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ESOPs facing tougher scrutiny by regulators and courts

January 4, 2016 / 3 min read

Whether you have, or are considering, an ESOP, keeping abreast of current regulations and court cases — and evaluating how your plan is overseen by fiduciaries — is a must.

Employee Stock Ownership Plan (ESOP) fiduciaries are facing closer scrutiny by the Department of Labor (DOL), while federal courts, including the U.S. Supreme Court, are weighing in on ESOP cases. As a result, ESOP sponsors should take a fresh look at how their ESOPs are structured and overseen by fiduciaries.

The DOL estimates put the number of existing ESOPs at around 6,800, covering approximately 13.4 million workers — a 7.5% gain since 2006. The Employee Benefit Research Institute estimates that, for about one-third of those ESOP-sponsoring companies, the ESOP is the only retirement plan.

DOL and ESOP regulations

The DOL is hoping to finalize regulations to strengthen the standards and accountability for firms that perform the annual company valuations for ESOP plan purposes. The regulations were originally proposed in 2010 and the DOL hopes to finalize them in 2016. Among other things, the DOL proposed making those firms performing ESOP evaluations de facto fiduciaries of the ESOPs whose stock they value.

The proposal was criticized by several industry groups, including the American Institute of Certified Public Accountants (AICPA). The AICPA and other critics feared many appraisers would exit the field due to the lack of, or high cost of, fiduciary liability insurance for practitioners in their field. Some voiced the opinion that the DOL proposal was an overly harsh response to a small number of ESOP appraisals.

DOL and ESOP settlements

In testimony before Congress, Labor Secretary Thomas Perez compared some ESOP stock appraisals to real estate valuations performed during the real estate bubble that “masterfully came in at what you needed.” The DOL has at least a dozen cases pending in which it has accused privately held ESOP sponsors of using inflated company stock valuations to enable company owners to sell their shares to the ESOP at above fair market value. The DOL has filed 28 such cases since October 2009.

In June 2014, the DOL reached a $5.25 million settlement with Illinois-based GreatBanc Trust Co. illustrating the DOL’s position in these cases. GreatBanc was the trustee of an ESOP sponsored by Sierra Aluminum Co. The DOL charged GreatBanc with allowing the ESOP to buy company shares from top company executives for above-market prices. According to the DOL, GreatBanc failed to “adequately inquire into an appraisal that presented unrealistic projections of [the company’s] future earnings and profitability... and adjustments to financial statements that went into the appraisal.”

In addition to paying the penalty to the ESOP, GreatBanc agreed to put in place new procedural safeguards. These included new requirements for selecting and overseeing a valuation advisor, analyzing the fiduciary process, and documenting the valuation analysis.

In a similar case settled in January, the DOL extracted $10 million (to be paid to the ESOP) from the former owners of People Care Holdings, Inc. According to the DOL, People Care overvalued the company when it was sold to the ESOP with optimistic revenue projections, even after People Care lost a key contract.

Compounding their legal problems, the former owners attempted in the stock purchase agreement to indemnify themselves and hold the ESOP responsible for costs incurred by the owners in conjunction with any future investigation or litigation. The DOL asserted that that provision invalidated the agreement.

Supreme Court and ESOP litigation

In June 2014, the U.S. Supreme Court unanimously ruled in Fifth Third Bancorp et al v. Dudenhoeffer that ESOP fiduciaries can no longer be presumed to have exercised their fiduciary duties in certain ESOP cases. Specifically, the Court shot down a well-established legal standard called the “Moench presumption,” accepted by federal appeals courts.

Under the now-void “Moench presumption,” plaintiffs had to make allegations implicating the company’s viability as an ongoing concern or show a precipitous decline in the employer’s stock. This presumption of prudence essentially gave ESOP fiduciaries offering company stock as an investment option in their defined contribution plans the benefit of the doubt.

However, the Supreme Court held that ESOP fiduciaries aren’t entitled to any special presumption of prudence. Instead, they’re subject to the same duty of prudence that applies to ERISA fiduciaries in general, except that they don’t have to diversify the ESOP fund’s assets.

ESOPs in the future

With ESOPs growing in numbers, staying on top of current DOL regulations and court litigation is in your best interest, whether you already have an ESOP or are considering one. Contact a benefits specialist to learn more.

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