DOL Decrees New Rules For ESOP Fiduciaries
Monday, 09 April 2018
All transactions involving the purchase or redemption of employer stock by an Employee Stock Ownership Plan (“ESOP”) must be conducted at fair market value. This assures that the statutory prohibited transaction exceptions available to compliant ESOPs will apply. Fair market value for private companies must be determined by an independent appraisal. This would include annual valuations and, more important, the valuation of the ESOP’s critical acquisition of the employer stock that it is required to maintain as its “principal investment.”
ESOP appraisals can be influenced by misleading information provided by company management. Appraisers can even give their approval to ESOP transactions that leave the employer-sponsor insolvent as in the case of the Chicago Tribune ESOP. The resulting litigation was concluded by a settlement agreement with the Department of Labor that charges ESOP fiduciaries with the responsibility of performing their own due diligence investigation of any ESOP appraisal report.
A recent Department of Labor settlement agreement with First Banker Trust Services (“FBTS”) resolves three separate cases and outlines additional valuation guidelines that ESOP fiduciaries (including the employer-sponsor of an ESOP) should consider any time they deal with a valuation report issued by the ESOP appraiser, or “Valuation Advisor.”
Each of the three cases alleged that FBTS approved ESOP transactions without undertaking a thorough investigation of the value of the company stock involved. Because the stock valuations were based on unrealistic projections of future company earnings, they overstated the value of the stock of each sponsor. As a result, the three subject ESOPs allegedly overpaid for the stock purchased by each of them. As part of the settlement agreement, FBTS also agreed to pay $15.75 million to the three ESOPs.
The FBTS settlement agreement sets out the following requirements and, although they technically apply only to FBTS, ESOP trustees and administrative committees should consider them as generally applicable compliance guidelines (these are just highlights of the new requirements):
The selection process for any Valuation Advisor must include at least three references and review of any regulatory proceedings involving the Advisor. The Valuation Advisor cannot have previously worked for either the ESOP sponsor or a committee of its employees.
Any valuation report must comment on, among other things, the financial impact of a proposed ESOP transaction and related securities acquisition debt on the ESOP sponsor (remember the Tribune ESOP!).
Valuation reports should be based on audited financial statements of the sponsor for the prior five year period. If unaudited or qualified financial statements are used, any selling shareholders who are officers, managers or directors of the ESOP sponsor must agree to compensate the ESOP for any losses attributable to inaccuracies in the sponsor’s financial statements.
If the ESOP pays a control premium for company stock, ESOP fiduciaries must document that the ESOP is obtaining voting control in fact. Any limitations on such voting control must be identified and valued in terms of amounts paid to the ESOP as “consideration” for those limitations.
Valuation reports must consider whether a proposed ESOP loan is at least as favorable to the ESOP as any loan between the ESOP sponsor and any of its executives in the prior two years.
The ESOP trustee must provide the Valuation Advisor certain specific information about the sponsor, including offers to purchase or sell its stock in the prior two year period as well as any sponsor defaults under a loan agreement, any management letters from the sponsor’s accountant and information relating to any sponsor valuations provided to the IRS during the prior five years.
The ESOP trustee must consider whether or not it is appropriate to include a purchase price adjustment or claw-back provision in any share purchase agreement in order to take into account a future corporate event or other event that might adversely affect the value of the sponsor’s stock.
The ESOP trustee must meet certain documentary requirements, including a certification by its employees who participated in decision making with respect to an ESOP transaction that they have read the valuation report and considered the reasonableness of its underlying assumptions and value conclusion.
ESOP sponsors and financial institutions involved in ESOP transactions should consider the new territory staked out in the FBTS settlement agreement. First of all, note the requirement that company insiders agree to compensate the ESOP for errors in company financial statements if those statements are not audited financial statements. Second, the normal practice of assigning a control premium in the valuation of majority stock interests purchased by ESOPs must now be questioned by ESOP fiduciaries. This means that typical arrangements that leave incumbent management in control of the voting of ESOP stock must not only be investigated by ESOP fiduciaries but also may require the fiduciaries to determine a value for any such limitations on control – and to provide that the ESOP be “compensated” accordingly.