Newman Howard Gilbert Leon Allen Joan Howard Theodore H. Pope, as Representatives of Plan Participants Similarly Situated on Behalf of the Employee Stock Ownership Plan of Pacific Architects and Engineers Incorporated v. Edward A. Shay Martin L. Lehrer Richard L. Smith Allen Shay Pacific Architects and Engineers, Inc.

Citations: 100 F.3d 1484; 96 Daily Journal DAR 14043; 96 Cal. Daily Op. Serv. 8477; 20 Employee Benefits Cas. (BNA) 2097; 1996 U.S. App. LEXIS 30228Docket: 93-56605

Court: Court of Appeals for the Ninth Circuit; November 21, 1996; Federal Appellate Court

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Participants in the Employee Stock Ownership Plan (ESOP) of Pacific Architects and Engineers, Inc. initiated a lawsuit against former fiduciaries Edward Shay, Martin Lehrer, and Richard Smith, alleging breaches of fiduciary duty under the Employee Retirement Income Security Act (ERISA). In 1974, the ESOP acquired 40% of Pacific's stock from Shay for $4,269,162, approximately $10.67 per share. In 1988, the ESOP sold this stock back to Shay for $14.40 per share, a price determined by valuator Arthur Young, Inc. Despite the sale, the ESOP only achieved a 2.2% annual return, while the company benefited from significant increases in Japanese real estate values.

The district court ruled in favor of the defendants, concluding that the ESOP did not suffer a breach of duty and received adequate compensation for its stock. However, the Ninth Circuit Court of Appeals reversed this decision, indicating that further examination of damages was necessary. The background details highlight that Shay, Smith, and Lehrer were fiduciaries and members of the ESOP advisory committee, and that prior to the 1988 transaction, there were concerns regarding the valuation methodologies employed, leading to the engagement of Arthur Young for a new valuation.

On November 8, 1988, Arthur Young issued a valuation report determining that the stock of the Employee Stock Ownership Plan (ESOP) was valued at $14.40 per share. On the same day, the board of Pacific, including members Shay, Lehrer, and Smith, voted to terminate the ESOP, and the following day, the ESOP administrative committee decided to sell all ESOP shares to the E. A. Shay Irrevocable Trust, with Shay abstaining from both votes. Lehrer acknowledged that the administrative committee had pre-agreed to use Arthur Young's valuation for setting the transaction price, despite not having seen the valuation beforehand.

The fiduciaries relied heavily on Arthur Young's valuation without further scrutiny, necessitating an examination of the methodology employed. Arthur Young based its valuation on historical financial statements and independent real estate appraisals provided by the fiduciaries, asserting these sources represented the fair market value and operational conditions of Pacific and its real estate investments. They also relied on Pacific attorney Carol May's assertion that California Corporations Code § 1800 did not entitle the ESOP to initiate involuntary dissolution.

Arthur Young defined fair market value as the price that would occur between a willing buyer and seller with reasonable knowledge and without compulsion. The valuation involved separating Pacific's assets into three components: a 50% interest in K.K. Halifax valued at $59,997,000, other real estate valued at $18,178,000, and operations valued at $5,250,000. The total net asset value exceeded $83 million, but after applying significant discounts—60% for lack of control over K.K. Halifax, 40-50% for minority interest, and 50% for lack of liquidity—Arthur Young arrived at a fair market value of $14.40 per share.

The rationale behind the discount factors included the lack of control Pacific had over K.K. Halifax and concerns about the volatility of Japanese real estate, though no supporting studies or comparable analyses were provided for these discounts. Notably, the discount for K.K. Halifax was increased from 40% in a prior May valuation to 60% in November, without justification for this change.

Arthur Young assessed a 40 to 50% minority interest discount, noting that in late 1987, investors typically paid a 40% premium for control, translating to a 28.6% discount. However, Arthur Young deemed this percentage insufficient for Pacific, adjusting it to 42.9% by multiplying the original figure by 1.5. This adjustment was based on concerns about Japan's real estate price volatility, higher tax rates, and currency exchange risks. Arthur Young did not evaluate potential impacts from California Corporation Code 1800, nor did it justify the 150% increase or compare Pacific to other companies with similar discounts.

Regarding liquidity discounts, Arthur Young referenced studies indicating a 30 to 35% marketability discount but argued for a 50% liquidity discount instead. This decision was influenced by Pacific's rights regarding ESOP stock and its litigation risks, along with the overvaluation of the Japanese real estate market. Arthur Young, however, failed to clarify the basis for choosing 50% over a figure closer to the average or to compare Pacific with other companies that had a 50% liquidity discount.

After a six-week bench trial, the district court ruled in favor of the ESOP fiduciaries, finding that they had provided Arthur Young with all pertinent information and that California law was preempted by ERISA. The court applied the business judgment rule, concluding that the fiduciaries did not breach their duty by relying on Arthur Young's valuation, determining that they exercised the necessary care and diligence, and affirming that $14.40 per share constituted full and fair consideration.

ERISA mandates that fiduciaries act solely for the benefit of plan beneficiaries and adhere to high standards of care and prudence in their decisions. The court examines both the merits of the transaction and the thoroughness of the fiduciary's investigation into the transaction’s merits. Additionally, ERISA prohibits fiduciaries from engaging in self-dealing transactions but allows for the acquisition or sale of qualifying employer securities if done for adequate consideration.

Under 29 U.S.C. 1108(e), fiduciaries involved in self-dealing transactions must demonstrate they acted with care and loyalty and that the ESOP received adequate consideration, a burden that is notably demanding. An essential aspect of this inquiry is the thoroughness of the fiduciary's investigation into the transaction. While obtaining independent assessments from financial advisors or legal counsel is indicative of a diligent investigation, it does not serve as an absolute defense against claims of imprudence. Fiduciaries must ensure they investigate the qualifications of any expert, provide them with complete and accurate information, and justify their reliance on their advice.

The plaintiffs contended that the district court improperly applied the business judgment rule instead of the prudent man standard, which led to a misapplication of the latter as well. The court found that the fiduciaries failed to prove they fulfilled their responsibilities and that the ESOP received adequate consideration. The investigation's thoroughness was particularly lacking; the fiduciaries executed the transaction without negotiation, did not seek alternative valuations, and inadequately scrutinized the Arthur Young valuation, which had significant flaws. 

Specifically, the fiduciaries overlooked a 60% discount on the value of Pacific's ownership without empirical support, failed to challenge a minority interest discount that was disproportionately high, and accepted a liquidity discount that exceeded historical averages without sufficient justification. A prudent fiduciary would have questioned these assumptions and sought additional clarity.

Arthur Young indicated that the high liquidity discount factor was attributed to the overvaluation and volatility of Japanese real estate, which had already been cited for increasing K.K. Halifax and minority interest discounts. A prudent fiduciary should have scrutinized the fifteen-point adjustment and considered whether the overvaluation and volatility were counted multiple times. An independent appraisal is merely a tool, not a guaranteed safeguard for fiduciaries. While conflicted fiduciaries are not required to be valuation experts, they must earnestly review and understand the appraisal, questioning any questionable methods or assumptions. If uncertainties remain after this review, seeking a second opinion is advisable. Relying solely on an independent appraisal as a defense against imprudence is unwise, particularly in potential self-dealing situations, as fiduciaries can influence the final valuation through expert selection or information control. The case exemplifies this risk, as Smith discussed discounts with potential valuators and faced resistance from Ernst & Whinney regarding his conditions. The fiduciaries did not adequately review or question Arthur Young's valuation before completing the transaction, failing to meet ERISA’s investigative obligations. The district court's conclusion that fiduciaries had met their ERISA duties was overturned, and the case was remanded. In dissent, O'Scannlain agreed that ERISA fiduciaries are held to a higher standard than a prudent layperson and must seek independent advice if lacking expertise. However, merely obtaining an independent appraisal does not fulfill prudence requirements; fiduciaries must ensure the appraiser is well-informed and that the data provided is complete. The dissent noted that there are no precedents for finding fiduciaries in breach of duty when they properly select and inform independent appraisers.

Cunningham does not support the proposition at hand because the fiduciaries in that case relied on an outdated expert valuation of stock, knowing that the company's performance did not match earlier growth projections. The Fifth Circuit ruled that the fiduciaries breached their duties by not providing current information to the expert. In contrast, the fiduciaries in the current case are criticized not for inaccurate data but for failing to question the expert's methodology. The district court found that the fiduciaries properly selected Arthur Young and provided all relevant information. Unless this finding is deemed clearly erroneous, the fiduciaries acted prudently. The majority's requirement effectively demands that fiduciaries possess expertise they lack, which contradicts the purpose of hiring experts. The district court also deemed Arthur Young's valuation and recommended price as appropriate. Unless this finding is also clearly erroneous, the fiduciaries' reliance on the valuation cannot be deemed unreasonable. Additionally, the dissent notes that the district court erred in finding that ERISA preempts California Corporate Code 1800, but acknowledges that even with preemption, the statute would still reduce Pacific's minority interest discount.