Keach, Debra K. v. U.S. Trust Company

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