United States: View From McDermott: Fifth Circuit Focuses On Process In ESOP Valuations

Though the Supreme Court's 2014 unanimous ruling in Fifth Third Bank v. Dudenhoeffer announced the Employee Retirement Income Security Act (ERISA) standards for stock valuation in the context of a large public employee stock ownership plan (ESOP), the vast majority of ESOPs are still grappling with valuation issues. ESOPs that hold stock of closely-held corporations—approximately 90% of all ESOPs— remain almost unaffected by Dudenhoeffer's valuation discussions, and face continued scrutiny by the Department of Labor (DOL). Appraisal of closely-held stock is an inexact science that involves an inherent level of uncertainty in assessing a variety of potential fact patterns.

This article summarizes valuation issues in acquisitions of closely-held corporation stock by ESOPs in the context of Perez v. Bruister, a recently decided Fifth Circuit case. The case stressed the importance of ''process'' in valuation determinations being utilized for acquisitions of a corporation's stock by an ESOP. In reviewing the case, this article provides a detail of the process that should be followed to ensure consideration of the appropriate factors by fiduciaries in reviewing valuations for ESOP transactions. The article concludes with a discussion of guidance provided by the court in Bruister that may be instructive as to best practices for ESOP fiduciaries charged with establishing the value to be used by an ESOP holding shares of stock of a private company.

What Exactly Is an ESOP?

In order to understand why the valuation of stock being purchased by an ESOP matters, it's first necessary to review how an ESOP typically purchases a corporation's stock.

An ESOP is a type of tax qualified retirement plan designed to invest an employee's retirement savings primarily in the stock of his employer—tying at least a portion of the employee's retirement nest egg to the value, really the success or failure, of the corporation for which he works.

There are countless ways in which an ESOP may buy stock, though the most common transactional structure results in a ''leveraged ESOP.'' This leveraged ESOP structure is often used because it provides a means for employers to fund ESOP stock acquisitions with tax-favored capital. While there are many permutations of this transaction, the basic structure requires that:

  • Step 1: Corporation establishes an ESOP. As part of this process, the corporation must identify one or more named ERISA fiduciaries to control and manage the operation and administration of the ESOP and its assets.
  • Step 2: Corporation acquires the necessary cash to allow the ESOP to purchase shares of corporation stock. Such cash is generally provided by outside financing (e.g., a bank loan to the corporation) or by using extra cash on the balance sheet of the corporation.
  • Step 3: Corporation lends the cash from above to the ESOP pursuant to the terms of an ''exempt loan'' which is governed by certain requirements set forth in the Internal Revenue Code (IRC) and ERISA. This loan is commonly referred to as the ''inside loan'' which simply refers to the fact that it is between the corporation and the ESOP versus involving an outside lender.
  • Step 4: ESOP uses the cash proceeds of the inside loan to purchase shares of corporation stock held by the owner(s) of the corporation.

As a result of the leveraged ESOP transaction, the ESOP will now hold shares of corporation stock that have been purchased with the proceeds of the inside loan. These shares are placed into a holding or ''suspense'' account and are released and allocated to participants' accounts as the inside loan is repaid by the ESOP. The ESOP will repay the loan using tax-deductible annual contributions from the corporation. If used properly, a strong, profitable company can use a leveraged ESOP to simultaneously provide significant tax savings for itself, and substantial benefits for its employees. As a result, more and more owners of closely-help corporations are investigating whether an ownership transition utilizing an ESOP might provide advantages to the owner, the corporation, and its employees.

What Exactly Is a Fiduciary?

ERISA requires that all ESOPs have one or more fiduciaries who are responsible for controlling and managing the operation and administration of the ESOP and its assets and it imposes certain responsibilities upon those fiduciaries including the following:

  • Duty of Loyalty: A fiduciary must act solely in the interest of plan participants and their beneficiaries (i.e., also known as the ''Exclusive Benefit Rule'').
  • Duty to Diversify Plan Investments: A fiduciary must invest plan assets in a range of investment alternatives designed to minimize the risk of large losses. (Note, an ESOP is designed to invest primarily in corporation stock and, therefore, is generally not diversified with respect to its plan assets. This is permitted under both the IRC and ERISA to the extent that it is prudent to retain this investment structure. Fifth Third Bancorp et al v. Dudenhoeffer et al. (June 25, 2014) makes it clear that there is no presumption that an ESOP does not have to diversify investments to the extent that it would be prudent to do so.)
  • Duty to Follow Plan Documents: A fiduciary must follow the requirements of the plan documents with respect to administration and operation unless it is not prudent to do so.
  • Duty to Monitor Expenses: A fiduciary must ensure that a plan pay only reasonable and necessary plan expenses.
  • Duty Not to Participate in a Prohibited Transaction: Both the IRC and ERISA identify transactions among certain parties as being at-risk for abuse based on actual or apparent conflicts of interest and provide a general prohibition on a plan entering into such transactions.

Certain of the prohibited transaction rules (and the associated exemptions) are fundamental to the holding in Bruister. Specifically, under both the IRC and ERISA, there is a general prohibition on sales of property between a plan (such as an ESOP) and a party-in-interest (referred to as a ''disqualified person'' under the IRC). A shareholder of the corporation sponsoring the ESOP is a party-in-interest. Therefore, transactions by and between the ESOP and the shareholder are largely prohibited - absent specific rules to the contrary. Both the IRC and ERISA provide a general exemption to the prohibited transaction rules that allows an ESOP to purchase stock from a party-in-interest if certain protections are in place to ensure that the ESOP is able to protect its participants. One such protection is that the ESOP is prohibited from paying more than ''adequate consideration'' for the purchased stock. Therefore, a fiduciary must not engage in a transaction if he knows, or should know, that the transaction constitutes a direct or indirect sale or exchange of any property between the plan and a party in interest unless the transaction is made for adequate consideration.

For purposes of complying with the appropriate regulatory exemptions that allow an ESOP to purchase shares of the sponsoring employer's stock, it is the ESOP trustee's responsibility to oversee the valuation process to determine that the ESOP pays no more than adequate consideration for the corporation stock. Adequate consideration is considered to be equal to the ''fair market value'' of the securities being purchased. Fair market value is generally defined by Proposed Labor Regulation Section 2510.3-18 as ''the price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties are able, as well as willing, to trade and are well-informed about the asset and the market for the asset.''

The determination of what constitutes ''adequate consideration,'' and the process undertaken in connection with such analysis, is at the heart of the Bruister case. For closely-held corporations, ESOP fiduciaries often rely on the work of independent financial appraisers to determine fair market value of the corporation's stock. It is this selection and supervision of financial appraisers that has come under significant DOL scrutiny in the past decade. The DOL appears to view private company valuation work with a high degree of skepticism as to its accuracy. After the DOL filed a number of lawsuits relating to ESOP acquisitions of corporation ownership, with most alleging poor valuation work, Timothy Hauser (deputy assistant secretary at the DOL's Employee Benefits Security Administration) noted that ''[v]aluation is the first, second, third, and fourth problem'' with respect to ESOP transactions.

View full report.

Originally published by Pension & Benefits Daily, The Bureau of National Affairs, Inc.

View From McDermott: Fifth Circuit Focuses On Process In ESOP Valuations

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