Opinion ID: 794065
Heading Depth: 2
Heading Rank: 3

Heading: The Terms of the ESOP Transaction

Text: 10 On March 8, 1994, U.S. Trust and KMC met with senior CommutAir management to negotiate improvements to the convertible preferred stock offered by the sellers. Goldberg testified that the following issues were discussed at this meeting: (1) a limitation on management compensation; (2) the insertion of an anti-dilution provision; (3) a liquidation preference and redemption rights for the preferred stock; (4) full voting rights for the preferred stock; (5) the dividend rate for the preferred stock; (6) the participating feature of the dividend rights; and (7) the perpetual nature of the dividend. There is no written record of this meeting, but the negotiations resulted in improvements favorable to the ESOP, including an increase in the stock's cumulative dividend rate from 7% to 9%. These improvements pertained to the value of the security and not its purchase price. At trial, Goldberg explained: It [was] what do you get for sixty million dollars or what do you give up for sixty million dollars, that was the negotiation. 11 On March 10th, the day U.S. Trust's special fiduciary committee was to determine whether to approve the proposed transaction, Goldberg received two faxes. The first was a due diligence report from KMC. The second was a memo from HLHZ stating that [t]he heavy fare reductions instituted by USAir in February 1994 as a preemptive move against low-cost entrants, Southwest and CALite, are contributing to the company's widening losses. The memo asserted that cost-cutting might be necessary at USAir, but that, as it is currently structured, USAir Express is satisfied from an economic standpoint with the arrangement it has with its commuter franchisees. The memo also contained an amended page of the HLHZ opinion that revised the terms of the convertible preferred stock by altering the terms of the performance dividend and changing the cumulative dividend rate from 7% to 9%. Shortly after receiving these faxes, the special fiduciary committee unanimously approved the proposed transaction. 12 On March 15, 1994, HLHZ presented U.S. Trust with a 104-page final valuation report on the CommutAir stock to be purchased by the ESOP. 2 HLHZ's report discusses the commuter airline industry and CommutAir's history and the nature of its business (including its competitors, facilities, management, and code-sharing arrangement with USAir), and provides a financial review of the company's balance sheet and projections. The report describes HLHZ's valuation methodology, its valuation analysis (including a discussion of CommutAir's performance and risk factors in relation to comparable companies), the attributes of the securities offered to the ESOP and how they compare to similar publicly-traded securities, and the financing terms of the transaction. It concludes that the consideration the ESOP received was fair, that the price it paid for CommutAir stock was no greater than fair market value, and that the overall terms of the financing of the purchase were reasonable. 13 Upon receipt of this report, CommutAir, the sellers, and U.S. Trust signed a stock purchase agreement. Per the agreement, the sellers agreed to sell 540,000 shares of convertible preferred CommutAir stock to the ESOP at a price of $111.11 per share for a total of $60 million. The sale was financed through a $9 million loan from CommutAir and three promissory notes totaling $51 million issued by the ESOP to the individual sellers. The convertible preferred stock had a fixed annual 9% dividend and a non-cumulative performance dividend. Dividend payments to the ESOP were to be used to pay down its indebtedness to the sellers and shares were to be allocated to individual employees' accounts as the debt was retired. 14 In 1998, the IRS issued CommutAir notices of deficiency asserting that the ESOP had overpaid for company stock in the 1994 transaction. CommutAir and the sellers challenged the notices in the United States Tax Court, and in September 1999, the parties reached a settlement that substantially reduced the alleged tax deficiencies. The parties assumed, solely for the purpose of settling the tax dispute, that the 1994 transaction shares were worth $51 million. Neither the IRS nor the sellers sought an independent valuation of the shares. Thus, the IRS settlement did not represent a finding that the fair market value was $51 million at the time of the purchase, but only that the IRS believes it to be — a belief in no way binding in the subsequent ERISA action. See Henry v. Champlain Enters., Inc. ( Henry I ), 288 F.Supp.2d 202, 228 n. 15 (N.D.N.Y. 2003). 15 Plaintiffs-appellees filed their initial complaint on November 1, 2001, and an amended complaint on February 21, 2003. The only claims that survived summary judgment were brought under §§ 404 and 406 of ERISA. These claims alleged that U.S. Trust's investigation into the terms of the CommutAir ESOP transaction failed to qualify for ERISA's good-faith exception to the prohibition against transactions by ESOPs with interested parties, thereby rendering the transaction prohibited. On September 3, 2004, after an eleven-day bench trial, the district court issued its findings of fact and conclusions of law, finding that U.S. Trust's investigation into the terms of the 1994 transaction failed to satisfy the good-faith requirement for the establishment of ESOPs and that the transaction was thus prohibited under ERISA § 406. U.S. Trust appeals from the district court's judgment and award of $15,713,745.11 in damages, prejudgment interest, and attorney's fees to the plaintiffs-appellees.