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The Employee Ownership Update

Corey Rosen

November 11, 1996

(Corey Rosen)

Circuit Court of Appeals Holds Trustees Cannot Simply Accept a Valuation

In a major employee stock ownership plan (ESOP) decision (Howard v. Shay, 9th Cir., No. 93-56605, 11/22/96), the U.S. Court of Appeals for the Ninth Circuit reversed a lower court ruling that approved a valuation that provided ESOP participants with a price that was 16% of the enterprise value of the company. The case involved Pacific Architects and Engineers, which set up an ESOP in 1974 that bought 40% of the company at $10 per share from Edward Shay, then the president and chairman. Shay also acted as a trustee throughout the ESOP along with two other officers. In 1988, the ESOP was terminated at a price of $14.40 per share. The company hired Arthur Young, Inc. to do the valuation. The resulting appraisal said the business as a whole was worth $83 per share, but applied a 60% discount to its minority interest in Japanese real estate, an additional 40% discount for the ESOP's minority interest in the company, and a 50% liquidity discount for not having publicly traded shares. All these discounts were substantially above normal practice.

ESOP participants sued, but the trial court ruled in favor of the fiduciaries. On appeal, the court reversed the trial court decision, concluding that conflicted fiduciaries have an obligation to do more than just select a qualified professional appraiser and give that person good information. Instead, fiduciaries must make "an honest, objective effort to read the valuation, understand it, and question the methods and assumptions that do not make sense. If after a careful review of the valuation and a discussion with the expert, there are still uncertainties, the fiduciary should have a second firm review the valuation." The decision does not address the issue of whether non-conflicted trustees would have a similar obligation. While the facts of this case were particularly egregious, the decision should stand as a warning to ESOP fiduciaries that their role should be much more proactive than simply accepting an opinion from a qualified appraiser.

ESOP Participants Do Not Have a Right to ESOP Valuation

In another appellate decision (Faircloth v. Lundy Packing Company, 4th Cir., 8/2/96), the U.S. Court of Appeals for the Fourth Circuit ruled that ESOP trustees are not required to provide a copy of the ESOP appraisal to participants who have requested it. The appraisal could become available through discovery in court proceedings, however.

Merger of ESOP and 401(k) Plan Can Satisfy 30% Ownership Threshold for ESOPs

In Private Letter Ruling 9639071, for release on September 23, 1996, the IRS ruled that the employer stock owned in a 401(k) plan that is merged into an ESOP will count towards the total amount of stock owned by the ESOP for purposes of meeting the 30% threshold to qualify for section 1042 treatment. Section 1042 allows sellers to ESOPs in closely held firms to take a tax deferral on reinvestments of their gains if the ESOP owns 30% or more of the company and certain other requirements are met.

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