A new ESOP litigation is underway in federal district court related to a 2011 transaction in which the majority owner of the company sold his remaining stock to the company’s ESOP. The Department of Labor is the plaintiff, and many of its allegations against the seller, company directors, and the independent trustee have a familiar ring. Recently the court denied both parties’ motions for partial summary judgment, finding resolution of the issues required development of the evidentiary record.
Backstory: The company is Kurt Manufacturing, a closely held Minnesota company. William Kuban was the majority shareholder (75.6%) and chairman of the board. Besides Kuban and his daughter, the board included three non-Kuban-related members. In 2011, the non-Kuban directors approved the sale of Kuban’s shares to the company’s ESOP. The deal left the ESOP with 100% of company stock. This was a debt-financed transaction. On advice of the seller-side financial advisor, Chartwell, the directors appointed Reliance Trust to represent the ESOP’s interest in negotiating a purchase price. Stout Risius Ross (SRR) was the designated ESOP appraiser. The transaction closed on Oct. 5, 2011. The closing price was $39 million.
Breach of fiduciary duty claim: Six years later, the DOL filed an initial complaint, which it amended. In essence, the DOL alleges that Reliance and the non-Kuban directors breached their fiduciary duties to the ESOP and Reliance allowed the ESOP to pay more than fair market value for the seller’s stock, enriching him and the defendant directors (“prohibited transaction” claim). The DOL argues the directors are liable as co-fiduciaries and were knowing participants in the transaction.
According to the DOL, the directors “orchestrated” the transaction in that they and the seller arranged the price, structure, and financing in advance and only considered Reliance and SRR, but not other ESOP professionals, for the transaction. Reliance’s role was to “rubber-stamp” a done deal.
Also, the DOL contends, Reliance breached its duties to the ESOP when it failed to act with an “eye single” to the ESOP. Emails, the DOL says, show Reliance was only concerned about closing the deal, not with getting the best result for the ESOP. For example, when the seller insisted on securing compensation of nearly $500,000 to serve as consultant to the company, Reliance was primarily concerned about this amount raising a “red flag” for the DOL and IRS, saying “any counter changes we ask for are to help protect [Kuban], [Kurt], and Reliance from the DOL.” Reliance counters that $39 million was the price the parties settled on after discussions, primarily over Kuban’s salary. The purchase price included a substantially reduced salary to Kuban. Reliance also says it secured various favorable terms for the ESOP.
Control premium: The issue of control also features in this case. SRR, in a draft analysis of transaction fairness, said a primary benefit of control was the ability to change the capital structure of the company. This was one factor SRR considered in applying a 10% control premium to the stock prices of the guideline companies it used for its guideline company method (SRR also did a DCF analysis and combined the results). The DOL claims that the ESOP did not gain control of the company’s board and its voting rights did not change. Reliance’s failure to question the use of a control premium alone resulted in the ESOP’s overpayment of at least $4.7 million. Reliance argues valuing the stock on a control basis was appropriate. For one, the parties negotiated an investor rights agreement that allowed the seller to designate one member of a five-member board until the seller’s noted was paid. The ESOP was able to elect the remaining members.
The court found all of these, and a host of other issues raised, are disputed issues of material fact that preclude summary judgment.
Stay tuned for further reporting as the litigation develops.
A digest of Scalia v. Reliance Trust Co., 2021 U.S. Dist. LEXIS 38705 (March 2, 2021), as well as the court’s opinion will be available soon at BVLaw.