On January 20, 2025, an executive order froze two new pieces of proposed employee stock ownership plan (ESOP) guidance announced in a notice of proposed rulemaking and originally set for publication in the Federal Register on January 22, 2025.
Issued in the final days of the Biden administration, the proposed ESOP guidance included:
- A long-awaited proposed rule (RIN No. 1210-AC20) defining “adequate consideration” in the context of an ESOP transaction involving private corporation stock (the January Proposal); and
- A prohibited transaction class exemption creating a safe harbor in connection with an ESOP formation transaction (the January PTE).
This guidance, summarized below, set forth guidelines that the US Department of Labor (DOL) believed an ESOP fiduciary should be required to follow in the context of an ESOP transaction involving private corporation stock.
Now that the proposed ESOP guidance has been frozen and withdrawn from publication in the Federal Register, it has no legal force or effect. And, while it remains to be seen whether—and to what extent—this ESOP guidance may be rereleased or reissued under the current, or under a future, presidential administration, the January Proposal was the first formal indication in nearly 40 years of the DOL’s position on the determination of fair market value of private company stock. As such, although unpublished and withdrawn, there may still be some value in understanding the guidance, if only to be prepared for the next effort undertaken by the DOL.
Adequate Consideration Definition
As we noted in a prior post, the Worker Ownership, Readiness, and Knowledge Act (WORK Act), contained in Section 346 of SECURE 2.0, directed the DOL to develop “acceptable standards and procedures to establish good faith fair market value for shares of a business to be acquired by an employee stock ownership plan.” The WORK Act’s directive is designed to fill a regulatory gap in the conditional relief offered under the prohibited transaction rules of the Employee Retirement Income Security Act of 1974, as amended (ERISA).
Under ERISA Section 408(e), an ESOP’s purchase of private corporation stock is exempt from ERISA’s prohibited transaction rules only if the ESOP pays no more than “adequate consideration” for the stock, which ERISA defines as
the fair market value of the asset as determined in good faith bythe trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary [of Labor] (emphasis added)
No final regulations have been promulgated on this point by the Secretary of Labor. The only formal regulatory activity to date has been in the form of Proposed Labor Regulation Section 2510.3-18 (the 1988 Proposed Rule), which was released in 1988 but never finalized. The January Proposal formally withdrew the 1988 Proposed Rule and replaced it with a new two-part test that borrowed heavily from recent settlement agreements involving ESOP fiduciaries, and then applied this test to purchases as well as sales by ESOPs.
It should be noted that the WORK Act’s directive expressly referred only to shares acquired by an ESOP, but the January Proposal went a step further and addressed sales of shares by ESOPs as well. The reasoning for this, noted by the DOL in the January Proposal’s preamble, is the agency’s belief that similar issues may arise in connection with both ESOP acquisitions and sales of employer stock.
For a given stock price to reflect adequate consideration under the January Proposal, an ESOP fiduciary must not only determine the stock’s actual fair market value but also arrive at that determination through a good-faith process that meets ERISA’s high behavioral standards for fiduciary decision-making:
Fair Market Value
The price must reflect the “fair market value” of the employer stock, which the January Proposal generally emphasizes should be objective, rather than based on a given buyer or seller’s “unique circumstances, motivations, idiosyncrasies, or characteristics.” In other words, according to the January Proposal, fair market value should reflect the price at which the asset would trade in the broader market rather than the price a particular investor might ascribe to the asset based on the investor’s unique attributes.
As part of this, the January Proposal explicitly states that fair market value should be determined as if the ESOP were purchasing the stock on a cash or cash equivalent basis without any consideration of the terms of any debt—direct or indirect—used to finance the transaction.
Pulling in an element of subjectivity, the DOL concludes the fair market value prong with a note that the fiduciary must determine the fair market value as of the date of the transaction and such determination must reflect appropriate consideration of all known or reasonably knowable information relevant to the value of the asset as of that date. The January Proposal does not contain an objective definition of what would constitute “relevant information.”
Good-Faith Process
The ESOP fiduciary valuing the stock must follow a good-faith process designed to ensure a sound conclusion as to the stock’s fair market value that conforms with ERISA Section 404(a)(1)(A)’s standards of prudence and loyalty.
Key components of this process include:
- Prudent selection of a qualified independent valuation advisor
- Prudent oversight of a written valuation report that reflects complete, current, and accurate information about both the ESOP sponsor and ESOP transaction
- Prudent review of the valuation report
- Prudent exercise of fiduciary judgment to ensure that, in light of all relevant facts and circumstances, the report may be reasonably relied upon as a basis for determining fair market value
According to the DOL, this two-part test would protect an ESOP in the circumstance the ESOP trustee made a good-faith and prudent effort to value the stock but the seller, who owned and controlled the company, provided misleading or incorrect information about the company’s financial circumstances (e.g., when the fiduciary carefully reviewed the company’s business and prospects but the seller withheld information that the company was about to lose a license that was critical to its continued operation, a key customer had decided to terminate its relationship with the business, or the company’s financial statements were materially inaccurate).
Throughout the preamble to the January Proposal, the DOL emphasized the potential for abuse inherent in ESOP transactions and highlighted multiple “ERISA violations” discovered by the DOL as part of its 20-year ESOP National Enforcement Project. The DOL notes that such ERISA violations include cases in which:
- The ESOP paid for stock on a controlling-interest basis (or paid a control premium), but the ESOP did not in fact gain control following the transaction
- The ESOP trustees hired a valuation advisor who previously worked for the selling shareholders to establish the sellers’ offer price, or imprudently relied on a valuation that assumed that the company’s revenues would grow at a rate that far exceeded its historical growth or the expected growth rates for industry peers
- The ESOP trustees disregarded their fiduciary duties in favor of maintaining ongoing ESOP business and referral relationships with sell-side agents
- The ESOP trustees relied on noncomparable companies as comparables
- The ESOP trustees disregarded preexisting debt in arriving at the equity valuation
- The fiduciary was not prudent when selecting an appraiser, as evidenced by the hired appraiser having a prior conviction for felony embezzlement from a trust
- The fiduciary failed to take proper account of the company’s dependence on a single supplier
Interestingly, several of the violations listed by the DOL in the preamble to the January Proposal are traceable to the same case.
Prohibited Transaction Class Exemption
In addition to the adequate consideration regulation outlined by the January Proposal, the DOL also issued a new prohibited transaction class exemption offering a safe harbor for new ESOPs. The January PTE builds off of the January Proposal to set forth a detailed list of steps that ESOP fiduciaries and selling shareholders may follow to ensue ERISA compliance.
At a high level, these steps include:
- Trustee Independence – The trustee must be independent of the plan sponsor and must have the sole responsibility for determining the price at which the initial transaction will take place
- Appraiser Independence – The trustee may rely upon the assistance of an independent appraiser in determining the transaction price but, in order for this reliance to be reasonable, the trustee must determine that the appraiser is independent of the plan sponsor and the appraiser is effectively acting in accordance with ERISA’s high fiduciary standards
- Transaction Documentation and Transparency – The independent trustee and appraiser must prepare thorough documentation and certifications to verify compliance with the exemption
If these steps are met, the exemption would provide relief to selling shareholders, independent trustees, independent appraisers, and monitoring fiduciaries from the prohibited transaction rules in ERISA Section 406 and the related sanctions imposed by Section 4975 of the Internal Revenue Code.
The January PTE only applies in narrow circumstances, that is, when an ESOP makes an initial purchase of non–publicly traded common stock. The exemption would not apply to transactions that include other types of employer securities. Despite the narrow application of the exemption, the January PTE states that the fiduciary principles included provide guideposts for other stock transactions as well.
What’s Next?
The president’s regulatory freeze, and the subsequent withdrawal of the January Proposal and January PTE, echoes a similar regulatory pause issued when he first took office in 2017. It is not uncommon for incoming presidents to freeze or issue a withdrawal of regulations not yet published in the Federal Register, allowing time to determine whether such proposals comply with new administration priorities.
It is unclear whether the new presidential administration will revise (in whole or in part) or take other actions with respect to the January Proposal and January PTE. In any event, the January Proposal and January PTE give some insight into the way that the DOL was considering these issues prior to the change in presidential administration.
We will be watching the DOL closely and will supplement this blog as information becomes available.