Overview of an ESOP trustee’s duties
A transaction between a company or its shareholders and an ESOP that the company has established is a transaction that is full of conflicts of interest. Because of those conflicts and to meet the requirements of section 404 of the Employee Retirement Income Security Act (ERISA), the person(s) acting as the trustee or fiduciary of any employee benefit plan, including an ESOP, must carry out their duties independently and solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses. Fiduciaries must act prudently and must diversify the plan's investments to minimize the risk of large losses. In addition, they must follow the terms of plan documents to the extent that the plan terms are consistent with ERISA.
Implicit in the above, a trustee or fiduciary must avoid conflicts of interest. In other words, they may not engage in transactions on behalf of the plan that improperly benefit parties related to the plan, such as the plan sponsor, selling shareholders, or the key management employees. One way of documenting their prudence is to show that they paid adequate consideration for the shares.
In 1988, the Department published but never finalized regulations defining adequate consideration with respect to transaction(s) engaged in by plans and which applied to any employee benefit plan, not just an ESOP. Over the years, ESOP fiduciaries and fiduciaries to non-ESOP plans have come to rely on these 1988 regulations as a source of guidance when reviewing the purchase of hard to value assets by a plan. Even though the Department is withdrawing the 1988 proposed regulations, the Department stated that it does not intend to contest parties’ reasonable and good faith reliance on the 1988 proposal in situations that fall outside the current proposal, i.e., a non-ESOP transaction.
The Department’s proposed (but withdrawn) guidance
1. Definition of adequate consideration: The updated proposed regulation applies to the purchase or sale of qualifying employer securities by an ESOP. The regulation says a purchase or sale of qualifying employer securities by an ESOP will be for adequate consideration and thus not prohibited if the plan trustee or an independent fiduciary determines the fair market value of the shares as of the date of the transaction using a prudent process, i.e., a reference to the general standards of prudence in ERISA section 404(a). Further, the regulations require the trustee to prudently select a qualified independent valuation advisor, and the regulation provides details as to how a trustee or other fiduciary is to go about selecting that valuation advisor.
The difficulty with this proposed regulation for employers considering an ESOP and fiduciaries considering whether to potentially serve as an ESOP trustee is that the definition of the prudent review of the valuation report requires the trustee or independent fiduciary to review the valuation expert’s report in such detail that effectively they must redo the entire valuation process as if they were a valuation specialist to see if they come to the same conclusion as the expert they hired. This seems to be a duplication of efforts that far exceed the requirements of ERISA’s prudence standards.
2. Safe harbor for an initial purchase by an ESOP: In the case of a newly created ESOP, the initial purchase of shares will often be thirty percent or more of the outstanding common shares of the company. Thus, these are substantial transactions, and these transactions have been the focus of Department investigations as well as litigation against trustees and selling shareholders. The safe harbor proposes a very narrow path that if followed would provide relief from the prohibited transaction rules of ERISA section 406 and the related excise taxes of Internal Revenue Code section 4975. This relief would apply to the selling shareholders, independent trustees, independent appraisers and any monitoring fiduciaries that are engaged in an initial transaction involving an ESOP’s purchase of non-publicly traded employer stock from a selling shareholder (a “covered transaction”).
Only simple straightforward transactions can qualify as a covered transaction. If the transaction involves, as ESOP transactions often do, preferred stock, convertible preferred securities, debt instruments, synthetic equity, warrants or other types of ownership interests, the transaction will not qualify as an exempt covered transaction. One of the requirements regarding seller-financed ESOPs is that if any selling shareholder lends money or provides credit to the employer in connection with a covered transaction, that loan or extension of credit must be on terms that are identical to the terms of any loan between the ESOP and the employer in connection with the covered transaction. This seems to preclude the ability of an employer to prepay its debt to a selling shareholder as future cash flows permit – even though paying down debt is often the best financial move for the employer and the ESOP participants.
The proposed safe harbor also requires a monitoring fiduciary who is to select a qualified independent fiduciary, ensure that the independent fiduciary has access to all the information necessary for the independent valuation specialist to do its job, and then monitor the activities of the independent fiduciary and if necessary, fire the independent fiduciary or if the monitoring fiduciary deems it necessary stop the covered transaction from occurring.
Takeaway: Revised regulations possible
With the change from the Biden to the Trump administrations, the fate of the current form of the two proposals is in doubt. Congress has requested the Department to issue regulations to provide guidance to ESOP trustees. However, if the Trump administration releases revised guidance, it is unlikely that such guidance will take the excessively complicated approach of the now withdrawn proposals.
In the meantime, ESOP trustees can look to the original 1988 proposed regulation and more meaningfully what they have learned from the Department’s ESOP valuation enforcement program and the related litigation results. However, what the trustees really need is for the Department to complete the objective it stated in the preamble to the withdrawn regulation of providing a principles-based approach in setting out a fiduciary framework for employer stock valuation and proper use and development of appraisals but without the unnecessarily complicated approach of detailing each step a fiduciary must take to ensure that its reliance on an independent valuation meets ERISA’s standards of fiduciary prudence.
