Despite the lack of consistent or official guidance, the Employee Benefits Security Administration (EBSA), the enforcement arm of the DOL, has placed “particular investigative emphasis” on ESOPs for over a decade, designating them a national enforcement project continuously since 2005. This prioritized approach has resulted in regulation by litigation. From 2018 to 2022, the DOL filed at least nine lawsuits related to ESOP transactions. In most instances, these lawsuits involved challenges to various aspects of the valuation process or methodology relied on in valuing the shares purchased by the ESOP. In 2021 and 2022 alone, the DOL obtained settlements in six investigations that were resolved short of litigation related to ESOP transactions for a total of over $149 million in settlement values. These settlements also resulted in the payment of at least $14.6 million in ERISA Section 502(l) penalties.
The absence of formal valuation guidance has proved challenging not just for plan fiduciaries but even for the DOL itself, as its own expert witness’ valuation methodology was rejected by the court in the recent case of Walsh v. Bowers. The Bowers court ruled in favor of the defendant that it did not cause the ESOP to overpay in purchasing the company’s stock, while disagreeing with several of the DOL’s expert’s valuation calculations for failing to take into consideration certain items. Official guidance making valuation processes and standards clear could likely prevent disputes such as this, and the attendant costs. Despite the favorable ruling for the defendant, the case still lasted three years, proceeded through discovery to trial, and resulted in substantial defense costs (which the defendants are seeking to recover in an appeal to the Ninth Circuit).
This ever-present risk of costly enforcement actions has created fear and uncertainty for ESOP sponsors and fiduciaries. From 2014 to 2020, despite Congress’ stated goal of increasing ESOP growth, the number of ESOPs decreased annually, and the growth rate of new entrants stagnated. The DOL’s enforcement initiatives and the lack of formal guidance have likely had the effect of deterring companies from creating ESOPs due to the associated risks. Similarly, the risk landscape appears to be contributing to a downward trend of institutional trustees willing to serve as trustees for ESOP transactions. The expense and risk that trustees can incur in responding to DOL inquiries and defending investigations and litigation can, for some, outweigh the financial and other benefits of serving as fiduciaries for these transactions.
Although there are several steps before a final regulation will be promulgated, the DOL’s recent commitment to begin the long-awaited process of official notice-and-comment rulemaking brings hope that the DOL will work with the industry and issue clear and fair standards for ESOP valuations that will provide for a more attractive environment for the growth of ESOPs. This formal guidance that fiduciaries, trade associations, and legislators have been clamoring for can provide real guidance for ESOP sponsors and fiduciaries and potentially reduce the risks, uncertainty, and expense that are currently associated with making an ESOP available to employees.