Guest Article

(From the April 29, 2002 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

Sixth Circuit Case Examines Fiduciary Duties in ESOP Transactions

You know it is not going to be good news for the ESOP fiduciaries when the court rejects one of the fiduciary's arguments by saying determining "adequate consideration" for a purchase of employer stock is "not a search for subjective good faith-- a pure heart and an empty head are not enough." Chao v. Hall Holding Company, Inc. et al, 2002 U.S. App. Lexis 5929 (6th Cir., April 3, 2002). And that's one of the kinder things the court said. The economic slowdown, coupled with the melt down of stock values in many companies, is already making suits against retirement plan fiduciaries more common. And it will be increasingly important for fiduciaries-- and their service providers-- to establish clear procedures and to follow and document those procedures. One of the points this case makes is that plan fiduciaries must give their service providers all the facts, not just limited information.

In Hall Holding, the U.S. Department of Labor successfully challenged the ESOP fiduciaries for failing to conduct a prudent and independent investigation to establish the fair market value of employer stock purchased by an ESOP. The appeals court affirmed the district court finding, including finding the fiduciaries personally liable for an award of money damages to ESOP participants to compensate for the fiduciaries' failure to determine the "adequate consideration" that should have been paid for the stock.

Facts

Goldman Financial Group, Inc. (GFGI), 100 percent owned by Mr. Goldman, also owned Hall Holding (Holding), which in turn owned 95 percent of Hall Chemical (Chemical). The president of Chemical owned the other 5 percent of Chemical. The GFGI director of human resources determined Chemical should establish an ESOP. She hired an appraiser who had earlier appraised Chemical to make another appraisal of Chemical. The appraiser, who was not one of the defendants, appraised Chemical again, with a value of between $32.4 and $37.4 million, exclusive of debt. But he testified he did not know that he was to establish a value for an ESOP's purchase of a stake in Chemical and he would have done a different valuation had he known the ESOP was buying a stake in the firm. And, indeed, the Chemical ESOP did not buy Chemical stock. Rather, the ESOP purchased stock in Holding, not the entity the appraiser had valued, but relied on the Chemical valuation to value the Holding stock.

The HR director then took the midpoint valuation figure of $34.9 million and multiplied by 9.9 percent (the actual amount of stock the ESOP was purchasing was 9.96 percent), reaching a cost of $3.4551 million, which she then rounded up to $3.5 million. She did the rounding because, according to her testimony, $3.5 million would be easier to communicate and document than the actual figure. She then checked with Goldman to be sure he was willing to sell at that price, and another person at GFGI, but did not check with others, including any one at Chemical.

The Chemical ESOP was set up with Holding as the administrator and named fiduciary. Goldman named Chemical's president and CFO as trustees and as members of the committee administering the plan. The HR director then arranged a loan to the ESOP from the GFGI Master Trust, which held funds for other GFGI pension plans. The HR director testified she was more concerned about how the interest rate affected the Master Trust than how that rate would affect the ESOP.

The president and the CFO of Chemical testified they had very little input on Chemical's purchase of Holding's stock even though they were trustees. The plan document required the employer to notify the trustees of the identity of an administrator, but no administrator was ever appointed. The CFO/ESOP trustee testified he had "no idea" how the price for the stock was decided, saying "I wasn't the owner. I would expect the owner decides how much of the company he's willing to sell."

Lower Court

On motion for summary judgment, the district court determined the value of the ESOP stock purchased for $3.5 million was in fact worth only $2,731,174.75, after subtracting Holding's $13.5 million in debt and factoring in a 13 percent minority holder discount based on the ESOP's holding only 9.96 percent of the Holding stock. The district court also awarded more than $1 million in prejudgment interest.

The defendants appealed on these grounds:

Appeals Court Holdings

In rejecting the defendants' argument that material issues of fact existed, making summary judgment improper, the appeals court reviewed the facts before the lower court, beginning with reliance on the appraiser's valuation of Chemical's stock value. The appeals court outlined three requirements in the 9th Circuit for fiduciary reliance on experts:

The fiduciary must (1) investigate the expert's qualifications . . . (2) provide the expert with complete and accurate information . . . and (3) make certain that reliance on the expert's advice is reasonably justified under the circumstances.

Slip op. at 23.

The court noted the facts established that the appraiser was not given the information that the appraisal would be used for an ESOP's purchase of stock and the stock purchased was not the Chemical stock the expert appraised, but was in fact the Holding stock, which the expert had not been engaged to value. But the court also noted the facts established:

Not only did the fiduciaries completely fail to negotiate as to the purchase price for the Hall Holding stock, but they were generally unaware of who determined the purchase price.

Slip op. at 23.

The court concluded:

. . .the Hall Chemical ESOP was established in an environment where the trustees were unaware of what was going on, the trustees were not consulted on major decisions affecting the Hall Chemical ESOP, there was no negotiation as to the price of the Hall Holding stock, there was more concern for the return on investment for the Master Trust, and the inconvenience of dealing with uneven numbers could justify charging the Hall Chemical ESOP an additional $44,900.00 for the stock it purchased. Such facts demonstrate not only the uniquely careless and haphazard manner in which the Hall Chemical ESOP was created, but also clear violations of defendants' fiduciary duties.

Slip op. at 24.

Claim of Causality of Loss

To the defense that the lower court did not determine what a hypothetical fiduciary would have paid and hence failed to establish a connection between the fiduciaries' actions and any loss to the participants, the appeals court held that the violation of prohibited transaction rules under ERISA sec. 406 is a per se fiduciary duty violation, which does not require the establishment of causation. In so doing, the court rejected the finding of Herman v. Mercantile Bank, N.A., 143 F.3d 419 (8th Cir. 1998), an ESOP purchase case which concluded that even if a trustee failed to make a good faith effort to determine the fair market value of the stock, he would be insulated from liability if a hypothetical prudent fiduciary would have made the same decision.

Rather, the appeals court looked to the specific language of the prohibited transaction exception for ESOP purchases authorized under ERISA sec. 408, which permits such purchases for "adequate consideration." As defined in ERISA, "adequate consideration" in purchasing privately held stock requires the price to be "the fair market value of the asset as determined in good faith by the trustee." In applying this standard the ordinary duties under ERISA sec. 404(a), prudence, diligence, etc., still apply. Consequently, the appeals court found:

When determining "adequate consideration," [the ERISA definition] requires not only a determination of fair market value, but also an examination of the process that led to the determination of fair market value in light of sec. 404's fiduciary duties.

Slip op. at 56. The appeals court again relied on the facts cited on page 24 of the opinion to conclude the defendants did not make a good faith determination with respect to the price of the Holding stock. As a result the court concluded the price of a hypothetical reasonable fiduciary is irrelevant in determining whether the defendants violated the prohibited transaction rules under ERISA §406(a)(1).

The court also rejected the defendants' reliance on an earlier case from the 6th Circuit, Kuper v. Iovenko, 66 F.3d 1447 (6th Cir. 1995), because that case only addressed compliance with fiduciary duties involving the ordinary duties with respect to operation of the plan and issues of diversification under ERISA sec. 404(a)(1), whereas the Hall Holding case involved an exception to the ERISA sec. 406 prohibited transaction rules. The appeals court also rejected the argument that "subjective intent" to benefit a party in interest was required to find a prohibited transaction, by distinguishing an earlier case and, again, citing case and secondary authority references to the per se violation nature of ERISA sec. 406(a)(1) prohibited transaction rules.

Finally, the court rejected the defendants' arguments against the lower court's award of monetary damages based on the fact the defendants cited no authority to forbid such damages and because their "arguments are based upon faulty premises." The defendants had argued (1) the plan participants had no direct interest in how much the ESOP paid for its stock because the participants had no ownership rights in the ESOP when the stock was purchased and (2) the participants only cared about the price of the stock when they retired. The court noted that had the ESOP paid less for the stock, the ESOP loan could have been paid more rapidly, thereby discharging more stock to the participants and that the ESOP was a form of deferred compensation, and because the ESOP received over-valued stock, that compensation was debased.

Given that the appeals court was forced to distinguish other fiduciary duty cases, an argument could be made that Hall Holding will be of little authority in subsequent cases. However, the facts of the transaction are so distinctive and so clearly illustrate that none of the parties could provide any evidence of the exercise of fiduciary duties during the transaction, the case is likely to be frequently cited as an example of how not to carry out fiduciary roles.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have questions or need additional information about this article, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Copyright 2002, Deloitte.