Despite criticism from the ESOP community, the Department of Labor is not abandoning its litigation-prone approach toward ESOPs, as a recently filed lawsuit makes clear. Following its playbook, the DOL, in its complaint with the Southern District of New York, alleges the ESOP trustee violated its fiduciary duties to the plan by causing the ESOP to overpay for the company stock. The trustee failed to negotiate in good faith as to the price and terms and scrutinize the valuation underlying the transaction, the DOL says.

Conflicted appraiser? The contested transaction involved Stargate Apparel and a sister company, Rivstar Apparel, private companies that produce denim jeans and swimwear for the junior market. Stargate’s founder and CEO owned essentially 100% of the two companies.

According to the DOL complaint, in the latter half of 2010, the owner hired CSG Partners, an investment bank specializing in ESOPs, to advise him on a possible ESOP transaction. On CSG’s recommendation, the owner engaged an appraisal firm to produce an initial valuation of the companies. The DOL claims that, before any valuation was done, CSG communicated to the appraiser what kind of offer the owner was prepared to make. The appraisal firm then produced a draft valuation that was in line with the offer.

CSG then proposed Wilmington Trust as ESOP trustee. Wilmington hired as ESOP appraiser the very firm that had done the initial valuation for the owner/seller, on recommendation of CSG. The DOL contends Wilmington either failed to investigate the ESOP appraiser’s prior relationship with the owner and CSG or Wilmington hired the ESOP appraiser knowing that the latter had earlier worked for the owner “in connection with the same proposed transaction.” Either way, Wilmington failed to hire an independent appraiser, the DOL claims.

The complaint also says Wilmington was remiss in its duty to “thoroughly review, analyze, and question any valuation report on which it relied.” The valuation report here was “rife with red flags,” the DOL says. It points to projections concerning the companies’ future revenue and earnings “that far outstripped the Companies’ historical performance” and that had operating expenses that “were far more modest than the Companies’ historical spending.” Also, Wilmington was aware of a third-party lawsuit against Rivstar in which the plaintiff alleged accounting irregularities, which Wilmington’s counsel called “rather serious.” Regardless, Wilmington “accepted at face value the Companies’ internally prepared financial statements for 2010,” which “showed a dramatic increase in earnings and unexplained efficiency gains over the previous years,” the complaint says.

The complaint makes other allegations. The DOL asks the court to order Wilmington to restore all losses to the ESOP and return to the ESOP all fees earned from the contested transaction and subsequent work as ongoing ESOP trustee.

 Stay tuned for more commentary on this litigation as it unfolds. The case is Acosta v. Wilmington Trust, U.S. District Court for the Southern District of New York, Civil Action No. 19-2793 [Complaint filed 3/28/19].

If you are contemplating selling your business, one of the most important considerations is whether to structure the sale as a stock or asset deal.  Most public company acquisitions are on a stock basis.  However, privately held company transactions can be either stock or assets sales.  Deal structure can be highly important as the advantages for one side can create disadvantages for the other side. 

Generally, a seller typically favors a stock deal and a buyer typically favors an asset deal.  All transactions are different, so facts and circumstances should be analyzed fully with tax and legal counsel.  Here are some advantages and disadvantages to a buyer and seller in an asset sale. 

Buyer Advantages:

·         Tax basis of assets acquired is fair market value. 

·         Price paid is deducted, amortized, or depreciated. 

·         Buyer can choose the business structure or form.

·         Selected assets are bought and liabilities assumed. 

·         More debt and equity structuring flexibility.

·         Less exposure to contingent liabilities. 

Buyer Disadvantages:

·         Buyer usually can’t use seller’s tax accounting methods – problem if assets on books are worth more than fair market value.

·         The Buyer may desire to keep certain contract rights.

·         May get a step-down in basis if there is bargain purchase.

·         C and reorganizations may limit basis step-up.

·         Built-in capital gains tax for certain S-corporations.

Seller Advantages:

·         Less warranty exposure obligation to the buyer. 

·         If no built-in capital gains tax, the buyer gets more flexibility often with little cost to the seller. 

·         Easier to retain selected or non-operating assets. 

·         Seller may keep some tangible or intangible assets.

·         Gives the buyer greater flexibility in structuring the transaction.  

Seller Disadvantages:

·         C corporation or recently converted S corporation and double taxation.   

·         If the company is a C or S corporation with built-in capital gains tax exposure, can be double tax cuts for seller.

·         Buyer may underpay for unwanted assets.

Contract rights may not be easily transferred.