The opinion of the court was delivered by: CONSTANCE BAKER MOTLEY
This is an action brought by the Secretary of Labor against Valley National Bank of Arizona (Valley) and others. In this suit the Secretary of the Department of Labor (DOL) alleges, inter alia, that when Valley served as fiduciary to the Kroy Inc. Employee Stock Ownership Plan, Valley breached its fiduciary duties under the Employee Retirement Income Security Act of 1974 ("ERISA"), 29 U.S.C. § 1001, et. seq. Both parties have submitted cross-motions for summary judgment on the breach of fiduciary duty claim and several other claims asserted against Valley. In addition, Valley has interposed numerous counterclaims and affirmative defenses which the Secretary seeks to dismiss. The parties have stipulated to certain facts. However, in order to decide the pending motions, it has been necessary for the court to make additional findings. For the reasons set forth below, the court grants the Secretary's motions and denies the cross-motions of Valley. Damages in the amount of $ 17,500,000 are awarded to the Secretary. The action with respect to all other defendants has been settled.
FINDINGS OF FACT AND CONCLUSIONS OF LAW
In December of 1986 the upper-level management officers of Kroy, Inc., took the company private in a management-led leveraged buyout ("LBO"). In order to finance this transaction, Kroy created an Employee Stock Ownership Plan ("ESOP") which upon creation purchased $ 35.5 million worth of Kroy shares.
An ESOP is an employee benefit plan designed to invest primarily, or when certain safeguards are present, solely in securities issued by the sponsoring company. Under ERISA, ESOPs are subject to a web of rules and regulations governing their creation, maintenance, and administration. Congress has favored ESOPs with preferential treatment under the Internal Revenue Code that renders the sponsoring company eligible for bountiful tax benefits.
An ESOP is typically established by an employer via a written instrument that defines the terms of the Plan and the rights of participants therein, usually called the "Plan documents". See 29 U.S.C. § 1102(a) (1976). A trust is established to hold the assets of the ESOP, see 29 U.S.C. § 1103, and fiduciaries are named within the Plan Documents to "control and manage the operation and administration of the plan." 29 U.S.C. § 1102(a)(1).
An employer may then make tax-deductible contributions to the ESOP in the form of employer securities or outright cash. Typically, when cash is disbursed the ESOP will then use those moneys to purchase securities in the sponsoring employer. In many instances the ESOP finances its purchase of employer securities with debt, then uses the cash contributions from the employer to retire that debt. (See Donovan v. Cunningham, 716 F.2d 1455, 1458-59 (5th Cir. 1983).
Sections 406(a)(1)(A) and (D) of ERISA, 29 U.S.C. § 1106(a)(1)(A) and (D), prohibit an Employee Stock Ownership Plan from acquiring stock or other marketable obligations of the plan sponsor from a party in interest unless the transaction qualifies under the exemption provided for in ERISA § 408(e), 29 U.S.C. § 1108(e). This exemption is allowed for qualifying employer securities if and only if the purchase is for "adequate consideration."
ERISA 3(18)(B), 29 U.S.C. § 1002(18)(B), defines "adequate consideration" in the case of assets for which there is no generally recognized market as "the fair market value of the asset as determined in good faith by the trustee or named fiduciary. . . ." See also 29 C.F.R. § 2550.408(e).
The Secretary of Labor alleges that when Valley served as the trustee of the Kroy Employee Stock Ownership Plan, Valley breached its fiduciary duties under ERISA in connection with the Kroy LBO. Valley allegedly breached its duty by causing the ESOP to purchase stock in Kroy, the ESOP sponsor, without the ESOP obtaining adequate consideration for the purchase.
Specifically, the Secretary claims that Valley breached its fiduciary duties under ERISA § 404(a)(1), 29 U.S.C. § 1104(a)(1), to act prudently and solely in the interest of the plan participants and beneficiaries by, among other things, failing to conduct a good faith independent investigation of the buyout transaction to determine whether the transaction was fair to the ESOP and the price being paid for the stock was no more than fair market value, acquiring the stock at a price that was more than fair market value, and consenting to an allocation of Kroy stock between the ESOP and other investors which was not substantially fair to the ESOP in light of the equity contributions to the buyout by the ESOP and other investors. The Secretary also claims that, by permitting the ESOP to purchase Kroy shares for more than "adequate consideration" within the meaning of ERISA § 3(18), 29 U.S.C. § 1002(18), Valley caused the ESOP to engage in various prohibited transactions in violation of ERISA § 406(a)(1), 29 U.S.C. § 1106(a)(1).
(Consolidated Brief in Support of the Secretary's Cross-Motion for Summary Judgment and in Opposition to Valley's Motion for Summary Judgment, 2).
Valley answered on June 29, 1990, and asserted in its defense numerous counterclaims and affirmative defenses, many of which are the subject of the instant motions.
Before the court are: 1) the Secretary's motion for partial summary judgment on some of its claims against Valley; 2) Valley's motion for partial summary judgment against the Secretary's claims against Valley for money damages; 3) Valley's cross-motions for summary judgment on its counterclaims and affirmative defenses; and 4) motions by the Secretary to dismiss Valley's counterclaims under F. R. Civ. P., Rule 12(b)(6) as well as Rule 12(f) motions to strike Valley's affirmative defenses.
The Secretary has moved, pursuant to F.R.Civ.P. 56(c), for summary judgment as a matter of law, alleging that Valley, as trustee of the Kroy ESOP, failed to arrive at a good faith determination of the fair market value of the stock it caused the ESOP to purchase. The Secretary claims that it merits summary judgment on the ground that as trustee Valley failed to make a prudent decision because it did not understand what it was doing and how the transaction affected the interests of the ESOP participants and beneficiaries. Valley vigorously opposes this motion.
Valley has cross-moved for summary judgment on this claim, arguing that there was no loss to the ESOP and, therefore, monetary liability cannot attach to the fiduciary. The Secretary vigorously opposes this motion. An evaluation of the validity of these interrelated claims first requires an understanding of the factual context in which the Kroy ESOP was created.
The Preliminary Investigation of a Leveraged Buy-Out (LBO)
Kroy, Inc. was in the printing and typography business. It designed, constructed, marketed, and distributed lettering systems and operated several retail copy centers. During the late 1970s and early 1980s Kroy prospered. (Korsvik Memorandum, 5, attached as Ex. C to the Secretary's Response to Valley's Rule 3(g) Statement ("Korsvik Memorandum"). However, by the mid-1980s Kroy's fortunes declined as competition from competing businesses established by former Kroy employees cut into Kroy's sales and profitability. (Id.)
In February of 1986, Kroy's Board of Directors began to review available options for improving Kroy's financial status. (1986 Kroy, Inc. Proxy Statement: Special Meeting of Shareholders to be Held on December 18, 1986, at 10, attached as Ex. 79 to Memorandum in Support of Secretary's Motion). The Board concluded that it would explore the possibilities of creating an employee stock ownership plan. (Id. at 11). In May of 1986 Kroy retained Banker's Trust Company to investigate the feasibility of this option. (Id.).
In response to their deteriorating economic viability, Kroy management developed in early 1986 a strategy to take the company private via a leveraged buy-out of Kroy, Inc's publicly-held shares. (Memorandum in Support of Valley's Motion for Partial Summary Judgment, 3; Bartine Aff. PP 2-3, Ex. 1 to Rule 3(g) Statement of Defendant Valley).
The inclusion of the ESOP was central to the proposed LBO transaction. The motivating factor behind the creation of the ESOP was the fact that its creation would significantly lower the costs to Kroy of the LBO. If not for the congressionally-accorded tax benefits of creating an ESOP, the transaction would not have gone forward. "The ESOP was created by Kroy's management for one reason and one reason alone--it made available to Kroy much desired below interest rate financing for a large portion of the purchase price for the publicly held stock it was to acquire in the leveraged buyout." (Memorandum in Support of Valley's Motion for Partial Summary Judgment, 2-3; Bartine Aff., Ex. 1 to Rule 3(g) Statement of Valley in Support of Its Motion for Summary Judgment).
The LBO transaction was commenced in August of 1986, when Kroy's senior management and some outside investors incorporated Kappa Acquisition Corporation ("Kappa"), an entity created solely to facilitate the LBO. Kappa's only employees were its officers, who were also Kroy management officials. (Memorandum in Support of Valley's Motion for Partial Summary Judgment at 3-4).
Kappa established the Kappa Employee Stock Ownership Plan ("Kappa ESOP") soon after the incorporation of Kappa to which Kappa made no contributions. (Memorandum in Support of Valley's Motion for Partial Summary Judgment at 4). Kappa and Kroy then merged and formed Kroy, thus inducting Kroy employees as participants in the Kappa ESOP, which after the merger became known as the Kroy ESOP. (Id).
The Appointment of the Initial Trustees and Their Resignation
During July of 1986 Kroy appointed three management officials, Nancy Van Der Voort, Thomas Connoy, and Ken McCuskey to serve as trustees for the newly-created ESOP (Stipulation of Undisputed Facts, ("Stip.") P 12). They served until early December of 1986 when they resigned because of difficulties in obtaining fiduciary liability insurance. (Memorandum in Support of DOL's Motion For Partial Summary Judgment at 5; Connoy Dep. of June 16, 1992 at 34-36, 65, attached as Ex. 7 to Valley's Response to the DOL's Rule 3(g) Statement; McCuskey Dep. of June 25, 1992, at 39-40, 44, attached as Ex. 8; Van Der Voort Dep. of June 17, 1992, at 58, attached as Ex. 9).
Before their resignation, these newly-appointed trustees did not negotiate the price to be paid by the ESOP for the outstanding stock; rather, Bankers Trust determined what price the ESOP would pay for its stock before their appointment as trustees. (Affidavit of Nancy Van Der Voort, PP 5-6, attached as Appendix A to Secretary of Labor's Rule 3(g) Statement; Memorandum in Support of the Secretary of Labor's Motion for Partial Summary Judgment, 3-4).
The original trustees first met on July 18, 1986. (Meeting Minutes of July 18, 1986, attached as Ex. 11 to Valley's Response to the DOL's Rule 3(g) Statement). During this and the following meetings, the original trustees considered applications for the positions of legal counsel and financial advisor to the ESOP. (Valley's Memorandum in Opposition to the Secretary's Motion for Partial Summary Judgment, 6-10). One applicant, James H. Zukin of the firm of Houlihan, Lokey, Howard & Zukin, was not retained as financial advisor due to the fact that the original trustees believed that his personality would lead to difficult negotiations. (Minutes of August 11, 1986 Meeting, attached as Ex. 14 to Valley's Response to the DOL's Rule 3(g) Statement; Spector Dep. of January 23, 1991, at 173-74, attached as Ex. 10). Mark Lee of Benchmark Valuation Consultants was favored because they considered "Mr. Lee's substantially lower fees as indicative of his confidence that he could accomplish the' task on a time efficient basis." (Valley's Memorandum in Opposition to the Secretary's Motion for Partial Summary Judgment, at 10; Minutes of August 18, 1986 Meeting, Ex. 15 to Valley's Response to the DOL's Rule 3(g) Statement).
On behalf of the original trustees Scott Spector of Webster & Sheffield attempted unsuccessfully to negotiate a lower price for the ESOP by obtaining 265,000 more shares for the ESOP. (Spector Dep. of March 5, 1992, at 89-90, attached as Ex. 10 to Valley's Response to the DOL's Rule 3(g) Statement). Indeed, the original trustees relied completely on Mr. Spector to negotiate on behalf of the ESOP, as they were "inexperienced ESOP trustees." (Valley's Memorandum in Opposition to the Secretary's Motion for Partial Summary Judgment, 12).
Due to their inability to obtain fiduciary liability insurance, the three original trustees officially resigned on December 17, 1986, effective as of December 5, 1986. (Memorandum in Support of DOL's Motion For Partial Summary Judgment, 5).
First Bank Minneapolis (FBM) was the leading bank involved in financing the Kroy ESOP LBO transaction. FBM invited Valley's commercial division to participate in a $ 35.5 million credit facility by lending between $ 5 million and $ 15 million to Kroy for the LBO, the loan to be secured by a first security interest in Kroy's assets. (Korsvik Memorandum, 1-3; September 23, 1986 Letter from FBM to Valley, Ex. 28 to Secretary's Rule 3(g) Statement).
Scott Korsvik, an employee of Valley's Commercial Division, analyzed the feasibility and desirability of participating in the Kroy ESOP financing. He reviewed the July 1986 Direct Placement Memorandum, the July 14, 1986 Kroy Transaction Memorandum, Kroy's Fiscal 1986 Review and Fiscal 1987 Outlook, Kroy's 1986 Annual Report and Form 10-Q filed with the Securities and Exchange Commission in June 1986, Banker's Trust Revised Projections, and Kroy's 1984 and 1985 Annual Reports. (See, e.g., Korsvik Memorandum; Ex. 28, 29 to Secretary of Labor's Rule 3(g) Statement). Valley's Commercial Division also conducted direct interviews with Kroy personnel. (Korsvik Dep. of Feb. 21, 1991, 40-48, attached as App. E to Secretary's Rule 3(g) Statement).
After a detailed analysis, Scott Korsvik recommended that Valley decline to participate in the proposed financing. In reaching this conclusion he cited these factors: (1) Kroy's sales had declined steeply between 1984 and 1986; (2) new competitors had entered the field; (3) present operations did not generate enough cash flow to finance the debt required to finance the LBO; (4) Kroy proposed to finance the LBO through developing new technology and increased sales instead of through current sales. (Korsvik Memorandum, 1).
Tom Wojcik, Korsvik's direct supervisor and the Vice-President and Manager for Valley's Metropolitan Banking Department, reviewed Korsvik's recommendation and concurred in Korsvik's determination that Kroy's declining sales and falling profitability rendered it unlikely that Kroy could service the debt it would incur as a result of the LBO. (Wojcik Dep. of March 28, 1991, 10-12, 15, 32-36, 39, App. D to Secretary's Rule 3(g) Statement).
Finally, Dave Tininenko, Valley's Vice-President and Manager of its United States Banking Division, reviewed Korsvik's analysis that Wojcik forwarded to him, and agreed with the analysis. (Tininenko Dep. of March 27, 1991, 28-30, 34, attached as App. F to Secretary of Labor's Rule 3(g) Statement).
As a result, Valley declined to participate as a lender in the LBO financing. In addition, because he apparently believed that the risk in the LBO transaction rendered participation in the financing unwise, Tininenko appended to the bottom of the credit review memorandum the following: "I would be interested to see if First does this deal or how/why it makes sense?? (sic)" (Korsvik Memorandum; Tininenko Dep. of March 27, 1991, at 30).
Valley Enters the Deal as Trustee
On December 10, 1986, Korsvik notified Valley's trust department and informed Russell Gunderson ("Gunderson") that Kroy was looking for a corporate trustee to look out for the interests of the ESOP in the LBO transaction. (Stip., P 20; Korsvik Dep. of Feb. 21, 1991, at 77-79, App. D to Secretary's Rule 3(g) Statement; Gunderson Dep. of Feb. 5, 1991, 60-62, App. H to id.). Gunderson was told by Korsvik that the Commercial Department had declined the offer to participate in the financing of the LBO. (Id., at 73). Gunderson did not ask why the bank declined the offer to participate, although Gunderson did receive and review a copy of the Commercial Division's credit review analysis. (Id. at 73-75).
Gunderson's job at Valley was to act on referrals for potential business coming to the Trust Department and he was neither expected to nor did he know how to review stock valuations. (Gunderson Dep. of Feb. 5, 1991, at 23; Gunderson Dep. of Feb. 6, 1991, at 4, both attached as App. H to Secretary's Rule 3(g) Statement). Robert Johnson, the Executive Vice-President in charge of the Trust Department at Valley, characterized Gunderson as Valley's "chief employee benefit salesperson." (Johnson Dep. of December 12, 1990, at 19-20, Supp. App. K to Secretary's Motion for Partial Summary Judgment; see also Hegeman Dep. of February 20, 1991, at 20, Supp. App. C to id.). Gunderson testified that his work experience prior to coming to Valley was as a salesperson. (Gunderson Dep. of June 25, 1987, at 11, Supp. App. A to id.).
At the time that he became the successor trustee, Gunderson's experience with trusts was limited to his reading and review of 600 or so custodial trust documents (Gunderson Dep. of June 25, 1987 at 29-30; Gunderson Dep. of February 5, 1991, at 10; Gunderson Dep. of February 3, 1992, at 105; all attached as Supp. App. A to id.).
Gunderson was told by Jim Fitzpatrick at Kroy on December 16, 1986, that Valley's proposal concerning the terms on which Valley would serve as trustee was acceptable. (Gunderson Dep. of June 25, 1987, at 31-32, attached as Ex. 19 to Valley's Response to the Department of Labor's Rule 3(g) Statement). At the time that Valley accepted this position, it had never before served as a trustee in connection with a multi-investor ESOP-financed leveraged buyout such as the Kroy LBO. (Johnson Dep. of December 12, 1990, at 56, Supp. K to Supplemental Appendix to the Secretary's Motion for Partial Summary Judgment).
The Actions of Kappa's Law Firm, Patterson, Belknap, Webb & Tyler
After its creation as a mechanism to facilitate the LBO, Kappa hired the law firm of Patterson, Belknap, Webb & Tyler ("Patterson") to advise it. (See, e.g., Memorandum in Support of the Secretary's Motion to Strike, 4).
The DOL had established a procedure in 1976 by which persons may obtain opinion letters from the Secretary on certain issues arising under ERISA: ERISA Procedure 76-1. The scope of issues for which such opinion letters would be given was limited. ERISA Proc. 76-1 § 5.02(a) stated, for example, that the Secretary will not ordinarily issue advisory opinions regarding ERISA "section 3(18) relating to whether certain consideration constitutes adequate consideration." Valley's ESOP counsel, the law firm of Webster & Sheffield, knew of this limitation, and advised Valley that "the DOL has announced that it will not issue advisory opinions concerning whether the adequate consideration requirement has been met in any particular case. Section 5.02(a) of ERISA Procedure 76-1, 41 Fed. Reg 36,281, 36,282 (August 27, 1976)." (December 23, 1986 Letter of Webster & Sheffield to the Trustees of the Kappa Acquisition Corp., 18, Ex. B to the Secretary's Memorandum in Support of Motion to Strike).
Virginia Bartlett, a DOL staffperson, is described by Valley as the alleged "contact person" at the Department for this alleged "informal review." Valley claims that this informal pre-closing review found nothing wrong with the LBO and gave the transaction the DOL's implicit approval.
Bartlett worked at the DOL in the Division of Investigations of Pension Welfare Benefits Administration ("PWBA") as a senior investigator. (Lerner Declaration, P 5, App. A to the Secretary's Response to Valley National Bank's Rule 3(g) Statement ("Lerner Decl."). She lacked the legal authority to approve or disapprove the LBO transaction and so bind the DOL. (Lerner Decl. P 5). Internal regulations of the DOL, Chapter 14, para. 21 of the PWBA Compliance Manual, forbid employees from publicly discussing "whether or not an investigation is underway or even under consideration." (Lerner Decl. P 6).
Valley claims had it known the Secretary would object to the transaction and bring the instant action, it never would have gone through with the deal and would have refrained from serving as trustee for the ESOP.
The Office of Enforcement, Division of Investigations of the PWBA, DOL, opened an investigation of the Kroy LBO on November 21, 1986. (Lerner Decl. P 1). This investigation was not yet completed when the transaction closed on December 23, 1986. (Lerner Decl. P 1; Consolidated Brief in Support of The Secretary's Cross-Motion for Summary Judgment and in Opposition to Valley's Motion for Summary Judgment, at 5). This investigation into the LBO was not completed until late 1987. (Lerner Decl. P 1).
No written approval was ever given Valley or any other participant in the LBO transaction, at any time, by the Secretary notifying interested parties that the DOL would take "no action" with respect to the ESOP's participation in the Kroy LBO transaction. (Lerner Decl P 4; Consolidated Brief in Support of The Secretary's Cross-Motion for Summary Judgment and in Opposition to Valley's Motion for Summary Judgment, at 6). Indeed, Valley, in support of its motions, appends as evidence of DOL approval various letters written by Patterson to DOL staffers. No answer from the DOL is included in the vast record supporting the instant motions.
On December 11, 1986, Gunderson spoke to James Fitzpatrick, Kroy's Vice-President of Finance, who gave him some background information on the proposed LBO; specifically, Gunderson stated that he was sent a draft of the ESOP document and trust agreement and a copy of the proxy statement. (Gunderson Dep. of Feb. 5, 1991, 61-68, 83-88; Gunderson Dep. of June 25, 1987, 25-26, 34, both attached as App. H to Secretary's Rule 3(g) Statement; Memorandum in Support of DOL's Motion For Partial Summary Judgment, 10). Gunderson reviewed no other documents prior to this time. (Gunderson Dep. of February 5, 1991, at 117-119, Supp. App. A to Secretary's Motion for Partial Summary Judgment). Fitzpatrick told Gunderson via telephone on December 16, 1986, that Valley's bid to serve as trustee had been accepted by Kroy. (Gunderson Dep. of Feb. 5, 1991, 89, App. H to Secretary's Rule 3(g) Statement). On this date, the LBO transaction was scheduled to close roughly three days later, on December 18, 1986. (See Memorandum in Support of DOL's Motion For Partial Summary Judgment, 11).
Gunderson flew to New York City in the afternoon of December 16, 1986 (Stip. P 32). The next day Gunderson spent in the offices of Patterson, the New York law firm that represented Kroy's management. (Gunderson Dep. of Feb. 5, 1991, 117-19). During the morning Gunderson again reviewed the plan and trust documents. At lunch he met for the first time with Scott Spector of the law firm of Webster & Sheffield, and Mark Lee of Benchmark Valuation Consultants, the lawyer and valuator hired by the original trustees. (Stip. PP 35-36). At this lunch Gunderson received for the first time the Benchmark Report. (Stip. P 40). The Benchmark Valuation Report was one of the key documents relied upon by Gunderson.
Benchmark's Valuation Report noted that the following documents were reviewed while making its analysis: (1) SEC Forms 10-K for the five-year period through March 29, 1986; (2) SEC Forms 10-Q for the period ending September 27, 1986; (3) Kroy's Annual Reports for the five-year period ending March 29, 1986; (4) Kroy's most recent proxy statement; and (5) the financial projections created by Kroy management for use in the ESOP LBO. (Benchmark Valuation Report, 2, Ex. 38A of the Secretary's Rule 3(g) Statement). Mark Lee did not utilize or review Kroy's financial plan for the 1987 fiscal year which was prepared by Kroy's manager of Financial Analysis, created in October of 1986. (Affidavit of Mark Bowker (Bowker Aff.) P 13, App K to id.; Declaration of Bridget Lundahl (Lundahl Decl.) PP 4-8, App Q to id.). Benchmark did not independently assess whether or not Kroy could meet the sales projections upon which the LBO was predicated. (Lee Dep. of July 12, 1991, at 11, App. L to id.). For example, Kroy's distributors made negative comments regarding Kroy and its products, comments that were not investigated by Benchmark. (See id.; Ex. 38A to id.).
During that afternoon Gunderson read Benchmark's Draft Valuation Report. He testified that he did not review the Benchmark report page by page with Mark Lee but instead discussed it in "general terms" only. (Gunderson Dep. of February 4, 1992, at 358, App. H to Secretary's Rule 3(g) Statement). Gunderson testified that instead of making an independent analysis, he relied upon the assurances supplied by Lee and Benchmark. (Gunderson Dep. of February 3, 1992, at 263; Gunderson Dep. of February 4, 1992, both App. H to id.) Gunderson knew that as a trustee he had a fiduciary duty to make an independent assessment of the benefits and detriments to the ESOP of participating in the LBO transaction. (Gunderson Dep. of February 6, 1991 at 95-96., App H to id.).
At this time Gunderson did not realize that the $ 5.92 price per share to be paid by the ESOP included some premium for control. (Gunderson Dep. of February 3, 1992, at 266-67, id.). Webster & Sheffield's legal opinion did not address whether the ESOP would be able to exercise control in fact. (See Ex. 37 to Secretary's Rule 3(g) Statement).
Gunderson never contacted the original trustees to ascertain their opinion about the LBO or to determine what efforts they made, if any, to negotiate the terms of the ESOP's participation in the LBO transaction. (Van Der Voort Aff. P 18, Van Der Voort Dep. of June 17, 1992, at 115, both in App. A to Secretary's Rule 3(g) Statement; Connoy Aff. P 2, Connoy Dep. of June 16, 1992, at 96, both App M to id.; McCuskey Dep of June 25, 1987, at 63-64, McCuskey Dep. of June 25, 1992, at 78-79, both App. N to id.; Gunderson Dep. of February 3, 1992, at 222-52, App H to id.). Valley admittedly never met with the prior trustees to ascertain what investigation the prior trustees had undertaken. (Gunderson Dep. of February 3, 1992, at 222-252 (Supp. App. A to Secretary's Motion for Partial Summary Judgment). Additionally, Gunderson testified that he had not reviewed copies of the minutes of all the meetings of the original trustees. (Id. at 248-250).
Both Lee and Spector mentioned to Gunderson the fact that the prior trustees had attempted to negotiate more shares for the ESOP for the price to be paid. (Spector Dep. of March 5, 1992 at 90, Ex. 10 to Valley's Response to the Department of Labor's Rule 3(g) Statement). Gunderson did not attempt on behalf of Valley to undertake any negotiations for the ESOP; rather he stated that he thus "concluded from these discussions that further attempts to negotiate the price to be paid by the ESOP were not apt to be fruitful." (Gunderson Dep. of February 4, 1992 at 458-59, Ex. 19 to id.).
Gunderson did not visit the premises of Kroy. He never read the relevant corporate governance documents, and never interviewed Kroy management. (Gunderson Dep. of Feb. 4, 1992 at 391, Gunderson Dep. of February 3, 1992 at 191, 277, 279, App. H to Secretary's Rule 3(g) Statement; Van Der Voort Aff. P 18). While Valley contends that Gunderson met with Errol Bartine to discuss, on December 18, 1986, the involvement of the Kroy management group in the LBO transaction (See Valley's Memorandum in Opposition to Secretary's Motion for Partial Summary Judgment at 21-22), Gunderson testified that at that time the substance of their discussion was limited to Bartine's expressing interest in having Kroy's payroll account handled by Valley (Gunderson Dep. of June 25, 1987, at 116-17, Supp. App. A to the Secretary's Motion for Partial Summary Judgment), an encounter that Gunderson later described as taking "10, 15 minutes at the most." (Gunderson Dep. of February 4, 1992, at 326, Supp. App. A to id.). Bartine testified that he did not recall any direct discussions with any personnel from Valley prior to the closing of the LBO transaction on December 23, 1986. (Bartine Dep. of February 14, 1992, at 199, Supp. App. 5 to id.).
Gunderson reviewed the existing Plan documents and decided that the prior negotiations had produced a deal favorable to the potential ESOP participants. (Rule 3(g) Statement of Valley in Support of its Motion for Partial Summary Judgment, P 20; Gunderson Dep. of 6/25/87, 14-15).
There is some dispute as to how extensively Gunderson discussed with Lee the Benchmark Valuation Report. The evidence indicates that Gunderson's review of, and for that matter understanding of, the Benchmark Valuation Report, was shallow at best. While Lee did testify on behalf of Valley that Gunderson "grilled him" and asked many questions (Lee Dep. of July 12, 1991 at 21, Ex. 16 to Valley's Response to the DOL's Rule 3(g) Statement), Lee could not recall discussing any of the following subjects with Gunderson: (1) the relative provisions of the different classes of stock (Lee Dep. of July 11, 1991, at 11, Supp. App. J to Secretary's Notion for Partial Summary Judgment); (2) Kroy's three year projections (id. at 20); (3) whether the ESOP should negotiate any of the terms of the Kroy LBO transaction (id. at 53, 58); (4) voting or nomination and removal of directors, (id. at 72-74); (5) the relative value of what the ESOP received compared to that received by other cash investors (id. at 185); (6) what due diligence Benchmark had conducted and how up to date and complete the information relied upon by Benchmark was (Lee Dep. of July 12, 1991, at 12, 16, Supp. App. J to Secretary's Motion for partial Summary Judgment); (7) or Kroy's ten-year projections (id. at 111).
All told, even when considered in a light most favorable to Valley, Gunderson spent at most a total of eight hours with Spector and four hours with Lee. In contrast to their behavior before the commencement of this litigation, Valley's prudence expert, Jeffrey Clayton, testified that in preparing his testimony he spent over 100 hours reviewing the records. (Clayton Dep. of October 2, 1992, at 624, Supp. App. O to Secretary's Motion for Partial Summary Judgment).
Gunderson also knew that Valley had been approached to participate in financing the LBO but did not provide a copy of Valley's analysis to either of his advisors so that they could consider this fact. (Spector Dep. of March 6, 1992 at 186-89, App. O to Secretary's Rule 3(g) Statement; Lee Dep. of July 11, 1992 at 223-26, App. L to id.). While there is some dispute as to whether the concerns raised by the Korsvik Memo were discussed at all with Valley's advisors, what is admitted by Valley is that none of the parties supposedly acting on behalf of the ESOP believed that Valley's doubts about the viability of the Kroy LBO raised "cause for concern about the proposed ESOP investment in the LBO." (Spector Dep. of March 6, 1992, at 186-88, Ex. 10 to Valley's Response to the DOL's Rule 3(g) Statement; Lee Dep. of July 11, 1991 at 224-25, Ex. 16 to id.; Gunderson Dep. of June 25, 1987, at 58-59, Ex. 19 to id.). "Valley's decision not to participate in the Kroy loan was of little significance to Valley's decision as trustee to the Kroy ESOP." (Valley's Memorandum in Opposition to the Secretary's Motion for Summary Judgment; Clayton Dep. of October 1, 1992, at 432-35, Ex. 20 to Valley's Response to the DOL's Rule 3(g) Statement).
Gunderson testified that he "reviewed Mr. Korsvik's memorandum, [but] discounted its conclusions because the memorandum did not directly address the issue under consideration, namely whether the investment opportunity presented to the Kroy ESOP was a good one." (Valley's Memorandum in Opposition to the Secretary's Notion for Summary Judgment at 53-54; Gunderson Dep. of June 25, 1987, at 58-63, Ex. 19 to Valley's Response to the DOL's Rule 3(g) Statement). Valley notes that Mark Lee of Benchmark testified that even had he reviewed the Korsvik memorandum he would have ignored it. (Valley's Memorandum in Opposition to the Secretary's Motion for Summary Judgment at 54). Valley relied on the review of the transaction conducted by Benchmark (Id. at 33) and, as noted, took no independent steps to investigate the transaction on behalf of the ESOP, even though they, themselves, had declined to put any of their own capital at risk because they believed the deal to be unwise (Korsvik Memorandum).
Lee and Spector both testified that they were unaware of the fact that Valley previously had been presented with an opportunity to participate in the Kroy LBO as a secured lender but had declined after review of the transaction. (Spector Dep. of March 6, 1992, at 186-89, Supp. App. F to the Secretary's Motion for Partial Summary Judgment; Lee Dep. of July 11, 1991, at 223-26, Supp. App. J to id.).
There was an attempt to close the LBO transaction on December 19, 1986, at the law off ices of Battle Fowler. (Gunderson Dep. of June 25, 1987 at 69-70, App. H to Secretary's Rule 3(g) Statement). In mid-afternoon of December 19, Gunderson was notified that the closing was to be postponed at the request of another investor. In the evening of December 19, 1986, he flew back to Phoenix. (Gunderson Dep. of Feb. 3, 1992 at 223-30; Gunderson Dep. of June 25, 1987 at 69- 71, all App. H to Secretary's Rule 3(g) Statement). The transaction closed on December 23, 1986.
In the LBO the publicly-held shares were purchased for $ 78.0 million, $ 35.5 million from a loan from First National Bank of Minneapolis collateralized with Kroy assets; $ 25 million from a subordinated loan from Quest Entities, not a party to the current action; $ 4.5 million from cash invested by senior management of Kroy and other investors; and the purchase of warrants by Quest and cash on hand from Kroy. (See Memorandum in Support of Valley's Motion for Partial Summary Judgment at 4-5; Amended Complaint P 15).
Kroy then immediately turned around and sold six million shares of class A common stock to the ESOP, with the ESOP paying for the stock with two promissory notes made payable to Kroy in the amount of $ 35.5 million. (Class A Common Stock Purchase Agreement, Ex. 4 to Valley's Response to DOL's Rule 3(g) Statement).
These promissory notes were non-recourse notes and were secured by the unallocated stock sold by Kroy to the ESOP. Kroy committed itself to make contributions to the ESOP in the amount needed to service the notes. The ESOP was in turn obligated under the Plan documents to return this money to Kroy in repayment of its debt. (Bartine Aff., P 6, Ex. 1 to Valley's Response to DOL's Rule 3(g) Statement). The ESOP's obligation to pay Kroy was derivative to Kroy's obligation to make contributions in the amount necessary to service its debt to the ESOP. (Id. at P 10). By using this method of financing Kroy was able to secure significant tax advantages.
By creating the ESOP, Kroy was able to significantly lower the after-tax cost of the LBO. First National Bank Of Minneapolis then reflected the value of the tax break by reducing the interest rate on the loan to Kroy. (Memorandum in Support of Valley's Motion for Partial Summary Judgment at 6). Kroy was able to get a lower rate on its $ 35.5 million loan by passing on the debt to the ESOP which it created specifically for this purpose. (Id.; See also Bartine Aff. P 8).
From 1987 to 1990, Kroy made contributions into the ESOP in the amount of $ 17.5 million which the ESOP then used to repay its loan from Kroy. (Memorandum in Support of Valley's Motion for Partial Summary Judgment at 7).
The instant lawsuit was brought on December 18, 1989, by the Secretary against Valley as trustee of the Kroy ESOP and other parties involved in the transaction. All of the other defendants other than Valley have settled.
THE CLAIMS OF THE PARTIES
Pending before the court are motions by both remaining parties for summary judgment on various claims and counterclaims and by the Secretary to strike Valley's affirmative defenses and counterclaims. These motions fall into two categories: those concerning the Department's claims against Valley and those concerning Valley's counterclaims and the affirmative defenses it asserts against the Department. For the sake of convenience the motions concerning the Department's claims against Valley shall be dealt with first.
I. THE SECRETARY'S MOTION FOR SUMMARY JUDGMENT AND VALLEY'S "NO LOSS" DEFENSE
The Department of Labor has moved for partial summary judgment on its claims
against Valley National Bank with respect to paragraphs 40-42 of the Secretary's Amended Complaint which allege that Valley caused the Kroy Employee Stock Ownership Plan ("ESOP") to engage in a non-exempt prohibited transaction in violation of ERISA §§ 406(a)(1)(A), (B) and (D), 29 U.S.C. §§ 1106(a)(1)(A), (B) and (D), by causing the ESOP to purchase Kroy shares for more than "adequate consideration" as defined in ERISA § 3(18), 29 U.S.C. § 1102(18).
(Notice of Secretary's Motion for Partial Summary Judgment, 1; Amended Complaint PP 40-42).
The Department's claim is that Valley breached its fiduciary duty to the ESOP by causing it to pay more than adequate consideration for the Kroy stock it purchased. "Adequate consideration" is statutorily defined as follows: "in the case of an asset other than a security for which there is a generally recognized market, [as] the fair market value of the asset as determined in good faith by the trustee or named fiduciary." 29 U.S.C. § 1002(18)(B).
Since the facts of this case are not genuinely in dispute, it is the scope of this Section that provides the battleground for the Secretary's instant motion for partial summary judgment.
The Secretary's claim contains three components:
A. Valley failed to conduct the independent good faith inquiry of the LBO transaction required by law thereby violating its fiduciary duty.
B. Due to Valley's nonfeasance, the ESOP did not get adequate consideration for its outlay.
C. As a result, loss was caused to the ESOP in the amount of $ 17.5 million dollars (the amount of the $ 35.5 million that the ESOP still owed on debt created out of the LBO) minus $ 250,000 (the amount that the ESOP sold its stock pursuant to order of the Bankruptcy Court overseeing the Kroy bankruptcy) plus interest.
The Secretary's motion for partial summary judgment argues that the undisputed facts demonstrate that Valley failed to arrive at a "good faith determination of the fair market value of the stock it caused the ESOP to purchase" because when it caused the ESOP to purchase the shares as trustee of the ESOP, Valley could not make a prudent decision because it did not understand what it was "doing and why it [was] in the interests of the plan participants and beneficiaries." (Memorandum in Support of the Secretary's Motion for Partial Summary Judgment, 2).
Thus two requirements are imposed: fair market value and good faith. The DOL contends that the "adequate consideration" exemption to the general prohibition against a Plan acquiring the stock of a sponsoring employer applies only where (1) the price paid by the ESOP reflects the fair market value of the asset and (2) the trustee or named fiduciary conducts a careful, independent and good faith investigation of the circumstances prevailing at the time of the valuation. (Secretary's Reply to Valley's Opposition to the Secretary's Motion for Partial Summary Judgment at 39). Valley contends that the exemption applies if the trustee either causes the ESOP to pay adequate consideration or if a good faith inquiry into valuation is conducted. The court need not decide between these two formulations since it is clear from the evidence adduced by both parties that adequate consideration was not paid and that a good faith inquiry into the transaction was not made.
The Legal Standards for Summary Judgment
F.R. Civ. P. 56(c) authorizes the granting of summary judgment when "the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law." The Secretary asserts that its motion should be granted because Valley's evidence is not sufficiently probative to create a genuine issue of material fact. It is clear from the evidence that the Secretary is correct.
"By its very terms, this standard provides that the mere existence of some alleged dispute between the parties will not defeat an otherwise properly supported motion for summary judgment; the requirement is that there be no genuine issue of material fact." Anderson v. Liberty Lobby, 477 U.S. 242, 247-48, 91 L. Ed. 2d 202, 211, 106 S. Ct. 2505 (1986) (emphasis in original). If the evidence is merely colorable or not significantly probative, summary judgment may be granted. Id., 477 U.S. at 249-50, 91 L. Ed. 2d at 212. In regard to the Secretary's motion for partial summary judgment, there are no sufficiently probative and genuine issues of material fact to prevent the issuance of summary judgment for the Secretary.
While all doubts are to be resolved in favor of nonmovants, "the plain language of Rule 56(c) mandates the entry of summary judgment after adequate time for discovery and upon motion against a party who fails to make a showing sufficient to establish the existence of an element essential to that party's case and upon which that party will bear the burden of proof at trial." Celotex Corp. v. Catrett, 477 U.S. 317 at 322, 91 L. Ed. 2d 265 at 273, 106 S. Ct. 2548 (1986).
A fiduciary like Valley who claims that ERISA §§ 408(b)(3) and (e), 29 U.S.C. §§ 1108(b)(3) and (e), exempt such a transaction from the prohibitions of ERISA § 406(a)(1)(A), (B) and (D) has the burden of proving by a fair preponderance of the credible evidence that the stock was purchased for no more than "adequate consideration" within the meaning of ERISA section 3(18). Lowen v. Tower Asset Management, Inc., 829 F.2d 1209, 1215, (2d Cir. 1987); Donovan v. Cunningham, 716 F.2d 1455, 1467-68 (5th Cir. 1987); Marshall v. Snyder, 572 F.2d 894, 900 (2d Cir. 1978). To meet its burden in opposing the Secretary's motion for summary judgment as the party bearing the burden of proof on the adequate consideration issue, "Valley must prove that it arrived at its determination of fair market value by way of a prudent investigation in the circumstances then prevailing." Donovan, 716 F.2d at 1467-68. Gunderson's admissions, in addition to the rest of the evidence, demonstrate that Valley, by failing to take any independent steps, by failing to understand the basis for and the evidence used to create the Benchmark Report, and by failing to take the steps enumerated in the Spector Opinion, failed to arrive at a determination of fair market value by way of a prudent investigation into the circumstances then prevailing.
The Statute at Issue and the Applicable Legal Standard Thereunder
The Prudent Person Standard.
ESOP trustees are fiduciaries and must discharge their duties "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 like character and with like aims." 29 U.S.C. § 1104(a)(1)(B). A fiduciary's duties under ERISA are "the highest known to law." Donovan v. Bierwirth, 680 F.2d 263, 272 n.8 (2d Cir. 1982). Prudence is measured according to the objective prudent person standard developed in the common law of trusts. Katsaros v. Cody, 744 F.2d 270, 279 (2d Cir.), cert. den. 469 U.S. 1072, 83 L. Ed. 2d 506, 105 S. Ct. 565 (1984).
The trustee must "prove that adequate consideration was paid by showing that they arrived at their determination of fair market value by way of a prudent investigation in the circumstances then prevailing." Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983).
"A fiduciary's independent investigation of the merits of a particular investment is at the heart of the prudent person standard." Whitfield v. Cohen, 682 F. Supp. 188, 194 (S.D.N.Y. 1988) (emphasis supplied).
"A trustee's lack of familiarity with investments is no excuse." Katsaros v. Cody, 744 F.2d at 279. As noted in Donovan v. Cunningham, 716 F.2d at 1467, a "pure heart and an empty head are not enough." A trustee must make reasonable investigation into the representations of interested parties and where that investigation would have revealed evidence that the investment was unsound, the trustee can be held liable. Katsaros v. Cody, 744 F.2d at 279. Here, Valley relied on an analysis by Benchmark that utilized projections and assumptions supplied by Kroy and which did not undertake even minimal independent investigations such as contact with those who had dealings with Kroy which would have revealed the riskiness of the Kroy LBO transaction to any would-be investor.
ERISA § 404(a)(1)(B), 29 U.S.C. § 1104(a)(1)(B), is a more stringent version of the prudent person standard than in the common law of trusts. Donovan v. Mazzola, 716 F.2d 1226, 1231 (9th Cir. 1983). "Prudence is measured according to the objective 'prudent person' standard developed in the common law of trusts." Katsaros v. Cody, 744 F.2d 270, 279 (2d Cir. 1984). "Rather than explicitly enumerating all of the powers and duties of trustees and other fiduciaries, Congress invoked the common law of trusts to define the general scope of their authority and responsibility." Central States Pension Fund v. Central Transport, 472 U.S. 559, 570, 86 L. Ed. 2d 447, 457, 105 S. Ct. 2833 (1985) (emphasis in original) (citations omitted).
This is an objective standard that focuses on the conduct of the fiduciary causing the ESOP to make the investment. Thus even though Congress endorses the use of ESOPs and has implemented this policy via the tax codes, a trustee still must, before causing the ESOP to invest in employer stock for which there is no generally recognized market, conduct a good faith inquiry subject to close scrutiny under the prudent person standard. See Fink v. National Savings Bank, 772 F.2d 951, 955 (DC Cir. 1985); Eaves v. Penn, 587 F.2d 453, 459 (10th Cir. 1978).
The Mere Fact That the ESOP was Created as a Mechanism to Finance the LBO Does Not Excuse the Trustee's Failure to Exercise Prudence in Regard to Investing the ESOP's Assets.
The ESOP's obligation to make payments on its promissory notes was effective under the Plan documents only upon contributions being made by Kroy to the ESOP. Thus, the ESOP obtained its six million shares without any initial cash outlay. (See ESOP Loan "A" and "B" Agreements, Ex. 5, 6 to Valley's Response to the Government's Rule 3(g) Statement).
Valley asserts that it "approached the decision as to whether to allow the ESOP to participate in the Kroy LBO mindful of its fiduciary responsibilities and aware that the adoption of the ESOP was consistent with the Congressional goal of employee participation in stock ownership of the employer, and that without participation in the LBO the ESOP would not be funded." (Valley's Memorandum in Opposition to the Secretary's Motion for Partial Summary Judgment, 50 (emphasis in original)). However, the duty of a fiduciary is solely directed toward the interests of the Plan participants. The implementation of Congressional policy is not the concern of an ESOP trustee.
As the Secretary notes, it is irrelevant how the ESOP got the $ 35.5 million in cash in regard to the question of whether the ESOP paid more than fair market value for the stock. If the investment is not prudent, the fiduciary duty owed by Valley is not to invest, even if without that decision the ESOP would not be created. Valley cannot excuse a poor investment by claiming that the ESOP would not exist if not for the imprudent decision to make that investment.
Judicial Review of ESOP Transactions
The task of the District Court is to review the challenged transaction in order to determine whether the trustees, "at the time they engaged in the challenged transaction, employed the appropriate methods to investigate the merits of the investment and to structure the investment." Donovan v. Mazzola, 716 F.2d 1226, 1232 (9th Cir. 1983), cert den. 464 U.S. 1040, 104 S. Ct. 704, 79 L. Ed. 2d 169 (1984); Katsaros v. Cody, 744 F.2d 270, 279 (2d Cir.), cert. den. sub nom. Cody v. Donovan, 469 U.S. 1072, 83 L. Ed. 2d 506, 105 S. Ct. 565 L. Ed. 2d (1984); Fink v. National Savings & Trust Co., 249 U.S. App. D.C. 33, 772 F.2d 951, 955 (D.C. Cir. 1985); Donovan v. Cunningham, 716 F.2d at 1467. It is clear from the record that in the LBO transaction Valley was not prudent, did not use the appropriate methods to investigate the merits of the transaction and thus violated its fiduciary duty under ERISA.
The Duty to Conduct an Independent Review and Investigation
A. Independent Appraisals
"An independent appraisal is not a magic wand that fiduciaries may simply wave over a transaction to ensure that their responsibilities are fulfilled." Cunningham, 716 F.2d at 1474.
"While a trustee has a duty to seek independent advice where he lacks the requisite education, experience and skill, the trustee, nevertheless, must make his own decision based on that advice." Whitfield v. Cohen, 682 F. Supp. 188, 194 (S.D.N.Y. 1988) (citations omitted). Here, Valley did not even seek independent advice. The use of Benchmark's Report, which relied solely on representations by Kroy, and Spector's Opinion, whose mandate Gunderson did not fulfill and who was hired by Kroy management officers, amounts to dependent advice.
Case law makes crystal clear that passive acceptance of reports do not immunize trustees from ERISA liability. The trustees in the case of Katsaros v. Cody were found liable because "they passively received a superficial picture of the [business they caused the pension fund to invest in] 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." Katsaros v. Cody, 744 F.2d at 275.
B. Cannot Rely Solely On Advice Of Advisors.
Neither the Benchmark valuation opinion nor the Spector opinion analyzed the terms of the loan. As testified to by Gunderson, no one at Valley made any efforts whatsoever to undertake an independent analysis of the loan terms; instead, Valley, as the ESOP trustee, relied solely on the representation by the company as to the fairness of the agreement and the loan terms. (Gunderson Dep. of June 25, 1987, 113-14). To contend that this action constitutes prudence seems remarkable; after all, how many people or institutions would undertake a $ 35 million investment in a company (which for the ESOP was the entirety of its investments) based solely on representations by the company as to its health and the fairness of the deal by which the investment was made?
Gunderson testified that the efforts made to determine that adequate consideration was given were limited solely to relying upon Benchmark's Valuation Report (Gunderson Dep. of Feb. 3, 1992, at 205-06). A fiduciary cannot rely on a financial or legal opinion without understanding the basis for the recommendations therein which was clearly the case.
C. Cannot Rely On Legal Counsel.
Valley contends that Webster & Sheffield provided a formal legal opinion and reached the "opinion that the ESOP transaction did not violate ERISA." (Valley's Memorandum in Opposition to the ...