The Department of Labor (DOL) has made it no secret that it actively engages in enforcement activities against employee stock ownership plans (ESOPs) with a particular focus on the valuation of the stock of privately held companies that is held or bought by the ESOP. The valuation of the company stock is important to the DOL because the Employee Retirement Income Security Act of 1974 (ERISA) includes provisions to allow an ESOP to purchase employer stock as a retirement investment for employees participating in the ESOP, provided the stock purchase was for “adequate consideration.” When the purchase price of the company stock held or purchased by an ESOP on behalf of participants is more or less than adequate consideration, there may be a violation of ERISA in terms of a breach of fiduciary duty.
While any size company can implement and sponsor an ESOP, many small business owners have found ESOPs to be an attractive business succession plan as the owner, often a baby-boomer, approaches retirement and wishes the company to be owned by its employees through an ESOP rather than finding a buyer or selling its ownership to a competitor. Because of this, many of these DOL enforcement actions regarding valuation issues end up targeting small businesses.
Dearth of Guidance
In these transactions, there is very little official guidance from the DOL regarding how to value the stock that is bought or owned by the ESOP. Valuators still rely on Revenue Ruling 59-60 to value privately owned stock for purposes of an ESOP transaction, even though that guidance is 60 years old and was originally issued for estate and gift tax purposes. Additionally, old proposed regulations from the DOL in 1988 set forth a two-part test to determine fair market value. The DOL never finalized these proposed regulations, which are now 31 years old. The lack of official guidance leaves many ESOP fiduciaries wondering if a valuation is proper and will ultimately survive an investigation by the DOL.
On October 1, 2018, twenty-seven members of Congress wrote a letter to President Trump, with a copy to the DOL Secretary, stating that the “Department [of Labor] has released very little guidance on substantive issues including, for example, valuation…we believe the Department [of Labor] could immediately eliminate some of the regulatory uncertainty by collaborating with the ESOP community to develop clear guidance with respect to valuation and other important issues.” That letter goes on to accuse the DOL of regulating ESOPs by litigation instead of through officially issued guidance.
Indeed, despite very minimal official guidance from the DOL regarding the valuation of the stock that is owned or bought by the ESOP, there is a high level of enforcement and investigation activity from the DOL for valuation issues. Unfortunately, with such a void in official guidance from the DOL, trustees and fiduciaries are left to glean guidance from enforcement actions and settlement agreements with the DOL regarding valuation issues. Rather than issue official guidance regarding these issues, the DOL has even promoted recent settlement agreements with trustees and ESOP fiduciaries as “best practices” to satisfy a fiduciary duty under ERISA with respect to the appraisal guidelines, process requirements, and fiduciary engagements.
The procedures and due diligence process set out in a 2014 settlement agreement with the DOL for appraisal guidelines serve as the industry’s standard for fulfilling a fiduciary duty when determining the fair market value of privately held stock purchased by the ESOP. Since then, the DOL has updated its procedures and migrated on a few details in later settlement agreements with other trustees after 2014 regarding valuation issues. Generally, despite some differences, all of the settlement agreements with the DOL focus on how the valuation advisor is selected, the oversight and monitoring of the valuation advisor during the process, and how the ESOP terms affect a repurchase obligation as well as the ability to repay the loan obtained to purchase the stock by the ESOP if the projections used to determine the fair market value of the stock do not later come to fruition.
The bottom line is that trustees and ERISA fiduciaries often have a challenging task when ascertaining whether the valuation of privately held stock bought or held by an ESOP is a reasonable fair market value that will pass DOL muster in an investigation, and this is an arena in which the DOL often referees without an official rulebook. Until official guidance is issued by the DOL regarding ERISA duties in a valuation of privately held company stock held or bought by an ESOP, these trustees and ESOP fiduciaries must find value in old IRS Revenue Rulings, old proposed DOL regulations, and recent DOL settlement agreements that were not decided in a courtroom and often differ regarding valuation issues.
ENDNOTES  See “National Enforcement Projects” tab at https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/enforcement where ESOPs are listed as the first of several enforcement projects.  Section 3(18)(B) of ERISA states that “adequate consideration for a closely held business interest is the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan.”  Revenue Rulings 650192 and 65-193 later broadened the application of Revenue Ruling 59-60 for income tax and other purposes. Proposed DOL regulations issued in 1988 also relied on Revenue Ruling 59-60.  See “National Enforcement Projects” tab at https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/enforcementwhere five recent settlement agreement are provided with titles such as “Appraisal Guidelines,” “Process Requirements,” and “Fiduciary Engagements.”