Reich v. Valley Nat. Bank of Arizona

Decision Date10 September 1993
Docket NumberNo. 89 Civ. 8361 (CBM).,89 Civ. 8361 (CBM).
Citation837 F. Supp. 1259
PartiesRobert B. REICH, Secretary of the Department of Labor, Plaintiff, v. VALLEY NATIONAL BANK OF ARIZONA, Kroy Inc., Kroy Inc. Employee Stock Ownership Plan, Errol W. Bartine, James P. Fitzpatrick, John M. Glitsos, Randall E. Gnant, Kim D. Gustafson, David Gustafson, David D. Kielty, Vittal G. Srimushman, Defendants.
CourtU.S. District Court — Southern District of New York


Leslie C. Perlman, Eric G. Serron, Office of Sol., U.S. Dept. of Labor, Washington, DC (Suzanne Windle, Maria Makris-Gouvas, on brief), for Dept. of Labor.

Arthur P. Greenfield, Jeffrey Walsh, Snell & Wilmer, Phoenix, AZ (Gilbert B. Weiner, of counsel), for Valley Nat. Bank.


MOTLEY, District Judge.

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.


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. ?? 2-3, Ex. 1 to Rule 3(g) Statement of Defendant Valley).

The Kroy management group proposed to the Board on July 11, 1986, that the Board purchase all of Kroy's outstanding shares on behalf of a management-led leveraged buyout. (Id.) Participants in the Kroy LBO included Kroy senior management, some outside investors and lenders, and the ESOP, which was created specifically to facilitate the LBO. (Memorandum in Support of Valley's Motion for Partial Summary Judgment at 3.)

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...

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