No shortage of recent activity related to ESOPs

Tax reform, DOL fiduciary regulations, process agreement–valuation, trustee defenses

Brad Henschen, Sr. ESOP Consultant

2017 has come and gone. It’s been a year of change, adjustment and unpredictability. In the wake of a new administration, Russian probes, fake news and tax reform, the U.S. Department of Labor (DOL) and the courts continue to address issues related to plan sponsor and trustee duties and responsibilities to employee stock ownership plans (ESOPs). First, the DOL entered into settlements which expanded upon the GreatBanc “process agreement” imposed on fiduciaries in ESOP transactions. Second, the courts issued opinions that further explored the applicability of the Dudenhoeffer (Company Stock in ESOPs: What Should a Fiduciary Do?) pleading standards to privately held stock in an ESOP. And, last but not least, the DOL officially delayed full implementation of the fiduciary regulations that redefine activities that may be considered investment advice. If that weren’t enough, Congress passed tax reform legislation at the end of the year which promises to affect how ESOP sponsors operate their plans.

Tax reform

At the 11th hour of 2017 (December 22, 2017), the President signed the Tax Cuts and Jobs Act of 2017 (Tax Reform). While the legislation does not dramatically affect the regulatory environment for ESOPs, the fallout of the new corporate tax provisions will likely have an impact affecting the decisions made by ESOP sponsors in administering their plans. Significant for this discussion is the preservation of the ESOP tax exemption for S corporations from income and unrelated business income taxes. However, there may be other areas ESOP sponsors may need to address.

Reduced corporate tax rates for C corporations are expected to increase corporate after-tax earnings leading to increases in ESOP stock valuations. With increased valuation, an ESOP sponsor’s repurchase liability is also expected to increase. The rise in repurchase liability will likely affect decisions related to management of ESOP benefit levels and funding strategies. For partially owned ESOP S corporations, there may be less funding provided by S distributions due to the lower individual tax rates and deductions available to S corporation outside shareholders. An ESOP’s tactics for managing repurchase liability and cash flow may change because of Tax Reform.

Leveraged ESOP companies may be affected by new limits on interest deductions. The new law will initially limit interest deductions to 30% of a company’s EBITDA (earnings before interest, taxes, depreciation, and amortization). Beginning in 2022, the 30% limit for interest deduction will be based upon EBIT (earnings before interest and taxes). For leveraged ESOP sponsors with large debt amounts relative to earnings, there may be an increase in taxable income, albeit at the lower corporate tax rates.

As you can see, the ESOP fiduciary environment continues to change and evolve. ESOP sponsors and fiduciaries will want to remain informed as the landscape changes. Tax Reform will certainly lead ESOP sponsors to consider and measure the consequences that the new legislation may have. Stay tuned for further developments!

DOL fiduciary regulations update

The DOL issued final regulations generally effective June 9, 2017 pertaining to the definitions of fiduciary and investment advice for qualified retirement plans, including ESOPs. Portions of the final regulations initially had a transition period providing for full implementation to January 1, 2018. Due to pressure to further review the implications of the new rules on plan participants, congressional interest and industry concerns, the DOL officially extended the regulations transition period from January 1, 2018 to July 1, 2019, a full 18 month extension. While the transition extension was welcomed by many interested parties, the heart of the rules originally effective June 9, 2017 continue to apply. Areas of interest for ESOPs include situations where ESOP sponsors are providing recommendations directly or hiring service providers who will assist participants in making decisions regarding electing a distribution, rollover of a distribution, choosing diversification elections or directing the investment of segregated funds, i.e. terminated participants or participants with a 401(k) participant directed component of the plan. Plan sponsors responsible for hiring service providers or advisors who assist participants in making decisions regarding distributions from a plan, including ESOPs, will still want to consider the nature of the services provided and the capabilities of those service providers and advisors to fulfill their fiduciary responsibilities to the plan and plan participants.

Process agreement–valuation update

In 2014, the DOL entered into a settlement agreement with GreatBanc Trust Co. (an institutional trustee) that identified a rigorous process the DOL considers necessary for an ESOP fiduciary to follow in order to reasonably rely upon an independent appraisal of privately held stock (Perez v. GreatBanc Trust Co.). The process agreement outlines policies and procedures an ESOP fiduciary must address and document before entering into a transaction involving the purchase or sale of privately held stock on behalf of an ESOP. The focus of the process for the fiduciary is to prudently ensure the integrity of the independent valuation technique and the information relied upon in support of the valuation of privately held stock.

The DOL agreed to two additional settlements with ESOP fiduciaries in 2017 that enhanced and expanded upon the GreatBanc process agreement (Acosta v. First Bankers Trust. Services, Inc. and Acosta v. BAT Masonry Company, Inc.). One of the settlement agreements included an individual trustee rather than an institutional trustee, signifying that the process agreement applies to all ESOP fiduciaries. The process agreement with the individual trustee was tailored to recognize the differences between an institutional trustee and an individual trustee. Notably, the process agreement with the individual trustee includes a requirement to make a good faith effort to obtain insurance coverage, either through a separate policy or through the ESOP sponsor’s insurance.

Pleading standards (trustee defenses)

Prior to 2014, ESOP fiduciaries defended their decisions to offer or invest plan assets in employer securities by relying upon a special presumption of prudence favoring ESOP fiduciaries. Virtually all courts had adopted this presumption. That is, until the Supreme Court issued its opinion in Fifth Third Bancorp v. Dudenhoeffer. In its opinion, the Supreme Court unanimously ruled that there was no special presumption of prudence for investment in employer securities provided to ESOP fiduciaries within the Employee Retirement Income Security Act (ERISA).

Dudenhoeffer involved publicly traded employer securities and suggested that plaintiffs claiming a breach of fiduciary duty would need to base their allegations on publicly available information or on the failure to disclose inside information. This pleading standard has proven difficult for plaintiffs to overcome.

However, the pleading standards identified in Dudenhoeffer do not directly apply in a private company context. There is seldom publicly available information regarding a private company’s stock price or prudency of the investment on which to base a claim. Thus far, one appeals court has rejected the Dudenhoeffer pleading standards in the private company context (Allen v. GreatBanc Trust Company).

Other courts have addressed the pleadings issue with private company stock by acknowledging Dudenhoffer and the standards, deciding the case on another basis without directly rejecting Dudenhoeffer. It remains to be seen how the pleading standards for private company stock will progress within the courts.

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.