United States: Settling The Standard For Prudence? Fall Brings New Guidance For ESOP Trustees

Summary

Through a series of recent settlements, the US Department of Labor has outlined the process steps fiduciaries should follow in connection with a transaction involving a purchase from, or sale to, an employee stock ownership plan.

In Depth

Through a series of recent settlements, the US Department of Labor (DOL) has outlined the process steps fiduciaries should follow in connection with a transaction involving a purchase from, or sale to, an employee stock ownership plan (ESOP). Largely based on the "fiduciary process steps" first introduced by the DOL in the 2014 settlement of Perez v. GreatBanc Trust Co., this new guidance has neither the force of law nor the ability to change any current laws or regulations. The recent settlements may, however, provide helpful insight into the DOL's position regarding what is required to meet fiduciary obligations under the Employee Retirement Income Security Act of 1974 (ERISA) when engaging in an ESOP transaction. 

Background

Approximately 90 percent of ESOPs hold stock of closely held corporations. The ESOP will purchase stock from one or more company owners at a price determined by an ESOP fiduciary. Because most ESOP fiduciaries are not valuation experts, ERISA generally requires the fiduciary to determine the stock's fair market value by relying upon the work of an independent appraisal expert. If the fiduciary relies on an inadequate appraisal, however, the fiduciary can breach its duties and/or violate ERISA's prohibited transaction rules.

ERISA requires that an ESOP's fiduciaries—which generally include its trustees, the sponsoring employer, the individuals that sit on the sponsoring employer's board of directors, and any employees involved in the administration and operation of the ESOP—establish and operate the ESOP for the exclusive purpose of providing benefits to ESOP participants and beneficiaries, while defraying reasonable expenses of administering the plan. This is a high standard that is often expressed as the idea that an ESOP fiduciary must act as a "prudent expert" would act. Given this "prudent expert" standard, ERISA permits, and may in fact require, the ESOP fiduciary to rely on an independent appraisal expert to assist the ESOP fiduciary in determining the value of closely held employer stock.

Process Steps

The DOL has not (in more than 20 years) promulgated formal rules addressing when a fiduciary may reasonably rely on a valuation provided by an independent appraisal expert. When the DOL settled GreatBanc Trust Co. in 2014, however, it noted that the ESOP industry would "do well to take notice" of the process steps it put in place. The recent settlements in Acosta v. First Bankers Tr. Servs., Inc., and Acosta v. BAT Masonry build on these process steps and provide guidelines that the DOL believes an ESOP fiduciary is required to follow to establish that the fiduciary's reliance on an independent appraisal of closely held employer stock was reasonable.

These guidelines are outlined below. In all instances involving an institutional trustee, all employees of the institutional trustee involved in the process must also be identified and their participation documented.

Selecting an Appraisal Expert

  • When selecting an appraisal expert, a fiduciary should retain written documentation of at least three references checked and a discussion of those three references' views.
    • The fiduciary must discuss, in writing, whether the selected appraisal expert has been the subject of criminal, civil or regulatory proceedings and/or investigations in connection with its previous valuation work, as well as the results of such criminal, civil or regulatory actions. 
    • The above requirements are not applicable if the fiduciary has recently (within the last year if an institutional trustee and the last two years if an individual trustee) vetted the appraisal expert and the appraisal expert certifies, in writing, that the results of the fiduciary's prior investigation are still accurate. This marks a distinct change from GreatBanc Trust Co., which required that an institutional trustee's previous analysis be completed within the prior 15 months.
  • A fiduciary may not rely on an appraisal expert that has previously performed any work—including a preliminary valuation—on behalf of the plan sponsor's ESOP committee.
  • The fiduciary must document all the steps it took to determine that the appraisal expert received complete, accurate and current information, and to ensure the fiduciary understood the advice of the appraisal expert.

Overseeing the Appraisal Expert

  • The valuation report should include background about the individuals that provided the projections, as well as how the projections compare to the company's history, and the historic metrics of comparable public companies. If these details are absent, the fiduciary must prepare a supplement to the valuation report (if an individual trustee) or request that supplementary documents be prepared (if an institutional trustee).
  • The valuation report should include the risks facing the plan sponsor that could cause the plan sponsor's financial performance to fall materially below the projections relied upon by the appraisal expert, and any material differences between the present valuation and the most recent prior valuation of the plan sponsor performed within the past 24 months by any valuation firm for any purpose (if any).
  • If the fiduciary is an individual trustee and its valuation report does not include any reliance on the discounted cash flow (DCF) valuation methodology, the valuation report must specifically explain, in writing, why the DCF methodology is missing.
  • The fiduciary must also include details regarding the terms of any loans the ESOP receives in connection with the transaction, and must ensure that the loan terms are as favorable as the terms of any loans between the plan sponsor and any executive of the plan sponsor made within the two years preceding the transaction.

Requirements for Financial Statements

  • In the absence of audited, unqualified financial statements, the fiduciary may only engage in a transaction if the stock purchase agreement includes a provision requiring the selling or purchasing shareholders who are officers, managers or members of the board of directors of the plan sponsor to compensate the ESOP for any losses or other harms caused by or related to financial statements that did not accurately reflect the plan sponsor's financial condition.

Fiduciary Review Process

  • All employees of the fiduciary who participated in decisions regarding (1) whether to proceed with the transaction or (2) the price of the transaction are expected to engage in reasonably prudent investigation and retain—for six years—all notes, minutes or other documentation on which they relied.
  • If the fiduciary believes the projections in the valuation report are unreasonable, the fiduciary must ask the appraisal expert to account for the unreasonable projections in its valuation, request new and reasonable projects from management, or reject the transaction, and must document the basis for its decision.
  • The fiduciary must ensure that the information the appraisal expert obtains from the plan sponsor and purchasing or selling shareholder(s) includes each of the following, to the extent it exists:
    • Any prior attempts by the purchasing or selling shareholder(s) to purchase or sell their stock in the plan sponsor within the proceeding two years
    • Any prior defaults within the past five years by the plan sponsor under any lending or financing agreement
    • Any management letters provided to the plan sponsor by its accountants within the past five years
    • Any information related to a valuation of the plan sponsor provided to the Internal Revenue Service within the past five years

Requirements Relating to Control

  • If a fiduciary approves a transaction in which the ESOP cedes any degree of control to which it would otherwise be entitled based on its ownership interest, including but not limited to the unencumbered ability to vote its shares (for example, by electing members of the board of directors), the fiduciary must document any consideration received in exchange for such limitation on the ESOP's control (or how the limitation on control is otherwise reflected in the purchase price) and why it is fair to the ESOP.
  • If a fiduciary approves a transaction in which the ESOP pays a control premium, the fiduciary must document why it believes that the ESOP is obtaining voting control, and control in fact, and identify any limitations on such control as well as the specific amount of consideration the ESOP received for such limitations.

Insurance Coverage – Individual Trustee Only

Before agreeing to serve as a trustee or fiduciary in connection with any transaction for the purchase or sale of ESOP stock, an individual trustee should make a good faith effort to obtain insurance coverage under a non-wasting policy that is sufficient to provide coverage for liability under ERISA in connection with the proposed transaction.

In the event that the individual trustee is unable to obtain its own insurance after good faith efforts, the individual trustee must obtain a written agreement from the ESOP sponsor that that the individual trustee must be named as a covered individual under the ESOP sponsor's insurance policy as a condition for the individual trustee to serve as trustee or fiduciary of the ESOP.

Conclusion

It is important to note that the recent DOL settlements discussed in this article do not specify all of a fiduciary's obligations under ERISA, nor do they supersede such obligations in any way. Rather, such guidance provides additional detail as to the DOL's expectations for fiduciaries to meet their obligations as ERISA fiduciaries. Ultimately, the fiduciary is the party responsible for understanding the full risks posed by a transaction involving a private company ESOP and for asking serious questions about any government audits or legal action, customer concentration, industry risk, and financial and legal disclosures. 

Settling the Standard for Prudence? Fall Brings New Guidance for ESOP Trustees

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

    Disclaimer

    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

    Registration

    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

    Cookies

    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

    Links

    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

    Mail-A-Friend

    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

    Emails

    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

    Security

    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions