Walsh v. Preston, 2022 

Background.

On Dec. 30, 2014, the plaintiff, Walsh (Secretary of Labor), filed this action pursuant to ERISA against the defendants. The complaint alleged the following: (1) breach of fiduciary duties; (2) engaging in prohibited transactions; and (3) co-liability of defendants. “The Secretary’s claims relate to two (2) separate transactions between Robert Preston and the ESOP, which occurred on October 1, 2006 (the ‘2006 Transaction’) and February 29, 2008, respectively (the ‘2008 Transaction’ and, together with the 2006 Transaction, the ‘Transactions’).”

Findings of fact.

Background and creation of the ESOP.

• TPP, an architectural firm, a Georgia corporation, was formed in 2004 in Atlanta.
• TPP was at all times the administrator of the ESOP.
• Robert Preston is the majority owner of TPP and has always been the sole administrator of the ESOP.
• Robert’s brother, Andrew, was the CFO of TPP and a member of the board of directors.
• The ESOP was established in 2004 to provide some ownership to the employees and to provide some liquidity to Robert Preston.
• Defendants employed Michael Jacobs of Jacobs Capital LLC to provide an initial valuation of TPP for the initial transaction.
• Jacobs met extensively with TPP’s management team (including Robert) and obtained pertinent information and documents for review in determining the initial value.
• “On July 5, 2004, Jacobs Capital issued a draft valuation of the Company as of May 31, 2004 (the ‘2004 Draft Valuation’), in which it valued the company at $10.3 million.”
• The 2004 draft applied a 23% DLOC.
• After receiving the draft, Robert inquired how much of the DLOC could be eliminated if certain control mechanisms he was proposing were put into place.
• Robert proposed a minimum three-member ESOP committee with veto power over the following:
  • Robert’s entire compensation package;
  • Issuance and payment of dividends;
  • Acquisition or payment of treasury shares;
  • Acquisition or liquidation of assets of the firm itself;
  • Diversification through acquisitions or internal development;
  • Consolidation through divestiture merger;
  • Alteration of articles or bylaws;
  • Right to liquidate, dissolve, sell out, or recapitalize; and
  • ESOP plan will have 51% voting rights.
• Robert’s list was from his understanding as to what Jacobs required to eliminate the minority discount.
• TPP’s counsel prepared a draft ESOP document including six items of control.
• Jacobs issued a final valuation on July 29, 2004. Jacobs removed the 23% DLOC with the understanding that the ESOP documents and corporate charter and bylaws would include the “control mechanisms.”
• One other control mechanism was added, that being that the ESOP would have three trustees, at least two of which would not be the controlling shareholder.
• At all times, the ESOP had only one trustee, Robert.
• Jacobs testified that, if the control elements were not in place in the documents, there would need to be a DLOC.
• “Removing the minority discount from the 2004 Final Valuation increased the value of the Company as of May 31, 2004, by $2.1 million.”

The ESOP committee and its supervision off TPP’s activities. There was a three-member “ESOP committee” including Steven Byerly, Susan Locke, and Robert. Locke and Byerly were not trustees of the ESOP. Byerly and Locke approved three of Robert’s salary increases after due diligence. Further, the ESOP committee approved an acquisition of Schwartz Engineering Co., according to Byerly. Locke did not remember the committee approving the Schwartz acquisition.

TPP’s organization and the effect of that organization on the ESOP. Class A stock held 49% of the votes and the right to appoint two of the three members of the board of directors. Robert, at all times, held controlling interest of the Class A shares. Class B shares have 51% of the vote and can appoint one director. The ESOP was at all times the sole owner of the Class B shares. As trustee of the ESOP, Robert appointed himself as the Class B director. “Provision 4.6 of TPP’s Bylaws provides that a majority of the Board of Directors, which must include the Class B Director, shall approve the corporate activities defined in Control Mechanisms A through E.” The bylaws do not mention either the ESOP or the ESOP committee.

The ESOP plan documents. The original ESOP documents, prepared by Timothy Boyd, were adopted on Sept. 30, 2004. Stuart Baesel prepared new documents in 2007. The plan document does not address any of the “control mechanisms.” “The ESOP Plan Document removed the provision in the original plan document giving the ESOP Committee authority to direct the Trustee in voting the ESOP stock.”

The 2006 transaction. In January 2006, TPP engaged Jacobs to provide a valuation as of Dec. 31, 2005, for purposes of an ESOP transaction. Jacobs asked TPP for written confirmation that Control Mechanisms A through G “have been incorporated into the ESOP document as well as the corporate charter and bylaws.” Byerly responded that some had not been but that he would make that happen. He failed to correct the mistake that the ESOP did not have three trustees. Jacobs issued a valuation report that a 100% interest was worth $25 million. No DLOC was included with the same language that it was because Control Mechanisms A through G had been adopted.

On Oct. 1, 2006, the ESOP purchased 496,032 shares of Class A stock for $1 million, using the eight-month-old Dec. 31, 2005, valuation. Robert remained the majority shareholder of Class A stock after the transaction. Robert testified that he reviewed the valuation and did not notice that it stated that there would be three ESOP trustees. He also stated that he was “pretty sure” that the ESOP attorney had told him that it was OK to rely on the Dec. 31, 2005, valuation without having the report updated. The attorney, Mr. Baesel, testified that he does not advise clients whether a specific valuation should be used for a transaction.

The 2008 transaction. Jacobs was engaged to provide another valuation as of Dec. 31, 2007, for another transaction. On Jan. 20, 2008, Robert issued an email to all employees expressing caution about potential revenues for 2008 because of a slowdown in the economy, stating he would not be surprised if there was no increase in revenues for 2008. He indicated that staffing cuts might occur if that happened. Robert sent the Jan. 20, 2008, email to Jacobs in late January. 

On Feb. 15, 2008, TPP laid off 24 of approximately 300 employees, saving about $146,000 monthly in payroll. Robert indicated that the layoffs were “belt tightening” and not due to economic conditions. TPP failed to stop an automatic deletion process that erased internal email traffic regarding these layoffs. Robert did not notify Jacobs of these layoffs. Sometime before Feb. 22, 2008, Andrew provided Jacobs with new projections of revenues for 2008 of $60.4 million. The 2008 Draft Valuation was not signed and had the word “DRAFT” on the front. There were blank spots and spots where information needed to be updated. Notwithstanding, Robert believed the draft valuation to be final from a financial and analytical standpoint. He did not ask Jacobs whether this was the case.

Per Robert, Andrew, and Byerly, the draft was not finalized because Mr. Jacobs wanted to sell TPP and was waiting on audited financial statements. Jacobs’ primary business was in selling companies, so ESOP valuations were “loss leaders.” Jacobs testified that he had not signed a final valuation because he had asked for audited financial statements and had not received them and he would not trust the information absent an audit.

Relying on the draft valuation, a Feb. 29, 2008, transaction was completed. As part of the transaction, the ESOP purchased 1,331,558 Class A shares for $5 million, a price of $3.75 per share. TPP took out a $5 million loan from Georgian Bank to pay Robert the $5 million. Robert personally guaranteed 100% of the loan from Georgian. 

Expert witnesses.

The Secretary presented Steven Sherman, CPA, as an expert witness. Sherman opined that the 2006 and 2008 Jacobs valuations were materially in excess of FMV. He valued the 2006 transaction at $523,923 and the 2008 transaction at $2,575,501.

The defendants presented Jesse Ultz, ASA, of Stout Risius & Ross as their expert. He testified that the results of the first (2006) Sherman report are unreliable and fatally flawed. In the first Ultz report, he valued the 2006 transaction at $812,226 and the 2008 transaction at $4,836,797.

Sherman provided a second report valuing the 2006 transaction at $731,987 and the 2008 transaction at $2,449,055. The new report was based on new information that Sherman had but did not come to his attention. Ultz also provided a second rebuttal report. Both experts used management projections that Jacobs did not use but the experts dispute what was known or knowable by the defendants at the time of the 2008 valuation. The court went into a lengthy discussion of the arguments of the parties on whether and what information was known at what time for the 2008 transaction. However, “[t]he use of the $50 million revenue projection for 2008 in Trial Exhibit J-10 versus the $61 million revenue projection for 2008 in Trial Exhibit J-11 is the largest driver of difference between the experts’ valuations for the 2008 Transaction.” In both his first and second reports, Sherman applied a 20% DLOC.

Ultz testified that Sherman’s discount was inappropriate because he used as-is cash flows that already state the business on a minority basis. Sherman acknowledged the as-is cash flows but asserted that an additional discount was warranted because Robert was still in control.

Other differences in the cash flows were discussed by the experts and recorded in the opinion.

Events following the 2008 transaction.

Eight days after the 2008 transaction, TPP management started talking about “the next round of layoffs” and a 5% pay cut for employees. In March 2008, Byerly reported that Robert thought that the managing directors should take a 20% pay cut. The March collapse of Bear Stearns caused six or seven of TPP’s projects to be put on hold. They were worth about $13 million in revenue. More TPP layoffs followed. Ultz said the Bear Stearns collapse was sudden and unforeseeable.

“In June 2008, TPP sought another valuation from Jacobs Capital. Jacobs Capital issued a valuation on September 15, 2008, valuing TPP at just $15 million as of June 30, 2008.” On Dec. 17, 2009, Applied Economics found that TPP did not have a positive value, and the ESOP was terminated on the following day. Robert repaid $2 million of the Georgian Bank loan from a personal $1 million CD and $1 million of his personal money paid into TPP. The ESOP was ultimately responsible to pay TPP for the shares it purchased from Robert as a result of the acquisition loan.

Conclusions of law.

Defendant TPP’s status as a fiduciary. Fiduciary status under ERISA was not an all-or-nothing proposition. The defendants argued that TPP did not act as a functional fiduciary. That ignored the fact that TPP was the named fiduciary in the ESOP documents. Thus, TPP was a fiduciary of the ESOP.

Breach of fiduciary duty claims. If any duties of loyalty or prudence were broken, then the fiduciary was responsible for any damages caused to the ESOP as a result of those breaches.

Duty of prudence. The Secretary argued the defendants violated the duty of prudence by: (1) not providing accurate information to Jacobs on the issue of control; (2) relying on the nine-month-old valuation for the 2006 transaction; (3) relying on a draft valuation for the 2008 transaction; and (4) relying on a draft valuation for the 2008 transaction that included projections that the defendants should have known were overly optimistic. The defendants argued they acted prudently because they hired and relied on experts to value the transactions and relied on legal counsel for the control mechanisms.

“The Court finds that a preponderance of the evidence establishes that Defendants failed to adequately review the 2006 Valuation and 2008 Draft Valuation to ensure that their reliance on the expert’s advice that a minority discount should not be applied was reasonable.” Likewise the court found that the defendants did not correct information in the documents they should have known were inaccurate. Relying on a 2008 draft valuation that had blanks and out-of-date information was not prudent. Additionally, “[a]lthough the ESOP had an element of control—Control Mechanism F: voting rights equal to 51% of all outstanding stock of the Company—it did not have the other Control Mechanisms contemplated by the Jacobs Valuations.”

The court found that the removal of the minority discount caused a loss to the ESOP, but they did not breach the duty of prudence on other arguments the Secretary made. It had not been shown that any changes of assumptions or facts would have invalidated the 2006 appraisal at the later date. The court also found that the defendants did take into account that the revenue would not be as great as initially thought in the 2008 draft valuation, but they could not have known that what was happening to the economy turned out to be “The Great Recession.” The draft valuation stated, “The revenue growth expected by management is reflective of a much slower economic environment than in recent years” and that, “[w]hile the Company currently has substantial work and potential work in its pipeline, the amount of work in the pipeline is below 2007 levels.” The court concluded that it was not established that the revenues would be closer to $50 million for 2008 (as Sherman used in his report) instead of the $60 million Jacobs used. As such, the defendants did not breach their duty of prudence for the 2008 transaction.

Duty of loyalty. ERISA required fiduciaries to act “solely in the interests of the participants and beneficiaries” of the ESOP. Thus, fiduciaries must not have conflicts of interest. The court found that the defendants did violate their duty of loyalty by removing the minority discount while not ensuring that the control mechanisms were in place. Robert affirmatively sought to eliminate the minority discount, which increased the price of his stock being sold. Robert never noticed “that the Jacobs Valuations premised the removal of the minority discount on the ESOP having three (3) trustees, with no mention of an ESOP Committee.” The defendants created a conflict of interest and thereby breached the duty of loyalty.

Prohibited transactions. ERISA “prohibits the fiduciary of any ERISA plan from causing a ‘sale or exchange … of any property between the plan and a party in interest.’” There was an exception in the case where the ESOP paid “adequate consideration” for the employer’s stock. Adequate consideration was fair market value as determined in good faith by the trustee or named fiduciary. The primary focus of the adequate consideration inquiry rested on the conduct of the fiduciary and the “prudent man standard of care.” The court agreed that a determination of whether adequate consideration was paid depends on whether the fair market value was determined in good faith and through a thorough investigation. “Therefore, because the Court finds that Defendants have not established by a preponderance of the evidence that they came to fair market value for the 2006 and 2008 Transactions by way of a prudent investigation, the Court concludes that the Transactions were not for adequate consideration.”

Co-fiduciary liability. The court found that the Secretary had failed to establish TPP’s co-fiduciary liability. There were no facts from the bench trial that support a finding of actual knowledge on the part of TPP. No evidence showed that Robert had any knowledge that his actions (or lack thereof) relative to the transactions were breaches of his fiduciary duties as the ESOP’s trustee. The court denied any co-fiduciary liability.

Relief.

Calculation of damages—fair market value. ERISA stated that breaching fiduciaries must “make good” any losses to the plan from breaches of fiduciary duty. “[A] court typically subtracts the stock’s fair market value, as determined by the court, from the inflated price paid by the ESOP.” Five sets of valuations were combined for the 2006 and 2008 transactions. The court found that the ESOP overpaid for the 2006 and 2008 transactions because the Jacobs valuations did not apply a minority discount and the ESOP did not actually have control.

Both of the parties used information for the 2008 transaction that was not known or knowable by Feb. 29, 2008. The court also questioned the reliability of the management projections used in the 2006 valuations. The court will not rely on the second Sherman report and the second Ultz report in calculating the FMV of the stock for the 2006 and 2008 transactions.

The court will not use the alternative FMV approach by the Secretary, either. It noted that the ESOP did have one element of control, being 51% of the voting shares of TPP stock. There was no evidence in the record as to what this 51% means and what impact it might have on the value. The court also noted that the 23% minority discount applied in the 2004 draft valuation was not applied to the guideline public company method. “And although the Court may approximate the extent of damages, it may not engage in speculation or guesswork.”

The court found that Ultz’s first report was more reliable than Sherman’s. Ultz pointed out errors in Sherman’s report and clearly explained how Sherman’s application of an additional 10% DLOC was a double application since Sherman’s “as-is” basis of valuation already made his conclusion on a minority basis.

“[T]he Court finds the most reliable valuation of fair market value of the 2006 and 2008 Transactions to be those in the First Ultz Report. Accordingly, the Court finds the fair market value of the shares acquired by the ESOP in the 2006 Transaction to be $812,226.00, and the fair market value of the shares acquired by the ESOP in the 2008 Transaction to be $4,836,797.00. Therefore, the total loss to the ESOP is equal to $350,977.00.”

Setoff argument.

The defendants argued that the decision in Walsh v. Vinoskey supported their argument that any damages to the ESOP should be reduced by $2 million as a result of post-transaction payments Robert made on the Georgian Bank loans. The court found the facts of the payments in this case were clearly distinguishable to the Walsh v. Vinoskey decision. The court here found that the $2 million of loan payments did not reduce the amount that the ESOP owed to TPP, but rather reduced the amounts that TPP owed to Georgian Bank.