The Business Divorce Law Report
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The application of a control premium more than doubled the claimed value of a business purchased its employees through and ESOP
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An investment banking firm involved in the transaction is subject to claims that it was biased because the fee it earned was contingent on the purchase price.
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The valuation firm that conducted the annual valuation required by federal regulations faces claims that it was not independent.
A valuation that applied a control premium to shares acquired by an Employee Stock Ownership Plan (ESOP) would have inflated the value of the now-bankrupt company by as much as 61 percent, according to the plaintiffs in an action against the trustees of the ESOP, its investment bank and the firms that valued the business.
In a case heard by the Seventh Circuit Court of Appeals, the plaintiff’s claims of breach of fiduciary duty and engaging in prohibited transactions under the federal Employee Retirement Income Security Act (ERISA) were upheld even though the defendants wanted to dismiss the complaint. This was because the plaintiff sufficiently alleged wrongdoing in the valuation of the business.
ESOP Owning Bankrupt Company Sues Over Value Reports
The Seventh Circuit Court of Appeals in Appvion Inc. Retirement Savings and Employee Ownership Plan v. Butha held that the plaintiff’s claims for ERISA violations related to the valuation of the
business after 2012 would proceed.
The gist of the plaintiff’s claims in the lawsuit is that employees approved the acquisition of the stock of the company based on the flawed valuation presented by an investment banking firm that received a contingent success fee of more than $8 million and that the annual valuations of the company were inaccurate and misleading.
Appvion, formerly known as Appleton Papers, specialized in carbonless paper and thermal paper. The French conglomerate Arjo Wiggins Appleton (Arjo), which owned it, had been unable to find a buyer. Arjo offered a contingent fee of up to $10 million to Appvion’s officers, including its then-CEO Douglas Buth, if they managed to sell Appvion for over $700 million. Aro authorized Buth to attempt to sell the company to its employees in an ESOP.
In an ESOP, the plan purchases the shares of the company as a trustee for the employees. After that, the plan allots shares to the employees and then buys them back when they retire. ESOPs are governed by regulations of the U.S. Department of Labor and must be valued annually.
Plaintiff’s Claim: Investment Bank Earned Contingent Value Based on Tainted Valuation
Appvion hired investment banking firm Houlihan Lokey, agreeing to pay Houlihan 1% of the final sale price if the deal closed. Houlihan in turn engaged State Street Bank and Trust Company to be the trustee of the employees’ ownership interest in Appvion and hired Willamette Management Associates to appraise Appvion. Willamette valued Appvion at $810 million. Houlihan then issued its own opinion that $810 million was a fair price for Appvion, even though the company had asserted that no firm with a contingent fee was qualified to issue a fairness opinion.
In November 2001, the employees voted in favor of buying Appvion, contributing $107 million and borrowing $700 million.
Appivon failed and ultimately filed for bankruptcy. The plaintiff claimed that not only was the initial valuation biased and inaccurate, so were the subsequent annual valuations.
The involved valuation firms are accused of relying on financial projections provided by Appvion’s directors and officers that were overly optimistic. These projections did not accurately reflect the realistic future cash flows or financial performance of the company, leading to inflated valuations.
The defects in the valuation reports, according to the plaintiff, included the following:.
Faulty Use of a Control Premium: A control premium is typically added to reflect the added value of having a controlling interest in a company, which could allow the controlling party to dictate strategic decisions.
However, in this case, the plaintiff contended that the ESOP participants did not genuinely have such control, since the real control was retained by the company’s directors and executives. The premium inflated the value of the stuck and, therefore, applying a control premium misrepresented the value and misled the plan participants.
The most troubling allegation is that Stout used a control premium in appraising the price of a share of Appvion. From 2012 to 2014, Stout added a 10% control premium “to the company’s enterprise value to account for the Plan’s controlling interest. The control premium had an outsized effect on Appvion’s appraised value. For example, in the December 2014 valuation, the control premium accounted for roughly 61% of the appraised value of the Plan’s equity in Appvion. That translated directly into much higher share prices for Plan participants. Yet these price increases were not justified by actual control. State Street had long ago ceded to Appvion’s CEO most of the Plan participants’ power over the composition of Appvion’s Board, and the Plan participants were allowed to vote only on extraordinary actions by the Board (such as a sale of the company). For all other matters, the trustee was required to vote the Plan’s shares as directed by the ESOP Committee.”
Exclusion of Significant Liabilities: The plaintiff claimed that the valuations consistently failed to consider account for all of Appvion’s liabilities, particularly unfunded pension liabilities. This omission significantly inflated the company’s net worth and equity value presented to the ESOP participants.
Independence and Conflict of Interest Misrepresentations: The complaint details that the appraisers’ evaluations were represented as independent and fair while not disclosing the potential conflicts of interest, particularly the contingent nature of fees paid to the financial advisors and appraisers involved. Such fees were dependent on the transaction closing, which could incentivize higher valuations to ensure the deal proceeded.
The court noted that as fiduciaries of the plan, the ESOP directors were subject to a “duty of prudence” that required them to make an honest, objective effort to read and understand the valuation, and to question the methods and assumptions that do not make sense.
This case articulates the risks and responsibilities of fiduciaries under ERISA. Companies engaged in ESOP transactions and their advisors must heed ERISA standards, particularly concerning valuation and conflict of interest.