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      Common ESOP Violations and the DOL: If They've Seen It Once, They've Seen It … a Lot!

      When the U.S. Department of Labor (DOL) conducts field investigations of Employee Stock Ownership Plans (ESOPs), several violations of the Employee Retirement Income Security Act (ERISA) relating to the ESOP transaction come up again and again.  This article discusses a few of the most common and how to avoid them.

      Accelerating the Amount Due in the Event of a Default

      Under ERISA, ESOP loans to a party in interest such as the ESOP sponsor or some selling shareholders are known as "exempt loans."  The regulations provide that when an ESOP defaults on an exempt loan, the plan assets transferred or foreclosed on to satisfy the loan default must not exceed the amount in default.  If the lender is a party in interest, it may only foreclose on plan assets sufficient to meet the loan payment schedule and only as payments come due.  This effectively means that a party in interest may not be able to seize all of the ESOP's shares still posted as collateral in the event of a default, as might be the lender's expectation.  A failure to meet this requirement would result in a prohibited transaction under ERISA section 406.

      Therefore, under no circumstances should ESOP loan documents contain language that requires the acceleration of the scheduled loan payment in the event of default.  Documents such as promissory notes, security and pledge agreements, and loan agreements not complying with these rules should be amended to conform to the regulations.

      Treatment of Voting Rights in the Event of a Default

      It is common for ESOP loan documents to state that in the event of default, voting rights of all of the suspense account shares come under the control of the lender.  This may not be an unusual provision in a commercial loan where the lender expects to protect its interest by not allowing stock to be voted in a way that would defeat its creditor's rights.  However, in the event of default on an exempt loan, the "value" of plan assets transferred in satisfaction of the loan must not exceed the default amount.  The DOL is looking at whether allowing all suspense account voting rights to go to the lender on default is a violation that would result in a prohibited transaction.  We are aware of at least one case where the DOL cited proxy voting language as a violation that resulted in a prohibited transaction.

      To avoid the issue, plan fiduciaries should ensure that ESOP loan documents limit the voting rights transferred to the lender to the voting rights associated with the shares that have a fair market value that complies with the foreclosure limits discussed above.

      Mitigating Language in ESOP Loan Documents

      ESOP loan documents often contain a "general mitigating" language provision which may be included in the hope of covering all the bases in case some specific provision of the document is a violation of the law.  For example, a provision might state that "nothing in this document shall be construed to be inconsistent with Title I of ERISA."  The intention is that the document not be interpreted or applied in a way that violates the law.

      In our experience, the DOL's position is that general mitigating language does not negate a loan provision that violates Title I of ERISA.  Therefore, you should not rely on a general mitigating language provision to cover all defects.  Plan fiduciaries should amend loan documents to remove any prohibited language that might trigger a prohibited transaction.

      ESOP's Overpayment / Underpayment for Shares

      ERISA section 408(e) permits the acquisition or disposition of qualifying employer securities only if the acquisition is for no more than, or the sale is for no less than, adequate consideration.  ERISA section 3(18) defines adequate consideration as a "price not less favorable to the plan than the offering price for the security as established by the current bid and asked prices quoted by persons independent of the issuer and of any party in interest."  An ESOP's payment in excess of adequate consideration is a prohibited acquisition.  Additionally, Revenue Ruling 80-155 and Code section 401(a)(28) require that assets of an ESOP, including employer securities, be valued at least once a year on a specified date by a qualified independent appraiser.

      When selecting an appraiser, the trustee should ensure that the selection process is thoroughly documented.  The selecting individual(s) should independently review and evaluate the independence and credentials of the appraiser.  The DOL will review the record to determine if multiple appraisers were considered, as well as the thoroughness of the selection process.

      Ensuring that the appraiser receives the most accurate financial information is an important step to avoid or survive a DOL investigation.  The information should be complete, accurate, and current.  When a new trustee is appointed to the plan, prior appraisals and previous trustee decisions should be reviewed.  This is a significant responsibility of a successor trustee.  The appraisal report should be clear and consistent.  Generally, the DOL looks to ensure that the appraisal methodology used is appropriate for the particular company, and that the appraisal takes into consideration the various risks faced by the company.  Trustees and other fiduciaries, if you would like a copy of our "Reviewing an Appraisal Report" checklist, please contact us.

      DOL investigations look to ensure that proper adjustments are incorporated into the valuation.  The DOL tends to focus on adjustments regarding marketability and lack of control.  Additionally, DOL investigations check for consistency in the application of premiums or discounts.  For example, if a control premium was paid on acquisition, the DOL looks to ensure that the premium is also applied on distributions from the ESOP.

      What To Do

      In most cases, avoiding these common mistakes is a matter of doing things right when negotiating or documenting an ESOP transaction.  Investigating and implementing an ESOP can be a daunting task that requires a great deal of hands-on investigative work by the client and a good team of advisors.  The upside of choosing an experienced team and taking the right steps in the right order is not falling into these most common, and yet most avoidable, ESOP pitfalls.

      Editor's Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government's rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or email us at