Using an employee stock ownership plan (ESOP) as a vehicle for a company owner to sell to family members or their management team has been made more expensive — and may become a lot less popular — after the settlement of a lawsuit between the U.S. Department of Labor (DOL) and First Bankers Trust Services Inc.
Through a civil claim, the DOL accused First Bankers of breaching its fiduciary duties by approving the sale of 49 percent of Maran Inc., a private label denim manufacturer, to the Maran ESOP (employee stock ownership plan), for which it served as independent trustee.
A settlement in the case agreed to on Sept. 21 effectively adds to the rules that must be followed by other ESOPs: Trustees that establish ESOPs must now demonstrate that there was proper consideration given to the ESOP as a buyer of a company and/or that it has effective control; such demonstration might include establishing a board that includes an independent director or, alternatively, receiving a discount in the purchase price.
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The requirement for control absent consideration for lack of control is found in Section K of the court's consent order, which says an ESOP must have "the unencumbered ability to vote its shares."
If effective control remains with the same parties after the transaction as before the deal (i.e., the former majority shareholder and his or her appointees), then the ESOP does not have control.
In practical terms, since the easiest way for the ESOP to demonstrate control might be to appoint independent directors, that makes the logical extrapolation of this new "rule" that ESOPs must have an independent board member.
Given that ESOPs are popular among closely held private companies, hiring an independent director may be challenging. For example, a New Jersey-based construction company won't want a director from a competing firm in the same state.
However, hiring an independent director from elsewhere — perhaps Pennsylvania or Maryland — can make retaining that independent director more expensive.
It also gives a board vote to an outsider — a drawback for many owners that might otherwise have considered setting up an ESOP.
The Maran case is a reminder that any firm considering an ESOP should follow best practices, many of which were set out in the 2014 settlement of the DOL's case against GreatBanc Trust Co. Critical among those considerations is ensuring that the fiduciary conducts an independent valuation to determine the true value of a company's shares — an area where the Maran settlement adds greater detail.
Too often, fiduciaries are swayed by the price the seller wants and overlook their duty to ensure that the buyer pays no more than fair market value.
In the Maran case, the court found that First Bankers failed to negotiate over the purchase price and so did not determine the fair market value of Maran in good faith.
Getting such details right is especially important now because, in recent years, the DOL has been aggressively enforcing Employee Retirement Income Security Act (ERISA) regulations governing ESOPs to protect plan participants against owners that unduly influence the outcome of the sale.
ESOPs are a popular way for a business owner to sell all or part of their firm to cash out, to facilitate management succession or to allow employees to share the profits of their work.
Setting up such plans typically costs hundreds of thousands of dollars, but the reality is that many owners and trustees try to cut corners to minimize that cost. The Maran case, where the majority owner agreed to pay $6.6 million in restitution and penalties for failing to adequately monitor First Bankers, is a cautionary tale for anyone considering setting up such a plan without proper oversight and attention to detail. First Bankers, too, was fined — $1.3 million.
Any company considering an ESOP should beware of several potential banana skins. First among those concerns is that an independently determined fair market value might be lower than the owner expects. Owners often imagine the value their firm as if it were being bought by an outside investor or competitor, adding a strategic value that is not realized in an internal deal.
An independent fiduciary (almost always used in deals worth more than $10 million) eliminates concerns about self-dealing, as does an independent valuation firm and an independent board director, but all that can be expensive.
In addition, ongoing governance can be expensive and cumbersome.
The Maran case could leave thousands of companies all across America now desiring to find an independent board director. All told, more than 9,000 American firms, employing more than 15 million workers and valued at more than $1.3 trillion have ESOPs or similar plans.
As a result, the settlement could result in fewer ESOPs being formed in the coming years.
Joe Rankin leads Plante Moran's employee benefits consulting practice.
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