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In light of the recent stock and accounting scandals involving businesses such as Enron, WorldCom and Arthur Andersen, the U.S. Department of Labor (DOL) and the courts are enforcing more strictly the provisions of the Employee Retirement Income Security Act (ERISA), 29 U.S.C. 1001-1461, the statute that governs the creation and administration of employee stock ownership plans (ESOPs). As a result of this heightened scrutiny, ESOP fiduciaries must thoroughly understand and completely perform the ESOP duties which employees entrust to them, or risk becoming embroiled in costly and time-consuming litigation. Generally, ESOPs are plans authorized under ERISA that permit substantially all of a plan’s assets to be invested in employer securities for subsequent distribution to employee participants upon their retirement. As with other ERISA plans, ESOP fiduciaries must administer the plan with the “care, skill, prudence, and diligence” that a “prudent man” would exercise. 29 U.S.C. 1104(a)(1)(B). NO SELF-DEALING ERISA generally prohibits employee benefit plans from purchasing employer stock because such transactions pose an intrinsic risk that plan trustees will engage in “self-dealing” and “conflicts of interest,” to the detriment of plan participants. Herman v. Mercantile Bank N.A., 143 F.3d 419, 425 (8th Cir. 1998) (Bright, J., dissenting) (citing 29 U.S.C. 1106(a)(1)(A), (D)). A narrow exception to this prohibition, permitting the creation of ESOPs, applies when the purchase of the employer stock is for “adequate consideration” as defined by ERISA. 29 U.S.C. 1108(e). Accordingly, one principal duty of every ESOP trustee is to make sure that the ESOP purchases the employer stock for adequate consideration. In recent cases involving ESOP transactions, the DOL has alleged that ESOP trustees breached their fiduciary duties and violated ERISA when they purchased employer stock for the ESOP for greater than fair market value. These developments reflect an increasingly strict enforcement of the statute. In ordinary English usage, “adequate consideration” is defined as fair compensation or sufficient “recompense for work done.” “Random House Webster’s Dictionary” 434 (2d ed. 2001). However, in a recent decision by the 6th U.S. Circuit Court of Appeals, the court held that payment of “fair market value” by an ESOP for employer-issued stock is only one of the two essential elements comprising “adequate consideration.” Chao v. Hall Holding Company Inc., 285 F.3d 415, 436 (6th Cir. 2002) (citing the dissent in Herman v. Mercantile Bank N.A., 143 F.3d 419, 425 (8th Cir. 1998)). In addition to that element, ESOP trustees must also demonstrate they made a “good faith determination” of the price of the employer stock before they purchased it. Id.In so holding, the 6th Circuit joined the 2d, 3d, 5th, 7th and 9th circuits in requiring a good-faith determination to be made at the time of the purchase of the stock by the ESOP. See In re Unisys Savings Plan Litigation, 74 F.3d 420, 434 (3d Cir. 1996); Eyler v. Commissioner of Internal Revenue, 88 F.3d 445, 454-55 (7th Cir. 1996); Katsaros v. Cody, 744 F.2d 270, 279 (2d Cir. 1984); Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983); Donovan v. Mazzola, 716 F.2d 1226, 1231 (9th Cir. 1983). In Chao, the 6th Circuit affirmed a lower court’s finding that the trustees of an ESOP for the employees of Hall Chemical Co. breached their fiduciary duties during the valuation of the Hall Chemical stock to be purchased by the ESOP. Id.at 432-34. Apart from improprieties arising from the expert valuation conducted for the ESOP, the court found that the trustees were generally not informed about the status of the ESOP formation, had not been conferred with concerning significant decisions regarding it, had failed to negotiate as to the $3.5 million purchase price of the employer stock and overpaid in excess of $1 million above fair market value for the $3.5 million worth of stock. In addition, the court found there was “more concern” over the interest rate on the loan for the funds being borrowed by the ESOP to purchase the stock with the investment return of the bank, than with the ESOP, and the trustees had never consulted with legal counsel concerning the formation of the ESOP. Id.at 432, 434. The court found that the trustees had “no idea” how it was decided that $3.5 million worth of shares was going to be purchased, and could not remember whether an administrator of the ESOP was appointed as required by the plan. Finally, the trustees had even permitted the director of the human resources department to round up the calculated odd-numbered stock purchase price of $3.4551 million to $3.5000 million for “purposes of communication,” effectively overcharging the ESOP $44,900 for the stock it purchased. Id.at 420-22; 429-434. In affirming summary judgment for the plaintiff, Labor Secretary Elaine L. Chao, the 6th Circuit found that the above facts demonstrated that the defendant ESOP trustees had failed to make a “good faith determination” of the Hall Chemical stock value prior to its purchase by the ESOP. 285 F.3d at 419. ADOPTING ‘HERMAN’ DISSENT By requiring the ESOP trustees to prove on a strict basis that they made a good-faith determination of the value of the employer stock, the 6th Circuit explicitly adopted the approach of the dissenting opinion in Herman, 143 F.3d at 422-28, creating a disparity among the circuit courts on this issue. In Herman, the 8th Circuit held that ESOP trustees did not breach their fiduciary duties when they “bought back” employer stock from Jerry Ford, a third party. Id.at 423-24. The day before the buyback, the board of directors of the company sold it to Ford. However, Ford had difficulties obtaining financing and had to leverage the company to purchase it. Id.Because of Ford’s financing difficulties, the ESOP was required to buy back the stock of the company then held by him. Id. The lengthy dissent by Senior Judge Myron H. Bright sharply criticized the majority, having been persuaded that the ESOP trustees failed to determine whether the buyback was in the long-term best interests of the employees. Id.at 425-27. According to the dissent, in the ESOP’s initial sale of the company stock to Ford, the ESOP trustees breached their fiduciary duties by failing to investigate either the management qualifications of Ford or the heavily leveraged financing scheme he was using to acquire the company stock. Id.at 426. A BREACH, INDEED According to the dissent, the trustees breached their fiduciary duties again when they bought the stock back from Ford at the same price he paid for it. Id.The dissent agreed with the plaintiff’s expert that the company lost a significant portion of its value when it incurred substantial debt during Ford’s leveraged acquisition. Id.at 426-27. Finally, the dissent found that the co-defendant ESOP trustee Mercantile Bank breached its fiduciary duties to the ESOP because of an apparent conflict of interest between the ESOP and certain other trusts of which it also served as trustee. Id.at 423, 426. TIP OF THE ICEBERG Given the outcry of national concern over employee-retirement savings plans, more courts may be deciding cases like the 6th Circuit in Chaoand the 8th Circuit dissent in Herman. Accordingly, to avoid and defend against allegations of breach of fiduciary duties, ESOP trustees may have to demonstrate that they paid fair market value for the employer stock on the precise day the ESOP purchased the employer stock; made a good-faith determination of the value of the stock prior to its purchase, regardless of whether they paid fair market value for it; and that the ESOP purchase benefited the long-term interests of the plan employees. Even the advice of an expert appraiser to value employer stock before purchase by the ESOP may not necessarily insulate ESOP trustees, particularly if the evidence shows that the appraisal was a “whitewash.” Chao, 285 F.3d at 430 (quoting, Howard v. Shay, 100 F.3d 1484, 1489 (9th Cir. 1996)). In Chao, the 6th Circuit held that there are three fiduciary requirements that ESOP trustees must meet with regard to relying upon expert valuations. First, the ESOP trustee must investigate the qualifications of the expert. Second, the trustee must provide the expert with thorough and precise information regarding the transaction. Third, the trustee must independently ensure that reliance on the expert’s advice is “reasonably justified” under all the facts and circumstances. Id.(quoting Howard, 100 F.3d at 1489). EXPERTS NOT ENOUGH In Chao, the trustees of the Hall Chemical ESOP unsuccessfully tried to rely on the expert valuation of an independent appraiser the trustees retained prior to the ESOP’s purchase of the Hall Chemical stock. Chao, 285 F.3d at 429. The 6th Circuit held that their reliance was not justified because the ESOP trustees had failed to meet two of the three fiduciary requirements. First, the trustees did not provide the appraiser with sufficient information regarding the transaction. The trustees neglected to inform the appraiser about the purpose of the valuation, which was to establish an ESOP, or that the president-trustee had certain rights to acquire stock in Hall Chemical — which might dilute its value. Id.at 430-31. The 6th Circuit relied on the appraiser’s deposition testimony that he would have conducted the valuation differently, had he known that its actual purpose was to form an ESOP to acquire a minority interest in a privately held company. Id. Second, the 6th Circuit found that the trustees’ reliance on the expert valuation was not reasonably justified since he did not value the correct entity. Id.The appraiser valued Hall Chemical despite the fact that the trustees were actually selling the stock of Hall Holding, of which Hall Chemical was its principal asset. Id. Although the entities were related, they were not identical since Hall Chemical was presumably only one among other assets of Hall Holding, and the appraisal was thereby inadequate. Id. EXPERT VALUATION IS NOT ALL Chaoholds that fiduciary obligations regarding proper valuation of employer stock for the ESOP are not satisfied by reliance on expert valuations alone. In essence, Chaois imposing on ESOP trustees a requirement that they become more knowledgeable, informed and familiar with the ESOP transactions to which they have been entrusted. Such additional knowledge and information are necessary for ESOP trustees to impart all the requisite ESOP stock-purchase information effectively to their chosen expert appraiser to enable the expert to make a fully informed valuation, and for the trustees validly to decide to rely on it. Significantly, a trustee can breach its fiduciary duties unintentionally. The 6th Circuit specifically held in Chaothat there is no “subjective intent” requirement to prove an ESOP trustee breached its fiduciary duties with regard to overpaying for employer stock for the plan., 285 F.3d at 442. Rather, as the 6th Circuit discussed, most courts have found that ERISA violations relating to the purchase of stock for an ESOP are “per se violations.” Id.Accordingly, with regard to expert valuations, ESOP trustees must be aware that an unintentional failure under ERISA may render the trustees as liable as they would have been for an intentional violation. In light of the current national focus on the preservation of retirement savings of older Americans, the DOL and courts are closely scrutinizing ESOP trustee purchases of employer stock and bringing suit under ERISA for breach of fiduciary duties in appropriate circumstances. Based on the recent ESOP court decisions, ESOP trustees seeking to assure full legal compliance may seek to establish the following five prerequisites before purchasing employer stock. � Thoroughly learn and completely understand the basic method of the stock valuation. � Participate in the process of negotiation of the stock price. � Avoid even the appearance of self-dealing or conflicts of interest (especially in situations where the trustee is a fiduciary of another entity with opposing interests). � Independently investigate any expert appraiser’s qualifications and provide the expert appraiser with complete and accurate information. � Perhaps most importantly, independently assess and assure that the purchase of employer stock will benefit the long-term interests of the employees and the growth of the company. Peter H. Harutunian is an associate with Phillips Nizer LLP, www.phillipsnizer.com, in New York.

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