ESOP Valuation and Other Considerations in the Age of the Coronavirus

Many corporate clients that currently sponsor employee stock ownership plans (“ESOPs”) are addressing ESOP plan administration matters for the plan year ending December 31, 2019 (or another recent non-calendar plan year-end that aligns with the end of their corporate fiscal year other than December 31). In light of the coronavirus pandemic (“COVID-19”), ESOPs may face unique issues and challenges as described below.

For non-publicly held ESOP companies with a December 31, 2019 year-end, the valuation process already should be underway since the ESOP trustee or named fiduciary committee is required to make a good faith determination of the fair market value of ESOP company stock for ESOP annual administration purposes as of the year-end.

In connection with making this good faith valuation determination, the trustee or named fiduciary either has engaged or will engage an independent appraiser which has the expertise to provide year-end stock valuation advice regarding the fair market value of company stock owned by the ESOP. In light of COVID-19, it is highly likely that the independent appraiser engaged for this required process has been requested to address whether the impact of COVID-19 has or will be taken into consideration as part of the year-end valuation analysis.

Generally, for annual administration purposes, independent appraisers are engaged to provide company stock valuation advice as of the prior year-end based on actual financial information that was known or knowable at the applicable year-end date designated by the trustee or named fiduciary committee responsible for the annual process. The current crisis and corresponding economic impact of COVID-19 was not known or knowable as of December 31, 2019, based on numerous factors including that U.S. publicly-held stock market pricing reached record highs in February 2020, and that broad efforts to mitigate the impact of COVID-19 were not being implemented by U.S. federal, state, and local governments until March 2020.

As a result, it is highly unlikely that the independent appraiser’s analysis and opinion of the fair market value of the ESOP’s company stock as of December 31, 2019 provided to the trustee or named fiduciary will address the impact of COVID-19, and, therefore, the ESOP trustee’s or committee’s good faith determination will not take such impact into account.

This result places ESOP plan administrators in a very difficult position since these administrators are (i) considered fiduciaries under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and (ii) subject to ERISA’s prudent man standard, found here.  This difficulty under ERISA arises since it is highly likely that the ESOP requires distributions in 2020 to or with respect to participants who may have terminated employment, become disabled or died in the prior plan year ending December 31. In addition, it is also possible that certain participants – those who have attained age 55 or older and have at least 10 years of ESOP participation as of December 31, 2019 – are required to be provided with initial diversification elections, which could result in diversification of up to 25% of the company stock held in their ESOP account.

In both of the circumstances described above, an ESOP-related distribution or diversification generally will be based on a December 31, 2019 valuation, which may be outdated before ERISA-required participant statements are even sent by plan sponsors in order for participants or beneficiaries to make potential elections.  It is entirely possible that many ESOP companies (especially mature ESOPs with a majority of stock allocated to participant accounts and which own a majority percentage of outstanding company stock) could end up in a liquidity-squeeze position if highly-treasured cash resources are now required to be used for stock repurchase liability obligations arising from triggering events such as employment terminations or required diversification elections.

Plan administrators and related plan sponsors finding themselves in this situation should not only consider the financial consequences on the company and all ESOP participants of using a potentially outdated valuation, but also look at any alternatives that may be available including the following possibilities:

• Selecting an interim valuation date under existing ESOP provisions;
• Amending the ESOP to provide for an interim valuation date if none otherwise exists; or 
• Modifying the existing ESOP distribution schedule (e.g., installment distributions rather than a lump sum) in order to lower the existing ESOP repurchase liability obligation.  

Interim Valuation Date

Selection of an interim valuation date by the ESOP plan administrator may be warranted as a result of a material change of circumstances in connection with COVID-19, but this alternative should not be selected without the administrator engaging in a procedurally prudent review and documentation process under ERISA provisions, including (i) whether the ESOP document currently permits this selection and (ii) if such a selection would be considered prudent at this time and consistent with the plan administrator’s duty of making decisions for the exclusive purpose of providing benefits to participants and beneficiaries.

ESOP Amendment

If the ESOP does not currently provide for interim valuations, then any amendment to permit such interim valuations is a sponsor function, which would not be subject to ERISA’s fiduciary standards referenced above. One of the key issues in connection with the adoption of an amendment (e.g., in 2020) which permits an interim valuation date then will be a determination by the plan administrator whether that amendment may be implemented with respect to participants who terminated employment in 2019 or earlier or who were eligible for diversification as of December 31, 2019. This determination would be subject to ERISA fiduciary considerations.  

ESOP Distribution Schedule Modification

Many ESOPs have implemented repurchase liability obligation methods which include a lump sum cash out of participant account balances at or shortly following the participant’s termination so that only active participants receive the benefit of what may have been a pre-COVID-19 stock value increase. Now, as a result of a more-than-likely COVID-19-induced stock value decrease and also the possibility of a cash liquidity issue, the ESOP plan administrator may wish to consider the elimination of lump sum distributions and possible implementation of an installment method. Any modification which is being considered needs to take into account the requirements under the anti-cutback rules under Internal Revenue Code Section 411(d)(6) found here.

Other Issues

In addition to the valuation issues and alternatives discussed above, ESOP plan sponsors and fiduciaries may need to consider many other issues, including the following, as result of COVID-19: 

• Effect of employee census reduction on ESOP loan amortization (i.e., if ESOP stock remains leveraged);
• Potential 100% vesting of terminated participants if a partial plan termination has occurred as a result of involuntary terminations (generally, 20% or more of the workforce);
• For S-corporation ESOPs, the effect on Code Section 409(p) prohibited allocation testing of employee terminations and potential termination distributions;
• Potential investment changes in connection with the ESOP’s other investments account which is not invested in ESOP company stock; and
• Furlough and leave of absence issues under existing plan provisions including allocation of future contributions.

In summary, ESOP plan sponsors and fiduciaries including trustees, plan committees, and administrators have many issues to consider as a result of COVID-19-related effects. This Employee Benefits Insight edition discusses some but not all of the many issues that have arisen or may arise in the near future in light of the coronavirus pandemic. For more information about developments associated with the coronavirus pandemic, click here.  To receive this content directly in your inbox, click here and submit the form. 

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