ESOPs, Benefits & Compensation Client Alert
By ESOPs, Benefits & Compensation
On January 16, the Department of Labor released long-awaited guidance on how to determine the value of employer stock in purchase and sale transactions involving an ESOP. Unfortunately for those in the ESOP community hoping the new rules would provide clear guidance, the proposed regulations were frozen on January 20 pending review by the new Trump administration. Whether and in what form the proposed rules will emerge from the review process is difficult to tell at this point.
As background, ERISA requires that sales of employer stock to or from ESOPs must be conducted for “adequate consideration.” In other words, an ESOP cannot overpay when buying stock or allow a buyer to underpay when an ESOP is selling stock. The legal standard for adequate consideration has never been fully defined. The closest attempt was a 1988 proposed regulation that was never finalized. Since then, the requirement of adequate consideration – how the stock is valued in practice – has been subject to intense scrutiny, and often litigation, by the DOL as well as class-action lawsuits.
In 2022, federal legislation required the DOL to issue formal guidance on an acceptable valuation method. The January 16 proposed regulations attempted to fulfill that directive. At this point, they have only been released in proposed form and have not been formally published in the Federal Register. They are not effective unless and until they undergo the full regulatory process.
The guidance package contained two separate proposals. The first is a proposed regulation defining “adequate consideration” for purposes of ESOP transactions. The second is in the form of a prohibited transaction “class exemption” – essentially a voluntary safe harbor approach that outlines transaction procedures certain parties to an ESOP formation transaction may follow to avoid legal violations.
Adequate Consideration Regulation
The adequate consideration regulation is the more significant of the two proposals. In its proposed form, it applies only to an ESOP buying or selling employer stock (not ongoing annual valuations). However, unlike the class exemption, the rules for determining adequate consideration would be mandatory for ESOP transactions.
The DOL lays out two requirements to meet the adequate consideration requirement: (1) the price used must be the “fair market value” of the employer stock, and (2) the fiduciary valuing the stock must follow a prudent good-faith process. Importantly, both of these requirements must be met; in other words, to meet the proposed standard, a trustee cannot accidentally or negligently arrive at the right price or arrive at the wrong price in a good-faith manner.
- Fair market value must be objective and cannot be based on unique attributes or motivations of one of the parties.
- Fair market value is determined on a cash basis, without regard to the transaction’s form of financing, or lack thereof (for example, an ESOP cannot overpay for stock in exchange for a below-market interest rate on seller financing).
- Fair market value must be determined as of the date of the transaction, based on all information known or reasonably knowable as of that date.
- Valuation advisor selection: For starters, the fiduciary or trustee must engage a valuation advisor to determine the stock’s value. The trustee – and not another party such as the selling shareholder or employer – must select the valuation advisor, who also must be “independent” of the other parties, a standard the proposal does not define specifically. The valuation advisor must be qualified and have the expertise necessary to complete the valuation. Finally, the trustee must undertake and document a review process of valuation advisors considered and the basis for the advisor selected.
- Valuation oversight: Once the valuation advisor is selected, the trustee must ensure the valuation advisor receives all material information about the company and its finances, including current, historic, and projected financial information, as well as all other relevant information. The trustee must also understand and disclose all recent expressions of interest from other buyers, as well as provide the valuation advisor access to the employer’s management personnel.
- Valuation review and reliance: The last element gets the most detailed treatment in the proposal. In order to prudently rely on the valuation advisor’s report, the trustee must read, critically review, and understand the full valuation report, its underlying assumptions, and its internal logic and consistency. Where necessary, the trustee must probe the report’s assumptions and test them against alternatives and sensitivity to inaccuracies in any projections. When determining the stock’s value, the valuation report must also account for any warrants, stock appreciation rights, or other income streams that may be provided to the selling shareholders beyond the purchase price. It must also adequately take into account appropriate discounts for lack of control if the ESOP does not gain sufficient control over the company’s management, as well as appropriate discounts for lack of marketability, in addition to the impact of the employer’s obligations for contributions and transaction debt repayment. Finally, the report must conclude that the proposed share value is consistent with the rate of return expected by equity investors in light of the risks. Perhaps most controversial without further clarification, the proposal also requires that the shares ultimately released in a leveraged transaction be worth at least as much as the purchase price plus a reasonable rate of return.
Where the adequate consideration rule largely take a principles-based approach, the proposed class exemption provides very detailed requirements. Again, the class exemption is a voluntary safe harbor that parties may choose to follow in hopes of avoiding DOL scrutiny or litigation. However, given the many requirements and arguably onerous terms, it is difficult to foresee many in the ESOP community trying to comply with the class exemption approach.
Among other things:
- The class exemption only applies to the initial sale of employer stock directly to an ESOP. It does not apply to any other form of transaction, including a sale of stock by an ESOP or a purchase of stock from the employer or a redemption of stock by the employer.
- No selling shareholder can receive warrants, stock appreciation rights, synthetic equity, or any equity-like interests (other than ESOP shares) in connection with the transaction.
- Like the proposed regulation, the ultimate share release must be expected to be above the purchase price plus a reasonable rate of return.
- Selling shareholders are prohibited from certain parts of the process and deliberations.
- Any seller notes must be on equivalent terms to any internal notes, meaning sellers could not be paid faster than the internal share release, often 15-20 years or more.
- The overseeing parties would have to ensure the others have sufficient resources or insurance to pay any losses arising from the transaction.
- At least two years of audited company financials must be provided.
- Various advisors cannot have previously performed any work for certain parties to the transaction.
- The trustee and valuation advisor cannot receive compensation for the transaction that exceeds two percent of their prior year revenue.
- Trustees and appraisers generally cannot be indemnified by the employer.
- The employer cannot pay any professional fees incurred by the selling shareholders.
- Dividends generally cannot be used to pay transaction debt.
- Among other people, ESOP participants and their representatives (presumably, including their lawyers) must be provided access to records sufficient to prove the transaction met the class exemption’s requirements.
We will continue to monitor updates as the regulatory process moves forward. In the meantime, please feel free to contact us with any questions.
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2025.