ESOP valuation issues: Lessons from Pizzella v. Vinoskey

The U.S. Department of Labor recently prevailed in a district court of Virginia case involving multiple ESOP valuation issues. 

The case involved allegations that the selling shareholder, who was also a fiduciary of the employer stock ownership plan, as well as the bank hired to represent the ESOP as an independent fiduciary, breached their fiduciary duties by allowing the plan to overpay for the shareholder’s stock. 

The district court issued a detailed ruling on the case which addressed multiple common valuation practices such as normalization adjustments, discounting, capitalization rates and proper look-back periods for the purposes of capitalization. 

The court also provided a point-by-point critique on the problematic aspects of the valuation report prepared at the time of sale and re-calculated the overpayment for the company’s stock based on testimony of several valuation experts as well as court’s own interpretation of the applicable valuation tenets. 

Some of the salient valuation issues decided by the court as well as a summary of the case are provided below. 

Case Summary: Patrick Pizzella, Acting Secretary of Labor, U.S. Department of Labor, Plaintiff, v. Adam Vinoskey, et al, defendants: 

In 1980, Adam and Carole Vinoskey founded Sentry Equipment Erectors, Inc., which designs and sells equipment to soft drink manufacturers. 

Sentry offered a generous benefit package, which included health insurance benefits as well as an Employee Stock Ownership Plan (ESOP).  Adam Vinoskey served as the CEO and chairman of the board of directors, while Carole Vinoskey served as Sentry’s secretary/treasurer at the time of sale. 

The ESOP owned 48% of Sentry’s shares prior to the litigated transaction (sale of the remainder interest). Around 2010, Adam Vinoskey decided to sell the remainder of his interest in Sentry, which would result in the ESOP owning 100% of the company. 

A certified appraiser, Brian Napier, drafted and finalized appraisals of Sentry’s stock from 2005 until at least 2015. He had prepared Sentry’s valuations for ESOP purposes prior to the litigated 2010 transaction, he worked on an appraisal of the ESOP stock for the purposes of transferring the remaining interest owned by Adam Vinoskey to the ESOP in 2010, and he prepared subsequent valuation reports for the company after the litigated transaction had closed. 

The per share value of stock as disclosed in Napier’s report amounted to $285 per share the year immediately preceding the sale of Vinoskey’s shares and increased to $406 per share at the time of the litigated sale a year later. 

The valuation decisions that precipitated the increase in the value of Sentry’s stock largely revolved around control issues and the valuator’s conclusion that the ESOP would own a controlling interest in Sentry after the sale. 

As will be discussed in this article, the court concluded that 100% ownership of the purchased entity did not result in effective control of the company.  

While control in-appearance (percentage of ownership) had been passed to the ESOP and its beneficiaries, the operative control of the Company remained with the selling shareholder.  Some of the specific issues discussed in the court decision included the following.

Controlling interest assumption

 Vinoskey’s case clearly demonstrated that ownership (even ownership of 100% of the company’s stock) does not necessarily equate control.

 In the case of the Sentry ESOP, the implications of Sentry’s corporate structure were such that absent removing the selling business owners from their positions as ESOP trustees and as corporate directors, the same owners would exercise nearly total control over the ESOP shares and over the Company itself in the vast majority of corporate matters.  

The fact that the owners retained a tight grip on the corporation even after they sold their ownership interest to the ESOP was a major factor in the court’s subsequent denial of any control-related adjustments that the valuators utilized in preparing the ESOP valuation report. The transfer of 100% of ownership in the corporation to the ESOP was not enough to substantiate that de facto control of the underlying operations had passed to the ESOP upon the sale. 

The lack of substance in the transfer of control was crucial in swaying the court’s decision to reject any assumptions valuators made regarding controlling normalization adjustments. 

Controlling normalization adjustments

The valuator used several control-related add-backs for the purposes of employing the capitalization of earnings (income) approach to value Sentry. 

Specifically, he added back the health care costs of the company, reasoning that a controlling shareholder would cut the healthcare benefits to the employees in order to improve the bottom-line. 

The court concluded that the add-back was inappropriate given the absence of de-facto control that would enable the shareholders to effectuate such a change in conjunction with the fact that these benefits had a major impact on worker satisfaction, recruitment, and retention and Mr. Vinoskey's consistent representations that he would not consider cutting healthcare benefits after the sale of the company to the ESOP.  

The court also rejected the add-back of ESOP retirement contributions to the company’s gross cash flows agreeing with the Department of Labor valuator who opined that such as add-back was highly discretionary and favored the seller in the transaction. 

Capitalization rate

In addition to questioning the valuators decision to add back certain expenses for the purposes of calculating a controlling value in the stock of the corporation, the court took issue with the capitalization rate used in valuing the ESOP transaction. The same valuator had used rates ranging between 16% and 18% for the purpose of his annual valuations of ESOP stock prior to the litigated transaction but chose to use a rate of 12.2% to value Vinoskey’s sale of remaining shares in Sentry. 

The inconsistencies in rate selection were discussed at great length in the court’s decision, with all building blocks of the capitalization rate compared and contrasted year-to-year.

The court looked at risk-free rates, equity risk premiums, company-specific premiums and growth rates to trace back how each discretionary capitalization rate choice made by the appraiser favored the defendants. The court questioned the reliability of the valuator’s discretionary choices in light of striking inconsistencies between his rates in the litigated report and rates chosen in prior years. 

The court rejected the appraiser’s argument that the transition to a controlling interest in the company necessitated a change in the underlying capitalization rates. 

Lack of projections and discounted cash flows (DCF) methodology

The court emphasized testimony from the plaintiff’s valuation expert who testified that DCF “is the most widely used valuation methodology.” The original appraiser was faulted for rejecting the DCF methodology even though no budgets or forecasts of financial performance were available for him to review and utilize in a DCF model calculation.

The court found that “by a preponderance of the evidence that Evolve [independent bank trustee] could have asked Sentry’s management to assist with developing projections, required Napier [the appraiser] to create projections with input from Sentry’s management, or hired a third-party firm to assist with making projections for Sentry.”

Lookback period

The court took issue with the appraiser’ decision to use a three-year lookback period for the purposes of determining the average cash flows to capitalize under the income approach. The court reasoned that a longer look-back period would have been more reliable due to the cyclical nature of Sentry’s operations. The court’s decision quoted data from the National Bureau of Economic Research which suggested that an average business cycle lasts 5.7-5.8 years. 

Working capital

The court disliked the appraiser’s decision to lower his working capital requirements for the purposes of completing the litigated sale while higher working capital needs were projected after the sale took place and the company kept significantly higher reserves of cash to support its day-to-day operations. 

Conclusion

Although the district court’s decision in Pizzella v. Vinoskey outlined numerous flaws in the valuation report prepared to support the sale of Sentry’s shares, a few items stand out and serve as great reminders to the valuation community. 

A big-picture review of the valuation report and a comparison of valuation results year-to-year should have spurred much needed discussion and raised red flags in reference to the precipitous rise of stock value immediately prior to the litigated transaction.  

An impartial review of the valuation results may have influenced the appraiser to lower the price of Sentry stock to levels comparable to the past or to, at the very least, provide a thorough and definitive explanation for the reasons in increased stock price. The fiduciaries would have been wise to remember that fiduciary duties imposed by ERISA are “the highest known to the law” and any decisions made in fiduciary capacity should have been made with an “eye single to the interests of the participants and beneficiaries.” 

A genuine negotiation with respect to the purchase price of the shares would have bolstered the fiduciaries’ assertion that they held the best interests of ESOP beneficiaries in mind when signing off on the transaction. 

Unfortunately, the independent fiduciaries in this case were found to have divided loyalties with respect to the ESOP and the selling shareholder. They did not fully understand the gravity of their obligations to the ESOP nor act in such a manner as to impress the court that their actions complied with the stringent fiduciary obligations imposed by ERISA.