Court Opinion

ID: 2998108
Source: CourtListenerOpinion
Date Created: 2015-09-24 19:41:04.799257+00
Date Added: 2024-06-11T13:22:45.493560
License: Public Domain

In the
 United States Court of Appeals
              For the Seventh Circuit
                        ____________

No. 04-1901
DEBRA K. KEACH and
PATRICIA A. SAGE,
                                            Plaintiffs-Appellants,
                               v.

U.S. TRUST COMPANY, formerly
known as U.S. Trust Company of
California N.A.,
                                              Defendant-Appellee.
                        ____________
           Appeal from the United States District Court
                for the Central District of Illinois.
            No. 01 C 1168-—Michael M. Mihm, Judge.
                        ____________
    ARGUED DECEMBER 10, 2004—DECIDED AUGUST 17, 2005
                        ____________

 Before RIPPLE, MANION and WOOD, Circuit Judges.
  RIPPLE, Circuit Judge. Debra Keach and Patricia Sage,
participants in the Foster & Gallagher, Inc. Employee Stock
Ownership Plan (“ESOP”), filed this action against U.S.
Trust Company, N.A. (“U.S. Trust”) and others for alleged
2                                                      No. 04-1901

violations of the Employee Retirement Income Security Act
of 1974 (“ERISA”), 29 U.S.C. § 1001 et seq., in connection
with the ESOP’s December 20, 1995 purchase of shares of
Foster & Gallagher, Inc. (“F&G”) stock from the defendant
F&G officers and directors. The district court conducted a
fourteen-day bench trial and then entered judgment in favor
of U.S. Trust. Ms. Keach and Ms. Sage now appeal from that
decision. For the reasons set forth in the following opinion,
we affirm the judgment of the district court.

                                  I
                        BACKGROUND
A. Facts
                                                                     1
  The facts of this case are, for the most part, undisputed.
F&G was a direct mail marketing company engaged in the
marketing of gifts, housewares and novelty items. Over
time, F&G acquired several companies, many of which
marketed horticultural products through the mail. The F&G
ESOP began in 1988, when it purchased about thirty percent
of F&G’s stock from the company’s founders. In 1995, after
Thomas Foster, CEO and Chairman of the F&G board of
directors, became terminally ill, a leveraged purchase of a
large number of F&G shares by the ESOP was proposed. At
that time, F&G had been enjoying record profitability for
several years and was forecasted to continue this trend into
the future. On December 20, 1995, the ESOP, with U.S. Trust
acting as its trustee, purchased 3,589,743 shares of F&G
stock from several F&G officers and directors at a price of

1
  The district court’s opinion contains an extensive plenary re-
view of the facts in this case. See Keach v. U.S. Trust Co., N.A., 313
F. Supp. 2d 818 (C.D. Ill. 2004). This summary sets forth those
facts relevant to the parties’ contentions on appeal.
No. 04-1901                                                 3

$19.50 per share (the “ESOP II transaction”). For the next
two years, F&G did enjoy record business; however, in 1998,
its profits began to decline steadily until F&G declared
bankruptcy in 2001. Ms. Keach and Ms. Sage filed this
action in April 2001 after the value of F&G shares had
reached less than fifty percent of their original purchase
price.

  1. Michigan Bulb Company
  In 1995, F&G’s largest subsidiary was Michigan Bulb
Company (“MBC”), a direct mail marketer of horticultural
products. MBC conducted direct mail sweepstakes pro-
motions to its customers primarily in three different for-
mats: (1) an “everybody wins” sweepstakes, in which every
person who returned an entry form won a “special prize,”
regardless of whether or not they placed an order; (2) a base
sweepstakes that awarded a total of $250,000 annually and
had a grand prize of $100,000; and (3) a pre-selected give-
away, in which the winners were determined before the
mailing.
  In 1991, MBC retained an attorney, John Awerdick, a
specialist in advertising law and sweepstakes issues, to
review its mailings for compliance with the law. Initially,
Awerdick advised MBC that the laws of nine states could be
read to prohibit the “everybody wins” type of promotions,
and he advised that states increasingly were using prize and
gift laws to regulate sweepstakes. In the attorney’s view, the
level of risk to MBC was difficult to assess because the laws
were not enforced strictly. By the spring of 1992, MBC had
established a practice of having Awerdick review each new
proposed promotion; if he advised MBC not to send out a
particular mailing, the mailing was not sent.
  On February 23, 1994, and February 22, 1995, Awerdick
4                                                 No. 04-1901

provided letters to F&G’s outside auditor, Price Waterhouse,
in which he discussed trends in the regulation of sweep-
stakes. The 1994 letter noted:
    Increasingly, states are using consumer protection laws
    to regulate sweepstakes further. In particular, a number
    of states are regulating some promotions in which every
    recipient of a mailing is advised that he or she is a prize
    winner. Many of the Company’s mailings include such
    a statement. Generally, either through statutory lan-
    guage or as a matter of prosecutorial discretion, these
    “gift and prize” laws are being applied against busi-
    nesses using “900” telephone numbers, offering time
    shares, vacation homes and camp sites, or requiring
    attendance at a sales presentation to receive a prize. I
    know of no current attempts to enforce these laws
    against traditional conventional direct mail sweepstakes
    operators. However, the Company would be required to
    make fundamental changes in many of its mailings if a
    “prize and gift” statute were applied to the “everybody
    wins” element of its promotions. Michigan Bulb’s
    management has been advised of the risks of these state
    statutes.
R.271, Ex.186. The 1995 letter contained substantially similar
language to that quoted directly above, except that it
deleted the sentence, “I know of no current attempts to
enforce these laws against traditional conventional direct
mail sweepstakes operators,” because MBC had received an
inquiry about its sweepstakes from the Attorney General of
North Carolina. Although Awerdick informed MBC of these
risks, he never advised MBC to stop using “everybody
wins” promotions. Nor did he ever advise MBC that any
changes required to bring its sweepstakes into compliance
with the state laws would have a significantly adverse
No. 04-1901                                                5

impact on MBC’s financial situation.
  MBC received thousands of inquiries each year from state
attorneys general (“state inquiries”), better business bu-
reaus, action lines and others about its promotions. In and
before December 1995, MBC had responded to inquiries
from the attorneys general of eight states. Dale Fujimoto,
MBC’s senior vice president of marketing, testified that such
inquires were viewed as part of the routine of the direct
mail order business and were not considered a source of
concern. None of the state inquiries resulted in an enforce-
ment action against MBC or otherwise had material adverse
consequences on MBC. At trial, U.S. Trust’s expert Stephen
Durchslag, an attorney with thirty-seven years’ experience
in the field of promotions and advertising law, including
sweepstakes, testified that the legal environment surround-
ing sweepstakes in 1995 was favorable and that he and other
sweepstakes experts would have considered these type of
inquiries to be normal and not an indication that MBC was
at risk of significant regulatory or enforcement problems.

  2. ESOP II Transaction
   F&G retained Valuemetrics, Inc. (“Valuemetrics”) as its
financial advisor to help structure the proposed ESOP II
transaction. On September 30, 1995, Valuemetrics issued its
first transaction memorandum to the F&G board of directors
describing a proposed offer to sell 2,916,667 shares to the
ESOP at $24 per share.
  U.S. Trust served as an independent trustee for the ESOP
to consider the merits of the proposed transaction.
U.S. Trust, in turn, engaged Houlihan, Lokey, Howard &
Zukin (“Houlihan”) to assist it in valuing the transaction
and to render a written opinion to U.S. Trust as to whether
the transaction was fair to the ESOP from a financial
6                                                No. 04-1901

perspective. On October 17, 1995, Norman Goldberg and
Michael Shea of U.S. Trust and Martin Sarafa and Todd
Strassman of Houlihan met with F&G executives to perform
corporate due diligence for the stock transaction. At that
meeting, Goldberg of U.S. Trust also spoke with Robert
Ostertag, president of MBC at the time, about MBC and its
sweepstakes promotions. At the October 17 meeting: (1)
Ostertag did not identify government regulation of sweep-
stakes as a risk; (2) no F&G representative identified either
the primary role of sweepstakes to MBC’s business or
possible government regulation of sweepstakes as a risk;
and (3) there was no discussion of MBC’s dependency on
sweepstakes being a negative, of the pending state inquiries
or of state laws that regulated MBC’s sweepstakes market-
ing. Shea also toured the MBC facilities and spoke with
additional members of MBC’s management. Testimony
from F&G officers, found to be credible by the district court,
indicated that state regulation and sweepstakes issues were
not considered to be material factors in the ESOP II transac-
tion at any time.
  Around this same time, B.A. Securities, a subsidiary of the
Bank of America corporation, conducted its own due
diligence of F&G and issued a private placement memo-
randum for potential lenders into the prospective ESOP II
transaction. The memorandum did not identify sweepstakes
as an inherently risky promotional tool or identify any legal
or regulatory risk. By November 20, 1995, four institutional
lenders, in combination, were willing to loan F&G the
requested $70 million on favorable terms for the ESOP II
transaction.
  After its inquiries into F&G and MBC, Houlihan prepared
an analysis for U.S. Trust of F&G financials with respect to
the offer price of $24 per share. Based on Houlihan’s anal-
No. 04-1901                                               7

ysis, U.S. Trust determined that Valuemetrics’ analysis was
too optimistic in some respects. Houlihan prepared a new
analysis reflecting a lower valuation range for the price of
the F&G shares. On November 7, 1995, U.S. Trust suggested
a share price of $18.50; F&G officers rejected the offer and
negotiations broke off. Negotiations later resumed, and, on
November 29, 1995, U.S. Trust announced that it was will-
ing to recommend that the ESOP purchase a controlling
block of F&G shares at $19.50 per share, subject to further
due diligence by U.S. Trust.
  On December 19, 1995, Houlihan presented a report to
U.S. Trust concluding that the midpoint value of the F&G
stock was $19.81 per share at the time. In preparing this
fairness opinion, Houlihan did not know what percentage
of MBC’s sales were generated by sweepstakes, did not
know what MBC’s primary sweepstakes approaches were
and did not know of any regulatory inquiries or risks
associated with MBC’s sweepstakes.
  To perform due diligence for the proposed ESOP II trans-
action, U.S. Trust retained the law firm of Sonnenschein,
Nath & Rosenthal (“Sonnenschein”). At U.S. Trust’s request,
Sonnenschein did not begin significant due diligence until
early December 1995. On December 12, 1995, Sonnenschein
faxed to F&G’s outside corporate counsel a list of the docu-
ments to be gathered for due diligence review. Among the
documents requested were copies of any significant corre-
spondence with any regulatory agencies. An attorney with
Sonnenschein traveled to F&G and discussed each item on
the due diligence request list with F&G’s corporate control-
ler. The attorney made general inquiries into pending legal
matters, but he did not ask for any specific document, such
as the letters of inquiry from the states attorneys general
or MBC’s response to those inquiries. The attorney did not
speak to Awerdick and did not see Awerdick’s audit
8                                                No. 04-1901

response letters to Price Waterhouse.
  On December 18, 1995, the attorney met with the
Sonnenschein partner responsible for the legal due dili-
gence. The attorney did not prepare a written report of his
due diligence investigation. He testified that he had reported
finding nothing significant in his review, but that he did not
recall discussing MBC’s sweepstakes marketing with the
partner. The partner no longer is with Sonnenschein and
could not be located to testify in this case. No record exists
documenting that the partner analyzed MBC’s sweepstakes
business or the state inquiries but decided that those issues
were not material. The record likewise is devoid of evidence
of the substance of any communications between U.S. Trust
and the Sonnenschein due diligence counsel.
  There appears to be no dispute that Sonnenschein did not
provide U.S. Trust with copies of the documents that the
attorney had received, including Awerdick’s February 1995
audit response letter advising that MBC would have to
make fundamental changes in its mailings if state prize and
gift laws were enforced, and an October 19, 1995 memoran-
dum contained in the F&G board book for that month
noting that MBC had received inquiries from three states in
two weeks in October 1995. Goldberg of U.S. Trust testified
that, if he had seen those two documents, he would have
asked for a further explanation from the company. When
the ESOP II transaction closed on or before December 20,
1995, Goldberg had only a general understanding of MBC’s
sweepstakes marketing program and had not focused
specifically on “everybody wins” type promotions. He also
did not know that between eighty to eighty-five percent of
MBC’s sales were generated through sweepstakes market-
ing.
    3. Post-Closing Occurrences
    For two years after the ESOP II transaction on
No. 04-1901                                                 9

December 20, 1995, F&G continued to enjoy record profits.
In July 1996, the Attorney General of Connecticut filed
lawsuits challenging the sweepstakes practices of fifteen
companies including MBC. In February 1997, the Attorney
General of Vermont opened an investigation into MBC’s
sweepstakes promotions. MBC resolved both matters in the
summer of 1998 by entering into assurances of discontinu-
ance, in which MBC paid a total of $70,500 in costs and
agreed to certain injunctive relief. In October 1997, MBC
entered into an assurance of discontinuance with the
Attorney General of Michigan. By October 1997, MBC
decided that only non-“everybody wins” versions of its
promotions would be sent to consumers in states that had
strict laws concerning such promotions. MBC projected a six
and one-half percent decrease in sales for the spring of 1998.
By 1998, MBC had stopped using “everybody wins”
promotions in eleven states and was proceeding to modify
its business in order to comply with the laws in all states.
  The stock purchase agreements through which the parti-
cipants in the Executive Investment Plan (“EIP”) reinvested
the proceeds from the ESOP II transaction included an
annual provision allowing EIP participants to sell back all
or some of their shares to F&G. In 1997, F&G’s board of
directors offered the ESOP the opportunity to purchase the
vested shares available under the EIP agreements. A num-
ber of F&G officers chose not to participate in the trans-
action because they believed that the stock’s value would
continue to increase. Also in 1997, F&G became a
Subchapter S corporation. This arrangement allowed it to
avoid paying taxes on a substantial portion of any profits,
but did not allow the company to take a tax deduction for
business losses. Also during 1997, a purchase by the ESOP
of the remaining F&G shares at $25 per share was proposed.
Two major shareholders, the Foster Estate and Melvyn
Regal, refused to sell their shares because they believed the
10                                                No. 04-1901

price to be low.
  In February 1998, several news stories appeared focusing
on the sweepstakes practices of American Family Publishing
and Publisher’s Clearinghouse. Although MBC did not use
many of the practices at issue in the news reports, the
negative publicity about sweepstakes in general caused an
immediate and dramatic decline in MBC’s consumer re-
sponse rates. The negative publicity spurred class actions
and multi-state enforcement actions against other direct
mail marketers, which further fed the anti-sweepstakes
sentiment. According to U.S. Trust’s expert, Durchslag, the
striking change in the regulatory enforcement climate that
followed the public backlash was not expected by sweep-
stakes professionals. A number of former MBC and F&G
officials testified uniformly that they believed the principal
cause of MBC’s economic reversal was this negative media
coverage. In 2001, F&G and its subsidiaries filed for bank-
ruptcy.

B. District Court Proceedings
  Ms. Keach and Ms. Sage alleged that U.S. Trust breached
a fiduciary duty owed under ERISA when, in determining
the purchase price for the F&G stock, it failed to assess fully
the risks associated with MBC’s use of sweepstakes promo-
tions. This lack of a complete and good faith inquiry, Ms.
Keach and Ms. Sage contended, meant that the ESOP II
transaction was not for “adequate consideration” and,
consequently, did not come within a statutory exemption
from the prohibited transaction restrictions of ERISA. See 29
U.S.C. §§ 1106(a)(1)(A), 1108(e). However, the district court
concluded that the ESOP II transaction met the definition of
adequate consideration and, therefore, was not prohibited
by ERISA. In the alternative, the district court held that,
No. 04-1901                                                11

even if U.S. Trust had breached a fiduciary duty, no remedy
was appropriate because any such breach had not caused
the losses to the ESOP.

                             1.
  In deciding that U.S. Trust was entitled to the adequate
consideration exemption of ERISA section 408, 29 U.S.C.
§ 1108, the district court recognized that U.S. Trust had the
burden to prove two elements: (1) that the ESOP paid the
fair market value for the asset, (2) as determined in good
faith by the trustee. The district court found that the ESOP
had paid fair market value for the F&G stock based on three
expert evaluations that reported that the per share price in
1995 was well more than $19.50. The district court found
these evaluations to be more credible than a report valuing
the shares at less than $19.50 per share.
  The district court next determined that U.S. Trust had
conducted a sufficient investigation into the merits of the
ESOP II transaction. Specifically, the court found that nei-
ther MBC’s dependency on sweepstakes nor the increase in
governmental regulation of the sweepstakes industry posed
a material risk to F&G in 1995 or a foreseeable material risk
in the future:
    [T]he weight of the evidence indicated that F&G’s
    officers and directors did not consider these issues to be
    material at the time, as evidenced by the following: (1)
    an otherwise inexplicable conversion to a Subchapter S
    corporation in 1997 (which would only have had
    positive tax consequences for a company expecting
    continued profitability); (2) the undersubscription of
    another stock purchase transaction by the ESOP in 1997
    because many officers and directors believed that the
    stock was worth much more and would continue to
12                                                No. 04-1901

     increase in value; (3) the immediate refusal of Foster
     and Regal to sell their remaining shares to the company
     at $25.00 per share in 1997; and (4) an unsecured $10
     million loan from Regal and the Foster Estate to F&G in
     1999 in order to assist the recovery of the company. Nor
     were such issues deemed material by the four lenders
     that performed their own due diligence investigation
     prior to loaning F&G $70 million to finance the 1995
     stock purchase transaction at favorable interest rates
     and without requiring collateral. Some of these same
     lenders agreed to loan an additional $100 million on the
     same terms in 1997. Uncontroverted and credible
     testimony at trial from an industry expert [Durchslag]
     also established that such issues were not material at the
     time of the 1995 stock purchase transaction and did not
     present a reasonably foreseeable material risk of future
     harm to F&G.
R.618 at 2-3.
  In addition, the district court discussed two specific
components of U.S. Trust’s investigation into the merits of
the transaction: the valuation of the purchase price and the
legal due diligence. The court ruled that U.S. Trust reason-
ably relied on Houlihan’s opinion as to fairness of the $19.50
purchase price for the F&G shares. The court noted that U.S.
Trust and Houlihan had analyzed exhaustively F&G’s
financials, had conducted independent valuation analyses
and had challenged the financial forecasts made by F&G
management as too optimistic. However, the district court
determined that U.S. Trust had not appropriately relied
upon the legal due diligence review performed by
Sonnenschein. Specifically, the court found troubling the
absence in the record of any meaningful communications
regarding legal due diligence between Sonnenschein and
U.S. Trust. The court believed that this lack of a record did
No. 04-1901                                                 13

not allow it to find that U.S. Trust’s counsel was aware of
MBC’s extensive use of sweepstakes marketing and of the
state inquiries. Nevertheless, the court concluded that these
were not important issues. The district court therefore
concluded that the inadequate legal due diligence did not
mean that the ESOP II transaction was not for adequate
consideration:
    Had there been further investigation into the sweep-
    stakes inquiries, the uncontroverted evidence of record
    indicates that U.S. Trust would have discovered that
    none of the state attorney general inquires received by
    MBC prior to December 20, 1995, had resulted in any
    enforcement action or negative consequences to the
    company and that the inquiries pending at that time
    were expected to be resolved in the normal course of
    business without any material consequences. While
    sweepstakes marketing was beginning to receive a
    higher degree of scrutiny from governmental regulatory
    agencies, and therefore posed the possibility of a greater
    likelihood of enforcement through consumer protection
    laws, the evidence presented at trial indicated that 1995
    was a “quiet” period in the industry from a regulatory
    perspective.
      Defendants’ expert Durchslag testified that experts in
    sweepstakes law would not have considered the few
    state inquiries received by MBC in 1995 to be material
    or a sign of significant impending regulatory problems.
    Accordingly, there is no basis for the assertion that
    consideration of sweepstakes risk by a prudent investor
    would have reduced the value of F&G stock or caused
    a prudent investor not to engage in the ESOP II transac-
    tion at all. The fact that U.S. Trust and its legal advisor
    did not identify a risk that the Court finds was not
    material cannot be considered evidence of an imprudent
14                                                No. 04-1901

     or bad faith investigation for purposes of precluding an
     otherwise applicable exemption under § 408(e).
Id. at 93-94.

                              2.
   In the alternative, the district court determined that, even
if U.S. Trust had breached a fiduciary duty, it was not liable
for damages because the losses to the ESOP were not caused
by any such breach. The court took the view that
     [t]he portion of the corporate legal due diligence that
     was either overlooked or undocumented, namely the
     regulatory inquiries made by state attorneys general
     into MBC’s sweepstakes marketing practices and the
     risk of sweepstakes dependency, was not a material
     consideration with respect to the propriety of the ESOP
     II transaction and posed no actual or reasonably fore-
     seeable material risk to F&G at the time of the 1995
     transaction. There is no credible evidence of record
     establishing that any different actions by U.S. Trust
     would have had any impact on the outcome of the
     ESOP II transaction.
Id. at 101-02. Furthermore, the district court determined that
the record demonstrated that the actual cause of the loss to
the ESOP was the collapse in customer response rates that
started in 1998 after the wave of negative press surrounding
the American Family Publishers Company scandal. The loss
to the ESOP, accordingly, was not due to any meaningful
risk to the profits of F&G from MBC’s dependency on
sweepstakes promotions or from governmental regulation
of sweepstakes.
No. 04-1901                                                         15

                                   II
                            ANALYSIS
A. Standard of Review
  We review a district court’s conclusions of law de novo,
and we review its findings of fact, as well as applications of
law to those findings of fact, for clear error. Eyler v. Comm’r
of Internal Revenue, 88 F.3d 445, 448 (7th Cir. 1996). We
review a district court’s decision to permit expert testimony
for an abuse of discretion. See David v. Caterpillar, Inc., 324
F.3d 851, 857 (7th Cir. 2003).

B. ERISA and the ESOP II Transaction
  Section 406 of ERISA prohibits a fiduciary of an ERISA
plan from causing the plan to enter into certain transactions
                                                2
with a “party in interest.” 29 U.S.C. § 1106. Section 406

2
    The transactions prohibited by section 406(a) include:
      Except as provided in section 1108 of this title:
          (1) A fiduciary with respect to a plan shall not cause the
          plan to engage in a transaction, if he knows or should
          know that such transaction constitutes a direct or in-
          direct—
               (A) sale or exchange, or leasing, of any property
               between the plan and a party in interest;
               (B) lending of money or other extension of credit
               between the plan and a party in interest;
               (C) furnishing of goods, services, or facilities be-
               tween the plan and a party in interest;
               (D) transfer to, or use by or for the benefit of, a party
               in interest, of any assets of the plan; or
                                                        (continued...)
16                                                     No. 04-1901

supplements an ERISA fiduciary’s general duties of loyalty
and prudence to the plan’s beneficiaries, as set forth in
                              3
section 404, 29 U.S.C. § 1104, “by categorically barring

2
    (...continued)
                (E) acquisition, on behalf of the plan, of any em-
                ployer security or employer real property in viola-
                tion of section 1107(a) of this title.
          (2) No fiduciary who has authority or discretion to con-
          trol or manage the assets of a plan shall permit the plan
          to hold any employer security or employer real property
          if he knows or should know that holding such security
          or real property violates section 1107(a) of this title.
29 U.S.C. § 1106(a).
3
    Section 404(a)(1) provides in part:
      [A] fiduciary shall discharge his duties with respect to a plan
      solely in the interest of the participants and beneficiaries
      and—
          (A) for the exclusive purpose of:
                 (i) providing benefits to participants and their
                 beneficiaries; and
                 (ii) defraying reasonable expenses of administering
                 the plan;
          (B) with the care, skill, prudence, and diligence under
          the circumstances then prevailing that a prudent man
          acting in a like capacity and familiar with such matters
          would use in the conduct of an enterprise of a like
          character and with like aims;
          ....
          (D) in accordance with the documents and instruments
          governing the plan insofar as such documents and
          instruments are consistent with the provisions of this
          subchapter and subchapter III of this chapter.
29 U.S.C. § 1104(a)(1). Section 404 also includes a general re-
                                                      (continued...)
No. 04-1901                                                        17

certain transactions deemed ‘likely to injure the pension
plan.’ ” Harris Trust & Sav. Bank v. Salomon Smith Barney,
Inc., 530 U.S. 238, 241-42 (2000) (quoting Comm’r v. Keystone
Consol. Indus., Inc., 508 U.S. 152, 160 (1993)). A plan need not
suffer an injury in order for a court to find a transaction
prohibited by section 406. Etter v. J. Pease Constr. Co., 963
F.2d 1005, 1010 (7th Cir. 1992).
  It is undisputed in this case that the ESOP II transaction,
a purchase of F&G stock by the ESOP from F&G officers and
directors, was prohibited under ERISA section 406(a)(1)(A)
as a “sale or exchange . . . of any property between the plan
and a party in interest.” 29 U.S.C. § 1106(a)(1)(A). However,
section 408(e) of ERISA provides that the prohibitions in
sections 406 and 407 of the statute shall not apply to the
acquisition or sale of qualifying employer securities by an
employee stock ownership plan if, among other conditions,
the acquisition or sale is for “adequate consideration.” Id.
             4
§ 1108(e)(1). For securities with no recognized market, as in

(...continued)
quirement of diversification of plan assets, id. § 1104(a)(1)(C), but
provides that the requirement is not violated by an investment in
employer securities by an employee stock ownership plan, id.
§§ 1104(a)(2), 1107(d)(5) & (6). See Donovan v. Cunningham, 716
F.2d 1455, 1464 n.14 (5th Cir. 1983).
4
    Section 408(e) provides:
      Sections 1106 and 1107 of this title shall not apply to the ac-
      quisition or sale by a plan of qualifying employer securities
      (as defined in section 1107(d)(5) of this title) or acquisition,
      sale or lease by a plan of qualifying employer real property
      (as defined in section 1107(d)(4) of this title)—
          (1) if such acquisition, sale, or lease is for adequate con-
          sideration (or in the case of a marketable obligation, at a
                                                      (continued...)
18                                                   No. 04-1901

this case, ERISA defines “adequate consideration” to be “the
fair market value of the asset as determined in good faith by
the trustee or named fiduciary pursuant to the terms of the
plan and in accordance with regulations promulgated by the
Secretary [of Labor].” Id. § 1002(18)(B). In order to rely on
the adequate consideration exemption, a trustee or fiduciary
has the burden to establish that the ESOP paid no more than
fair market value for the asset, and that the fair market
                                                         5
value was determined in good faith by the fiduciary. See

(...continued)
         price not less favorable to the plan than the price de-
         termined under section 1107(e)(1) of this title),
         (2) if no commission is charged with respect thereto, and
         (3) if—
             (A) the plan is an eligible individual account plan
             (as defined in section 1107(d)(3) of this title), or
             (B) in the case of an acquisition or lease of qualify-
             ing employer real property by a plan which is not
             an eligible individual account plan, or of an acquisi-
             tion of qualifying employer securities by such a
             plan, the lease or acquisition is not prohibited by
             section 1107(a) of this title.
29 U.S.C. § 1108(e) (emphasis added).
5
  The Department of Labor (“DOL”) issued a proposed rule in
1988 to clarify the definition of “adequate consideration.” See
Proposed Regulation Relating to the Definition of Adequate
Consideration, 53 Fed. Reg. 17,632 (May 17, 1988) (to be codified
at 29 C.F.R. § 2510-3(18)(b)). The DOL contemplated that ade-
quate consideration has two distinct elements:
     First, the value assigned to an asset must reflect its fair
     market value as determined pursuant to proposed § 2510.3-
     18(b)(2). Second, the value assigned to an asset must be the
     product of a determination made by the fiduciary in good
                                                    (continued...)
No. 04-1901                                                          19

Eyler, 88 F.3d at 454-55.
  In establishing that there has been compliance with the
statutory mandate, “[t]he degree to which a fiduciary makes
an independent inquiry is critical.” Id. at 456. “Although
securing an independent assessment from a financial ad-
visor or legal counsel is evidence of a thorough investi-
gation,” it is not a complete defense against a charge of
imprudence. Howard v. Shay, 100 F.3d 1484, 1489 (9th Cir.
1996). A fiduciary must “investigate the expert’s qualifi-
cations,” “provide the expert with complete and accurate

5
    (...continued)
       faith as defined in proposed § 2510.3-18(b)(3). The
       Department will consider that a fiduciary has determined
       adequate consideration in accordance with section 3(18)(B)
       of the Act . . . only if both of these requirements are satisfied.
Id. at 17,633.
   Although the proposed regulation has yet to be approved for
publication in the Code of Federal Regulations, see Unified
Agenda, Adequate Consideration, 69 Fed. Reg. 37,812-01 (June 28,
2004), this court and other courts of appeals have adopted this
two-part standard for evaluating the adequacy of consideration.
See Eyler v. Comm’r of Internal Revenue, 88 F.3d 445, 454-55 (7th
Cir. 1996) (stating that a fiduciary can prove adequate consider-
ation “by showing they arrived at their determination of fair
market value by way of a prudent investigation in the circum-
stances then prevailing”); Chao v. Hall Holding Co., 285 F.3d 415,
436-37 (6th Cir. 2002); Howard v. Shay, 100 F.3d 1484, 1488 (9th
Cir. 1996); Donovan, 716 F.2d at 1467; see also Henry v. Champlain
Enters., Inc., 334 F. Supp. 2d 252, 269-70 & nn.7-8 (N.D.N.Y. 2004).
But see Herman v. Mercantile Bank, N.A., 143 F.3d 419, 421-22 (8th
Cir. 1998) (“Even if a trustee fails to make a good faith effort to
determine the fair market value of the stock, he is insulated from
liability if a hypothetical prudent fiduciary would have made the
same decision anyways.” (internal quotation and citation
omitted)).
20                                                No. 04-1901

information” and “make certain that reliance on the expert’s
advice is reasonably justified under the circumstances.” Id.
(citing Donovan v. Mazzola, 716 F.2d 1226, 1234 (9th Cir.
1983), and Donovan v. Cunningham, 716 F.2d 1455, 1474 (5th
Cir. 1983)).
  Ms. Keach and Ms. Sage submit that U.S. Trust failed to
make the requisite good faith determination. They submit
that, contrary to the district court’s view, a prudent investor
making a $70 million investment decision would have
wanted to know whether state regulation of MBC’s sweep-
stakes promotions could have a material effect on the
finances of MBC and F&G. Therefore, Ms. Keach and
Ms. Sage maintain that U.S. Trust and its advisors should
have taken a careful look at the sweepstakes issues in order
to make a fully informed determination of the associated
risks. Ms. Keach and Ms. Sage also charge that U.S. Trust
was not justified in relying on the fairness opinion of
Houlihan or on the legal due diligence of Sonnenschein
because neither considered the risks associated with MBC’s
sweepstakes promotions.
  With respect to Houlihan’s valuation analysis, the district
court ably addressed Ms. Keach and Ms. Sage’s concern:
     While Sarafa and Strassman of Houlihan knew that
     MBC used sweepstakes marketing extensively and that
     MBC was a main revenue center for F&G, Houlihan did
     not consider the risk of governmental regulation of the
     sweepstakes industry or any threat posed by MBC’s
     dependency on sweepstakes in assessing the value of
     F&G stock. Considering the record in its entirety, it is
     clear that the reason why Houlihan did not factor these
     circumstances into its valuation analysis is that no one
     at the time of the 1995 transaction, including experts in
     the area of sweepstakes marketing, either knew or rea-
     sonably should have known that these matters posed
No. 04-1901                                                 21

    any material risk to F&G or could be expected to pose
    any material risk to F&G in the foreseeable future.
R.618 at 90-91.
  Like the district court, we are troubled by the absence in
the record of any substantive communication between
Sonnenschein and U.S. Trust concerning MBC’s sweepstakes
issues. However, the fact that the due diligence review did
not identify or did not document MBC’s sweepstakes
marketing does not negate, on this record, the reasonable-
ness of U.S. Trust’s overall analysis of the merits of the
ESOP II transaction in the circumstances prevailing in 1995.
Rather, it is important to place U.S. Trust’s reliance on
Sonnenschein’s legal due diligence within the context of the
totality of the circumstances of U.S. Trust’s valuation
process. For instance, the district court found that U.S. Trust
went to considerable lengths to understand F&G’s business
and to assess independently the merits of the transaction,
including interviewing members of management, visiting
F&G’s facilities, reviewing business plans and examining
financial documents. The district court also found that,
rather than blindly accept the forecasts of F&G officers as to
F&G’s financial future, “U.S. Trust and Houlihan probed
and challenged a number of assumptions in Valuemetrics’
evaluation before developing their own independent
evaluation that formed the basis for a price per share at
closing that was almost 20% less than the selling sharehold-
ers’ offering price.” Id. at 90.
  Although, as Ms. Keach and Ms. Sage point out, Goldberg
of U.S. Trust testified that he would have asked for further
information if he had known of the state inquiries and of
Awerdick’s audit response letters, he also stated that, based
on his understanding of the industry, the information that
would have been disclosed upon further inquiry would not
22                                                No. 04-1901

have changed the outcome of the ESOP II transaction. When
the record establishes that the overlooked matter was one
that no one perceived to be a material concern at the time or
to be outcome determinative, it cannot be said that the
overall investigation was imprudent or in bad faith. ERISA’s
fiduciary duty of care “requires prudence, not prescience.”
DeBruyne v. Equitable Life Assurance Soc’y of the United States,
920 F.2d 457, 465 (7th Cir. 1990) (internal quotation and
citation omitted).
  Furthermore, U.S. Trust’s inquiry into the ESOP II trans-
action does not exhibit the same level of imprudence as
those cases in which courts have held that the plan fiduciary
was not entitled to the adequate consideration exemption.
For instance, in Eyler, 88 F.3d 445, we held that the plan
fiduciaries failed to demonstrate a good faith determination
when
     [t]he record d[id] not show that even one director, let
     alone a majority, sought independent information on
     the fair market value of the stock. Rather, on the same
     day the project was presented, the board voted to
     guarantee a $10 million loan, the proceeds of which
     would be used to buy the majority shareholder’s stock.
     A prudent person would not have relied upon the
     dated . . . estimated price range for the ESOP stock
     purchase in light of the failed [initial public offering]
     and changed financial conditions at the corporation.
     Moreover, there is no evidence that the board was
     knowledgeable about the effects of these changing con-
     ditions on the fair market value of [the employer] stock.
Id. at 456. In Eyler, we specifically noted that several of the
factors that the board failed to consider “had a significant
impact on the financial condition” of the stock. Id. at 455. By
contrast, the absence of evidence that MBC’s sweepstakes
was a meaningful risk to MBC’s and F&G’s financial future
No. 04-1901                                                 23

at the time of the transaction was certainly an important
factor in the district court’s determination that U.S. Trust
had not failed to conduct a good faith inquiry into the
merits of the ESOP II transaction.
  Other cases confirm that the case before us today cannot
be characterized as lacking the requisite good faith on the
part of the fiduciaries. Similar to this court’s holding in
Eyler, the Fifth Circuit in Cunningham, 716 F.2d 1455, held
that the plan fiduciaries’ investigation was insufficient
because they had relied on an appraisal prepared thirteen to
thirty months before the transactions and had failed to
consider significant changes in the company’s business con-
dition that had occurred in the interim. Id. at 1468-73. The
court noted that a cursory study of the appraisal report
would have revealed that the underlying facts and assump-
tions no longer were valid at the time of the stock transac-
tions. Id. at 1469-70.
  The Sixth Circuit’s decision in Chao v. Hall Holding Co., 285
F.3d 415 (6th Cir. 2002), similarly supports the view that the
decision of the district court was correct. In Chao, the Sixth
Circuit concluded that the plan trustees had failed to prove
that they had made a good faith inquiry into fair market
value when: (1) the trustees relied on a valuation by an
individual who had valued the wrong company and who
testified that, if he had been told that his valuation would be
used for an employee stock ownership plan transaction, he
would have done a different valuation; (2) the trustees
generally were “unaware of what was going on”; (3) the
trustees were not consulted on major decisions, such as the
price to pay for the stock; (4) the trustees did not engage in
any negotiation as to the price of the stock; (5) the trustees
were more concerned with the return on the investment for
the trust that had financed the stock purchase than for the
plan; and (6) the trustees caused the plan to be charged
24                                                No. 04-1901

several thousands of dollars simply to enable the trustees to
communicate using round numbers. Id. at 429-31, 437.
  Finally, in Katsaros v. Cody, 744 F.2d 270 (2d Cir. 1984), the
Second Circuit upheld a finding that the trustees breached
the duty of prudence, under ERISA section 404, because
“they passively received a rosy superficial picture of the
[company in which they caused the plan to invest] and its
holding company from persons with an interest in obtaining
their approval. No effort was made to obtain independent
professional assistance or analysis of the financial data
presented to them.” Id. at 275. In Katsaros, a reasonable
investigation would have revealed that the transaction was
“totally unsound.” Id. at 279.
  The situation in these cases simply does not resemble that
before us. MBC and F&G management consistently testified
that the factors that U.S. Trust purportedly overlooked,
namely MBC’s reliance on sweepstakes and possible govern-
ment regulation of MBC’s sweepstakes and the sweepstakes
industry in general, were not considered a significant
concern to MBC’s and F&G’s financial outlook. In addition,
nothing in this record suggests that U.S. Trust’s valuation
process passively relied on the financial information
provided by F&G officers: It hired a qualified financial
advisor, conducted its own interviews and review of
industry information and negotiated a price for the F&G
shares that was twenty percent lower than the original offer
price. We conclude that the district court properly ruled that
the fact that U.S. Trust failed to identify a risk that would
not have been considered material does not render U.S.
Trust’s evaluation of the ESOP II transaction imprudent or
in bad faith for purposes of section 408(e).
  As we have noted previously, our conclusion that
U.S. Trust carried its burden to show adequate consider-
ation is based on the district court’s finding that “the reg-
No. 04-1901                                                 25

ulatory inquiries made by states attorneys general into
MBC’s sweepstakes marketing practices and the risk of
sweepstakes dependency, was not a material consideration
with respect to the propriety of the ESOP II transaction and
posed no actual or reasonably foreseeable material risk to
F&G at the time of the 1995 transaction.” R.618 at 101-02.
Ms. Keach and Ms. Sage, however, challenge this finding. In
their view, it is based on testimony that was admitted
improperly and is clearly erroneous.
  Ms. Keach and Ms. Sage first submit that the district court
should have excluded opinions expressed at trial by U.S.
Trust’s expert Durchslag that purportedly were not in-
cluded in his pre-trial expert disclosure report. A party
using a retained expert is required to furnish, prior to trial,
a report containing “a complete statement of all opinions
to be expressed and the basis and reasons therefor.”
Fed. R. Civ. P. 26(a)(2)(B). A party shall not be permitted to
use any information not so disclosed as evidence at a trial.
Fed. R. Civ. P. 37(c)(1). This sanction is “ ‘automatic and
mandatory unless the sanctioned party can show that its
violation of Rule 26(a) was either justified or harmless.’ ”
David, 324 F.3d at 857 (quoting Salgado v. Gen. Motors Corp.,
150 F.3d 735, 742 (7th Cir. 1998)).
  The decision to admit previously undisclosed testimony
is entrusted to the broad discretion of the district court.
Id. “ ‘A district court need not make explicit findings
concerning the existence of a substantial justification or the
harmlessness of a failure to disclose.’ ” Id. (quoting
Woodworker’s Supply, Inc. v. Principal Mut. Life Ins. Co., 170
F.3d 985, 993 (10th Cir. 1999)). However, the district court’s
discretion should be guided by the following factors: “(1)
the prejudice or surprise to the party against whom the
evidence is offered; (2) the ability of the party to cure the
26                                                    No. 04-1901

prejudice; (3) the likelihood of disruption to the trial; and (4)
the bad faith or willfulness involved in not disclosing the
evidence at an earlier date.” Id. The opinions of Durchslag
offered at trial of which Ms. Keach and Ms. Sage complain
include: (1) that neither the inquiries received by MBC from
states attorneys general in 1995, nor MBC’s use of possibly
illegal sweepstakes mailings, presented a material risk to
MBC or F&G, and (2) that nothing he knew about sweep-
stakes regulatory issues in 1995 suggested that MBC’s
sweepstakes promotions were at significant risk of regula-
                    6
tion at the time. Ms. Keach and Ms. Sage submit that

6
    The relevant parts of Durchslag’s testimony read as follows:
      Q. Is there anything about these inquiries that MBC received
      in 1995 that makes you think that MBC or its parent, Foster
      & Gallagher, was at risk of significant regulatory or enforce-
      ment problems involving sweepstakes?
      A. No sir.
      ....
      MR. RHODE: I object to that question. It goes beyond the
      scope of his disclosed opinions. In his opinions he said “risk
      of great regulatory or enforcement difficulties.”
      THE COURT: The objection is overruled. You can cross-
      examine on that.
      A. No, I don’t think that they presented risks that were
      serious. They were things that needed to be addressed with
      the attorney generals. They were. No action was taken in any
      of the cases, not even voluntary assurances, which is often
      the way those matters are resolved with the state attorney
      generals. And it seemed to me that they did not present a
      serious risk of regulatory action in 1995.
R.659 at 2159-60.
                                                     (continued...)
No. 04-1901                                                     27

(...continued)
    Q. Does anything you know about sweepstakes regulatory
    issues in 1995, whether they involve MBC or the industry in
    general, suggest to you that there was significant risk in
    MBC’s sweepstakes programs in 1995?
    MR. RHODE: Objection, Your Honor. This wasn’t covered in
    his report or deposition. His report specifically limits that
    opinion to his review of those pending inquiries.
    MR. ECCLES: The opinion is as to the risk of MBC’s pro-
    grams, Your Honor. This is surely within that risk.
    THE COURT: The objection is overruled.
    A. No. It was not a time that the regulatory climate seemed
    to be negative to these type of sweepstakes. Quite the con-
    trary.
    Q. Do you think there were clear warning signs in 1995 of the
    further collapse of direct mail sweeps?
    A. No.
Id. at 2166.
    Cross Examination:
    Q. Now in your written report, you stated: “It is my opinion
    that the inquiries received by Michigan Bulb in 1995 would
    not have been an indication that the company was at a risk
    of great regulatory or enforcement difficulties.” Is that what
    you said in your written report?
    A. Yes.
    Q. And “great,” that was the word that you used in your re-
    port, right? It was not at risk of great regulatory or enforce-
    ment difficulties?
    A. Correct.
Id. at 2219-20.
                                                    (continued...)
28                                                     No. 04-1901

these opinions were a sweeping expansion of Durchslag’s
opinion disclosed in his report prior to trial, that the state
inquiries received by MBC in 1995 did not indicate that the
company was “at risk of great regulatory or enforcement
difficulties.” Appellant’s Br. at 46. Ms. Keach and Ms. Sage
do not assert that the admission of the challenged testimony

(...continued)
     By the Court:
     Q. You said that MBC was not at great risk of regulatory
     difficulties in ‘95? That was your opinion?
     A. Yes, sir.
     Q. Is the word “great” a term of art?
     A. No. I was just trying to evaluate it from a lawyer’s/
     practitioner’s point of view in terms of what risks did I see.
     Q. Are you familiar with the term “material”?
     A. I am.
     Q. Is that a term of art?
     A. Yes, I think so.
     Q. Do you have an opinion as to whether it was a material
     risk?
     A. I do. I do not think it was a material risk.
     Q. How would you define the difference, if any, between
     material risk and great risk?
     A. I think they’re very similar, Your Honor.
     Q. How are they different?
     A. Well, material seems to me to be something that’s going
     to affect the financial wealth of the company. Great, to me,
     has more of a possibility of expectation of any action. In both
     cases, I think they were not material and they were not great.
Id. at 2260-61.
No. 04-1901                                                29

either disrupted the trial or that the lack of disclosure was
the result of bad faith or willfulness. Rather, they submit
that the previously undisclosed opinions caused them pre-
judice, which they were not able to cure, because the district
court relied on Durchslag’s opinions in rejecting their
claims. Furthermore, Ms. Keach and Ms. Sage maintain that,
if the broader scope of Durchslag’s opinions had been
disclosed, they could have deposed him accordingly, devel-
oped relevant cross-examination strategy and presented
rebuttal expert testimony.
  The district court acted well within its discretion in ad-
mitting the challenged testimony. The differences identified
by Ms. Keach and Ms. Sage do not suggest that Durchslag
did not fairly disclose the opinions he intended to provide
at trial. Moreover, counsel for Ms. Keach and Ms. Sage had
the opportunity to address the distinction between the terms
on cross-examination, and the district court clarified that
Durchslag did not use “great” as a term of art, but as a way
to describe his view of the existing risks. Durchslag ex-
plained that he believed that “material” was a term of art,
and he thought “material risk” and “great risk” were “very
similar.” R.659 at 2261.
  Ms. Keach and Ms. Sage next contend that the district
court clearly erred in concluding that the risks associated
with MBC’s sweepstakes marketing were not material to the
ESOP II transaction. In particular, they submit that, in 1995,
MBC’s “everybody wins” sweepstakes violated the laws of
some states, and that, if it were required to comply with
such state laws and therefore implement less aggressive
promotions, MBC risked lost profits in the future. Ms. Keach
and Ms. Sage contend that, if U.S. Trust had conducted a
good faith investigation into the risk to F&G’s business and
had pointed out the risk of having to comply with state
laws, U.S. Trust could not have proceeded prudently with
30                                              No. 04-1901

the transaction at the same price. In short, Ms. Keach and
Ms. Sage submit that Durchslag’s opinions as to the risks of
regulatory enforcement are irrelevant because they do not
speak to the risk in 1995 that MBC’s profits would decline
if it was required to comply with state laws.
  To support their position, Ms. Keach and Ms. Sage note
that, beginning in 1997, MBC did make changes to its
sweepstakes promotions in order to comply with laws that
existed at the time of the ESOP II transaction. Specifically,
they note that MBC discontinued its mailings to customers
in Vermont and Connecticut after those states complained
that MBC’s “everybody wins” promotions were deceptive.
Later in 1997, MBC ceased mailing “everybody wins” pro-
motions to nine additional states and decided to make
further changes to its sweepstakes. At the time, MBC as-
sumed for budget purposes that the changes would reduce
consumer response rates by six and one-half percent and
would reduce MBC’s profits by $4 million over the next six
months. Then, in 1998, MBC decided to change its market-
ing program in order to comply with the sweepstakes laws
in all states.
  As U.S. Trust notes, however, there is no evidence in this
record that a prudent investigation would have revealed
that MBC was violating the laws of any state. In 1995 or
before, no enforcement action was initiated, or resolved ad-
versely, against MBC related to its sweepstakes, and MBC
never admitted to being in violation of the law. At most,
Awerdick had advised MBC in 1991 of his opinion that
certain states’ laws could be read to bar “everybody wins”
sweepstakes. In addition, Awerdick also reviewed MBC’s
mailings for legal compliance, and the district court found
that by 1992 MBC had a practice that no mailings were sent
without his approval. Furthermore, none of the changes to
MBC’s sweepstakes promotions occurred until 1997, and the
No. 04-1901                                                31

district court found credible the testimony at trial of F&G
officers that they did not consider MBC’s dependency on
sweepstakes to be an important concern to the ESOP II
transaction. Accordingly, we conclude that the district court
was not clearly erroneous in finding that the risks associated
with MBC’s sweepstakes marketing, if discovered, would
not have impacted the propriety of the ESOP II transaction
and that those risks were not actual or reasonably foresee-
able material risks to F&G in 1995.

                        Conclusion
 Because the district court correctly determined that there
was no breach of fiduciary obligation, we affirm the judg-
ment of the district court.
                                                   AFFIRMED

A true Copy:
        Teste:

                          _____________________________
                           Clerk of the United States Court of
                             Appeals for the Seventh Circuit

                    USCA-02-C-0072—8-17-05