Requirement, Guidance, Advice and Implication: A Brief Look at a Couple of Recent ESOP Legal Events

By Anthony Mathews

In the last several weeks, the ESOP community has been given a couple of morsels to chew on that have the community buzzing like a bad transformer on an active power-line. We are, of course, talking about a pair of legal events related to fiduciary responsibility. The Supreme Court Ruling in the Fifth Third Bank "stock drop" case, and a publicly released settlement agreement reached between the Department of Labor (DOL) and Greatbanc Trust Company in a case in which it was being alleged that the ESOP had overpaid for stock.

It should be noted, first, that these cases have very different legal importance to ESOP companies.  The Fifth Third Bank case (mostly referred to as Dudenhoeffer among legal folks) is a Supreme Court decision that effectively removed a "presumption of prudence" that had been used by ESOP fiduciaries since 1995 as a protective cloak against attacks on trustees for buying, holding or failing to sell employer securities when market prices changed dramatically.  The Greatbanc settlement is just that, a settlement agreement between Greatbanc Trust and the DOL that has no direct impact on anyone else. 

Let's start with the settlement. First, if you are not Greatbanc or the DOL, it doesn't apply to you (full stop). It can, however, be interpreted by others than its parties as suggestive of what the DOL thinks is good practice for those engaged in purchasing stock on behalf of ESOPs. In the context, it should probably, and more precisely, be seen as what the DOL was able to extract as a penalty where it believed an entity had violated its fiduciary duty in purchasing ESOP stock and where the entity intends to continue to purchase stock on behalf of ESOPs in the future.

Some of the provisions are pretty daunting. For example, reference to numerous years of unqualified audited financial statements to assure that "fair market value" is actually that, would, if adopted as a standard, eliminate ESOPs altogether for a large majority of ESOP companies who do not have formal audits of financial statements at all. Proceeding past that flat statement, however, the settlement goes on to indicate that, where that is not available, the fiduciary must take steps to validate the financial information independently – not simply take them for fact.

And, as it turns out, that is exactly what the reputable members of our valuation community routinely do in assisting ESOP fiduciaries through the valuation process. They look at verified historical earnings (which the fiduciaries should be in a position to verify independently), they examine transactions within the subject company's industry (both public and publicly available private transaction information), they compare the ESOP company to companies in the public markets (comparable to the ESOP company in terms of industry segment and risk profile among other factors) and they develop models to analyze all of the available data and derive value assumptions that are as good as can be achieved given that there is no real market for closely held company stock, so valuation is the only approach possible to determine value for ESOP purposes.

Other provisions are similarly apparent in reputable ESOP fiduciary interactions with appraisers and their sponsoring companies, scaled to the reality of the companies' resources. For virtually all ESOP companies with which I am familiar, it would take no material change in behavior in order to comply with the spirit of the settlement. My fear in this area is that the real "bad actors" in this area will simply arrange for audited financial statements - like those published by Bernie Madoff, Enron, Tribune, and others, and will cloak their activities in a mantle of "compliance" that the DOL has provided by publicizing and promoting this private agreement.

The Fifth Third Bank decision is different in that it does apply to everyone from now on.  When making investment decisions for an ESOP, fiduciaries will not be entitled to any presumption that they are acting prudently except insofar as prudence requires them to diversify the account.  The statute only specifically exempts ESOPs from the diversification requirements otherwise applicable to ERISA retirement plans; otherwise the prudence of an investment in employer stock will be evaluated under the same guidelines that would be applicable to any fiduciary in any other retirement plan setting.  It is clear, under that standard, that ESOP fiduciaries are not underwriting the value of assets they hold for employees any more than a profit sharing plan or 401(k) fiduciary is guaranteeing that its investments will never decline in value. 

The basic DOL objective in regulating ESOPs was once described to me by an insider as, "to assure that no ESOP ever pays more than fair market value for stock, and, at the same time, assure that ESOP participants get the benefits to which they are entitled when they are entitled to them." Then and now, I could not find a reason why anyone in the ESOP world would ever disagree with those as objectives, but as always, the difficulty is in the details of how those responsibilities must be met. It has been my experience that the vast majority of the ESOP transactions that take place in our community already reflect adherence with all of these standards (in clear substance if not strictly in absolute form). But, we must not become complacent and allow these important actions to become so routine that we slip into careless actions that fall short. Whether we have a responsibility as a community to police ourselves to deal with the "bad actors" is something for an ongoing energetic debate among us that engages the regulators in the process.

We all have much to gain by working together to assure that ESOPs never pay more than fair market value for stock and that ESOP participants receive the benefits to which they are entitled when they are entitled to receive them. No argument.