The U.S. Department of Labor (“DOL”) continues a regulatory agenda that puts the valuation of Employee Stock Ownership Plans (“ESOPs”) in the spotlight. As a result, ESOP fiduciaries need to be cognizant of the impact of the reduction in corporate income taxes when determining the fair market value of ESOP plan assets. Such fiduciaries should also carefully review their ESOP valuation methodologies for reasonableness in light of these tax law changes to determine whether any changes are needed to protect against potential DOL scrutiny.

ESOP Litigation

ESOP litigation trends have focused on breaches of fiduciary duty related to valuation. Under the Employee Retirement Income Security Act of 1974 (“ERISA”), fiduciaries are those persons or entities who exercise discretionary control, authority, or responsibility for managing the plan or plan assets. This includes plan administrators, plan trustees, those who provide investment advice to the plan (and receive compensation for that advice), and members of the plan’s investment committee.

Fiduciary responsibilities under ERISA broadly include, among others, running the plan in the best interests of the participants and avoiding conflicts of interest. Importantly, fiduciaries are required to value plan assets at “fair market value” (i.e., the price in an arms-length transaction). Accordingly, fiduciaries must understand the methodologies and assumptions used in ESOP valuations.

Recent DOL litigation involving ESOPs has included situations where fiduciaries have improperly valued plan assets due to negligence or conflicts of interest. In one case, ESOP fiduciaries were found liable for using a valuation that relied on overstated projections based on a thirteen percent annual growth rate even though a rate of eight percent was historically achieved. The fiduciaries were also found liable for the failure to consider a discount for lack of control (“DLOC”) when a minority-level of interest was being valued (i.e., that a minority interest is less valuable to a buyer than control of the company). The overstated growth rate and omission of a DLOC resulted in the ESOP paying more than fair market value for the company stock, a breach of fiduciary duty.

In another recent case, the DOL challenged that an ESOP valuation failed to consider the riskiness of the subject interest relative to competitors as well as improperly used DLOC, even though 90 percent of outstanding shares were exchanged for warrants. The DOL also argued that a conflict of interest existed because the projections were provided by management whose bonuses were tied to the value of the transaction.

The Impact of Tax Reform

The passage of the Tax Cuts and Jobs Act (“TCJA”) has had a significant impact on ESOP valuation. Accordingly, fiduciaries need to understand the implications of the TCJA when determining the valuation of plan assets. Going forward, C-corporations and S-corporations alike will see a reduction in income taxes; however, the impact of tax reform will have varying results. The valuation methodologies affected by the TCJA are the income approach and market approach, whose assumptions are highly dependent on the underlying data and the subject interest being valued.

Both of these approaches consider guideline public companies and market conditions in the determination of the fair market value. In general, their impacts on share valuations are as follows:

• The reduction in corporate tax rates from 35 percent to 21 percent should lead to an increase in the cash flow available to C-corporations, which will likely lead to higher share values.
• By contrast, the share values of S-corporations, pass-through entities, and LLCs will likely not increase to the same degree. However, if rising market conditions in general lead to higher share values, this trend could potentially increase the repurchase obligation for ESOPs sponsored by small businesses. Therefore, fiduciaries should closely review substantial valuation increases of these entities to ensure that higher share values are justifiable based on market conditions and other applicable factors. (Although not as pivotal, the TCJA did provide some relief to small businesses, allowing for a 20 percent deduction on “qualified” business income at the individual level.)

Generally, ESOP valuation methodologies should be fairly consistent year-over-year, with adjustments made as necessary to reflect changes in the company operations or market conditions. Given the tax law changes by the TCJA, ESOP fiduciaries need to be mindful of how post-TCJA valuations diverge from the previous valuations under various valuation approaches (e.g., the impact of reduced taxes for corporations on the market approach multiples). For example, a lawsuit filed by the DOL argued that ESOP fiduciaries negligently relied on faulty appraisals, which also included flaws for reliance upon unreasonable management projections. These projections used inconsistent valuation methodologies because they envisioned dramatic increases in company profits. According to the DOL, those projected profit increases were inconsistent with the company’s performance in the preceding five years as well as the appraisal’s own description of the economy’s direction.

Best Practices to Avoid DOL Scrutiny

To avoid becoming a target of DOL litigation, ESOP fiduciaries should ensure that they understand the valuation methodologies and assumptions being used, and that projections and assumptions are not based on conflicting interests. It is important to, when appropriate, challenge assumptions and critically review the justifications of such assumptions. In addition, consideration for engaging an independent fiduciary to review and approve major transactions may be useful to ensure appropriate fair market valuation results as well as having a different perspective on concerns such as whether the company can carry the ESOP debt during an economic downturn. Also, it is vital to document the processes, the assumptions, and the information provided to valuation experts and fiduciaries.

In addition, understanding the impacts of the TCJA on valuation will help mitigate the potential risk for breaches of fiduciary responsibility.

Alvarez & Marsal Says:

In light of the recent tax law changes and uptake in DOL scrutiny of ESOP, it is becoming increasingly important for ESOP fiduciaries to understand the current ESOP rules, and, importantly, closely analyze their ESOPs for potential compliance. Given that the legal landscape is constantly changing (not just for ESOPs), it is also to keep an eye out for new tax and legal developments that impact ESOPs. The Compensation & Benefits practice at Alvarez & Marsal can assist with ESOP compliance, including due diligence, advice on tax issues, development of best practices to avoid DOL audits, and preparation of employee communications.