Defense Department Audit Agency's ESOP Position Challenged

In recent years, the Department of Defense Contract Audit Agency (DCAA) has taken the position that interest paid on ESOP loans is not a compensation cost reimbursable by the government in defense contracts. The DCAA argument is that the interest payment does not result in employees receiving any added value to their ESOP accounts. ESOP advocates have contended this is a too narrow view. First, some leveraged ESOPs release shares based on the principal and interest paid, so interest payments are related to compensation. Moreover, accounting guidelines now require compensation cost to be the value of shares released, not the principal paid on a loan. The DCAA further argues that the interest payments are really the company's debt, used to reacquire shares from sellers, something the government should not be financing. This issue has been going back and forth for several years, with periodic easings and tightenings.

The DCAA has recently gone further on this issue, arguing that the repurchase obligation in an ESOP should not reduce the lack of marketability discount that usually applies to shares in closely held companies. The impact the legal requirement that ESOP participants must be able to sell their shares back to the company or the ESOP has on valuation is a controversial and complex issue; most valuation advisors would say that it can have some impact, but usually should not reduce the discount to zero. The DCAA position is that the discount should never be affected and that ESOP shares would normally be overpriced by 20%. Moreover, the DCAA now takes the position first developed, then dropped, by the Department of Labor in the "Farnum" case that in a leveraged ESOP, the debt the company takes on to fund the plan should reduce the price the ESOP pays initially for the stock. ESOP advocates say that this would be like paying $20,000 for a $100,000 house because $80,000 is borrowed. The DCAA says it is not concerned with the practicality of ESOPs, but what value is actually being released to employees. If the shares are priced at $100 at the transaction but drop to $40 after it because of the debt, the DCAA argues, the government should only reimburse based on the $40 value. Similarly, if the shares are overpriced because of the marketability discount issue, the government should reduce what it pays.

ESOP advocates in Congress introduced an amendment to the Defense Reauthorization Bill to delay these positions until Congress could review them. The bill was dropped in the Senate, but included in the House version. Conferees are now discussing the issue; Michael Keeling of the ESOP Association says that there are unconfirmed reports that the conferees are taking a pro-ESOP position that would prevent the DCAA from imposing the guidelines on pre-1996 ESOPs and require further audits to wait until a Congressional review is completed. The conference outcome on the entire bill is still uncertain, however (it may not pass in any form), nor are the ESOP provisions definite.