Recent ESOP Legal Developments: Ongoing Emphasis on Company Valuations

By Tatiana Doran

In 2016, the Department of Labor (DOL) sued yet another company for allegedly using unreasonably flawed company valuations used in ESOP transactions. Considered at least by the SEC as retirement plans, ESOPs are overseen by the Department of Labor’s Employee Benefits Security Administration. DOL continued its pattern in recent years of suing companies, owners, and fiduciaries in federal court that DOL alleges use unreasonably flawed valuations resulting in significant gain to themselves but harm and damages to the ESOP and its participants.

Should you be afraid? We hope not!

The challenge for ESOPs is that there is no market for valuing companies’ stock for ESOPs of closely held companies. As a result, closely held companies looking to establish an ESOP need to work with consultants and fiduciaries to determine the company’s fair market value. If you are diligently providing actual data, forecasts derived from that data, and reviewing valuations based on that data, then you likely need not fear. The DOL generally focuses on very large sums and egregious violations, with an approximately $48 million valuation having twice gotten their attention. Additionally, DOL normally provides a warning letter with the opportunity to correct violations before suing.

The DOL is most concerned with fundamentally flawed valuations and “woefully deficient” investigation and negotiations. So, for example, in its complaint against Dr. Roy Geronemus, the owner of Laser and Skin Surgery Center of New York, and his personal accountant CPA and plan trustee Samuel Ginsberg, DOL alleged that the company’s valuation of $48 million was unreasonably flawed because it made projections grossly underestimating compensation for Dr. Geronemus and by valuing the company in comparison to 12 companies of which five were based in Europe, listed solely on European stock exchanges, and resulted in inflated valuations by contrast to their American counterparts. The most recent case generating attention is Perez v. First Bankers Trust Services, Inc., and involves the company Sonnax Industries, Inc., its owners, the ESOP trustee, and the ESOP’s independent fiduciary company, First Bankers Trust Services. Based on valuation from First Bankers in part from what the DOL alleges was Sonnax’s wrongful projections of future revenue and margin growth rate which was obviously inaccurate from the financial records, Sonnax purchased 100 percent of the company shares from its owners for $48.8 million and then simultaneously issued new shares to the ESOP for $10 million.

In the Sonnax case, DOL alleges that First Bankers Trust Services, as the independent fiduciary hired by Sonnax to advise its ESOP regarding proper valuation in purchasing 100 percent of the company shares from its owners, breached its fiduciary duties and violated ERISA’s prohibited transaction rules by relying on a flawed valuation of the stock, not prudently investigating, and failing to protect the ESOP, resulting in the ESOP purchasing highly leveraged stock for much more than its fair market value. The Sonnax ESOP thus acquired all of the stock of a company that had just incurred $48.8 million more debt to pay out that $48.8 million to the prior owners so as to give the ESOP all of the shares of stock to a company immediately valued at only $10 million with $48.8 million more debt to have to pay off.

It is important to engage in sophisticated financial analysis to obtain a fair market value, but some common sense also helps. When the numbers sound egregious, they often are. Anybody’s problem radar should go off from a devaluation of 5-1 in tens of millions of dollars in the value of stock from a buyout from the company owners to issuance of that stock to the ESOP. We do not have a rough and ready number that is okay in change of valuation from the loan transactions to buy out owners’ shares of stock and issue it to an ESOP, but the ESOP trustee, independent fiduciary providing a valuation of the company, and the company itself are responsible for acting prudently to provide honest financial data and to establish fair market value, with an emphasis on prudent and fair.

Tatiana Doran, graduate student associate, Beyster Institute and Rady MBA candidate 2018

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