ESOPs Are a Mine Fields for Valuation Analysts
Great Am. Fid. Ins. Co. v. Stout Risius Ross, Inc., 2021 U.S. Dist. LEXIS 158553; 2021 WL 3772876 (Aug. 23, 2021)
The Department of Labor (DOL) has a long history of challenging transactions involving company owners selling some or all of their interests to an ESOP. The most common challenge is to the value the trustees approved for executing the sale of company stock held by owners to the ESOP. In many of these cases, the ESOP subsequently either failed or had a substantial reduction in the value of the company.
Back in 1995, I testified in an ESOP-related tax case, Eyler v. Commissioner, TC Memo, 1995-123. While not brought directly by the DOL, the case was, as is normal, prosecuted in court by the DOJ. The case involved an assertion by the government that the price the ESOP paid for the stock the owner, Gary Eyler, held was too high. Not only did the Tax Court decide in favor of the ESOP, but it also roundly criticized me for my testimony. I had not performed a valuation but relied on other valuations that others had performed including Prudential-Bache and Duff & Phelps.
There are many other similar cases, both tax-related or involving the DOL, where similar results in favor of the ESOP and against the selling shareholders and trustees and even, in some cases, the administrators of the ESOP, have occurred from 1995 forward. Until recently, they have not directly involved the valuation analysts on the litigation side, but that seems to be changing.
Two recent cases have involved the valuation analyst. I wrote some comments on the first case, an offshoot of the long-running Brundle case (Wilmington Trust, N.A., as successor to Wilmington Trust Retirement and Institutional Services Co., Plaintiff, v. Stout Risius Ross Inc., Defendant). In this case, Wilmington was hired as the trustee for the Constellis Group Inc.’s ESOP. Wilmington later was sued by the ESOP and was ordered to pay almost $30 million in alleged overpayment for the stock by the ESOP. Wilmington countersued the ESOP’s valuation firm, Stout Risius Ross (SRR), for a contribution (to the damages) claim. That suit is ongoing. This is the first open indication of a party (Wilmington, the trustee) suing the valuation firm that they themselves had engaged to perform the valuation. It should be noted that the court in the case against Wilmington had stated that there were “four detectable defects” in the SRR report that Wilmington relied on and resulted in the $30 million overpayment.
Now, in August 2021, comes another suit involving SRR and ESOPs. In the case, cited above, SRR's malpractice insurer asks the court to relieve it from having to defend SRR in a case involving an ESOP. There is an exclusion in SRR’s malpractice policy for any violation of securities law that SRR might have participated in. While noting that ultimately the court might decide in the underlying case that SRR did not violate any securities law, the insurer’s exclusion of coverage for such a violation relieves it of the duty to defend the case.
Now we have a case where the valuator is sued for contribution to damages in one case and is sued in another case in which the surviving allegation is for a violation of securities law relieving the valuator’s malpractice insurer from having to defend such a case. The clear indication here is that valuations of ESOPs, particularly where the valuation is for the purpose of valuing a transaction for sellers of a company’s stock to sell their stock to the ESOP, can be a very risky business for the valuation firm.
The “collateral damage” for all of this is that it is becoming more difficult to enact and operate an ESOP for its intended benefits to the employees of the company. Not only will it be difficult to find valuators willing to value ESOP transactions, but it will also be difficult to find fiduciaries, such as Wilmington, willing to be trustees for ESOPs.
As a final thought: Valuation firms should be alerted to check their malpractice policies for the exclusions that might reside therein and be fully aware of those exclusions in accepting any valuation engagements, not just ESOP valuations. Even if you do not have a malpractice policy, you should review your firm’s policies on acceptance of valuation engagements so that you are fully aware of the risks of certain engagements. This is said with the recognition that anyone can sue anyone for anything. You cannot run a business risk free.