Enterprise Services, Inc. Business Transitions and Valuations
ESOP Articles

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

Originally published in The Valuation Examiner by the National Association of Certified Valuation Analysts, April/May 1998.

The court case of Hines v. Schlimgen is based on valuation issues as they relate to the common stock in a closely held company for the purposes of an Employee Stock Ownership Plan and Trust ("ESOP"). Since this article is part of a series, it is important to note that ESOP court cases often are very complex. The added level of complexity is introduced because ESOPs come under the regulatory authority of both the Internal Revenue Service ("IRS") and the Department of Labor ("DOL"). The landmark legislation, Employee Retirement Income Security Act of 1974 as amended ("ERISA"), officially introduced the concept of ESOPs in Federal tax statutes and in qualified retirement plans. ERISA legislation is often very general by design, and it is left to the courts to determine many points of interpretation. It is appropriate to place the ERISA legislation in perspective. ERISA is intended to safeguard the retirement system of the United States, and its enforcement provisions are very strong and must be carefully considered. This is a significant mandate, and the penalties for violation of the regulations may be severe.

The standard of value in ESOP valuations is "fair market value". The definition of fair market value is most clearly defined by the IRS in Revenue Ruling 59-60. The DOL substantially embraces all of the aspects of fair market value as defined in Revenue Ruling 59-60, but the ERISA legislation imposes additional considerations. ERISA mandates that all qualified plans have a trustee, and the trustee has to act in the best interests of the plan participants. ERISA imposes fiduciary responsibilities on all of the trustees. Fiduciary responsibilities are often at the center of ESOP based valuation litigation. This case is a good example of contested fiduciary responsibilities.

Court Case: Hines v. Schlimgen

This case, Martin Hines et al. v. Frederick P. Schlimgen, Mark C. Rowley and Rowley & Schlimgen, Inc., U. S. District Court, Western District Court of Wisconsin, Civil Case 85-C-1037-S, October 10, 1086, is one where the court determined that the purchase of stock in Rowley & Schlimgen, Inc. ("Schlimgen" or the "Company") by the ESOP trustees was flawed in several respects. The result is that the ESOP trustees and the Company were held liable for the overvaluation of the stock. A beneficiary of the Schlimgen ESOP brought an action against both the Company and the Company's ESOP trustees for breaching their fiduciary duties by directing the ESOP to purchase stock for more than its fair market value.

Background Information

In August, 1980, the Rowley & Schlimgen, Inc. ESOP purchased 740 newly issued shares of stock, a minority interest, for $125 per share. There was no intent at the time to sell a controlling interest in the Company to the ESOP. The price per share was determined on the basis of a valuation report prepared by an individual who subsequently became the controller of the Company.

The report contained a number of issues that were the subject of interpretation. While the operating results of the Company were generally profitable, the appraiser failed to consider one recent year with a reported loss. The appraiser did not interpret employee bonuses as ordinary expenses. The appraiser also failed to adequately consider specific risk factors attributable to the Company. The report contained inadequate narrative about the risk environment of the Company. Risk factors common in closely held companies include such things as thin management, lack of diversification, and undercapitalization. Such risk factors need to be discussed in the report and specifically considered when assessing the risk environment of the Company. The report established a controlling interest in the Company, and simply divided the number of shares outstanding into the aggregate controlling interest value to arrive at a price per share.

The central issue in the case is whether the ESOP trustees breached their fiduciary duties by directing the ESOP to pay a price for the stock in excess of fair market value. The value of the stock was determined by an individual who subsequently was hired as the controller of the Company. Due to the nature of the relationship between the appraiser and the Company, the independence of the appraiser is a central issue. The appraiser's independence is essential in ESOP valuations. The lack of independence by the appraiser in this case, proves to be a costly error on the part of the Company and the ESOP trustees. Finally, the ESOP trustees did not question the value placed on the Company shares by the Board of Directors.

Court Decision

The court decided that the ESOP trustees did breach their fiduciary duties by not acting in the best interests of the plan participants. They failed in their duties in several areas. The ESOP trustees failed to have their own qualified independent appraiser. The valuation opinion was fundamentally compromised because the appraiser was not independent. The valuation report was flawed in many respects by reference to Revenue Ruling 59-60. The court noted flaws in the report in a number of areas including: (1) ignoring a loss year without explaining the impact of the computation in the earnings base, (2) not considering employee bonuses as ordinary expenses, (3) failure to consider specific company risk factors such as thin management, diversification requirements, undercapitalization and lack of computer equipment, (4) using an inappropriate earnings multiplier, (5) the valuation failed to recognize the ESOP shares were a minority position.

The court allowed a minority position discount of 20%, and noted that the discount could be much higher. The court determined the fair market value of the stock to be $56 per share after considering the minority position discount and additional risk factors. The ESOP trustees and the Company were liable for difference in the stock price, the court costs, and attorneys fees for the plaintiffs. Due to the far reaching impact of ERISA, the legislation purposefully provides for financial relief to plaintiffs bringing an action against the ESOP trustees. ERISA allows plaintiffs to recover legal fees.

Summary

This case is significant in a number of critical aspects. The valuation report used by the ESOP trustees was inadequate for two primary reasons. First, the report was not prepared by a qualified independent appraiser. Second, the valuation report contained numerous flaws when the requirements of Revenue Ruling 59-60 were considered. Significantly, the court noted that the ESOP was in a minority position, and a minority position discount should have been applied. Finally, under ERISA statutes, the court has the authority to assess the ESOP trustees and the Company with the plaintiff's legal fees.

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