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NCEO Response to Department of Labor Proposal to Define ESOP Appraisers as Fiduciaries

Corey Rosen
Email: :: Phone: 510-208-1314
Initially posted November 30, 2010; updated September 20, 2011

New Development (September 2011): DOL to Re-propose Fiduciary Rule

Responding to considerable controversy about its proposed redefinition of plan fiduciary rules for investment and other financial advisors to retirement plans, on September 19, 2011, the Department of Labor's Employee Benefit Securities Administration announced that it would re-propose the rule in early 2012. Most of the proposed rule, as well the announcement of the re-proposal, deals with the role of investment advisors for 401(k) and similar plans, but part of it also would deem ESOP appraisers to be fiduciaries (see the NCEO response on this below).

In its press release, EBSA said that it would be "responding to concerns about the application of the regulation to routine appraisals." That was the entirety of its comments on the ESOP matter. Just how to read these tea leaves is not clear. It could be that EBSA is signaling it will ease the definition in some way, it could mean they intend to focus more specifically on initial valuations, or it could mean they haven't changed their position significantly, among other possibilities.

Once the new rules are proposed, there will be another period for further comments. As the re-proposal makes clear, the DOL does pay attention to these comments, so when they do come out, those interested in this issue should respond. Meanwhile, the have been bills and hearings in Congress on this matter, including S. 1232, which would exempt appraisers from being ESOP fiduciaries. There is a good chance that any final rule will be challenged in court as well.

Our original response to the DOL proposal follows below:

Executive Summary

This is the first time the National Center for Employee Ownership (NCEO), a private, nonprofit membership, information, and research organization, has submitted formal comments on Department of Labor regulatory proposals. We have commented here because we believe these proposals could have a serious and detrimental impact on the number and quality of ESOPs, which in turn would very adversely affect retirement security in the U.S. On the other hand, we agree there are faulty ESOP appraisals (as do all of the ESOP appraisers who do this work regularly that we consulted on this), and we therefore suggest a number of alternatives the DOL could consider to address this issue more effectively.

We identify several key problems with the proposal:
  1. The absence of final regulations on how ESOPs should be appraised would create considerable confusion for courts, ESOP trustees, and appraisers on how to judge whether appraisers were following their fiduciary duties, which necessarily would be a legally ambiguous question.
  2. Fewer ESOPs would get started, especially in smaller companies, because costs would rise substantially as valuation firms now required fiduciary insurance (assuming it could be obtained). This is especially worrisome because the data definitively show that ESOPs add not just to total retirement security but also to diversified retirement assets.
  3. There would be fewer qualified ESOP appraisers because some of the most qualified appraisers would drop out of the ESOP appraisal business.
  4. There would be considerable legal confusion over just who is responsible for the errors and how responsibility is allocated.
  5. Existing case law already provides that appraisers are fiduciaries when effectively exercising discretion over plan assets.

It is difficult to estimate just how common faulty appraisals are, and the discussion in the proposed regulations does not indicate how frequent the problem is in the DOL's view. We do know, however, that over the last 20 years, there have been only 17 lawsuits specifically concerning ESOP appraisals that have made it to court during that time. More tellingly, leveraged ESOPs have a default rate that is a small fraction of one percent per year, while LBOs in general have default rates several times that high. If appraisals were consistently faulty, ESOPs should often be overpaying for stock and ending up unable to repay the loan. Of course, there are problematic appraisals that never rise to these levels, but the proposal does not attempt to weigh the consequences of the changes suggested against the magnitude of the problem.
We believe there are a number of alternative approaches that may address the problems more effectively, including:
  1. Issue final ESOP valuation regulations: This would provide much clearer guidance to existing fiduciaries and appraisers, which should reduce the problem significantly.
  2. Provide regulatory guidance on what "independence" means: Current law requires that appraisers be independent, but this term has never been specifically defined.
  3. Require that employer stock appraisers be credentialed by a professional appraisal organization: Consideration should be given to whether this requirement should specify that employer stock appraisers have professional training related to employer stock appraisals.
  4. Set specific standards for fiduciaries with respect to valuation: Rather than creating an additional fiduciary with all the problems that arise from that, standards for existing fiduciaries could be tightened.
  5. Establish an industry-DOL advisory committee to seek alternative approaches to the problem.

Complete Response


The National Center for Employee Ownership, a private, nonprofit membership, information, and research organization, has never before submitted formal comments on Department of Labor regulatory proposals. We are not a lobbying or trade association. Our mission is to provide "the most objective, reliable information possible about broad-based employee ownership plans," including ESOPs. To draw a bright line on this, we have avoided commenting on legislative or regulatory matters unless specifically asked to do so. We are making an exception in this case, however, because we are concerned that this proposal could have serious and negative implications for the retirement security of millions of employees.

We agree there are some ESOP appraisals that are poorly done and/or being performed by people who are not truly independent and therefore may have a financial interest in the transaction. We also believe there are more effective and less blunt ways of dealing with these problems that will have fewer unintended and damaging consequences.

In this response, we first briefly outline what the data show on the contribution of ESOPs to retirement security (full details are available on request). Second, we look at how common faulty appraisals might be, admittedly a difficult question to answer very precisely. Third, we look at the likely impact of defining appraisers as fiduciaries in terms of ESOP adoptions and terminations. Fourth, we look at the issue of the existing law on fiduciary responsibilities of plan providers and how that might be affected by this. Finally, we suggest some alternative approaches that might help solve the problem without causing as much potential damage as the proposal likely will.

ESOPs and Retirement Security

It is important first to address the question of why we should even be concerned that the new rules are likely to lead to fewer ESOPs and to lead some existing plan sponsors to terminate them. It has been national policy, confirmed in a bipartisan fashion over many pieces of legislation over the last 36 years, to support these plans. President Obama recently told an audience in Virginia that ESOPs are "aligning the interests of workers with the interests of the company as a whole." While he noted that this means employees are subject to the ups and downs of companies, "theoretically, at least, it's something that can help grow companies, because the workers feel like they're working for themselves, and they're putting more of themselves into their job each and every day. I think that it's something that can be encouraged." But the real test is whether ESOPs are good for employee retirement security.

A common criticism of ESOPs is that they do not provide for adequate retirement security because they are too undiversified. While this argument has intuitive appeal, research on what actually happens in ESOP companies makes it largely irrelevant. First, ESOPs do tend to diversify somewhat over time because private companies often build up cash in the plan to handle the repurchase obligation (private company ESOPs are the only ones at issue here because public companies do not need an appraisal). ESOPs are also required by law to allow diversification to participants aged 55 with 10 years of plan participation. Most companies either pay people out or, more commonly, transfer diversified assets into a 401(k) plan. Second, diversification outside the ESOP is typical. More than half (56%) of ESOP companies offer a second defined contribution retirement plan in addition to the ESOP, making them more likely to have a second retirement plan than comparable companies are to have any retirement plan. Third, unlike 401(k) plans, which are primarily funded by employees and often end up with little or no participation among younger and less well-paid employees, ESOPs, by law, are funded primarily by the company and include all employees meeting the basic qualified plan rules.

In other words, ESOPs are less diversified than 401(k) plans or profit sharing plans, but ESOP companies tend to provide more retirement assets in more plans, and require less of a employee contribution. For most employees (especially the estimated 60% or so who do not actively participate in any retirement plan), being 100% undiversified in an ESOP with assets is better than being 100% diversified in nothing.

In 2010, the NCEO conducted the definitive research on this question by using all of the Form 5500 returns for ESOPs nationally and other defined contribution plans. ESOP companies, by definition, have at least one defined contribution plan: the ESOP. More than half of them (56%) have a second defined contribution plan, likely a 401(k). In comparison, the Bureau of Labor Statistics reports that 47% of companies overall have a defined contribution plan. In other words, an ESOP company is more likely to have two defined contribution plans than the average company is to have any.

The average ESOP company contributed $4,443 per active participant to its ESOP in the most recently available year. In comparison, the average non-ESOP company with a defined contribution plan contributed $2,533 per active participant to its primary plan that year. Controlling for plan age, number of employees, and type of business increases the ESOP advantage to 90%-110% above the non-ESOP companies in our sample.

The value of the assets contributed by the company to all defined contribution plans in ESOP companies is substantially higher than the value in non-ESOP companies. Controlling for company size, industry, and plan age, the average ESOP participant in the average ESOP company has company-sourced defined contribution assets worth 2.22 to 2.29 times as much as the assets held by the average participant in the average company with a non-ESOP defined contribution plan. This ESOP difference is an estimate. The data do not allow us to calculate the actual value of the assets per participant in combined defined contribution plans or the source of the accumulated assets. The data do show how much of each year's contribution is from the company, and this number is stable over the years. We believe it provides a reasonable basis to estimate how much of the accumulated assets in the average employee's account was originally a company contribution.

The results confirmed a 1998 study by Peter Kardas and Jim Keogh of the Washington Department of Community, Trade, and Economic Development and Adria Scharf of the University of Washington. This study used 1995 employment and wage data from the Washington State Employment Security Department, 1995 data on retirement benefits from a survey of companies, and federal Form 5500 data for 1995. The study matched up 102 ESOP companies with 499 comparison companies in terms of industrial classification and employment size. The study found the average value of all retirement benefits in ESOP companies was equal to $32,213, with an average value in the comparison companies of about $12,735. Looking only at retirement plan assets other than ESOPs, the ESOP companies had an average value of $7,952, compared to $12,735 for non-ESOP companies. Given that based on the most recently available Form 5500 data, the typical ESOP is actually about 17% invested in diversified assets other than company stock (with participant-directed diversifications typically not part of this because they are transferred or paid out), employees in ESOP companies would have had about as much in diversified assets as employees would have in all assets in non-ESOP companies. In ESOP companies, the average corporate contribution per employee per year was between 9.6% and 10.8% of pay per year, depending on how it is measured. In non-ESOP companies, it was between 2.8% and 3.0%.

Private companies fund ESOPs at these high levels because they are usually used to buy the shares of existing owners in a tax-favored way, and the high levels are needed to make the purchase. It is highly unlikely that these same companies, if they did not have an ESOP, would fund their retirement plans at anything close to these levels. So discouraging ESOPs would lead to a significant reduction in company-funded contributions to retirement plans.

How Common Are Poor or Conflicted Appraisals?

We agree with the DOL that there are faulty ESOP appraisals. We believe most of these faulty appraisals come from two sources:
  1. Appraisers who only occasionally do ESOP valuations and do not become sufficiently educated in the special issues ESOPs raise. In our experience talking with hundreds of ESOP companies every year, we find that a large majority of appraisals are done by a relatively small number of firms that specialize in this work. However, a significant minority does not use these firms.
  2. Appraisers who have a financial interest or other conflict with the company.

We believe these problems have become less frequent as ESOPs have matured. Early on, valuation models sometimes used "investment banker" approaches that were too aggressive. The ESOP valuation community was in its early stages, and there had not yet been time to develop the kind of intense and frequent dialogue among members of the community that now regularly goes on in conferences and meetings as well as in various publications. This does not mean that problems have disappeared, but they do seem to be much less common.

Assessing the frequency of these problems is difficult. Naturally, the DOL sees mostly the problem cases, and with over 10,000 private companies with ESOPs and ESOP-like plans, it would only take a very small percentage to produce a fairly large number. The best we can do to make an indirect assessment is look at the number of legal cases involving valuation and how often ESOPs default. It would be valuable to know how many faulty appraisals the DOL finds on audit to add to this.

The NCEO conducted a comprehensive review of litigation over employer stock in defined contribution plans between 1990 and 2010. We believe we located virtually every case. There were 175 court cases filed on these issues, 141 of which involved private companies. Of these 141 cases, only 17 concerned valuation, or fewer than one per year. Of course, just because a case is never filed does not mean all the other appraisals were acceptable, but this is a remarkably low figure given the litigation that occurs in all qualified plans and the amounts per participant that are often at stake in ESOPs. Valuation cases were also less common than claims over distributions.

A more indirect way to look at this issue is how often ESOP companies default on their ESOP loans. There can be many reasons why an ESOP company defaults, including unanticipated changes in the economy or a company's market. But an excessively high initial valuation (presumably generally the DOL's concern, as opposed to excessively low one that would favor employees) should put a company at substantially more risk. Based on data from plan providers we obtained in 2010, as well as Form 5500 data, we estimate the default rate on ESOP loans at about 0.2% per year, compared to estimates of 3% to 6% for leveraged buyouts in general. Most ESOPs are leveraged, at least to start, so this suggests that, at least, valuations are rarely excessively overstated.

What Would Happen If Appraisers Are Defined as Fiduciaries?

If appraisers now are deemed fiduciaries, appraisal costs would increase dramatically. Just how much they would increase is impossible to predict, although appraisers we asked about this expect it could double or triple the costs, meaning an added $20,000 to $60,000 for initial appraisals and about half that or somewhat more for ongoing appraisals. This assumes that insurance companies will write these kinds of liability policies. Given that this is a new and uncertain market, it is difficult to say just how quickly and efficiently this might or might not develop.

The effects of this are predictable:

While the proposed regulations might exclude some poorly qualified and/or conflicted appraisers, a desirable end, it would do so at a tremendous cost to retirement security that is hard to justify.

Issues Under Existing Law

In Mertens v. Hewitt Assocs., 508 U.S. 248 (1993), the Supreme Court defined fiduciaries not in formal terms but:
in functional terms of control and authority over the plan (see 29 U.S.C. 1002(21)(A), thus expanding the universe of persons subject to fiduciary duties--and to damages--under 409(a). Professional service providers such as actuaries become liable for damages when they cross the line from advisor to fiduciary; must disgorge assets and profits obtained through participation as parties in interest in transactions prohibited by 406, and pay related civil penalties, see 502(i), 29 U.S.C. 1132(i); and (assuming nonfiduciaries can be sued under 502 (a)(3)) may be enjoined from participating in a fiduciary's breaches, compelled to make restitution, and subjected to other equitable decrees. All that ERISA has eliminated, on these assumptions, is the common law's joint and several liability, for all direct and consequential damages suffered by the plan, on the part of persons who had no real power to control what the plan did. Exposure to that sort of liability would impose high insurance costs upon persons who regularly deal with and offer advice to ERISA plans, and hence upon ERISA plans themselves. There is, in other words, a "tension between the primary [ERISA] goal of benefitting employees and the subsidiary goal of containing pension costs." Alessi v. Raybestos Manhattan, Inc., 451 U.S. 504, 515 (1981); see also Russell, 473 U. S., at 148, n. 17. We will not attempt to adjust the balance between those competing goals that the text adopted by Congress has struck.
The court here is thus supporting the argument that a balance must be struck between the costs fiduciary status would impose on providers and the benefits it would provide, coming down on the side of non-fiduciary status for providers unless they exercised some functional control. With ESOPs, the law already specifically locates that functional control with the plan fiduciary or fiduciaries, who can be, and are, sued for failing to assure proper valuations.

On the other hand, the Mertens case does not simply preclude action against plan providers. ERISA Section 406(a) specifically refers to transactions in which parties-in-interest may not participate. Federal courts of appeals have unanimously held that ERISA Section 502(a)(3) can be used to take action against parties-in-interest in prohibited transactions, at least for equitable relief. In those cases where appraisers actually are exercising discretion or control with respect to the structuring of an ESOP transaction, they already are fiduciaries and are subject to liability for breach of fiduciary duty under existing law.

Under this theory, appraisers could be sued if they have conflicts of interest, addressing one of the principal concerns at issue in the proposed regulations. Of course, appraisers can also be sued (and have been) by plan trustees, most commonly the successor trustee in an ESOP, for simply making faulty appraisals.

If appraisers are deemed to be fiduciaries, would it not make sense, using this same line of argument, to name plan administrators, attorneys, and other advisors fiduciaries as well, even if they do not have specific discretionary authority? For instance, there have been more ESOP legal cases filed for improper distributions or allocations than for appraisals. As with valuations, ESOP trustees often rely on the advice of the plan administrators on these issues. If it seems wrong to declare that all administrators are fiduciaries, consider that the logic for naming them fiduciaries is the same as for naming appraisers as fiduciaries, namely that the ESOP trustee is, in effect, ceding authority to them. The same could be said for trustees who follow an attorney's advice on plan design and a financial advisor who provides a feasibility study.

A more serious concern may be that the courts routinely reject the proposed valuation regulations as law or guidance. Naming appraisers as fiduciaries could make it even harder to sue than suing untrained fiduciaries relying on their experts' reports and advice. An appraiser's own judgment will be the heart of the case, and the "range of value" will be a pure judgment call. Competing experts will go head to head. DOL experts could have a hard time testifying based upon "their experience as fiduciaries" (which is the standard for an expert to testify) as to what they would have done in such a transaction. The pool of ESOP appraisers will also be shallower, so the DOL will have even fewer qualified experts (appraisers who have acted as fiduciaries) to draw from.

Alternative Remedies

While deeming appraisers to be fiduciaries seems then an excessively blunt tool to solve the problem, we acknowledge that there is a problem in some cases, and it does make sense to address it.

In our own work, we have tried to do this by helping ESOP trustees and other fiduciaries understand just what their legal responsibilities are by providing substantial educational material and meetings at which we outline these responsibilities in detail. We also advise people at every opportunity that their appraisal firms should have substantial ESOP experience and have no other financial relationship of any kind with the firm.

The DOL could take several steps that would prove very helpful:
  1. Issue final ESOP valuation regulations: The DOL here is proposing to ask appraisal firms to become fiduciaries, but then, in effect, telling them there are no clearly articulated standards for determining fair market value. This seems unreasonable. If there were regulations, ESOP trustees and other fiduciaries would have a much clearer sense of what to look for in a valuation, and ESOP appraisers would have clear standards to follow.
  2. Provide regulatory guidance on what "independence" means: Current law requires that appraisers be independent, but this term has never been specifically defined. There is some question of whether this means the appraisal firm can do other work for the company, such as financial modeling, that may make it easier to do an appraisal. There are good arguments on either side of this, but we have not seen this be a significant problem. More troublesome is a situation where the appraisal firm or a firm associated with the appraisal firm would gain from a higher-than-justified price when the ESOP buys stock from a seller because a lower price could mean the company chooses not to do an ESOP. Setting a clear demarcation of independence for initial transactions, then could be a useful step. The ESOP Association asked for such guidance some years ago, but there has been no response.
  3. Require that employer stock appraisers be credentialed by a professional appraisal organization: Consideration should be given to whether this requirement should specify that employer stock appraisers have professional training related to employer stock appraisals. For instance, the American Society of Appraisers (ASA), the Institute of Business Appraisers (IBA), the National Association of Certified Valuation Analysts (NACVA), and the American Institute of Certified Public Accountants (AICPA) all provide rigorous coursework, demonstration report submission review procedures, and proctored testing for business valuation credentials.
    Each of the above-mentioned organizations has adopted professional business valuation standards. Among these professional valuation standards, the American Institute of Certified Public Accountants (the largest of these organizations) has adopted and issued a Statement of Standards on Valuation Standard No. 1: Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset (SSVS). As SSVS is adopted by state accountancy laws, SSVS is already the "law of the land" for approximately 500,000 CPAs. However, these SSVS valuation standards are as applicable to non-CPAs as they are to CPAs. And SSVS could be adopted for all employer stock appraisers. Similarly, the American Society of Appraisers (ASA) has developed the ASA Principles of Appraisal Practice and Code of Ethics the ASA Business Valuation Standards, and the Uniform Standards of Professional Appraisal Practice. The ASA also has an ESOP-specific appraisal track, with a recertification program.
    It may be worth considering requiring an "ESOP valuation certification" from an appraisal organization. In the presence of such a requirement, organizations would undoubtedly develop programs that DOL could then certify and monitor.
  4. Set specific standards for fiduciaries with respect to valuation: Rather than creating an additional fiduciary with all the problems that arise from that, standards for existing fiduciaries could be tightened to require that (1) at least one fiduciary certify in writing that he or she has the requisite financial skills to read and understand a valuation report; (2) sign an acknowledgement that the fiduciary is responsible for judging the appropriateness of the appraisal, not just accepting it because it was performed by an appraiser, and (3) sign a statement acknowledging financial liability as a fiduciary. It would also be very helpful if the DOL could develop a checklist of issues fiduciaries should look for and ask about in responding the appraisal reports.
  5. Establish an industry-DOL advisory committee to address the problem: The ESOP appraisers we spoke or corresponded with universally agree that there are poor appraisals, and that this is a problem that needs effective resolution. While this response outlines some of the key ideas, an alternative would be to create a council of people in the industry and the DOL to evaluate which steps could be taken most effectively.


We understand and appreciate the DOL's concern to protect plan participants from practices that can be harmful to their retirement security. Our organization was formed not to promote employee ownership per se, or try to make sure there are simply more employee ownership plans no matter how effective they are, but to do all that we could to research and disseminate facts about employee ownership. We believe that the unbiased truth will encourage the kind of employee ownership that benefits employees and society. It has been our privilege to work with various people at EBSA over the years to provide what we believe is objective feedback on plan practices.

We believe, however, that the remedy proposed here will, in the end, result in less retirement security for employees, not more. We believe there are more appropriate steps to take.

We appreciate your consideration of these comments.

A PDF version of this document is available at this link.