Employee Ownership Blog

Withdrawn DOL ESOP Valuation Regulations Provide Insight

Summary

In December 2024, the U.S. Department of Labor (DOL) issued proposed rules that would govern the valuation of company stock in an ESOP. Although the Trump administration withdrew the rules in January, the 2022 WORK Act requires the DOL to issue valuation regulations, so while the fate of those withdrawn rules is uncertain, they provide insight into the DOL’s perspective under the Biden Administration and possibly the new administration. When new political leadership at the department is in office, a new proposal for the rules may be materially different from the withdrawn rules.

This post avoids taking a position on the rules. It instead seeks to provide an objective overview of the most important aspects of these rules. 

These proposed rules come after 51 years of ESOPs being part of federal legislation. During that time, although ESOP stock has been valued without the benefit of final regulations, the DOL has been actively engaged in investigations, litigation, and reaching process agreements. There are differing views on whether this has affected the ESOP formation rate and, if so, how much. Researchers have also demonstrated the impact of ESOPs. See the Background below.

The first withdrawn rule, Proposed Regulation Relating to Application of the Definition of Adequate Consideration, would have been consistent with a number of process requirements commonly practiced in the ESOP field, such as the independence of the trustee, the independence of the appraiser, and standards for company performance projections. The withdrawn rule would, however, also have constrained the use of warrants and increased the typical discount for the lack of marketability. It would also have changed the way ESOPs pay for control, adding a number of elements of control, including control of the board, that an ESOP must hold to justify paying for control. The withdrawn rule would also have required the ESOP to receive a reasonable rate of return, although difficulties remain in determining an appropriate standard for reasonableness.

Perhaps the withdrawn rule’s largest departure from current practice is that a good process would not be sufficient if the actual price paid eventually proves to be wrong. Fiduciaries would not know if they had met the rule’s requirements for several years after the transaction. 

The second withdrawn rule, Proposed Safe Harbor Class Exemption For Initial Acquisition of Employer Common Stock by ESOPs from Selling Shareholders, would have offered easily verified conditions under which the appraisal would have been deemed acceptable. The conditions include items significantly different from common practice, such as hiring a monitoring trustee, having the seller note on the same terms as the outside note, sellers giving up all control rights, and others.

Background

The first employee stock ownership plan (ESOP) was created in 1956, and they were defined in legislation as part of the Employee Retirement Income Security Act of 1974 (ERISA). There have never been regulations for how the price an ESOP can pay for stock in closely held companies should be established, although regulations were proposed in 1988. The 2022 WORK Act required the Department of Labor (DOL) to do this. In 2025, the DOL issued proposed regulations and solicited comments. The proposed rules were issued just before the new Trump administration came into office and were not published in the Federal Register. The new administration rescinded all pending regulatory proposals when it took office. The ESOP proposals were thus withdrawn and will need to be reissued. It is impossible to know at this point whether they will be simply reissued, issued with modifications, or completely changed.

The lack of regulatory guidance for valuations has left the issue to courts to make decisions. These cases end up largely being battles between dueling experts, and the resulting decisions do not provide clear and consistent guidance on how to proceed. Since 1990, 105 cases concerning valuation have made it to court. The large majority have settled, meaning there is limited definitive guidance from courts on valuation. The proposed regulation on adequate consideration acknowledges congressional intent in creating ESOPs. The proposal notes that studies “support the concept that ESOPs are associated with positive outcomes for both companies and employees; however, the literature also finds that ESOPs are not without risk.” Most of what it cites emphasizes this risk. The DOL is also concerned about the lack of diversification, although it notes that only 23% of ESOP companies do not have a 401(k) plan.

Research indicates these risk concerns are overstated. ESOP companies have been shown to perform better after setting up an ESOP than would have been expected otherwise, and a study of the default rate on loans from outside lenders found it to be close to zero. ESOP plan participants have about twice the assets in their accounts as comparable employees in comparable companies have in their 401(k) accounts, and most ESOP companies also have a 401(k) plan. If ESOPs were overpaying for shares, it seems likely that these numbers would not be this strong because sponsor companies would struggle to pay off the excess debt. Overall, about 47% of the private sector workforce does not participate in any form of retirement plan, so the real risk is for the millions of employees with no retirement assets.

Proposed Regulation Relating to Application of the Definition of Adequate Consideration

Appropriately, the DOL proposal on adequate consideration does not provide formulas for determining value. Instead, it focuses on the process that should be used to arrive at fair market value, defined as what a willing buyer would pay a willing seller for investments of comparable risk. Most of the elements of the proposal are similar to or the same as in DOL process agreements with plan trustees, but some go beyond. Some of the elements of the proposal would have been consistent with practices recommended by most ESOP advisors. They include:

  • Independence of plan fiduciary: The regulations would have strongly encouraged using an outside, independent trustee when purchasing shares from any non-ESOP participant. This is already a common practice.
  • Independent valuation advisor: An independent appraiser should have no other business relationship with the plan sponsor or the seller or have a financial interest in whether the deal is completed at a price that is acceptable to the seller.
  • Information provided to the appraiser: A common issue in valuation litigation is an allegation that the forecasts provided to the appraiser are too optimistic. The proposal would have required the appraiser to carefully assess the reliability of the forecast and the trustee to thoroughly review this process. The company should also provide any information on recent offers to purchase the company.

Other areas of the proposal raised potential concerns. These include:

Both the Process and the Price Must Be Right

The proposal states that if the price is determined to be wrong even if the process follows all the other guidance, there would still have been a violation. Conversely, if the price were right but the process to arrive at it was wrong, there would still have been a violation. This may be one of the more contentious issues in the proposal because it would have made it hard for a plan sponsor and its board to rely on the process when they lack people internally with the expertise to reasonably second-guess it.

Stock Rights and Warrants

The proposal expresses concerns about how warrants for sellers and stock rights granted to employees can result in what it deems excessive dilution for the ESOP. Warrants have been a particular concern. Warrants give the seller the right to purchase shares at either the transaction price or the post-transaction value of the shares for a certain number of years. Warrants are generally issued in exchange for sellers taking a lower interest rate on seller notes. Mathematically, the issue is whether the present value of the warrant is equal to the present value of the foregone interest. Calculating this foregone interest requires the trustee and the appraiser to determine what an appropriate interest rate would be on the seller notes. If the presumed required rate of return is excessive, the seller would get a larger number of warrants than justified. The DOL has argued that this happens too frequently; defenders of warrants argue that they reduce the risk for ESOPs by lowering the interest rate that the company must pay, helping companies pay off transaction debt sooner. If the company does well, the warrants will eventually have a  cost, but the company should have ample liquidity to address the liability.

The proposal also expressed concerns about excessive stock appreciation rights (SARs) given to executives, although this has been less of an issue and rarely has been the subject of litigation.

Control

One of the most contentious elements of the proposal concerns whether the ESOP can pay for control, and if it can, how much that is worth. ESOP advocates argue that under the law, the trustee is the shareholder and has full voting rights. If the trustee has a majority interest in the company, that should constitute control. Other appraisers take a nuanced view of control, often distinguishing between financial control and strategic control (the right to make decisions about the future of the company). In process agreements, the DOL has taken a much more aggressive view, stating that control for the ESOP can be diluted by a variety of factors, such as the seller having a seat on the board, the seller having a veto over the use of certain funds, or the fully diluted value of the equity diminishing effective control. Their proposal includes a detailed description of the several elements of control the DOL believes that the plan would be required to have in order to justify paying for control. ESOP advocates have argued that this takes an unrealistic view of how control actually works in companies.

Marketability Discounts

Another highly contentious issue is the discount for lack of marketability. Most ESOP appraisals provide a discount for lack of marketability of between 5% and 10%. Discounts for the lack of marketability in many non-ESOP closely held companies would be substantially larger. The argument for the lower discount level in ESOPs is that the participants have a put right that makes their shares liquid after they receive a distribution. The DOL argues that this put right is a right of the participants, not a right of the plan, and cannot be considered unless the company has demonstrated it has the financial capacity to handle the repurchase obligation (and even then, they argue, the discount should probably be larger than the currently used 5%-10% range).

The larger discount could mean, were the rule to go into effect, that many potential sellers to ESOPs would decide the price is inadequate. A perhaps unintended impact of this approach would also be that existing ESOP participants would see a dramatic drop in their account value if the requirement became effective and the marketability discount had to be significantly increased. The overall impact on current ESOP participants  could reach tens of billions of dollars.

Assuring the ESOP Gets a Fair Return

A final area of concern is that the regulations would have required that the ESOP get a fair return. The DOL argues that the expected stock price should increase sufficiently over time so that the ESOP’s rate of return on its investment is justified. While this seems unarguable, interpreting what a reasonable rate of return needs to be is difficult and can vary greatly between individuals. A rate of return based on what a private equity firm expects, for instance, might be excessive because private equity firms often make riskier investments.

Proposed Class Exemption (Safe Harbor) Regulations

A separate proposed regulation provides a safe harbor for valuation compliance. If trustees follow these rules, the appraisal would automatically be acceptable. The rule incorporates all the requirements above but adds others, as outlined below. The withdrawn safe harbor proposal would have been highly unlikely to be adopted by more than a few (if any) ESOP companies. It contains several limitations:

  • Companies could use only one class of stock. Only a small number of ESOP companies have more than one class of  stock, but this could create structuring problems to fit various needs in the future.
  • The internal ESOP loan (the loan from the company to the trust) would have to be on the same terms as the external loan. This requirement would mean that ESOP companies have to allocate shares into participant accounts on a much faster schedule than is common, meaning all of the shares would be released over a short period. That would make the ESOP less sustainable and less fair for future employees, and the required annual contributions on the loan to satisfy this requirement could well violate existing annual contribution limits.
  • Companies would have needed to appoint a monitoring fiduciary. This proposal would have effectively created a second trustee, which would have increased the cost and time of transactions and introduced a second potential area of litigation.
  • Companies could not have issued warrants to sellers.
  • Sellers under the proposal would have had to give up any control rights.
  • Seller notes would have to be priced at the same rate as senior debt. Because seller notes are secondary to senior debt, it is customary for them to carry a higher rate of interest. To comply with the safe harbor, transactions could not use this structure.

The safe harbor proposal seeks comments on other potential safe harbor exemptions.