Succession

Employee Stock Ownership Plans (ESOP) in Succession Planning

Employee Stock Ownership Plans (ESOP) in Succession Planning

Author Executive Benefits Team
Date July 12, 2022
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A company that seeks to protect the assets of the organization and the interests of valued employees may choose an employee stock ownership plan as a key part of its succession planning. Attorneys Greg Daugherty and Rich Helmreich of Porter Wright have provided us this deep dive look into seller liability in the event of possible Employee Retirement Income Security Act (ERISA) missteps that could occur in the execution of an employee stock ownership plan. This article is so detailed it essentially becomes a case study.

For further insights on a range of business succession plans and strategies, including buy-sell agreements, and other ways to protect business owners, their families, and their companies, we encourage you to contact any member of our executive benefits team. They will be happy to answer your questions and help you explore your options.

Can sellers be liable for ERISA fiduciary breaches in ESOP transactions?

By Greg Daugherty and Rich Helmreich 

ESOPs* are increasingly a popular succession planning vehicle, and well they should be. When formed properly, an ESOP transaction preserves the legacy of the business that an owner helped create, while providing tax and financial benefits to the former business owner, the company and the employees.

Yet, as we have blogged in the past, the Department of Labor (DOL) remains concerned about private company employee stock ownership plan (ESOP) valuations in the formation of ESOPs. In particular, sellers are not immune from liability for Employee Retirement Income Security Act (ERISA) prohibited transaction and fiduciary breach claims when it can be shown that the ESOP paid a price that exceeded fair market value (“adequate consideration” in ERISA parlance).

On the other hand, selling business owners in an ESOP transaction can take advantage of many strategies to protect themselves from liability, particularly with respect to due diligence, valuation and corporate governance items. Many of those strategies continue to be relevant. Recently, there were two decisions that led us to want to highlight and update three particular lessons for sellers:

(1) the value of engaging an independent trustee,

(2) the importance of being engaged in the valuation process, and

(3) the ability to mitigate damages by forgiveness of debt.

These lessons not only help protect the selling business owners, but also help ensure the future success of the company — and the seller’s legacy — after the transaction.

Value of an independent trustee

One lesson is for the seller, long before the actual sale, to commit to hiring an independent trustee for the ESOP after the sale. One concern in the Vinoskey case, which provided the case study in our prior blog, (Sellers beware: Recent court case shows sellers – as well as ESOP fiduciaries – should be engaged in ESOP due diligence and valuation process) was that after the sale to the ESOP, corporate insiders comprised two of the three trustees. These individuals, who also included the seller, also represented a majority of the board of directors.

Although the company engaged an independent trustee to negotiate the transaction, both the trial court and appeals court concluded that the sellers never relinquished control of the company and thus had a fiduciary duty to participants even when they were negotiating the transaction. That type of holding would tie the hands of any seller because a seller would be restrained from negotiating the best possible purchase price. In contrast, in the Bowers case, the sellers agreed to hire an independent trustee after the transaction was completed. Because of that, the court held that the sellers were not fiduciaries, and thus they had more leeway to negotiate the best price they could receive.

These results are understandable. Independent trustees have more ESOP experience and present fewer conflicts of interest than insider trustees present. As a result, there has been a trend towards engaging independent trustees after a transaction is completed, and these cases should continue that trend. The independent trustee need not be the same trustee who negotiated the transaction, although that trustee typically will be the best one to serve because of the familiarity with the company.

Sellers should be engaged in negotiations

Sellers often defend themselves in ESOP valuation cases by claiming that they are not valuation experts, and thus they cannot be expected to know whether the ESOP paid more than fair market value for the company’s stock. After all, that’s why the trustee hires its own independent appraiser. Yet, the Vinoskey and Bowers decisions show that sellers still need to be engaged in the process.

The company in Vinoskey had received annual appraisals each year for its stock because it had been a minority ESOP-owned company prior to the transaction that became subject to the suit. Those appraisals (which were done by the same appraiser retained for the subject transaction) had ranged between $215-$285 per share over the preceding five years. The price that the ESOP trust paid per share upon assuming 100% of the shares was $406. Both the district court and appeals court explained that while the seller was not expected to be a valuation expert, the discrepancy from the prior appraisals should have prompted him to ask whether the higher valuation caused concern. As stated previously, the fact that the seller was a fiduciary made the courts less sympathetic to the argument that he was not a valuation expert.

In contrast, the sellers in Bowers were able to provide documentation and witnesses to support the valuation for the company. It also helped that the judge understood valuation principles. In particular, the judge noted that an informal indication of interest that represented a lowball offer was not representative of fair market value. The judge also criticized the DOL’s valuation witness for failure to follow various valuation best practices. The Bowers decision shows the importance of providing witnesses, experts and attorneys who fully understand ERISA principles and valuation principles and can fully educate the judge. In order to do that, it is helpful if the sellers are engaged in the process.

Mitigation of damages

Finally, we note a change in one of the lessons from our prior blog, which is good news — debt forgiveness after the transaction can in fact mitigate damages. In the Vinoskey case, the seller had forgiven a portion of the debt owed to him after the transaction and tried to argue that this debt reduction should mitigate damages. The district court rejected that argument, holding that the relevant question was whether the ESOP paid too much for the company stock on the date of the transaction. Whatever happened after the transaction was irrelevant. The appeals court rejected that holding, explaining that unmitigated damages plus the debt forgiveness would result in a windfall to participants.

This holding is good news because it shows that a company and seller can be proactive after the transaction, and courts should view that favorably.

Final thoughts

While sellers are not immune from liability, they are not expected to be valuation experts and are not expected to negotiate against themselves. Instead, sellers are expected to be engaged in the process and to understand that an ESOP is a regulated transaction. It is important to hire a team of professionals, including experienced legal counsel, to help navigate the various issues not only is a defensive strategy to protect from liability. Doing so also helps sellers make an ESOP a rewarding succession plan for themselves and the other stakeholders of the business.

Succession Planning: This look at 5 Mistakes in Life Insurance Planning provides evergreen guidance for your succession planning needs.

*ESOP  Employee Stock Ownership Plan 

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This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein.

Securities offered through Lion Street Financial, LLC (LSF) and Valmark Securities, Inc. (VSI), each a member of FINRA and SIPC. Investment advisory services offered through Lion Street Advisors, LLC (LSA) and Valmark Advisers, Inc. (VAI), each an SEC registered investment advisor. Please refer to your investment advisory agreement and the Form ADV disclosures provided to you for more information. VAI/VSI and LSF/LSA are non-affiliated entities and separate entities from OneDigital.

Unless otherwise noted, VAI/VSI, LSF/LSA are not affiliated, associated, authorized, endorsed by, or in any way officially connected with any other company, agency or government agency identified or referenced in this document.

Lion Street Advisors // Lion Street Financial

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