Howard v. Shay: ESOP Valuation Case Takes Peculiar Turn

One of the longest-running ESOP valuation cases is Howard v. Shay. The case has now been in court for eight years and still may not be resolved. The case revolves around a terminated ESOP at Pacific Architects and Engineers (PAE). PAE's principal business was real estate. PAE set up a 40% ESOP in 1974. In 1986, Arthur Young was hired to replace the existing valuation firm and valued the company at $83 per share, but the ESOP shares at only $14.40. It arrived at this conclusion by applying a 60% discount to a jointly held real estate asset in Japan, a 40% non-control discount, and a 50% lack of marketability discount. In 1988, the ESOP was terminated and the ESOP shares were repurchased by the firm's owners at this same $14.40 price. Participants sued. The district court for the Central District of California ruled against the plaintiffs, but, on appeal, the Ninth Circuit Court of Appeals ruled that the plan's fiduciaries had failed to comply with ERISA requirements.

In particular, the court stated that the fiduciaries should not have simply accepted the valuation. The fiduciaries, who were company insiders, had agreed in advance simply to accept whatever Arthur Young found. They did not question any aspect of the valuation, including discounts that were well above those traditionally applied in ESOPs. Marketability discounts typically range from 0% to 25%, for instance, while control discounts are most often in the 20% to 35% range. The circuit court could not rule on the facts concerning the valuation, however, but only matters of law. So it remanded the case to the district court. The circuit court's ruling, however, indicated a very strong presumption that the valuation was inappropriate and that the plaintiffs should receive damages.

The district court did not see it that way. Judge Dickran Tervizian wrote a strong opinion indicating he thought the circuit court was wrong, and that while he could not change their ruling on matters of law, he still thought the $14.40 per share value was accurate. The flavor of his remarks can best be summarized by his comment that the case made him think that "if I was ever an employer, I would never under any circumstances ever give a penny to any employee that I ever had because that employee would come back and bite me in the you-know-what."

While the strong "in your face" response of the district court to the circuit court is itself unusual, even odder is the judge's order that the employees can buy shares back at the $14.40 value. There will likely be little enthusiasm for that -- the shares are currently worth half that much, the company is closely held (and the employer would no doubt not be eager to buy back the shares in the future), and the company would first have to do extensive securities filings.

The decision is not likely to set any precedent for future cases, although it certainly will dampen the enthusiasm of people looking at it to pursue their own ESOP valuation cases.