Judge Rules on DOL ESOP Challenge with Mixed Results

The U.S. District Court for the Western District of Virginia has issued a mixed ruling on a lawsuit filed by the U.S. Department of Labor (DOL) against the fiduciaries of a Virginia-based employee stock ownership plan (ESOP), offered to employees of Sentry Equipment Erectors Inc.

The DOL lawsuit alleges the defendants failed to protect the assets of the plan as it purchased nearly $21 million in company shares from an executive of Sentry Equipment Erectors Inc., who was also a trustee of the ESOP. The firm’s executive Adam Vinoskey and several other defendants are called out by name for fiduciary violations relating to the sale of company stock to the ESOP at an inflated price in 2010. The overpayment, according to DOL, caused a direct loss to the plan and constituted a prohibited transaction under the Employee Retirement Income Security Act (ERISA). DOL investigators also sought to prove the sale directly injured plan participants who had already earned Sentry stock, as the value of their stock declined because of the company’s substantially increased debt load.

The mixed decision comes after DOL Secretary Alexander Acosta moved for summary judgment on these claims. The defendants responded by moving to exclude key testimony from a DOL expert on the doctrine of “adequate consideration,” crucial to the settlement of this matter. Additionally, some of the defendants have individually moved for summary judgment—to be carved out of the lawsuit for not in fact being fiduciaries.

The decision lays out the following conclusions of the court with respect to these cross motions: “The court will partially exclude the Secretary’s expert testimony because portions of his damages theory are novel and underdeveloped. Concomitantly, the court will grant the defendants’ motions for summary judgment on the claims the Secretary no longer has expert testimony to support. The court will also grant one of the alleged fiduciaries’ motions because no reasonable jury could find he is a de facto fiduciary.”

The district court also “will deny the parties’ motions on the remaining claims because factual disputes (namely whether reliance on a valuation report was reasonable) remain.”

Explaining the reasoning for the partial exclusion of the DOL’s expert commentary, the court highlights how the expert calculates two categories of damages allegedly suffered by the ESOP. First, the amount overpaid for Sentry shares, and second, the loss in value to existing plan participants’ shares because of the structure of the purchase.

The decision clarifies the matter as follows: “The expert’s report calculates the first category of damages by determining a fair market value for Sentry stock and then asking how much more than that the ESOP actually paid. The court finds the expert’s testimony concerning this category of damages will be partially admissible. The expert’s second category of damages is calculated by multiplying the amount allegedly overpaid per stock by the existing shares held by plan participants. These damages are supposed to represent a separate harm: the loss in value to the existing shares because of the transaction’s structure. Because the court finds this methodology is unreliable and underdeveloped, it will be excluded. The defendants’ other objections to the admissibility of the expert’s testimony will be overruled.”

On the first point, the court observes that the expert calculated the damages by subtracting his calculation of the fair market value of the shares purchased by the ESOP from the price the ESOP actually paid. “This is a common approach,” the decision states. “The expert determined the fair market value of Sentry shares with a discounted cash flow model and a comparison to a guideline company. Other courts have accepted the use of these models.”

The expert’s second category of damages, i.e., the damages the ESOP allegedly suffered from a decrease in the value of the Sentry stock it already owned, “suffers from a more fundamental problem.” The expert calculated these losses by multiplying the alleged overpayment per share from his first category of damages by the number of shares existing at the time of the transaction.

“This calculation falters for two primary reasons,” the decision states. “First, it double counts the losses allegedly caused by the defendants. The defendants correctly demonstrate that any reduction or increase in the first category has a proportional effect on this second category. This is problematic because it effectively claims the ESOP overpaid twice: once for the shares it was purchasing in this transaction and once for the shares it already owned. The expert is never able to sufficiently explain why he is applying the overpayment damages to the shares the ESOP already owned. … Second, despite the Secretary’s allegations of loss in stock value to the existing employees, the account balances of the existing Sentry plan participants increased as a result of the transaction. … It is difficult to see how the existing shareholders could have incurred this second category of damages if their accounts increased. Even if they hypothetically did incur some damage, for example, if their accounts would have increased more without the transaction, the expert’s methodology does not provide any basis to figure out what those damages would be.”

The DOL briefly raises other defenses concerning the relevance of its calculations and the tax ramifications of the deal’s structure. But “none of these arguments, even if credited, can rehabilitate the problems with reliability identified above.”

“The Secretary has not provided any examples of this methodology being used or accepted elsewhere, and the court has found none,” the decision states. “Accordingly, the court concludes the methodology used to calculate the second category of damages is unreliable, and so it will be excluded here. The court addresses the defendants’ remaining objections insofar as they concern the first category of damages.”

After substantial reflection on all these matters, the court concludes that, in sum, the majority of the expert’s testimony is still both reliable and relevant: “He is qualified to testify; he considered sufficient data to provide helpful testimony (even if his failure to adequately consider certain portions of the record should lead the court to discount some of his conclusions); he used a reliable methodology to calculate damages arising from overpayment for Sentry stock; and he reliably applied most of his methods. However, the court will limit his testimony in two respects: He will not be able to present the methodology used to calculate damages to the existing shareholders or utilize the market comparable methodology in his valuation of Sentry’s market value.”

The decision goes on to consider the cross-motions for summary judgement, also in great detail, before reaching the following conclusion: “The court will grant New’s motion for summary judgment [to be carved out of the case]. Otherwise, the motions concerning Counts I through III will not be granted. Based on the above determination to partially exclude the Secretary’s expert testimony, the defendants’ motion for summary judgment on Count IV will also be granted.”

The full text of the decision, in which the court summarizes the record before working through each of the claims, is educational.

Restating the conclusion of the decision, the court lays out the following in its conclusory statement: “The expert testimony will be admitted in part; he will be allowed to testify on everything except his second category of damages and his market comparable approach. The court will exclude that testimony as unreliable. New’s motion for summary judgment will be granted because reasonable factfinders would agree he is not a fiduciary. This is largely due to the Lenoir’s supervisory role. Summary judgment will be denied, for both Evolve and the Secretary, on Counts I and II. This is because of remaining factual disputes concerning the reasonableness of Evolve’s reliance on Napier’s appraisal. The Secretary’s motion for summary judgment against Vinoskey will be denied because Count III requires a breach by another fiduciary, something that is still disputed. Evolve’s motion for summary judgment on Count IV will be granted, however, based on the exclusion of Messina’s second category of damages.”