Mercer Capital has been engaged periodically by the U.S. Department of Labor (DOL) to review an historical ESOP transaction and offer our comments regarding the appropriateness of (1)Valuation and (2) Procedural Prudence. While these are two different and distinct areas, the DOL is interested in pursuing both. Violations of procedural prudence can influence the business valuation process and its determination of adequate consideration for ESOP shares.
Proposed regulations for the Department of Labor relating to the adequacy of consideration paid in ESOP transactions have been outstanding since May 1988. Pending their finalization, many appraisal firms, including Mercer Capital, are operating as if they were final. In essence, the proposed regulations incorporate the guidelines of Revenue Ruling 59-60 and add other specific requirements for the appraisal of employers’ securities for ESOP purposes.
We do not provide legal advice, and would look to legal counsel to interpret the standards of fiduciary responsibility in the pension plan context, a primary objective of the Employee Retirement Income Security Act of 1974 (ERISA). Nonetheless, a few general guidelines, based upon our experience, will highlight the need for professional advisors in the establishment and maintenance of an ESOP.
Does the valuation follow the basic guidelines of revenue Ruling 59-60, which sets the standard for Fair Market Value?
Does the valuation properly account for the degree of control to be purchased or sold by the ESOP: a minority or controlling interest?
Does the math check out?
Does the appraisal make sense?
Does that complex discounted cash flow model tucked in the back, and upon which substantial weight was placed, make sense when comparing future growth rates of sales, earnings and margins with historical results? Does the model reasonably reflect the risks of achieving those results? Are the reasons which support the model adequately disclosed in the text?
Do the guideline companies appear reasonably comparable to the subject company, or has the appraiser used multi-billion dollar sales companies in comparison to a $10 million family enterprise? Is the “fundamental discount” so large as to put the whole guideline approach into question?
Business valuation is an art as well as a science, and sometimes a company appraisal will not fit the normal standard to which the appraiser is comfortable. Appraisers and fiduciaries need to review appraisal reports to ensure that the premise, format and standard match the unique circumstances of the ESOP company.
Have fiduciaries reviewed and critiqued an independent appraisal report? As stated in Donovan v. Cunningham (716 F.2d 1455 (1983)), “An independent appraisal is not a magic wand that fiduciaries may simply wave over a transaction to ensure that their responsibilities are fulfilled. It is a tool and, like all tools, is useful if used properly. To use an independent appraisal properly, ERISA fiduciaries need not become experts in the valuation of closely held stock – they are entitled to rely on the expertise of others. However, as the source of the information upon which the experts’ opinions are based, the fiduciaries are responsible for ensuring that that information is complete and up-to-date.”
Have fiduciaries acted in good faith? There is a clear conflict of interest between the selling, controlling shareholder, who may also be President of the company, and the ESOP. This conflict should be mitigated by the input of other professional advisors.
Have the fiduciaries negotiated independently on behalf of the ESOP, in terms of transaction price, loan requirements and the structure of the deal?
Is there only one person who controls the whole process? There is an inherent conflict of interest if only one person is selling the shares, hiring the appraiser, providing the appraiser with company information and negotiating with the lending authority.
Did the appraiser receive full and adequate information? Most of what an appraiser can analyze is historical information, from which he can make a judgment about the future, based upon management performance. The appraiser must be advised how the future may change relative to the past, and how management will deal with or implement that change.
Are there clear lines of communication with responsible fiduciaries? Do they know their responsibilities and is it documented? Do the fiduciaries have the capacity to review the independent appraiser’s report and determine its adequacy?
Has the ESOP purchased or sold its shares for “adequate consideration” and can the reasonableness of that determination be validated by more than waving the appraisal report over the transaction?
Based on our experience, ESOP transactions are not always challenged by the DOL just because a participant complained. The DOL has periodically undertaken targeting initiatives to probe for violations of ERISA relating to whether ESOPs were independently valued, and whether that valuation supported the standard of adequate consideration.
If you would like to discuss a prospective ESOP transaction with us in confidence, please give us a call.
Reprinted from Mercer Capital’s ESOPval.com – Vol. 9, No. 2, 2000.