United States: DOL Settlement Is A Cautionary Tale For ESOP Trustees

Last Updated: July 14 2014
Article by David B. Joffe and Gordon Earle Nichols

The Department of Labor (DOL) recently settled a case involving an employee stock ownership plan (ESOP) that provides guidance but also a warning for trustees and employers contemplating ESOP transactions that later go awry. In Perez v. GreatBanc Trust Co., the DOL sued GreatBanc Trust Company (GreatBanc), the trustee of the Sierra Aluminum Company's ESOP, claiming that GreatBanc relied on a flawed appraisal report to support the ESOP's purchase of 3.4 million shares of company stock for $53 million. The DOL claimed that GreatBanc failed to adequately inquire into an appraisal that presented unrealistic and aggressively optimistic projections of the company's future earnings and profitability; failed to investigate the credibility of the assumptions, factual bases, and adjustments to financial statements that went into the appraisal; and asked for a revised valuation opinion in order to reconcile the higher purchase price the trustee agreed to pay with the lower fair market value of the company stock determined in earlier versions of the appraisal.

The DOL and GreatBanc agreed to settle the case for $5.25 million. Significantly, as part of the settlement agreement, GreatBanc agreed to implement very specific policies and procedures whenever it serves as a trustee or other fiduciary of an ESOP in connection with transactions in which the ESOP is purchasing or selling, is contemplating purchasing or selling, or receives an offer to purchase or sell employer securities that are not publicly traded. The policies and procedures are very detailed, highly proscriptive, and—in several cases—go beyond explicit requirements under the law. While all trustees would not necessarily have to follow the same policies and procedures, the framework provides some indication of what the DOL may be looking for in an audit or other investigation. As such, trustees may want to consider incorporating some or all of the policies and procedures as part of their due diligence.

The policies and procedures that GreatBanc agreed to include the following:

  • Selection and Use of Valuation Advisor. GreatBanc is generally required to hire a qualified valuation advisor, investigate the advisor's qualifications, and prudently determine that it can rely on the advisor before entering into the transaction. GreatBanc cannot use an advisor for a transaction that has previously performed work for the ESOP sponsor (as distinguished from the ESOP), any counterparty to the ESOP involved in the transaction, or any other entity that is structuring the transaction (such as an investment bank). GreatBanc is also generally prohibited from using an advisor that has a familial or corporate relationship to itself and other transaction parties. Most significantly, in selecting an advisor for a transaction involving the purchase or sale of employer securities, GreatBanc has to prepare a written analysis addressing specified topics such as the reason for selecting the particular advisor. GreatBanc also has to oversee the valuation process and make sure the advisor documents certain required items; if the advisor does not do so, GreatBanc then has to prepare supplemental documentation addressing a number of matters relating to the analysis.
  • Financial Statements. GreatBanc must request that the company provide GreatBanc and its valuation advisor with audited unqualified financial statements prepared by a CPA for the preceding five fiscal years, unless financial statements extending back five years are unavailable. In the absence of such audited financial statements, GreatBanc is required to take certain steps before proceeding with the transaction, including additional documentation of why it has chosen to proceed.
  • Fiduciary Review Process. GreatBanc must follow a specified process and document the valuation analysis. GreatBanc's reliance on an appraiser's valuation report is contingent on taking certain steps and providing certain documentation. If the valuation report is not consistent with the analysis, then GreatBanc must not proceed with the transaction. Again, the trustee is required to document its analysis of such issues.
  • Fair Market Value. GreatBanc cannot cause an ESOP to purchase employer securities for more than their fair market value or sell employer securities for less than their fair market value. GreatBanc specifically agreed not to cause an ESOP to engage in a leveraged stock purchase transaction in which the principal amount of the debt financing the transaction exceeds the fair market value of the stock acquired with that debt, irrespective of the interest rate or other terms of the debt used to finance the transaction.
  • Consideration of Claw-Back. In evaluating proposed stock transactions, GreatBanc is required to consider whether it is appropriate to request a claw-back arrangement or other purchase price adjustments to protect the ESOP against the possibility of adverse consequences in the event of significant corporate events or changed circumstances. GreatBanc must also document in writing its consideration of the appropriateness of a claw-back or other purchase-price adjustments.

These policies and procedures, in many ways, go beyond the stated requirements in the law. For example, while an ESOP trustee may ordinarily choose to document the retention of a particular appraiser, these policies and procedures impose stricter requirements including a written analysis of the reasons supporting the selection of a particular appraiser, which in all likelihood go beyond the customary practice for most trustees. Further, the requirements of the various written reports by the trustee, as opposed to the appraiser, will seemingly result in a great deal of duplication of effort with the almost certain increase in expense for the plan sponsor. The inclusion of certain specified items for consideration, such as the possible use of a claw-back provision, seems to be an attempt to implement an almost formulaic approach to what has historically been a holistic decision—whether the purchase of the stock of the employer on the terms in front of the trustee is in the best interests of the ESOP participants.

Although the settlement agreement only affects GreatBanc, all trustees should reevaluate their processes used in evaluating stock purchase transactions with respect to non-publicly traded companies in light of the settlement. While it may not be necessary for trustees to take all of the same steps with the same level of documentary compliance, the settlement could be interpreted as a cautionary tale to trustees who do not undergo a considered, careful, and well-documented process.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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