Overview
On January 16, 2025, the US Department of Labor’s (DOL) Employee Benefits Security Administration (EBSA) released two pieces of guidance that, if finalized, would dramatically change the landscape for fiduciaries responsible for determining the value of stock in privately held corporations when engaging in a transaction with an employee stock ownership plan (ESOP). The first piece of guidance involves the long-awaited and highly anticipated “adequate consideration” regulations under the Employee Retirement Income Security Act of 1974 (ERISA), which apply when setting the price at which an ESOP can buy and sell stock. The second piece involves a proposed prohibited transaction exemption (PTE) that would create a safe harbor for selling shareholders and plan fiduciaries when engaging in an initial transaction with a newly established ESOP.
On January 20, 2025, a slew of executive orders issued by the new administration froze all pending proposals from the prior administration, including the proposed regulations and the proposed PTE. Previously scheduled to be published in the Federal Register on January 22, 2025, the proposed guidance was withdrawn, and its unpublished versions were removed from the Federal Register website until new administration can review and approve – or modify in whole or in part – the proposed adequate consideration regulations and the proposed PTE.
Given the removal of the proposed guidance from the Federal Register, the recently issued proposed regulations and PTE have no force or effect. We caution against using such information to guide current thinking on ESOP transactions.
In Depth
ADEQUATE CONSIDERATION UNDER ERISA
Background
The proposed adequate consideration regulations released on January 16 aimed to provide more clarity on valuing non-publicly traded employer stock acquired or sold by ESOPs in accordance with ERISA’s requirements. The acquisition or sale of qualifying employer securities is not exempt from the prohibited transaction rules under ERISA unless, among other requirements, the transaction is for adequate consideration. Current guidance (namely, the 1988 DOL proposed regulations) defines adequate consideration as a price not less favorable to the plan than the “fair market value” of the stock determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations promulgated by the DOL. Fair market value for purposes of the definition of adequate consideration is the price at which an asset would change hands between a willing buyer and a willing seller. The absence of clearer and more objective guidance regarding the definition of “adequate consideration” – other than the “I know it when I see it test” – has exposed ESOPs and their fiduciaries to expensive lawsuits over the years that challenge the valuation process or methodology used, the substantive value concluded, and/or both in ESOP transactions.
Proposed Regulation
The January 16 proposed regulations set forth a two-part test for adequate consideration: fair market value and a good faith determination of that value:
- If the employer stock is not readily tradable, fair market value generally means the price at which the employer stock would change hands in an arm’s-length transaction between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, the parties are both willing and able to trade, and have reasonable knowledge of the facts relevant to the stock’s value.
- Whether the fair market value has been determined in good faith entails independent plan trustees or named fiduciaries determining value in accordance with a prudent process designed to ensure a sound conclusion as to the stock’s fair market value in accordance with ERISA’s fiduciary standards of prudence and loyalty. Components of such a process include requirements that the fiduciary prudently:
- Select a qualified independent appraiser to prepare a written valuation report.
- Oversee production of a written valuation report based on complete, current, and accurate information.
- Review the valuation report to ensure that it may reasonably be relied upon.
It is further noted that the preamble to the adequate consideration regulations emphasizes the need for a “prudent” and good faith process to determine if adequate consideration has been appropriately determined. Unfortunately, while purporting to focus on fiduciary process, the proposed adequate consideration regulations go further to prescribe certain absolute requirements that should, in our view, be left to the appropriate fiduciary review and process, as opposed to dictated by regulation. A deep dive into such issues is beyond the scope of this alert, but it is noted that even if reissued and finalized in their proposed form, the adequate consideration regulations are not likely to make establishing new ESOPs easier, less costly, or subject to less litigation.
The proposed adequate consideration regulations include a revocation of the 1988 proposed rule, which was never finalized or withdrawn by the DOL. However, until reissuance of the withdrawn January 16 proposed regulations, they may not be used as the standard for review by the DOL, and fiduciaries and courts must continue – reluctantly – to rely on the 1988 proposed regulations for guidance.
PROPOSED PTE SAFE HARBOR
The proposed PTE establishes a safe harbor for fiduciaries buying, and shareholders (of the ESOP sponsor) selling, non-publicly traded employer stock in an initial transaction with a newly established ESOP. The safe harbor in the proposed PTE is subject to protective conditions designed to ensure that any transaction relying on the safe harbor complies with ERISA.
Specifically, any trustee that represents the interests of the ESOP in a transaction must be independent of the employer and solely responsible for determining the appropriate transaction purchase price for the employer stock. The independent trustee may rely upon a valuation of an appraiser so long as the appraiser is independent of the employer and the independent trustee determines that the appraiser’s advice is sound, prudent, and loyal to the ESOP participants. Lastly, the independent trustee and appraiser would be able to provide to the selling shareholders certifications to verify compliance with the exemption upon which the selling shareholders would be permitted to rely.
As drafted, the tick-list approach of the proposed PTE would almost certainly have unintended negative consequences if ultimately finalized. As drafted, such guidance clearly erodes any focus on a thoughtful, principles-based valuation process and provides a false sense of security dependent on detailed and burdensome checklist items rather than an understanding of the underlying requirements and goals of an ESOP purchase. Further transactions following such PTE “rules” may or may not actually serve to protect participants who are the intended beneficiaries of an ESOP implementation transaction. The PTE also calls into question those plan sponsors, fiduciaries, and sellers who acted in good faith under the terms of the proposed adequate consideration regulations (if issued), which would further vitiate the certainty that was sought upon the ESOP community’s clamoring for appropriate guidance in the form of regulations.
Ultimately, the new administration must now work its way through the proposed, and now suspended, regulations and PTE issued by the prior administration to determine what, if anything, will be kept on reissuance (if any). Practitioners, in the meantime, are left with the prior, antiquated guidance and significant uncertainty. This process has underscored the need for appropriate and thoughtful regulation that will allow employers to create ESOPs to benefit employees through an almost-solely employer-provided program.
McDermott’s employee benefits team will continue to analyze in detail both proposals, ready comments on both proposals for consideration by the new administration, and provide a detailed analysis and commentary upon their release for public inspection in the Federal Register.
