The DOL and ESOP Trustee: There’s No Love Lost

If you eavesdrop on any conversation between an ESOP-experienced ERISA attorney and an ESOP trustee, you’ll likely hear this question: “When do you think the DOL will let up?” The truth is that the end is not in sight. For most of the last decade, the DOL has outpaced ESOP participants to the courthouse.

In this environment, what is an ESOP trustee to do? Many ESOP experts will tell you that understanding the recent court judgments and settlement agreements is the most important next step. These documents are where an ESOP trustee will find nitty-gritty guidance regarding the ERISA fiduciary process that the DOL apparently expects of ESOP trustees. Never mind that these judgments and agreements are supposed to bind only the DOL and the particular ESOP trustee involved. Never mind that this same guidance cannot be found in applicable regulations. ESOP trustees and attorneys report that in recent DOL audits, trustees have even been asked whether their process follows the “GreatBanc Agreement”. In effect, the DOL is regulating via litigation and investigation.

The impact of DOL settlement agreements

Since the DOL and GreatBanc Trust Company disclosed their settlement agreement in the summer of 2014, other agreements have followed, each adding their own wrinkles. The DOL’s public disclosure of these agreements announces the fiduciary processes it expects of ESOP trustees not only in a transaction setting, but also in annual valuations conducted in routine plan administration.

The protocols outlined by these agreements focus on (1) the valuation advisor’s independence, (2) the qualifications of the valuation advisor and (3) the valuation report. While the categories are broad, the requirements enumerated are detailed. And it is these detailed requirements that have caused ESOP trustees and advisors to significantly alter their practices.

Required independence of the valuation advisor

The agreements establish new requirements to ensure the independence of the valuation advisor,  include prohibiting an ESOP trustee’s use of a valuation advisor who had previously worked for any other party to the transaction other than the ESOP or the trustee. The prohibited work includes preliminary valuations for a company thinking about establishing an ESOP.  ESOP trustees must now document an exhaustive fiduciary due diligence process to evaluate valuation advisors, not only for their qualifications, but also in light of their own history and the history of every party to the transaction to demonstrate that there are no conflicts of interest.

Documenting the evaluation and selection of the valuation advisor

The agreements set out requirements for a formal, documented due diligence process for evaluating and selecting the valuation advisor, including the requirement to produce a detailed written report of how a particular valuation advisor was chosen. The analysis expected by the DOL must include:

  • The reason for the selection of the valuation advisor,
  • Who else was considered,
  • A discussion of the valuation advisor’s qualifications,
  • A list of at least three references,
  • Whether the valuation advisor was the subject of prior criminal, civil or regulatory proceedings, and
  • Why the selection was prudent.

If an ESOP trustee chooses to use the same valuation advisor in a subsequent transaction, the evaluation and selection process must be repeated if the last documented selection process is more than 15 months old (as stated in the GreatBanc agreement), or if the selection process was prior to the calendar year that precedes the new selection (as stated in the First Bankers Trust agreement).

The valuation report

With respect to the ESOP trustee’s oversight of the valuation itself, the agreements contain a long list of required reporting and disclosure for any valuation report relied upon by an ESOP trustee. The list includes:

  • Identifying the individuals responsible for providing projections and if they may have had any conflicts of interest as to the ESOP transaction,
  • Documenting why the projections, and all assumptions used in the projections, are reasonable in light of the ESOP sponsor’s five-year financial history,
  • Documenting if any of the metrics used to determine the projections were ignored,
  • Describing any adjustments applied to the ESOP sponsor’s historical or projected financial statements,
  • Describing how the plan provisions and demographics of the ESOP sponsor’s employees affect the prospective repurchase obligation,
  • Describing the risks facing an ESOP sponsor that could cause the company’s financial performance to fall short of the projections,
  • Analyzing whether the terms of any loan received by the ESOP in connection with the transaction are at least as favorable as any loans given to the ESOP sponsor’s executives by the company in the two years prior to the transaction, and
  • Explaining the differences between the current valuation and the most recent valuation of the ESOP sponsor performed within the prior 24 months by any valuation firm for any purpose.

These DOL expectations described in the agreements will likely drive up the cost for a compliant valuation report and limit the ESOP trustee’s choice of a valuation advisor, which may in turn raise the cost of the ESOP valuation significantly.

Documenting the valuation report review

The lessons from recent DOL lawsuits and agreements provide additional guidance for ESOP trustees — and additional work – in evaluating projections used in the valuation and the determination of other factors affecting the valuation.

This means that ESOP trustees must ensure that every aspect of a valuation report’s description of projections is reasonable. Merely following every provision of the agreements concerning projections may not be enough. The DOL wants to see that ESOP trustees are challenging the assumptions used and projections to make sure they are solid, which means documenting their thorough review and understanding of the report. The ESOP trustee must also scrutinize all other factors, including the valuation advisor’s assessment of control value, the potential dilution created by synthetic equity, and the choice of public companies that are truly comparable peers if they were used in establishing the valuation.

The bottom line is that ESOP trustees must now not only hire competent valuation advisors, they must challenge their valuation reports. The DOL expects to see an ESOP trustee engage with the valuation report and advisor and to document that engagement. Such engagement lengthens the timeline for an ESOP transaction or a routine annual valuation. Again, the costs of the transaction and the valuation will likely be higher, reflecting the significant additional work now required.

What’s in store for ESOP trustees

There appears to be no end to the DOL’s national enforcement initiative targeting ESOP trustees. In an environment in which ESOP trustees are under increasing DOL pressure to be omniscient (when it comes to all of the players in an ESOP transaction) and prescient (when it comes to the future financial health of the ESOP sponsor), it is little wonder that some ESOP trustees are considering hanging up their ESOP fiduciary hats. That result would be a shame for good companies that want to transition ownership to their employees and provide for their retirement benefits at the same time. The DOL’s actions appear to be resulting only in fewer ESOP trustee options, higher costs and, ultimately, discouraging employee ownership.

Recommended action steps for ESOP trustees in light of DOL actions

  • Arrange for an audit of your processes as a trustee:
  • Determine whether trustee meetings are appropriate in frequency and length,
  • Determine whether the minutes from trustee meetings are sufficiently detailed to assure the DOL that you meet their standards,
  • Confirm that interactions with valuation advisors, legal counsel and other service providers, outside of meetings, is documented and the notes retained,
  • Confirm that your valuation advisor receives complete, accurate and current information from the company necessary to value the employer securities, and
  • Confirm that the examination and acceptance of valuation reports are documented in detail, including any trustee questions and advisor responses
  • If you haven’t already done so recently, revisit the qualifications of your valuation advisor:
  • Document your current knowledge of its qualifications and experience,
  • Require written confirmation of no conflicts of interests,
  • Require written confirmation of (or absence of) prior criminal or regulatory proceedings,
  • Arrange for peer review of valuation reports, if the advisor is less well known, and
  • Confirm that the advisor is familiar with the DOL’s standards for ESOP trustees, and is prepared to comply with your requirements

Posted August 21, 2018

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Category: Findley Perspective, Retirement Plans