Walsh v. Bowers

Defendants Brian Bowers and Dexter Kubota owned all the stock in an engineering firm, Bowers & Kubota Consulting Inc. They created an ESOP to which they sold all of their stock for $40 million. The government sued, alleging that they had violated ERISA by manipulating data so that the ESOP paid more than fair market value (FMV) for the stock. The US District Court—Hawaii determined that no ERISA violation had been established.

Part of the government’s case is based on a nonbinding indication of interest by a private company to purchase the company for what the government says was $15 million. The court noted that the amount failed to account for the cash and debt on the balance sheet. The “value” would have been $29 million when adjusting for those amounts. However, no transaction was ever agreed to, so “[t]he indication of interest ends up having little relevance to the fair market value of the Company.”

Government expert Steven J. Sherman valued the business at $26.9 million, but the court noted that his valuation “rests on errors,” and the court was not persuaded by it.

The government did not show that the company was worth less than $40 million, nor did it show that Bowers and Kubota breached any fiduciary duty nor were liable for any prohibited transactions. Thus, the court ruled in favor of Bowers and Kubota and against the government.

Findings of Fact

Overview. On Dec. 14, 2012, Bowers and Kubota (B/K) sold all of the company’s shares to the ESOP for $40 million. The transaction was financed with a 25-year loan from Bowers and Kubota at 7% interest. Upon the sale, B/K ceased to be owners and became employees. The government contended that the deal for $40 million violated ERISA. “Before trial, the Government settled its claims against Saakvitne, the original trustee of the ESOP, and the Saakvitne Law Corporation.” The government made five claims as follows:

1. B/K failed to discharge fiduciary duties properly;
2. B/K were liable for breaches of fiduciary duties of other fiduciaries;
3. B/K engaged in prohibited transactions between a plan and a party in interest;
4. B/K engaged in prohibited transactions with the company’s ESOP; and
5. B/K knowingly participated in a transaction prohibited under ERISA.

The company. The company was a Hawaii corporation that provided architectural, engineering, and construction management services. Bowers bought 100% of the company in 1997. Kubota joined the company in 1988. Ultimately, both Bowers and Kubota put their shares in their respective trusts for their benefit.

Financials and valuations. Both revenues and EBITDA were calculated for several years before the sale and estimated for 2012, the year of the sale. Libra Valuation Advisors (LVA) valued the business as of the date of the sale. LVA had calculated the actual EBITDA at $7,050,000. The government’s expert, Steven J. Sherman (Sherman), calculated an adjusted EBITDA projection for 2012 of $4.9 million, more in line with historical amounts. In November 2012, B/K estimated 2013 to 2017 based on known contracts and their experience.

Initial discussions with URS. Between 2008 and 2012, B/K considered selling the company to others in company management, a private party, or an ESOP. B/K had discussions with URS, which then issued a nonbinding letter of interest indicating its willingness to consider a purchase of the company for $15 million-plus or minus the cash and debt of the company. URS indicated it had done “very little” due diligence before issuing the letter of interest. These addbacks would have brought the company’s value to about $29 million or $30 million. No agreement with URS was ever reached. The court found this nonbinding indication of interest had little relevance to this matter.

The company hired Gary Kuba, CPA/ABV(Kuba), of GMK to prepare “a limited report for internal use only.” Kuba expressed concern about the reasonableness of the company’s projection because it represented a significant increase over the company’s previous performance. Sherman echoed this concern during the trial. Ultimately, GMK and Kuba submitted a value of $39.7 million. The company sent the Kuba valuation to URS even though it was not done for that purpose. Shortly after that, URS and the company terminated negotiations. 

The decision to form an ESOP. Kuba recommended to Bowers that they should hire Gregory M. Hansen, a Honolulu attorney with significant experience in ESOPs. In response to a question from Hansen, B/K answered that they hoped to get $40 million for the company. Hansen conveyed that the purchase price could not exceed the FMV of the company. In the fall of 2012, B/K decided they would form an ESOP, and they desired to get the ESOP created and the transaction done by the end of 2012 to obtain certain tax advantages.

LVA appraisal of the company. In October 2012, Kuba told the company he no longer wanted to work on the valuation because he had become “uncomfortable with the transaction structure.” This might have been related to the transaction at that time being a minority interest with some preferred stock. And Kuba had previously been uncomfortable with the projections. Hansen recommended the company engage LVA and its lead valuation expert, Greg Kniesel, to perform the valuation. LVA sent an engagement letter on Oct. 20, 2012, agreeing to provide a preliminary FMV analysis by Nov. 12, 2012, and a final by Dec. 31, 2012. The preliminary value fell between $37.090 million and $41.620 million.

Hiring Saakvitne as the trustee. On Nov. 21, 2012, a meeting was held wherein Hansen “highly recommended” that the ESOP engage Nicholas L. Saakvitne and his law firm as the trustee for the ESOP. Saakvitne was very experienced in ESOPs and highly qualified to be a trustee. Hansen informed Saakvitne that the transaction was likely a $12 million preferred stock transaction with a “slight chance” to switch to a $40 million 100% transaction. Hansen said he was leaving town on Dec. 19, 2012, and the transaction would have to occur before that date. “Hansen told Saakvitne that he had asked Kniesel to revise LVA’s engagement letter to run directly to the ESOP trustee.” On Nov. 21, 2012, the company and Saakvitne entered into an ESOP plan fiduciary agreement. On Dec. 11, 2012, B/K, in their capacities as officers of the company, adopted the ESOP.

Negotiating the sale to the ESOP. The 100% sale was proposed at $41 million to be financed with seller financing at 10% interest over 20 years. The counteroffer from Saakvitne was $39 million over 25 years at 6% interest. Ultimately, the price was set at $40 million with a loan at 7% over 25 years. The negotiating by Saakvitne saved the ESOP millions of dollars. B/K understood the deal could not close at more than FMV.

The government expressed concern that the deal closed, and B/K had initially asked for the amount. However, Saakvitne had the LVA valuation in hand that indicated the company was worth “at least” $40 million.

Saakvitne did due diligence prior to closing. LVA was hired even though Saakvitne had complete discretion to hire any competent appraiser. LVA executed a new engagement letter with Saakvitne as trustee. “The engagement letter signed by Saakvitne now stated that LVA prepares an analysis concerning the fair market value of the Company’s stock and addressing whether the price the ESOP was paying for the stock was greater than its fair market value, whether the terms of a loan were at least as favorable to the ESOP as a comparable loan from an arm’s length negotiation, and whether any sale was fair to the ESOP from a financial point of view.” On Dec. 14, 2012, LVA concluded that the FMV of the company exceeded the purchase price of $40 million. It also opined that the loan was favorable to the ESOP and that the transaction was fair from a financial point of view to the ESOP.

The government’s expert, Mark Johnson, expressed concern that Saakvitne had rushed the process by spending only 30.1 hours on his due diligence. Johnson also believed that Kniesel did not qualify as an independent appraiser due to his prior work for B/K. Defense’s expert Gregory K. Brown disagreed with Johnson’s assertions.

The government did not carry its burden regarding Saakvitne. It is the government that must prove Saakvitne’s failings. However, the court wished to examine further whether LVA was independent as an appraiser.

LVA’s valuation dated Dec. 14, 2012.

 LVA used the guideline public company method ($44.59 million), the industry acquisitions method (aka comparable company transactions method) ($42.25 million), and the DCF method ($40.39 million). Under the DCF, LVA determined the value in the usual DCF way and then added a 30% premium for control to arrive at their final value. Although the government considered the valuation to be flawed partly because it used the projected EBITDA of $9.24 million, the court believed LVA did not use the projected EBITDA because its tax affected the cash flows arriving at a value. It is not clear from the opinion as to what earnings were tax affected. LVA weighted the three methods, with DCF receiving twice the weight of the other two methods for a combined 100% control value of $41.01 million. Adding $5.328 million of excess cash, LVA arrived at a final value of $47.24 million and then deducted a discount for lack of marketability of $7.09 million for a total value of the company of $40.15 million, or $40.15 per share. 

The government’s expert, Sherman, believed the appropriate EBITDA would have been $4.849 million, which would have yielded values of $21.821 million under the GPCM, and $26.670 million, under the “merged or acquired company analysis.” Defense expert Ian C. Rusk “says that the Company had achieved similar earnings. Because the Company’s earnings were trending upward in 2012 and because of a backlog of contracts, Rusk says the projections were not inaccurate.” The court noted that Sherman should have considered the particular circumstances that Rusk stated, and, therefore, Sherman’s EBITDA was unreliable.

Post-transaction valuations of the company.

LVA’s 2013 valuation. Some two weeks after the transaction, this valuation had adjustments for the debt incurred in the transaction and LVA and did not use the DCF method it used for the transaction. This valuation also had to consider the company’s market with the debt burden. This valuation did not assist the court in determining the value at the date of the transaction.

Steven J. Sherman. The court qualified Sherman, a CPA with over 30 years of experience, to provide a valuation of the company as of Dec. 14, 2012, and an analysis of the LVA valuation. On Dec. 14, 2012, Sherman valued the company at $32.197 million and then deducted $2.994 million for the ESOP’s “limited control.” The court determined that “Sherman significantly and unreasonably undervalued the Company.”

First, Sherman appeared to have ignored USPAP. Defense expert Kenneth Pia stated that “[a]pplication of USPAP was mandatory.” According to Pia, this failure resulted in “substantial errors” in Sherman’s analysis. These were outlined in the opinion and related primarily to the lack of a meeting with management.

Pia also criticized Sherman’s “limited control” discount relating to issues after the transaction. Pia noted that, when applying the AICPA business valuation standards, “the valuation analyst should consider only circumstances existing at the valuation date and events occurring up to the valuation date.”

Sherman also failed to account appropriately for subconsultant fees. This error and the limited control adjustment amounted to an undervaluation by Sherman of $13.515 million. Sherman’s valuation adjusted for this amount would be $40.415 million. Sherman did not credibly undermine LVA’s valuation.

Kenneth J. Pia. The court qualified Pia to provide an independent valuation of the company as of Dec. 14, 2012, and review LVA’s valuation and fairness opinions. “Pia opined that the fair market value of the Company on December 14, 2012, was $43.20 million, or $43.20 per share.” He further opined that Kniesel’s (i.e., LVA’s) conclusions of the FMV range were within a reasonable range. Pia helped evaluate Sherman’s opinion. In light of Pia’s valuation and his defense of LVA’s opinion, the court found that the $40 million does not exceed the FMV of the Company.

Ian C. Rusk. The court qualified Rusk, a business appraiser, as a defense expert to provide opinions as to the FMV of the company as of Dec. 14, 2012. The court found Rusk’s testimony helpful as to some of the financial aspects of the company. Rusk testified that the company’s value as of Dec. 14, 2012, on a nonmarketable control basis, was $43.05 million, or $43.05 per share after a deduction for the risk that the stock could be diluted.

The sale price did not exceed the FMV of the company on Dec. 14, 2012. 

The court summarized the evidence as to the value at the transaction date, including the problems with the Sherman valuation, which the court noted contained notable errors. “Taking into account all of the evidence presented, this court finds that the Company was not sold for more than fair market value.”

Conclusions of law

The defense offered arguments as to the statute of limitations that was discussed in the opinion but was not necessarily relevant since the court decided that the purchase price did not exceed the FMV of the stock. The government also asserted that B/K breached their fiduciary duties, and the court addressed each fiduciary responsibilities complaint.

First, the government asserted that B/K breached its fiduciary duty by sending LVA inflated revenue projections for 2012. The court noted that the government failed its burden of proof in that matter. The government further asserted that B/K sent LVA inflated revenue projections for 2013 to 2017. In the finding of facts, the court noted that the actual revenue growth was between 10% and 14%, so the projections understated real growth.

The government also asserted that B/K breached their fiduciary duties by relying on LVA’s preliminary and fairness opinion. The record did not establish that breach.

The government asserted that B/K breached their fiduciary duty by causing the ESOP to purchase the company’s stock for more than the FMV of the stock. The court found that the stock was not purchased more than the FMV.

The government asserted that B/K breached their limited fiduciary duty to monitor Saakvitne after being appointed the ESOP’s trustee and fiduciary. The government did not prove this assertion by the preponderance of the evidence.

“Paragraphs 40 to 43 of the Complaint assert that Bowers and Kubota are liable for breaches of fiduciary duties by others.” Included was the assertion that Bowers and Kubota were responsible for the fiduciary breaches of each other. The government assertions here relied mainly on the prior arguments of providing false financial projections. However, the evidence undercut the government’s assertions in this regard.

The government also asserted that B/K engaged in prohibited transactions under ERISA. The court noted that the section in the complaint was inapplicable if there was adequate consideration in a sale to an ESOP. The government had the burden of proving that the transaction would be prohibited. However, the court determined that the sale to the ESOP was for adequate consideration. “As already set forth above, because the Government fails to prove that Bowers and Kubota violated any provision of ERISA with respect to the sale of the Company to the ESOP, they have no liability.”

The defendants have asserted that the statute of limitations barred the government’s claims. However, the defendants have not met their burden of proof concerning this defense.

Conclusion

“Based on the above findings and conclusions, this court rules that the remaining Defendants … did not violate any provision of ERISA with respect to the sale of the Company to the Company’s ESOP. Accordingly, the Clerk of Court is directed to enter judgment in favor of the remaining Defendants and against the Government and to close this case.”