Enterprise Services, Inc. Business Transitions and Valuations
ESOP Articles

Valuation Issues in ESOP Court Cases: Delta Star v. Patton
Written by Scott Miller, CPA/ABV, CVA

Originally published in The Valuation Examiner by the National Association of Certified Valuation Analysts, January/February2002.

The court case of Delta Star, Inc., et al. (Plaintiff) v. Andrew W. Patton, et al. (Defendant), (United States District Court for the Western District of Pennsylvania, Civil Action No. 96-2183); is based on valuation and management compensation 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"). Due to excess compensation paid to the president of Delta Star, Inc. ("Delta" or the "Company"), the stock value for ESOP purposes was depressed. This is the first case of its kind to focus on the duties of an individual that is serving in multiple capacities for an ESOP company. In this case, an individual that determined his own compensation served in the following capacities: the president of the Company, an ESOP trustee, and a member of the board of directors.

ESOP Litigation Overview

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 needs a brief explanation. First, the IRS standard is "fair market value". The definition of fair market value is most clearly defined by the IRS in Revenue Ruling 59-60. Second, 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. The DOL has issued proposed regulations on May 17, 1988 (29 CFR 2510 Regulation Relating to the Definition of Adequate Consideration: Notice of Proposed Rulemaking) that details their understanding of the standard of value appropriate for ESOP applications where the stock is not publicly traded. The standard of value is "adequate consideration", which is generally understood to be fair market value determined in good faith. Determining fair market value in good faith is at the core of fiduciary responsibilities. This case is a good example of conflicted fiduciary responsibilities.

Background Information

Delta was created as a corporate spin-off from H. K. Porter Company ("Porter") in 1989. Under the provisions of the transaction, the ESOP acquired 98.63% of the stock in Delta and management, consisting of nine key employees, owned the remaining balance of just 1.37%. Mr. Andrew W. Patton ("Patton" or the "Defendant"), president, was one of the management shareholders with a small equity stake in the Company. It is significant in this instance that the ESOP has the overwhelming percentage of stock. For all practical purposes Delta is an entirely employee owned company.

When Delta Star was formed there were three individuals serving as the ESOP Board of Trustees, Patton and two other Company officers. The ESOP Board of Trustees voted the stock in the ESOP, and they elected themselves as the Board of Directors of Delta. The Board of Directors then elected the Company officers, and Patton was appointed chairman and president. Patton was advised to have at least one outside Board member, but that advice was rejected. In this instance the ESOP Board of Trustees effectively controlled 98.63% of the Company stock for ongoing operational considerations. This ESOP Board of Trustees had control of the Company and their fiduciary responsibilities in such circumstances are substantial.

At the time of the spin-off Porter established the base salary of Patton at approximately $201,000. During the next five years, 1990 to 1994, Patton unilaterally increased his base salary to just over $301,000 in annual increments not exceeding $50,000. During this same period, Patton also declared annual bonuses to himself that ranged from zero to $1,040,000, and averaging approximately $450,000. The bonuses typically represented a multiple of Patton's base salary, and far exceeded industry norms. Other compensation determined by Patton for himself included such things as: multiple country club memberships, several luxury cars and lawn care for his home. Patton unilaterally declared the salary increases, perks, and the bonuses without consulting either of the two other Company directors or the ESOP's Board of Trustees. Patton made active attempts to conceal his compensation from other board members. Further, Patton decided his compensation without any reference to such commonly accepted practices such as: industry standards, written compensation plan, compensation consultant, or consideration of the Company's financial performance.

The Company's Board of Directors approved the Delta Star Benefit Restoration Plan in 1990 to reward Company executives for reductions in ESOP benefits as a result of compensation limits imposed by the code. This Benefit Restoration Plan primarily benefited Patton. Additionally, the Board of Directors authorized the Delta Star Supplemental Executive Retirement Plan in 1991 ("SERP") to reward the same group of executives with additional retirement benefits. The two benefit plans were adopted and subsequently modified for the primary benefit of Patton. Patton was to receive unusually high proceeds from the benefit plans largely due to the excess compensation that he approved for himself. Indeed, compensation bonuses approved by Patton for his own account had the impact of significantly increasing the payments in the benefit plans to his advantage. The Company did not consult an outside compensation authority prior to adopting the benefit plans.

During the period from 1989 to 1994 the sales of the Company fluctuated rising from approximately $41.6 million in 1989 (the first year as an independent company) to a high of approximately $59.8 million in 1991, and falling to approximately $28 million in 1994. When sales increased from 1989 to 1991 the income remained stable averaging approximately $2.7 million for the three-year period. When sales declined in 1993 and 1994 the financial performance of the Company suffered, and an operating loss was reported in 1994. The depressed financial performance was largely attributed to the excess compensation paid to Patton. The substandard financial performance of the Company directly and negatively impacted the value of its stock for ESOP purposes. Delta stock was the only asset of the ESOP.

Court Decision

The Court examined ERISA statutes regarding fiduciary behavior and determined that they applied in this case. Patton was an ESOP fiduciary due to the fact he served on the ESOP Board of Trustees. The Defendant breached his fiduciary duties to the ESOP in several aspects. First, he was prevented from acting with total loyalty to the ESOP participants by his actions as a Company officer and director. Second, Patton failed to realize the inherent conflict of interest he had with his fiduciary duties by engaging in such unsupervised self-serving activities that maximized his salary, bonuses and fringe benefits. The matter of his total compensation package should have been the appropriate responsibility of the other members of the Board of Directors and ESOP Board of Trustees. Third, Patton violated ERISA statutes prohibiting self-dealing. He voted as a member of the ESOP Board of Trustees to retain himself on the Board of Directors. As a director Patton unjustly continued to enrich himself at the expense of the Company and the ESOP. By unilaterally approving his own compensation and benefits package, Patton was not independent, and did not act with complete fairness to the ESOP.

The Court ruled that Patton breached his fiduciary duties by paying himself an unreasonable base salary, by paying himself unreasonable bonuses, and by authorizing unreasonable fringe benefits. Patton was ordered to repay over $3,300,000 to the Company. This amount represents payments to the Defendant in excess of his base salary at the time of the spin-off from Porter. A portion of the proceeds are allocated to the ESOP account balances of plan participants that left the Company when the value of the stock was depressed due to the actions of Patton.

Summary

This case is significant in a number of critical aspects even if the facts and actions of the defendant are clearly egregious. It is common practice with many ESOPs in closely held companies to have the same individual(s) serving as both company officers and as ESOP fiduciaries. The circumstances of this case are excessive, but it is clear that senior managers in an ESOP company should avoid being left in a position to unilaterally approve their own compensation without some form of outside review or support. From a practical standpoint, it is often helpful to have individuals from outside the company on the Board of Directors. Outside directors may assist in such areas as approving compensation packages for senior management and resolving matters where conflicts of interest arise. Outside compensation consultants may also be an excellent source for data on compensation programs for executives in ESOP companies. If company officers agree to serve as ESOP fiduciaries they are advised to be mindful of the obligations imposed on them by ERISA.

Enterprise Services, Inc. Business Transitions and Valuations
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