Deborah Groban Olson, Groban Olson & Bachmann

The U.S. Department of Labor (DOL) can protect the rights of ESOP participants (who seldom have the decision-making rights of owners) not to overpay for ESOP stock, while maintaining a realistic view of the marketplace if they create a a safe harbor for arms-length-negotiated deals.

Stock purchased by an ESOP must be purchased for "adequate consideration," which is defined in ERISA Sec. 3(18)(B) to be the fair market value of shares, as determined by trading price for actively traded shares or by an "unbiased judgment" of value for shares that are not actively traded. However, in more complicated situations, the DOL has left its position as to what constitutes fair market value unclear. Developments since 1990 have suggested that DOL's view of what constitutes fair market value could prove limiting for ESOPs and especially for union involvement in ESOP buyouts.

DOL's "Dollar-for-Dollar" Position

The DOL announced its position that ESOP participants should get "dollar-for-dollar" equity in multi-investor ESOP transactions at a hearing on January 31, 1990 before the Subcommittee on Labor-Management Relations of the House Committee on Education and Labor. The DOL had already issued draft regulations in 1988 defining "adequate consideration" for purposes of ERISA Sec. 3(18)(B) and 29 U.S.C. 1002(18)(B), which did not state the "dollar-for-dollar" position.

The spirit of the "dollar-for-dollar" position is that employees should receive a benefit from shares equal to the amount paid for them. As can be seen from the following discussion, this position can significantly compromise ESOPs as competitive buyers of companies.

DOL and the Farnum Complaint

In the summer of 1990, DOL filed a complaint against Wardwell Braiding Machine Company that appeared to be based on the "dollar-for-dollar" interpretation of fair market value (Dole v. Farnum, 17 BNA Pension Reporter 1494 (D.R.I. 1990)). In this complaint, the DOL claimed that plan fiduciaries must take into account in their valuation of ESOP stock the "cash drain" on corporate finances resulting from expected ESOP contributions.

The Farnum complaint alleged the following facts. In December of 1985, the Board of Directors of Wardwell Braiding Machine Company adopted an ESOP effective January 1985, and the ESOP trustee agreed to purchase 2,600 shares of Wardwell common stock for $5,460,000 at the direction of the ESOP administration committee. The board borrowed all the funds needed for the purchase from several lenders and then reloaned the funds to the ESOP. Wardwell agreed to repay the lenders over 10 years and to contribute sufficient sums to the ESOP for it to repay its debt to the company over the same term. The ESOP stock was pledged as loan collateral. These are all standard procedures in an ESOP transaction.

However, based on these actions, the DOL charged that the Wardwell board, the ESOP administrative committee, and the ESOP trustees breached their fiduciary duty and engaged in nonexempt prohibited transactions by agreeing to pay more than "adequate consideration" for the Wardwell stock "by failing to take into account the cash drain on Wardwell represented by the company's anticipated contribution to the ESOP and the requirement that it repay the obligations owed Fleet [the lender]" (Complaint paragraph #18. For a full text of the complaint see McWhirter, Journal of Employee Ownership Law and Finance (Winter 1990): 137-143).

The problem presented by the DOL's position in this complaint is that if it became law it would make many leveraged ESOP transactions impossible. Traditionally, ESOP valuations have been made without regard to the ESOP transaction, which provides a determination of what "fair market value" would be to any buyer. However, once the ESOP is in place, the contributions to the ESOP required to pay off the ESOP debt are an anticipated cash drain that must be counted in any calculation of fair market value thereafter. While this may seem unfair to ESOP participants from one viewpoint, it is probably a necessary evil. If the law were to prohibit an ESOP from paying the same fair market value that other competing purchasers might pay, ESOP purchasers would become second class buyers, eligible only to purchase companies that no one else would buy.

For example, if the Farnum rule were to apply to the purchase of a company with a value of $10 million and no debt, and the ESOP were to borrow $8 million to purchase 80% of the company's stock, the seller might have to agree to take a price of $2 million for the company. Despite the tax advantages related to a sale to an ESOP, it seems unlikely that a seller who could get $10 million from another buyer would choose to sell to an ESOP for $2 million. However, a leveraged ESOP is often the only method available for a group of employees to purchase their company. The other alternative may be purchase by an unfriendly buyer or closing the facility.

Not long after filing, the Farnam complaint was withdrawn. The current DOL position on adequate consideration is unclear. It appears from the DOL statement made upon with drawal of Farnum that the Department is modifying its "dollar-for-dollar" position, at least as regards initial fair market value in advance of the ESOP purchase.

Reaction from the AFL-CIO

On September 12, 1990, after the filing of the Farnum complaint, a group of AFL-CIO unions that have been active in negotiating ESOP transactions for their members met in Silver Spring, Maryland and formed the AFL-CIO Exploratory Committee on ESOPs, with John Zalusky of the AFL-CIO Economic Research Department as its coordinator. The purpose of the Committee is to share ideas regarding union involvement with ESOPs and to monitor legislative and regulatory activity related to ESOPs.

During an educational conference held on September 13, 1990, DOL's view of ESOPs was discussed. The conference participants felt that the DOL had taken too narrow a view of ESOPs by not recognizing a "safe harbor" for the determination of when "adequate consideration" has been paid for ESOP stock pursuant to the requirements of ERISA Sec. 3(18)(B) and 29 U.S.C. Sec. 1002(18)(B). Such a safe harbor would cover those transactions where the parties have engaged in informed, arms-length negotiations. Union-led buyouts involving true arms-length negotiations with the assistance of qualified experts for both buyer and seller might provide an example of this safe harbor activity. This discussion arose out of a discussion of the recently issued DOL complaints in Farnum and Dole v. Valley National Savings of Arizona (Kroy), 89 Cir. 8361 (PKL)(S.D.N.Y. July 1990). However, the committee recognized that the AFL-CIO had never before asked the DOL to create such a safe harbor.

Informed Arms-Length Negotiations

Immediately after the September 13 meeting, the AFL-CIO ESOP Committee organized a subcommittee to discuss the safe harbor question with the DOL. On November 15, 1990, just after the withdrawal of Farnum, the subcommittee met with several DOL officials.

The union representatives presented their experiences with ESOPs and expressed the position that many labor organizations have the sophistication to ensure that their members get fair market value for ESOP stock. They also explained that over the past five to 10 years, labor unions have begun to make much greater use of ESOPs as a means to the protect retirement benefits and job security of their members. The union representatives presented a number of examples in which unions provided skilled professional business consultants as well as attorneys and negotiators to represent the employees buying from a corporate seller. The representatives contrasted these cases, such as the LTV Bar Division sale, with circumstances in which a seller may organize a transaction, hire an "independent" valuation expert and then hire an "independent" trustee a few days before the transaction, allowing little time or incentive for an arms-length negotiation. They acknowledged some experiences in which local union officials were not assisted by financial advisors and counsel. In those circumstances, such as South Bend Lathe, the outcomes were not considered by the labor spokesmen to constitute "informed" arms-length negotiations and should not fall within the safe harbor. According to John Zalusky, the group felt their position was well received, particularly by the senior DOL staff present. No formal opinion was sought.

An Argument for Flexibility in the "Dollar-for-Dollar" Position

As a labor practitioner in the ESOP field, I have sympathy for the "dollar-for-dollar" position. The idea underlying it appears to be that those outside investors who wish to benefit from the tax advantages provided by ESOPs should give ESOP participants the same value for their dollars as outside investors. Since everyone knows that ESOP financing will diminish the value of the company for some future period during which ESOP participants will be receiving distributions, it seems unfair for a plan participant to "pay" more through the ESOP for his or her stock than the value he or she is likely to get upon distribution. While this does seem unfair, it also reflects the real world economic position of ESOP buyers. Any buyer who must borrow all the cash for a purchase is, in fact, paying more for that item than one who can pay cash. As much as I would like the "dollar-for-dollar" position to be feasible, if it is applied to competitive bidding situations, it would probably keep employees from becoming successful bidders. In many cases, it may be in the long-range best interest of employees to pay a competitive fair market value and take the immediate drop in ESOP stock value in order to get control over a company that might otherwise be liquidated or sold into unfriendly hands.

However, there are certainly circumstances in which fair market value is manipulated by sellers. Guidelines enunciating a clear policy from the DOL would be welcomed by the ESOP community. The difficulty in producing them is a likely reason why they have not been forthcoming. A simple "dollar-for-dollar" rule does not seem to fit the reality of the current market, given the difficulty of raising funds for all types of leveraged buyouts and the complexity of determining value.

That is why it makes sense to allow a safe harbor for informed arms-length negotiated transactions, including collectively bargained ones. Labor traditionally represents its members in these types of business negotiations, and the government does not second-guess the outcome of collective bargaining in other areas, but merely insures that the parties negotiate fairly (29 U.S.C. Sec. 155 et seq).

It would also help the ESOP practitioner community if the DOL created a clear review procedure or a clear safe harbor for the determination of fair market value. But any rules or safe harbors cannot ignore the money marketplace without hurting those whom Congress most intended to help by creating employee ownership: workers who wish to protect and preserve their jobs and retirement security by becoming employee owners.

The withdrawal of Farnum and its implied modification of DOL's "dollar-for-dollar" position is a move in the right direction. If it is indeed a statement of DOL policy, it preserves the ability of ESOP buyers to compete with other buyers when bidding for a company.

DOL's Oversight is Needed

The role of the DOL as protector of the rights of naive plan participants is critical in the pension field. Practitioners who represent workers and unions in ESOP and pension matters see frequent abuses of ERISA rules and regulations by employers. Often the DOL does not have the resources to take on cases that it should. The role it plays in policing fiduciaries and the fairness of pension transactions is critically important to making the private pension system work for plan participants. That is why the DOL is generally well regarded by labor.

Since its enforcement resources are limited, it is especially important that the DOL maintain its credibility. To do this, it must take positions on crucial issues that practitioners can understand and that meet the realities of the marketplace without seriously undermining the intent of Congress to foster widespread employee ownership. We look forward to "adequate consideration" guidelines with a safe harbor that accounts for informed arms-length negotiations and a binding DOL review procedure on which parties to a transaction can rely.