May 28, 2015 | Valuations
Perez v. Bruister, 2014 U.S. Dist. LEXIS 148314 (Oct. 16, 2014)
An appraiser of dubious background proved to be a linchpin in a complex ESOP case that centered on allegations from the Department of Labor and individual plaintiffs against the plan’s trustees for buying stock above its fair market value. In an undertaking full of obvious conflicts of interests, the transgressions on the part of the appraiser are noteworthy. Although he represented himself as the plan’s independent appraiser, he blatantly aligned himself with the stock seller, shaping his valuations in accordance with the latter’s instructions. The court’s opinion includes a trove of damaging correspondence and serves as a cautionary tale that no misdeed goes undiscovered.
‘ESOP possibility.’ The company was a home service provider (HSP) for Direct TV, installing and servicing satellite television equipment. Direct TV was the company’s sole client, which meant it had all the leverage. This included the right to terminate its contract with the company unilaterally and without cause and being under no obligation to promise the company exclusivity over service areas. Starting in 2000, when the company’s founder and owner explored ways to divest himself of the company, the Direct TV contract proved a major obstacle to finding a buyer. With the help of a friend, the owner then developed an alternative exit strategy—what the court called the “ESOP possibility.”
In a series of transactions that took place between 2002 and 2005, he sold 100% of the company’s shares to its employees by way of an employee stock ownership plan (ESOP) and using a family limited liability company (LLC) that held the company stock. Three of the transactions gave rise to the case in front of the court. In each, the plan bought company stock through an employee stock ownership trust (ESOT) for which the owner-seller and two persons with a close working relationship to him served as trustees. The transactions involved a combination of cash payments and transaction loans.
A December 2004 transaction included cash and a transaction loan from the LLC to the ESOT for the purchase of pledged stock. The company, not the LLC, held pledged stock subject to the loan in a suspense account. Contributions the company made into the ESOT were used to make payments on the principal and interest. At the end of the year, the company would release a proportional amount of pledged stock from suspension. The loan was refinanced the following year to reflect a “mirror” loan whereby the company was substituted for the LLC as creditor incurring an obligation to repay the LLC as the company received payments from the ESOT. A second transaction that took place in September 2005 involved all cash. And a third transaction occurring in December 2005 was another mirror loan with no cash. The total amount of principal and interest the ESOT paid from employer contributions was about $9.6 million; the total price for the three transactions was about $19.2 million.
The trustees based the share price on valuations an appraiser had performed. In 2010, the U.S. Department of Labor (DOL) sued the trustees in federal court, alleging violations of ERISA under sections 404(a)(1) and 406 for breach of fiduciary duty, failure to monitor, and engaging in prohibited transactions. The district court (S.D. Miss.) consolidated the case for trial with a separate case two plan participants had brought based on similar allegations. The key issue was whether the trustees paid too much for the stock because the appraiser’s valuation did not reflect the fair market value (FMV) of the stock.
The company stopped operating in 2008 after negotiating a deal with Direct TV under which the latter assumed the company’s debt and acquired its assets in a foreclosure sale.
At the start of its decision, the court pointed out that “this is not a normal case,” considering the “enormous” record and many factual and legal disputes. But the crux of the case was whether the appraiser and the trustees were truly independent and looking out for the interests of the ESOP and whether it was reasonable for the trustees to rely on the appraiser’s valuations. The court’s answer to these questions was “no.”
Appraiser requires help with valuations. The court found the appraiser was compromised in several ways. Although he purported to work for the ESOT, he had a history of working for the owner-seller of the stock and his allegiance was to the seller and the seller’s legal advisor. The seller hired the appraiser around 2000 to do a feasibility study for him. At the time, the appraiser lobbied to be retained as the future “independent” ESOP appraiser by offering to cut his fee. He also was eager to please the seller’s lawyer, promising to “get you one good ESOP project every month, for the next 20-30 years.” No one in the company investigated the appraiser’s background, and, therefore, no one knew that he lacked a college degree and that he had a prior felony conviction for fraud and operated under an assumed name.
The appraiser claimed to have performed over a thousand valuations, many involving ESOP transactions. Yet, because there were gaps in his understanding of valuation concepts, he relied “heavily” on California-based Business Equity Appraisal Reports Inc. (BEAR) to assist with the calculations. Typically, he sent data and instructions to BEAR, which BEAR plugged into a computer program to generate an analysis or report. Contemporaneous emails and deposition testimony from a BEAR valuator who was the appraiser’s main contact revealed her concerns about the appraiser and his valuations.
While working on valuations on behalf of the ESOT, the appraiser communicated directly with the owner-seller and the seller’s counsel rather than with the two lay trustees or ESOT counsel. He sent draft valuations to the seller and his lawyer, modified valuations to align them with the lawyer’s instructions, and forwarded only the final valuation to the ESOT trustees and counsel.
The December 2005 transaction, the court found, best illustrated the undue influence the seller and his lawyer had over the appraiser. This event represented the last chance for the owner to sell stock because afterward the employees would own all of the company stock. The appraiser initially provided data to BEAR specifying a 17% capitalization rate. BEAR’s representative sent an email noting the calculated result was significantly less than one from five months ago, but she did not specify a value. In response, the appraiser said the company had incurred considerably more debt in the meantime. He went on to say that, since there was a proposal to buy the company’s assets for $50 million, “the owner needs to get his fair share or the ESOP will get it all.” He then considered the company’s profitability during the preceding three years and directed BEAR to give more weight to the most profitable year and to decrease the cap rate to 16.1%—all in an effort to increase the ultimate value. He also contacted the seller’s lawyer to relay the bad news, all the while assuring the latter he would “tweak” the valuation” to approximate the $50 million number.
He did, the court said. After the first valuation came in at $30 million, he kept changing the variables, including reducing the weight he had given to the 2005 numbers from three to one and dropping the cap rate to 16%. Based on instructions from the seller’s attorney, he told the BEAR representative to include an explanation in the valuation that 2005 was an aberrant year given the effect of Hurricane Katrina and a few other unusual events. When ESOT counsel was included in the correspondence and noted he had not seen the draft valuation that the appraiser had been discussing with the seller and the latter’s lawyer, the appraiser declined to provide the draft; instead, he promised to send ESOT counsel a finalized valuation at the same time he sent it to the seller.
“There is no legitimate reason why this appraisal was higher than the previous appraisals,” the court said. Trial expert testimony and the record showed that the company’s value dropped in the months prior to the December 2005 transaction. What’s more, the appraiser in his earlier message to BEAR explained why that was the case. But he subsequently increased the value, “showing that [the appraiser] followed through with his stated intent to help [the owner] in his final opportunity to sell stock.” This history showed the appraiser’s divided loyalties and put in doubt each of the transactions. “In sum, these were not arm’s-length transactions,” the court concluded.
Trustees lack valuation knowledge. According to the court, the structure of the transactions was rife with conflicts of interest, starting with the composition of the board of trustees. It included the owner-seller and two lay trustees, one of whom worked directly for the owner, as did her husband. She later testified that she always considered the owner’s and the company’s interests, even when acting on behalf of the ESOP. The other trustee was a CPA who considered the owner-seller a friend and noted he was a major client of her firm. She later said she was concerned about the owner’s interests, but those concerns were secondary to the concerns for the ESOT.
What’s more, the court observed, both lay trustees, although “decent people” and “certainly likable,” lacked the understanding of business valuation necessary to challenge the appraiser’s calculations. The employee trustee said so in writing and from the get-go voiced doubts about her ability to serve as trustee. The CPA trustee had an MBA and stronger qualifications, but she also did not understand the appraiser’s valuation methods to the degree that she could challenge his decisions and conclusions. Frequently, both trustees turned to the owner and his lawyer, asking for guidance on ESOP-related questions, including issues such as “accounting adjustments made for ‘valuation purposes.’”
But, said the court, the trustees’ lack of knowledge of the valuation process did not justify their total reliance on the appraiser. Although both persons understood accounting principles and the way the company operated, they failed to “spot a few glaring mistakes.” One involved a $6 million error the appraiser made in the December 2004 valuation when he added instead of subtracted $3 million. The trustees’ failure to catch this mistake may have resulted in considerable overpayment, the court observed. It also noted that the appraiser subsequently brought the mistake to the trustees’ attention and purportedly fixed it in a new report but, nevertheless, achieved the same FMV he obtained using different data earlier. “The Court has considerable suspicion that this post-closing fix could occur without manipulating the numbers.”
Also, the appraiser’s calculations for 2003 and 2004 included a “projection risk,” which he said reflected “our estimate of the risk that the projections may not be realized.” For 2003, he used an 8% risk, but for 2004 he lowered the risk to 3%. In testimony, the CPA trustee could not articulate a reason for the drop. For 2005, which was by all accounts a particularly difficult year for the company, the appraiser decreased the risk to 2.5%. “If anything, [the company’s] projection risk should have increased with the obstacles it faced in 2004 and 2005,” the court noted.
Protection for the plan participants could have come from ESOT counsel had he or she been independent, the court said. But this was not the case. When the first ESOT attorney, who was paid by the company, “proved too thorough and expensive,” the owner’s attorney replaced him with one of his former law partners. “Thus, the seller—acting through an agent—terminated the buyer’s independent counsel,” the court stated. The second ESOT counsel played a limited role and failed to ask relevant questions. Once he learned there was a draft report he had not seen, ESOT counsel failed to push back regarding the appraiser’s refusal to provide the report and failed to ask why the seller’s attorney had instructed the plan’s independent appraiser to adjust EBITDA in a draft report that he had not shared with the ESOT trustees or counsel.
According to the court, “the bigger picture is that the purchase price was always [the appraiser’s] number.” There was little communication involving the trustees and the ESOT counsel before the transactions took place. The latter rarely saw valuations before the eve of closing. Unlike the seller’s attorney, the trustees never negotiated with the appraiser over valuation reports. For all these reasons, the court determined that there was no reasonable justification for the trustees’ reliance on the appraiser.
Appraiser works with spotty data. The trustees also failed to provide the appraiser with accurate and complete financial data, the court concluded. They provided financial data that they said complied with GAAP, when they knew the data did not. Even their trial valuation expert acknowledged that the internal financial results “have known accounting inaccuracies and divergences from generally accepted accounting principles in the U.S.” Also, the appraiser based his valuation on an overly optimistic view of the company’s relationship with Direct TV, which he formed from conversations with the company’s owner and which no one seemed to correct. For his part, the appraiser never reviewed the contracts the company had with Direct TV. As a result, he concluded that it would be difficult for a competitor to take the company’s market. No one seemed to have informed him about crucial risk factors in the parties’ relationship, including Direct TV’s unilateral decision to keep reducing the rates it would pay to HSPs, its requirement that HSPs lease or purchase company vehicles in 2005, and the company’s growing cash flow problems.
The trustees’ argument that the rate changes were less significant because the company was able to generate revenue from other sources had no traction with the court. It found that the standard professional installation fees made up the majority of the company’s revenues and the dropping margins sent shock waves through the HSP community. Also, the court said, “a legitimate appraiser would want to know that the company’s sole client had begun slashing rates” because rate reductions “necessarily impact [the company’s] company-specific risk and projected EBITDA margins.”
Similarly, the vehicle policy was “a game changer that the trustees should have explained to [the appraiser],” the court pointed out. It meant increased expenses as far as gas, leases, maintenance, and insurance were concerned. The owner admitted that the added cost from gas alone was between $25,000 a day and $40,000 a day, depending on the price of gas. Direct TV’s policy change left HSPs squeezed, the court observed, but the appraiser was “generally oblivious to these dramatic shifts.” Therefore, he did not account for them in developing his projections. Rather, he assumed that the expenses would be reflected in the financial statements after they had been incurred, the court added.
The decreasing margins contributed significantly to the company’s cash flow problems in 2004 and 2005. For a while, the company’s owner loaned millions of dollars to the company to make payroll and cover other expenses, which the company paid back promptly. But after Hurricane Katrina hit in 2005, its ability to repay the owner was wanting. What the effect of the storm on the business was remained unclear, the court said, but the trustees should have explored the debt repayment issue with the appraiser.
While the trustees openly discussed questions as to the company’s viability among themselves at the time of the third transaction in December 2005, they painted a rosy picture to the appraiser, watching as the seller’s lawyer “coaxed [the appraiser] to the highest-ever valuation,” said the court.
For all these reasons, the court found the trustees had breached their fiduciary duty and paid an inflated stock price.
Court grapples with remedy. The court said determining an appropriate remedy was more difficult than determining liability in this case. The three parties advocated for different measures of damages. The DOL urged the court to rescind the transactions, noting the difficulty of determining the stock’s FMV at the time the transactions occurred, and it asked for an $8.77 million surcharge payment from the fiduciaries. The individual plaintiffs wanted an award representing the difference between the full contract price for each transaction and the actual fair market value on the date the transaction closed. The trustees objected, claiming they should only be liable for the difference between what was actually paid and what should have been paid. Considering there was debt related to the transaction loans that was never repaid, the amounts paid for the December 2004 and 2005 transactions were less than the FMV the plaintiffs’ own experts determined; consequently, the plan suffered no loss from these events, they claimed.
The court dismissed the trustees’ argument, as well as the DOL’s. The correct measure of damages was the amount the plan participants overpaid, it said. Although difficult, calculating that amount was not impossible. For its FMV determination, the court considered the testimony of the three noted valuation experts the parties presented at trial. Different experts used different methods or applied the methods they used differently, but they all used multiple methods to produce several FMV estimates on the transaction dates, the court pointed out. To arrive at a final conclusion, they averaged or weighted the results. “This method tempered the outliers that some methods produced,” the court observed with approval. Accordingly, it decided to take a number of valuations resulting from different methods and assumptions and average them. “In this way, the Court’s sample pool is larger than those averaged or weighted by the individual experts,” it explained.
This approach was reasonable because no expert was more credible than the others and no one methodology was clearly correct or incorrect, the court added. It noted conceptual and technical differences. For example, the trustees’ expert saw the company as a growth company during the relevant 2004 and 2005 years, based on interviews with the trustees. But, said the court, these interviews took place years after the transactions and after a lawsuit was underway. The information the expert received did not accord with contemporaneous records and overestimated the company’s projected EBITDA margins and long-term prospects. The government’s expert and the plaintiffs’ expert were on the other end of the spectrum, assuming a no-growth company. This perception may have been influenced by the company’s ultimate demise and seemed to lead to undervaluation, the court said. The trustees’ expert used the guideline public company method but made large adjustments, which prompted criticism from the plaintiffs’ expert that the need to do so showed the method was inappropriate. Unlike the other two experts, the government’s expert declined to rely on the company’s financial statements but instead re-created the numbers based on industry norms. This approach prompted critique from the trustees’ experts. According to the court, this showed that there were different ways to address the same ultimate issue and their validity depended on the validity of the expert’s judgment.
The valuations the court did not include in its calculation were those from the appraiser, “because they are not credible.” Based on the above approach, the court generated a per-share price for the three transactions and compared it with the per-share price the appraiser determined. The court noted that its own FMV numbers were consistently below the appraiser’s final results. The court’s calculations also showed that “the margin by which the numbers were inflated grows with each transaction.” This picture aligned with the record, the court said. It concluded that the total amount of overpayment was over $4.5 million, for which the trustees were jointly and separately liable. The owner-seller-trustee was also liable for nearly $2 million in prejudgment interest.
The court seemed to foresee an appeal, noting that, just as the individual appraisals lend themselves to critique considering the many subjective decisions the appraisers made to arrive at them, the court’s findings may be “vulnerable.” But, it added, in the end, “the undersigned is comfortable with this approach and the results.”