As part of a national enforcement project centered on ESOPs, the US Department of Labor (DOL) has increased its level of scrutiny of ESOP valuations relied upon by fiduciaries in ESOP transactions. This has led to an increase in the number of ESOP-related suits filed by the DOL. There also has been an increase in ESOP class actions filed by the private bar covering many of the same valuation areas of dispute. This publication provides several perspectives on ESOP valuation and enforcement, ranging from an interview with Tim Hauser of the DOL to essays from various ESOP advisors. The authors hope this publication not only provides insight on important ESOP issues but also shows that continued dialogue between all parties may result in a common perspective that reduces litigation in the future.
Table of Contents
Q&A with Tim Hauser of the US Department of Labor
General Valuation Factors ERISA Counsel May Consider in an ESOP Litigation Case
An Appraisal Review
Analysis of the Reasonableness of Compensation and Compensation-Related Agreements
Development and Application of Company Management-Prepared Projections in an ESOP Valuation
The DCF Method and Company Management-Prepared Projections
Forecast vs. Projection
Expected Cash Flow
Use of Historical Financial Data in Preparing Projections
General Due Diligence Related to Management-Prepared Projections
Reasonableness of Management-Prepared Projections
Crossfire: The Debate over the Consideration of the Fair Market Value of Seller Notes Used to Pay for Sponsor Company Stock
Seller-Financed ESOP Transactions
Face Value Argument
Fair Market Value Argument
Best Practices for an ESOP Trustee That Inherits Litigation
Best Practice No. 1: Review and Assess Claims
Best Practice No. 2: Determine What Role, If Any, to Take in Pending Litigation
Best Practice No. 3: Communicate with Plan Participants
From "Q&A with Tim Hauser of the US Department of Labor"
Separate from the appraisal, are there any other areas related to ESOP transactions that you want to comment on?
Moving apart from the appraisal issues, another big problem I sometimes see is a lack of seriousness about these transactions. If you are the person with the authority to make a multimillion-dollar decision, you really should be acting more like a private investor who is putting his own money on the line. You should act as if this is your retirement security at stake. Act as if you are investing 100% of your retirement. What process would you employ if that were the case? I guarantee you that the process you would employ would not be a checklist, pro-forma type of thing.
If you were investing your own money, you wouldn't just go through the motions. You wouldn't just hire the appraiser to make sure you got the opinion you wanted. You would be kicking the tires and making sure that the deal made sense both from a process standpoint and a substantive standpoint. I'm not saying this isn't the way it usually works, but in the cases we bring, it's never how it works.
Another issue we have seen in our cases that's troubling is that we don't actually see negotiations. If we do see negotiations, they are very marginal and generally regard some very minor provisions of the purchase agreement that do not result in increasing or protecting the benefits the ESOP is supposed to provide participants. We do not see a lot of haggling over price. We do not see a lot of pushing back. Indeed, in some cases, we see trustees actively working with the seller to come up with ways to maximize tax benefits for the seller to the detriment of the plan.
From "Development and Application of Company Management-Prepared Projections in an ESOP Valuation" (footnotes omitted)
It is intuitive that when applying the DCF method in an ESOP valuation, wholesale acceptance of management projections may reduce or eliminate the valuation analyst's objectivity. If data provided by management is blindly accepted by the valuation analyst as being appropriate and reasonable, the conclusion of value may not be indicative of the expected cash flows of the employer corporation.
In applying the DCF method in an ESOP valuation, the valuation analyst's due diligence process generally should include a detailed analysis of the assumptions on which management's projections are based. As presented in Understanding Business Valuation, several general factors that the valuation analyst should consider in analyzing management projections include company-specific factors, economic conditions, and industry trends.
In looking at company-specific factors, Current Perspectives on ESOP Valuation and Enforcement suggests analyzing the financial projections assumptions related to (1) revenue and receivables; (2) cost of sales and inventory; (3) other costs/expenses (e.g., selling, general, and administrative expenses); (4) property and equipment (capital expenditures), including the related depreciation; (5) capital structure; and (6) income taxes.