Washington Alerts

U.S. Department of Labor Releases Proposed Regulatory Guidance Regarding ESOP Stock Purchase and Sale Transactions

The ESOP Association
Washingtone Alert

On Thursday, January 16th, the U.S. Department of Labor (Department) released two proposed regulations containing rules that, if finalized, would govern ESOP stock acquisitions and sales. The first is the long-anticipated proposed regulation interpreting the definition of “adequate consideration,” the standard that exempts ESOP stock purchase and sale transactions from the prohibited transaction rules in the Employee Retirement Income Security Act of 1974 (ERISA). The Department simultaneously proposed a narrower safe harbor class exemption that would govern ESOP initial stock purchase transactions that meet certain criteria.

ESOP stakeholders have eagerly awaited a regulation clarifying the meaning of “adequate consideration” for decades. The current proposed regulation comes fifty years after Congress first instructed the Department to promulgate regulations interpreting ERISA’s adequate consideration exemption, 37 years after the Department proposed a regulation that it never finalized, two years after Congress’s second directive to the Department found in Section 346 of the SECURE 2.0 Act of 2022, and on the heels of a formal petition for rulemaking that The ESOP Association issued to the Department pursuant to the Administrative Procedure Act. 

Since ERISA codified ESOPs in 1974, parties to ESOP transactions wishing to comply with the federal statute could find guidance only in the adequate consideration exemption’s vague statutory definition—namely, “the fair market value of [company stock] as determined in good faith by the trustee or named fiduciary.” The decades-long regulatory vacuum has provoked uncertainty among those interested in establishing ESOPs, encouraged opportunistic plaintiff’s firms to file countless lawsuits that exploit the statutory gray area, and prevented courts from applying a uniform interpretation of the exemption—all of which have combined to disincentivize the creation of new ESOPs and frustrate Congress’s goal of expanding employee ownership.

While the Department’s proposals today are an important first step toward accomplishing the ESOP community’s longstanding request for specific rules governing ESOP transactions, unfortunately, both proposals will require substantial modification if they are to further Congress’s goal of expanding employee ownership through ESOPs. 

As written, the proposed adequate consideration regulation risks introducing further confusion to an already unclear standard. By way of example, the proposal incorrectly attempts to define the exemption as primarily focused on the accuracy of a trustee’s fair market value determination rather than on the trustee’s good faith process in determining value. This creates an internal statutory conflict with ERISA’s process-centric fiduciary duty standard. Further, the Department selectively quotes from case law and studies that supposedly justify the Department’s view that ESOPs present “risks” and “dangers” to plan participants while paying only lip service to authority that is contrary to the Department’s predetermined views and that describe the myriad benefits ESOPs provide to American workers. And its proposals regarding specific valuation issues—including warrants, control rights, and discounts for lack of marketability—are not only substantively erroneous, but also procedurally nonsensical in that the proposals both require trustees to hire an expert valuation advisor and also overrule or ignore their appraiser’s exercise of professional judgment and reliance on well-established valuation principles. These issues must be resolved in order to satisfy Congressional intent as well as The ESOP Association’s longstanding goal of an adequate consideration regulation that makes it easier, more transparent, and less costly for ESOPs to be formed and operated. 

Sadly, our initial conclusion regarding the safe harbor class exemption is that its extensive flaws render it unworkable in its current form; it proposes criteria that virtually no ESOP transaction would satisfy. For instance, it effectively prohibits ESOP sponsors from indemnifying fiduciaries—a protection expressly permitted by ERISA and decades of Department sub-regulatory guidance—and imposes minimum requirements for capitalization and insurance that virtually no trustee could meet. This is a missed opportunity for the Department to advance Congress’ clear desire and intent to lessen the difficulties and lower the risks associated with creating ESOPs.

The ESOP Association will continue to dive deeper into the concepts and approach suggested by the Department over the next several days and weeks and provide additional thoughts for the community. TEA will prepare a side-by-side comparison of the Department’s approach against the proposed model regulation that The ESOP Association developed and published during the stakeholder engagement process. A full session on the proposed draft will be discussed at the Association’s upcoming Professionals’ Forum in Charleston, SC February 3-5. 

Fortunately, the Department’s proposed regulations are just that—proposed, and far from final. The regulation now enters the comment period of the agency’s rulemaking process: interested parties will have 75 days to provide feedback in the form of written submissions, and the Department may schedule a hearing for interested parties to present their comments. Federal law requires the Department to revise its proposed regulations in response to those comments or explain its rationale for rejecting any feedback it doesn’t adopt in its final regulation. 

That, however, is the normal process—but the Department isn’t issuing its regulation under normal circumstances. The ESOP Association expects that, as it did in 2017, the incoming Trump administration will freeze all pending proposed rules—including the proposed adequate consideration regulation—after Inauguration on January 20 to allow incoming appointees time to determine whether to allow each to proceed through the comment period and toward finalization. Indeed, the proposed regulation and exemption have not been published officially—publication is scheduled for January 22—so it’s possible that the Trump administration prevents the Department’s proposals from becoming officially proposed rules. The takeaway: the Department’s proposals today simply represent the opening round of what is likely to be a drawn-out comment process.