The courts and the Department of Labor (DOL) have made it very clear that boards of directors in ESOP companies have a duty to monitor how the ESOP trustee oversees the valuation process and to make sure that the plan is not paying more than fair market value to outside sellers and not less than fair market value to plan participants at diversification or distribution. But the courts and the DOL have been much less clear about just how boards can fulfill their duty.
The four scenarios below lay out some common issues and how they might be addressed.
In an initial ESOP sale, the trustee says the valuation is $40 per share based on the valuation report. Board members think that figure is too low and the seller won’t accept it. The trustee has told them the value, and the process for arriving at it, but not allowed them to see the report because doing so could give the board and/or the seller too much leverage. Can or should the board try to get the trustee to accept a higher price? Will that violate ERISA?
In this case, if the board tells the trustee that under its duty to monitor, it believes the trustee should go higher, it may be asking for legal trouble. The board has now become the fiduciary for the valuation and, whether it is right or wrong, it will have a tough time in court arguing it was acting in the best interest of plan participants.
Imagine the trustee shows the board the comparison companies used in the report and the board believes that some are not good comparisons because they are in a different industry. Or imagine the board sees the projected future earnings the appraisal firm has decided to use and believes the appraisal firm has misunderstood some of the company’s key revenue opportunities. In these cases, it is reasonable for the board to have a discussion with the trustee and possibly the appraiser to see what their rationale is. This could lead to changes if the board makes a persuasive case. But the board should probably not insist that the trustee accept a higher price because, again, it may appear that it is not looking out primarily for employee interests.
The board gets back an appraisal number that seems unrealistically high. The seller will be happy, but the deal seems pretty expensive. The trustee assures the board the price is realistic. If the board just accepts the price, it fears it could be held responsible in a lawsuit and, in any event, does not want to burden the company with too much debt.
This is a difficult situation. The board should have a discussion with the trustee and possibly the appraiser to air its concerns and get a response. If its concerns are eased, it can document the meeting and move on. If they are not, the board has a tougher choice. Should it pressure the trustee to be more aggressive? Should it look for a new trustee? Or should it just decide that it is not expert enough to substitute its opinion for the trustee’s? There is no surefire answer, but the board should carefully document its procedure, the questions it asked, and its ultimate rationale.
A few years into the ESOP, the company has a pretty good year, but when it gets back the appraisal, the price has gone way up. The board finds it hard to believe this can be accurate. It asks the trustee to describe what the appraiser did and gets a copy of the appraisal report. The data are accurate, but the assumptions seem too optimistic and appear to be substituting the appraiser’s judgement for management’s.
Boards can protect themselves, the ESOP, and the company by taking several key steps:
● Make sure the forecasting process is reliable: A good forecast is built bottom up, looked at by multiple people for a reality check, and stress tested, with the appraiser given a baseline forecast and details on what would make it go higher or lower.
● Meet with the trustee and appraiser: Meet at least annually with the trustee and the appraiser, as well as for any transaction between the company and a non-ESOP owner. The NCEO document library contains a checklist based on DOL guidance for what an appraiser should do each year. The trustee should report to you on how the items in that checklist were met.
● Make sure the repurchase obligation is assessed and reported on: Provide information on the expected repurchase obligation for the next five years and make sure the appraisal has a detailed explanation of how this will affect stock price.
● Read the appraisal or, if not provided, get a detailed summary and explanation: You can’t monitor the trustee just based on a price — you need to know how it was arrived at.
● Document each step: Show the steps you took and the questions you asked.