DOL Settlement Is a Cautionary Tale for ESOP Trustees

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By B. David Joffe, Esq.

Gordon Earle Nichols* 

Bradley Arant Boult Cummings LLP, Nashville, TN

 

The Department of Labor (DOL) recently settled a case involving
an employee stock ownership plan (ESOP) that provides guidance but
also a warning for trustees and employers contemplating ESOP
transactions that later go awry. In Perez v. GreatBanc Trust
Co.
, the DOL sued GreatBanc Trust Company (GreatBanc), the
trustee of the Sierra Aluminum Company's ESOP, claiming that
GreatBanc relied on a flawed appraisal report to support the ESOP's
purchase of 3.4 million shares of company stock for $53 million.
The DOL claimed that GreatBanc failed to adequately inquire into an
appraisal that presented unrealistic and aggressively optimistic
projections of the company's future earnings and profitability;
failed to investigate the credibility of the assumptions, factual
bases, and adjustments to financial statements that went into the
appraisal; and asked for a revised valuation opinion in order to
reconcile the higher purchase price the trustee agreed to pay with
the lower fair market value of the company stock determined in
earlier versions of the appraisal.

The DOL and GreatBanc agreed to settle the case for $5.25
million. Significantly, as part of the settlement agreement,
GreatBanc agreed to implement very specific policies and procedures
whenever it serves as a trustee or other fiduciary of an ESOP in
connection with transactions in which the ESOP is purchasing or
selling, is contemplating purchasing or selling, or receives an
offer to purchase or sell employer securities that are not publicly
traded. The policies and procedures are very detailed, highly
proscriptive, and-in several cases-go beyond explicit requirements
under the law. While all trustees would not necessarily have to
follow the same policies and procedures, the framework provides
some indication of what the DOL may be looking for in an audit or
other investigation. As such, trustees may want to consider
incorporating some or all of the policies and procedures as part of
their due diligence.

The policies and procedures that GreatBanc agreed to include the
following:

  • Selection and Use of Valuation
    Advisor.
     GreatBanc is generally required to hire a
    qualified valuation advisor, investigate the advisor's
    qualifications, and prudently determine that it can rely on the
    advisor before entering into the transaction.
    GreatBanc cannot use an advisor for a transaction that has
    previously performed work for the ESOP sponsor (as distinguished
    from the ESOP), any counterparty to the ESOP involved in the
    transaction, or any other entity that is structuring the
    transaction (such as an investment bank). GreatBanc is also
    generally prohibited from using an advisor that has a familial or
    corporate relationship to itself and other transaction parties.
    Most significantly, in selecting an advisor for a transaction
    involving the purchase or sale of employer securities, GreatBanc
    has to prepare a written analysis addressing specified
    topics such as the reason for selecting the particular advisor.
    GreatBanc also has to oversee the valuation process and make sure
    the advisor documents certain required items; if the advisor does
    not do so, GreatBanc then has to prepare supplemental documentation
    addressing a number of matters relating to the analysis.
  • Financial Statements. GreatBanc must request
    that the company provide GreatBanc and its valuation advisor with
    audited unqualified financial statements prepared by a CPA for the
    preceding five fiscal years, unless financial statements extending
    back five years are unavailable. In the absence of such audited
    financial statements, GreatBanc is required to take certain steps
    before proceeding with the transaction, including additional
    documentation of why it has chosen to proceed.
  • Fiduciary Review Process. GreatBanc must
    follow a specified process and document the valuation analysis.
    GreatBanc's reliance on an appraiser's valuation report is
    contingent on taking certain steps and providing certain
    documentation. If the valuation report is not consistent with the
    analysis, then GreatBanc must not proceed with the
    transaction.  Again, the trustee is required to document its
    analysis of such issues.
  • Fair Market Value. GreatBanc cannot cause an
    ESOP to purchase employer securities for more than their fair
    market value or sell employer securities for less than their fair
    market value.  GreatBanc specifically agreed not to cause an
    ESOP to engage in a leveraged stock purchase transaction in which
    the principal amount of the debt financing the transaction exceeds
    the fair market value of the stock acquired with that debt,
    irrespective of the interest rate or other terms of the debt used
    to finance the transaction.
  • Consideration of Claw-Back. In evaluating
    proposed stock transactions, GreatBanc is required to consider
    whether it is appropriate to request a claw-back arrangement or
    other purchase price adjustments to protect the ESOP against the
    possibility of adverse consequences in the event of significant
    corporate events or changed circumstances. GreatBanc must also
    document in writing its consideration of the appropriateness of a
    claw-back or other purchase-price adjustments.

 

These policies and procedures, in many ways, go beyond the
stated requirements in the law. For example, while an ESOP trustee
may ordinarily choose to document the retention of a particular
appraiser, these policies and procedures impose stricter
requirements including a written analysis of the reasons supporting
the selection of a particular appraiser, which in all likelihood go
beyond the customary practice for most trustees. Further, the
requirements of the various written reports by the trustee, as
opposed to the appraiser, will seemingly result in a great deal of
duplication of effort with the almost certain increase in expense
for the plan sponsor. The inclusion of certain specified items for
consideration, such as the possible use of a claw-back provision,
seems to be an attempt to implement an almost formulaic approach to
what has historically been a holistic decision-whether the purchase
of the stock of the employer on the terms in front of the trustee
is in the best interests of the ESOP participants.

Although the settlement agreement only affects GreatBanc, all
trustees should reevaluate their processes used in evaluating stock
purchase transactions with respect to non-publicly traded companies
in light of the settlement. While it may not be necessary for
trustees to take all of the same steps with the same level of
documentary compliance, the settlement could be interpreted as a
cautionary tale to trustees who do not undergo a considered,
careful, and well-documented process.

For more information, in the Tax Management Portfolios, see
Kaplan, Brown, and Granados, 354 T.M.
, ESOPs, Horahan and
Hennessy, 365 T.M.
, ERISA - Fiduciary Responsibility and
Prohibited Transactions and in Tax Practice Series, see
¶5530, Fiduciary Duties and Prohibited Transactions.

© 2014 Bradley Arant Boult Cummings LLP.

 

 

   B. David
Joffe and Gordon Earle Nichols are partners at Bradley Arant Boult
Cummings LLP. They both regularly counsel employers, executive
management, and plan fiduciaries on all types of executive
compensation issues as well as the design, implementation, and
administration of qualified and nonqualified benefit plans
including ESOPs. Contact David at djoffe@babc.com. Contact Gordon
at gnichols@babc.com.