Thinking ESOPs: Amicus Brief Argues that DOL has been Misinterpreting the Adequate Consideration Exemption

On July 27, 2022, Faegre Drinker filed an amicus brief on behalf of The ESOP Association in the pending Ninth Circuit appeal in Walsh v. Bowers, et al. The brief supports an award of attorneys’ fees and costs against the Department of Labor (DOL) on the basis that the DOL has been taking unreasonable positions on ERISA’s “adequate consideration” exemption (the Adequate Consideration Exemption). In this Thinking ESOPs, we discuss the issue in the appeal and some of the points raised in the amicus brief. 

Issue in the Appeal

In 2021, a district court in Hawaii held a bench trial on the DOL’s claims relating to the Bowers + Kubota Consulting, Inc. Employee Stock Ownership Plan (the Plan). The DOL had sued several parties involved in a 2012 ESOP transaction in which the Plan bought stock from the company’s two former shareholders. The DOL’s principal claim was that the Plan’s trustee acted imprudently, primarily by causing the Plan to engage in a prohibited transaction that was not subject to the Adequate Consideration Exemption. The DOL sued other parties, including the selling shareholders, on the grounds that they either were co-fiduciaries or were liable for certain equitable remedies under ERISA. 

After the bench trial, the district court found in favor of the defendants (the reasons why are set forth in the court’s written opinion). The defendants then asked that the district court require the DOL to pay the defendants’ attorneys’ fees and costs, pursuant to federal statutes that authorize such awards against governmental entities that act in “bad faith” or assert positions that lack “substantial justification.” Although the district court had determined that the DOL’s positions lacked merit, the district court would not hold that the DOL’s conduct or litigation positions fell to the level that is required to enter an award of attorneys’ fees and costs against a governmental entity. The defendants then appealed to the Ninth Circuit. 

The Amicus Brief

The amicus brief begins by discussing the history of the Adequate Consideration Exemption and why that history is important to understanding why the DOL has been acting unreasonably. Although ERISA’s statutory definition of “adequate consideration” requires “fair market value” (or FMV) “as determined in good faith” by the trustee pursuant to DOL regulations, that was not always the definition that was proposed in several early bills. Some pre-ERISA bills proposed a definition that required independent quotations of “bid” and “asked” prices; other legislation proposed “fair value” or other metrics. Congress ultimately decided to use FMV as the standard — and specifically as determined in good faith by the trustee and pursuant to DOL regulations.

Congress envisioned that the DOL, in consultation with the Department of the Treasury, would promulgate regulations on the Adequate Consideration Exemption. Yet after ERISA passed in 1974, the DOL began suing parties to ESOP transactions for failing to take very particular approaches to valuation that the DOL preferred. That led to the Fifth Circuit’s pivotal decision in Donovan v. Cunningham, in which the Fifth Circuit admonished the DOL for not promulgating regulations on the Adequate Consideration Exemption. The Fifth Circuit also rejected the DOL’s interpretation of the exemption, which proposed strict valuation rules that the DOL wanted people to follow.  

After Cunningham, two branches of government — legislative and judicial — had urged the DOL to issue regulations on the Adequate Consideration Exemption. The proposed regulation in 1988 was the DOL’s response. But that regulation was not finalized, and no court has adopted that regulation wholesale as the standard for the Adequate Consideration Exemption’s requirements. There also is a bill pending in Congress today, which recently cleared a Senate committee, that would require the DOL to promulgate a regulation on the Adequate Consideration Exemption. 

With that history in mind, the amicus brief explained that in the absence of final regulations, courts should pay particular attention to ERISA’s statutory definition of “adequate consideration.” That definition contains two substantive requirements that provide statutory guidance on the exemption’s meaning: FMV and “as determined in good faith.” With some discussion of valuation principles and ERISA, it becomes clear that the DOL is violating both of these requirements. 

In the valuation field, FMV is a standard of value that has rules as to how it should be estimated. When Congress passed ERISA, Congress had been requiring FMV as a standard in other federal statutes, and FMV had an accepted definition for many decades. Congress purposefully chose FMV as the standard for a permissible ESOP stock transaction. Neither the DOL, nor any court, has the authority to require a standard other than FMV for purposes of the Adequate Consideration Exemption. 

The requirement that FMV be determined “in good faith” also has substantive meaning. Courts have recognized that the standard of good faith in the Adequate Consideration Exemption is governed by ERISA’s general “prudent person” standard. The prudent-person standard requires a fiduciary to act as a prudent person, familiar with such matters, would act in the conduct of an enterprise of “a like character and with like aims.” Courts also have recognized that this language means that the prudent-person standard depends on the particular type of plan and particular decision involved. In other words, a trustee of an ESOP has to act like a prudent trustee of an ESOP, considering the character and aims of an ESOP as a benefit plan. 

After discussing the FMV and good-faith requirements, the amicus brief argued that the DOL, and its retained experts, routinely advocate for interpretations of the Adequate Consideration Exemption that violate both of these requirements. Specifically, the amicus brief argued the following points: 

• The DOL argues for valuation approaches that violate principles for a FMV appraisal. FMV is not the lowest possible price that a private-equity buyer, or other private-party buyer, might prefer to pay for stock. It is an even-handed assessment of market forces that considered what a hypothetical buyer and hypothetical seller might agree to in the open marketplace. 
• The DOL’s retained experts routinely advocate for a standard that is closest to an “investment value” assessment, which is the price a particular buyer may want to pay for an asset in order to maximize returns, in view of the buyer’s various characteristics and requirements. Investment value is not FMV. 
• The DOL’s position on the “control premium” and the “discount for lack of control” are not consistent with standards for a FMV assessment. The DOL argues that total control of a company’s board and operations is required to support any control premium, but that is wrong. A control premium considers whether a block of stock would afford a buyer any indicia of control, and valuation treatises explain that there are many indicia of control other than total control of a company’s board and operations. 
• The DOL’s position on the requirements for a valuation advisor to be independent are inconsistent with accepted standards for advisor independence. The DOL’s requirements are extremely strict, and if it wants parties to follow such standards, the DOL must promulgate a final regulation, subject to public comment and judicial review. 
• The DOL tries to hold ESOP trustees to standards of conduct that might be customary in other ventures, like private-equity firms or 401(k) plans. But an ESOP is not like those ventures for several important reasons.  Congressional materials, including two U.S. Senate publications issued after ERISA passed, explain that an ESOP is not like a traditional retirement plan. An ESOP trustee has no duty to maximize returns on the purchase of stock. The ESOP trustee should focus on facilitating employee ownership, so employees have the opportunity to participate in the financial success of the company, through their hard work and dedication. 
• The DOL’s attacks on selling shareholders for seeking an exit strategy or informing an ESOP trustee of their desired price are unfounded. Congress wanted companies to use ESOPs to create markets for stock, even if other markets did not exist. Congress also understood that ESOPs would involve parties that can wear different hats and have different goals. Congress chose to protect ESOPs by requiring an independent trustee to represent a plan. Selling shareholders are counterparties, and there is nothing nefarious about a counterparty indicating its preferred price. 

Additional Thoughts

For decades, parties have been asking the DOL to promulgate regulations on the Adequate Consideration Exemption, and some have even submitted information and suggestions to the DOL. The DOL should be acting to protect participants in ERISA plans and ensure that ERISA plans are not mismanaged. But in the ESOP space, there is a specific statutory framework that binds not just ESOP practitioners, but also the DOL. That statutory framework invites the DOL to promulgate final regulations to guide ESOP practitioners on the determination of adequate consideration. If the DOL has strong opinions on what the Adequate Consideration Exemption should require, then the proper, and fairer, approach, is for the DOL to subject its opinions to public comment and judicial review by promulgating a final regulation.

What the DOL should not be doing is advocating legal positions and valuation positions that violate express, statutory requirements. If it does, then it should be ordered to pay the attorneys’ fees and costs of the people that it wrongfully targeted.