A&M Tax Advisor Weekly

The ESOP Landscape: Valuation Scrutiny and Tax Reform

Kim Schultz, Managing Director

kimschultz@alvarezandmarsal.com

Eric Schillinger, Senior Associate

July 16, 2019 / North America

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. 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.

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North America