ESOP Valuations: Are You Performing Your Fiduciary Responsibilities?

June 25, 2015

Employee Stock Ownership Plans (ESOPs) are increasingly becoming a target for review by the Department of Labor (DOL) due to the additional degree of difficulty and complex structure associated with these benefit plans. Aronson recently attended the annual conference for the National Center for Employee Ownership (NCEO) which confirmed one of the significant areas drawing attention from the DOL, and others, is the valuation of employer securities that are not publically traded. There is an increased focus when this valuation is related to a significant stock transaction.

It is the responsibility of the ESOP Trustee, either internal or external, to determine the fair value of the privately held company stock in an ESOP. ESOP Trustees have fiduciary responsibilities to the plan, as they are making investment decisions on behalf of participants, for which they can be held personally liable.

To determine the fair value of privately held company stock, the ESOP Trustees will typically hire an independent valuation company. The valuation company gathers information from plan sponsor management via interviews, projections and analysis to determine the fair value of the employer stock. The value of the stock may be determined using multiple methods carrying various weights based on the specific circumstances of the employer. This valuation is presented to the ESOP Trustees for review and approval. It is important to note that, although an independent valuation company calculates the fair value, it is the ESOP Trustees who have the ultimate responsibility to accept the fair value, thereby determining the fair value of the company stock on behalf of the participants in the ESOP.

Where the ESOP Trustees may be vulnerable in carrying out their fiduciary responsibility is a thorough examination of company projections used in the discounted cash flow method within the income approach to calculate the fair value of privately held stock. In June 2014 GreatBanc Trust Company settled with the DOL, resolving allegations the ESOP Trustee violated the Employee Retirement Income Security Act (ERISA) by allowing the ESOP to purchase stock for more than fair market value. This was due to the Trustee’s failure to adequately inquire into the use of unrealistic and aggressively optimistic projections of the company’s future earnings and profitability.

ESOP Trustees should perform a due diligence review over the forecasts prepared by company management to be used in calculating fair value of company stock. A good measure of these forecasts is past performance. Also, if the plan in question is long-standing, compare the forecasts from several years ago to actual results to determine how successful company management is at projecting future earnings.

As part of their settlement with the DOL, GreatBanc agreed to a set of policies and procedures (Process Requirements) that they must follow when they are acting as an ESOP Trustee to purchase or sell company securities not publically traded.  These Process Requirements provide ESOP Trustees with insight into the DoL’s expectations of the Trustees’ responsibilities in determining the fair value of privately held company stock. Phyllis C. Borzi, Assistant Secretary of Labor for Employee Benefits Security, said, “Others in the industry would do well to take notice of the protections put in place by this agreement.”.

Although the DOL has not mandated the use of the Process Requirements, it is a best practice for ESOP Trustees to follow them. This is particularly true for valuations involving stock transactions, but it has implications to the annual valuation as well.

It is critical for ESOP Trustees to document their review, considerations, and conclusion of the valuation of company stock, including management projections. Do not be afraid to inquire and push back on unreasonable projections as there is a fiduciary responsibility to do so. After a thorough review of the valuation is performed, the conclusion may be there is adequate evidence to support the fair value calculated by the valuation company. Documentation of the review of the facts and circumstances in “real time” is key, as an investigation can occur several years after the determination of fair value for company stock has been taken.

For more information about your duties as an ESOP Trustee or plan sponsor, please contact Aronson’s Employee Benefit Plan Services Group at 301.231.6200.