Executive Corner: An Inside Look at the Landmark ESOP Valuation Case
For over a decade, the Department of Labor (DOL) has carried out a controversial and aggressive enforcement effort targeting valuation issues in employee stock ownership plans (ESOPs). The DOL did not lose a major ESOP case on a valuation issue until the recent case of Walsh v. Bowers. The case involves many key valuation issues, and BVR was fortunate enough to have two of the testifying experts for the defense give the inside story of the case.
Background. The case involves Bowers + Kubota, an architecture and engineering firm based in Hawaii that decided to form an ESOP in 2012. After the two owners (Bowers and Kubota) and the trustee for the ESOP, respectively, obtained independent valuations and consulted with legal counsel, they sold 100% of their shares to the trustee of the ESOP for $40 million. According to deposition testimony, in 2015, DOL investigators were told by their superiors to “sniff around” Hawaii ESOP transactions. In 2018, the DOL filed civil actions against a number of parties, including the ESOP trustee and the company owners. The allegations were similar to those the DOL has made in past cases (e.g., breach of fiduciary duty, prohibited transactions), and the central contention was that the ESOP paid more than fair market value for stock of the sponsor company.
Trial experts. The defense engaged Ken Pia (Marcum LLP) and Ian Rusk (Rusk O’Brien Gido + Partners LLC) to review the prior valuations, rebut the DOL’s valuation, and provide their own independent retrospective valuations for the ESOP transaction. Pia has a national reputation for working on complex valuations; Rusk is also a valuation expert and has a strong focus on the architecture and engineering industry. They worked independently of one another and never actually met until after the trial. Interestingly, they both came up with very close valuations—$43 million and $43.2 million—which were also similar to the previous valuations done for the ESOP trustee.
Pia and Rusk also noted that the judge in the case was very well versed in financial matters and clearly understood business valuation concepts. The court considered four principal issues: 1) the DOL appraiser’s responsibility to follow USPAP and other valuation standards; 2) the use of information not known or knowable; 3) the weight to be accorded to a nonbinding letter of interest (the sponsoring company had received an offer to acquire the company one year prior to the transaction); and 4) the level of control the ESOP possessed.
Standards. The court recognized that the DOL’s valuation expert’s “failure to follow the Uniform Standards of Professional Appraisal Practice (USPAP) introduced substantial errors into [his] analysis.” For example, the expert did not conduct a management interview, which violates USPAP’s scope of work and competency rules.
Offer to buy. In 2011, before the decision to form an ESOP company, Bowers + Kubota considered a “nonbinding indication of interest” from a potential buyer for $15 million, and the DOL expert took the position that this was an indication of fair market value. But the offer was based on a mere three pages of information from Bowers + Kubota—very little due diligence was done. The company had a valuation in hand that came in at $39.7 million, and, when that was communicated to the potential buyer, it dropped out of the negotiations.
The court ruled that this offer to buy was not relevant in establishing fair market value and made this interesting analogy: “An individual who makes an offer of $15,000 for a used luxury car with a Blue Book value of $40,000 does not, by virtue of making a ‘lowball’ offer that is never accepted, tend to establish that the car is worth only $15,000.”
Control. The DOL’s position on control has been that, if the ESOP does not gain “unfettered control” over the company immediately after the acquisition of all company stock, appraisers must apply a discount for lack of control. But Pia and Rusk point out that an investor need not acquire the entire bundle of control rights in order to reflect some degree of control value in the purchase price. The court accepted this concept.
The DOL expert used a “limited control” discount, but this was based on information not known or knowable. Pia did not use a control premium because the cash flows in his analysis were already on a control basis. Rusk used a very small control premium based on dual-class capitalization studies to reflect the impact of voting control.
Does this ruling set a precedent supporting the use of control premiums in ESOP transactions? Rusk used a control premium, and one was used in the original valuation. While this case does not clearly set a precedent, if a control premium is used properly, the answer is, yes, a control premium may be appropriate. But Pia and Rusk point out that it is important to be cautious about the application of a control premium in ESOP transactions and to include a detailed narrative that supports the quantification.
Does this ruling finally dispose of the issue of “unfettered control” in ESOP transactions? That is the hope, but time will tell. The court did recognize that unfettered, absolute control is not necessary as long as the valuation attributes go along with the ownership. Elements of control such as corporate governance, oversight by the trustee, board of directors, operational control, and the like need to be considered.
Editor’s Note: Reprinted with permission from Business Valuation Resources, LLC. (Business Valuation Update, Vol. 27, No. 12, December 2021; www.bvresources.com)