Enterprise Services, Inc. Business Transitions and Valuations
ESOP Articles

Valuation Issues in ESOP Court Cases: Donovan v. Cunningham
Written by Scott Miller, CPA/ABV, CVA

Originally published in The Valuation Examiner by the National Association of Certified Valuation Analysts, June/July, 1997.

The landmark legislation, Employee Retirement Income Security Act of 1974, as amended ("ERISA"), was signed into law with the intent of achieving a number of important national goals. One of the most important of those goals was to provide a foundation for a comprehensive system of retirement plans that were intended to compliment Social Security. The ERISA legislation addressed a number of retirement programs including such things as pension plans, profit sharing plans, 401(k) savings plans and employee stock ownership plans ("ESOPs"). ESOPs were created by the legislation to provide both a long term retirement benefit and to encourage employee ownership. This special dual role of ESOPs marks them as unique among qualified retirement plans. In the situation of ESOPs in closely held companies where the securities are not actively traded, there is a requirement that the stock of the plan sponsor be valued by an independent professional. Additionally, this valuation mandate is ongoing as long as the plan sponsor, the company, continues to have an ESOP which owns stock in the plan sponsor.

The Importance of Court Cases

The ERISA legislation in many instances is very general in its wording by design. In 1974 it was deemed to be important to have a national program in place to encourage retirement saving. Congress knew that having legislation as sweeping as ERISA would eventually have to be interpreted by the courts and appropriate administrative agencies regarding a broad range of implementation issues. The interpretation of the statutes over time becomes essential to an understanding of the application of the ERISA legislation.

As a qualified retirement plan, ESOPs enjoy a host of tax benefits like all other qualified plans such as the compounding of asset values free of all taxes until the assets are withdrawn. To encourage employee ownership as another worthwhile social goal, ESOPs were also granted special tax oriented incentives. The strongest tax incentive in 1974 was the ability to repay ESOP related debt including principal with tax deductible dollars. Since that time, other powerful tax incentives have been legislated to encourage employee ownership.

Due to the special dual nature of ESOPs, they come under the direct administration of both the Internal Revenue Service ("IRS") and the Department of Labor ("DOL"). The IRS has a direct interest due to the fact that contributions to an ESOP are tax deductible within certain prescribed limits. Those contributions include a wide range of purposes such as: providing cash for plan liquidity, providing cash to repay ESOP related debt and contributing stock to increase the capital base of the plan sponsor. Determining the fair market value of stock in closely held companies as a basis for ESOP related transactions has a direct impact on the revenue of the U.S. Treasury Department. The DOL has a direct interest because it is the agency established by the ERISA legislation to enforce the provisions of the law and protect the retirement system of the country.

We emphasize that the power of the DOL is substantial, and the agency has a mandate to insure that the retirement system of the country is being safeguarded. When ERISA was enacted, the legislation contained a comprehensive ability to provide its own remedies. It was recognized by Congress that any dispute between plan participants and a plan is typically very one sided, particularly when the plan is backed by the full resources of the plan sponsor, the company. Congress enhanced the ability of plaintiffs in such disputes. ERISA provides to the prevailing party the right to recover attorneys fees and other costs incurred in the litigation. This recovery of litigation costs is in addition to any other recovery of resources attained by the prevailing party. In effect, the legislation provides that the full resources of the plan may be committed to pay the legal costs of the attorney suing the plan. Pronouncements and legal actions brought by the DOL with regard to ESOPs are closely watched by professionals and other interested parties because of the Department's authority and the far ranging potential penalties.

Court Case: Donovan v. Cunningham

This case, Donovan v. Cunningham, 541 F. Supp. 276 (S.D. Texas 1982), affirmed in part, vacated in part, reversed in part, 716 F.2d 1455 (5th Cir. 1983), is the first to address fiduciary responsibilities regarding an ESOP based valuation. Valuation professionals understand the concept of "fair market value", but an ESOP fiduciary must also be knowledgeable about "adequate consideration" as defined in Section 3(18) of ERISA. In this instance, Secretary of Labor, Raymond Donovan, brought an action against the ESOP Administration Committee of Metropolitan Contract Services, Inc. ("MCS" or the "Company") for its failure to comply with fiduciary responsibilities in determining the fair market value of the stock and the adequate consideration regarding the ESOP transaction.

Background Information

Metropolitan Contract Services, Inc. formed an ESOP and purchased two blocks of stock from the sole shareholder, Kenneth Cunningham. The first ESOP transaction was in August, 1976 for 14% of the outstanding stock of MCS, and the second transaction was in February, 1977 for an additional 20% block of stock. Mr. Cunningham served as the Chairman of the Board of Directors and as the Chief Executive Officer. The Board of Directors also served as the ESOP Administration Committee. The ESOP Administrative Committee relied on an independent valuation report dated June, 1975 that determined a 100% interest in MCS. This valuation report, dated well before the actual ESOP transactions, was used to determine the price per share the ESOP paid for MCS stock.

The Secretary of Labor commenced an action against Mr. Cunningham and the other members of the ESOP Administration Committee. The action charged that the members of the ESOP Administration Committee breached their fiduciary responsibilities in a number of areas. The fiduciaries relied on a single valuation report prepared in June, 1975 for two ESOP transactions that occurred in August, 1976 and February, 1977. At the time of the transactions, the valuation report was beyond one full year, and in the case of the second transaction the report was approaching two years. During that time, many of management's projections used in the valuation report no longer remained valid. Further, the valuation report established a 100% interest in the Company, a control position, but the ESOP purchased minority blocks of stock. The ESOP was not intended to gain a controlling interest in the Company. No adjustment was made for the minority position of the ESOP. Finally, the valuation report was not commenced for the purposes of an ESOP.

Court Decision

The court decided that the members of the ESOP Administration Committee breached their fiduciary responsibilities. They failed in their duties in a number of areas: the valuation report they relied upon was out of date by the time of the actual stock transactions, the financial projections used in the valuation report were no longer valid, the report was not originally undertaken for the purposes of an ESOP, and the ESOP purchased a minority position in the Company not a controlling interest. The court said it is appropriate for ESOP fiduciaries to rely in part on the reports of other professionals when discharging their responsibilities, but there is an obligation to understand the content of those reports. In this case, there is an obligation to understand such issues as: the underlying financial assumptions in the valuation report, knowing the difference between a minority position and a controlling position, and having the valuation report completed in a timely manner for the purposes of an ESOP.


The timing is important because ESOPs had only been in existence a brief period when the case was commenced. ERISA legislation was newly enacted and many of the administrative aspects of the law were being refined both in practice and in the courts. This case indicates what can happen when general standards of fiduciary conduct are applied to a specific situation. The valuation professional must be careful and diligent in the role of a financial advisor to an ESOP fiduciary. It is not enough to just understand the determination of fair market value, the valuation professional must also know the requirements of a valuation undertaken for the purposes of an ESOP.

Enterprise Services, Inc. Business Transitions and Valuations
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