012 U.S. Dist. LEXIS 103731 (July 24, 2012) in the December Business Valuation Update; the court’s opinion will be posted soon at BVLaw.
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