ESOPs are unique among employee benefit plans subject to ERISA in that, by design, they are intended to invest primarily in the sponsor’s stock, and may borrow money to purchase that stock from a party in interest. That borrowing, buying, and holding would be a prohibited transaction for any non-ESOP plan, but ESOPs enjoy statutory and regulatory exemptions for these otherwise prohibited transactions. But, as is often the case, PT exemptions come with conditions, and you have to meet the conditions in order to enjoy the exemption.
For an ESOP, one of those conditions is that the stock be transferred for “adequate consideration.”
ERISA defines “adequate consideration” as “the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary.” (FYI, there are no regulations promulgated regarding “adequate consideration.”)
Courts have held that adequate consideration is not about the actual price, but about the process the trustees/ fiduciaries followed in determining the price.
The Fifth Circuit has said the adequate consideration exemption “is expressly focused upon the conduct of the fiduciaries” and is “read in light of the overriding duties” in ERISA § 404, particularly the duty of care. ERISA’s § 404 duty of care requires an inquiry into whether the fiduciaries “arrived at their determination of fair market value by way of a prudent investigation in the circumstances then prevailing.”
Courts have allowed that a fiduciary can point to an expert’s (such as an appraiser’s) guidance as evidence of a good faith investigation, but the fiduciary must
(1) investigate the expert's qualifications,
(2) provide the expert with complete and accurate information, and
(3) make certain that reliance on the expert's advice is reasonably justified under the circumstances.
A recent case (Sealy v Bruister 5/3/16) in the Fifth Circuit Court of Appeals found that a series of ESOP stock purchases were prohibited transactions, not qualifying for the exemption, because they were not for “adequate consideration”. The issue was not whether the stock was actually transferred for a fair price, but how the fair price was determined.
In Bruister, the lower court found (and Fifth Circuit affirmed) that the trustees
(1) conducted insufficient investigation into their appraiser’s background and qualifications;
(2) overlooked communications in which the appraiser and the sponsor’s attorney were obviously working together to increase the appraised value,
(3) failed to inform the appraiser of significant information and risk factors for the company that should have influenced his valuation;
(4) and failed to double-check or significantly review the appraiser’s ultimate conclusions.
The Court concluded, the trustees were not reasonably justified in their reliance on the appraiser, and the Trustees’ actions were not those of prudent men.
Because the process was flawed, the conclusion was rejected, and the “adequate consideration” PT exemption was lost.
In ERISA, it’s hard to violate just one rule: In this case, the Court also found the trustees failed to meet their fiduciary duties to act solely in the interests of the plan’s participants.
