ESOP’s Fables: Increased Scrutiny for ESOP Fiduciaries

Webster’s dictionary defines a "fable" in several ways: 1. a feigned story or tale, intended to instruct or amuse; 2. a fictitious narration intended to enforce some useful truth or precept; 3. the plot, story or connected series of events forming the subject of an epic or dramatic poem; 4. any story told to excite wonder; 5. fiction, untruth, falsehood. The title of this article is a play on the venerable Aesop, whose musings turn out to be highly relevant to world of ESOP oversight and valuation. Mercer Capital renders services for ESOP fiduciaries that cannot remotely be characterized as fable. In over twenty years of providing valuation services in connection with ESOP installations, plan year updates and plan terminations, we have assisted many victims of bad advice and misinformation.

In recent years, Mercer Capital has seen a significant increase in the scrutiny of process and the propriety of conduct concerning ESOPs and their fiduciaries. In turn, Boards of Directors and ESOP Trustees (both inside and third party) are seeking more skilled and experienced service providers to enhance their understanding of the valuation process and to improve the credibility of their valuations. If you are an ESOP Trustee or a Board member of an ESOP-sponsor company, the ante for prudent decision-making continues to rise rapidly.

There are many reasons that ESOP valuation is an increasing concern for sponsor companies. Much has been written concerning Enron and other egregious cases of corporate malfeasance. As if greed was not bad enough to bring the hammer down, the demographic tsunami of plan participants requiring diversification or retirement is contributing to an inescapable tide of emerging liability issues. Compounding these concerns are the competing liquidity needs of non-ESOP shareholders who may be calling on finite resources to address their own needs. Last, but certainly not least, the economy is yawing and pitching in a storm of cyclical and fundamental waves which we have arguably never experienced. In the midst of all this turbulence, a strong dose of examination is required:

• Has the ESOP pool been examined for diversification and retirement needs? That next installment sale may be in direct conflict with meeting the needs of the existing plan participants. Liquidity at the company level may be required as a sinking fund for emerging liability issues. Absent such liquidity, borrowing capacity may be required to service the ESOP as opposed to redeeming the next shareholder desiring liquidity. Are you the fabled ant or the grasshopper? When it comes to ESOPs, preparation today is mandatory for the needs of tomorrow.
• Has the company experienced volatile and/or declining performance? How has the valuation report changed to reflect any such impact on value? Remember, the valuation is ultimately the responsibility of the Trustee. The appraiser is essentially an advisor whose work the Trustee must be able to understand, scrutinize, and ultimately promulgate as his/her own opinion of value. While hindsight always brings previously unrealized clarity, appraisers and Trustees must be able to comprehend the future implications of changing financial performance and position. While expectations can change and certain things are unknowable, appraisers and Trustees must not be guilty of fable by either omission or commission. Do not let the ESOP valuation constitute the flattery of the fox that bluffed the cheese from the crow. In the context of changing conditions, do not let your ESOP valuation report become a fable as it seeks consistency with past reports and downplays the severity of a real threat. Shortsighted gains and procrastination will ultimately come back to haunt shareholders and ESOP participants.
• Does the valuation report provide a reconciliation with prior opinions? Does the appraiser provide adequate support and/or discussion for changes in methods and/or critical assumptions from one report to the next? Does each annual report stand on its own while also reflecting the evolution of reporting and analytical standards?
• Is the relative illiquidity (by way of a marketability discount) of a minority ESOP appropriate in light of the sponsor company’s financial health and the plan?
• Does the valuation reflect a valuation adjustment to capture the so called "ESOP Benefit"? Careful scrutiny must be given to potentially controversial adjustments that could distort the value.
• Were excess premiums applied in the valuation of a control ESOP? These adjustments can be tantamount to writing checks that the company simply cannot cash. Over-valuation can plague an ESOP sponsor company and have serious ramifications for participants and selling shareholders.

Revisiting some of Aesop’s fables, we can find many relevant morals concerning the structuring and planning of an ESOP.

• They who act without sufficient thought, will often fall into unsuspected danger.
• In avoiding one evil, care must be taken not to fall into another.
• Precautions are useless after the crisis.
• It is best to prepare for the days of necessity.
• It is thrifty to prepare today for the wants of tomorrow.
• An ounce of prevention is worth a pound of cure.
• False confidence is the forerunner of misfortune.

This brief article cannot possibly provide a complete inventory of items and issues that may be important to assessing the health of an ESOP or the prudence of its sponsor company and fiduciaries. If your answers to some of the above questions have you concerned or curious, take action to prevent or correct potential problems. Mercer Capital has been providing valuation services on behalf of ESOP Trustees for over twenty years. Contact us to discuss a valuation need in confidence.

Reprinted from Mercer Capital's ESOP Valuation Advisor- Volume 13, No 1, 2004.