The spread of COVID-19 and the resulting disruption to the economy has led many employers to think creatively about how to manage cash, provide for the sustainability of their businesses and preserve the culture they have created with their employees and customers. These issues are especially critical for employee stock ownership plan (ESOP) companies, many of whom are in the process of their annual appraisal. These appraisals are important because they directly affect the size of the repurchase obligation – the cash companies must pay to participants for their distributions and diversifications during the year. Fortunately, there are some tools that ESOP companies may be able to utilize. This blog will describe ERISA fiduciary and other strategies ESOP companies can consider with respect to valuations and the related cash management needs those valuations will create.
Once the appraiser determines the value of employer stock for an ESOP company, this value generally is used for all participant distributions and diversifications from the plan until the next annual valuation. For ESOPs that have a calendar year plan year, these valuations will take into account only information known as of Dec. 31, 2019. Although valuations place considerable weight on forecasts, it is doubtful that 2020 forecasts would include the COVID-19 related disruption because it probably would not have been foreseeable at the end of last year. That raises the risk of creating valuations (and associated repurchase obligations) that are high in light of current economic trends. One recommendation from the ESOP Association is to have a clear statement in the valuation report that COVID-19 related factors were not considered as a part of the 2019 valuation.
As mentioned previously, the 2019 valuations for ESOPs could lead to larger repurchase obligations relative to what would likely be the case under current market circumstances. While generally these valuations for ESOP companies are performed on an annual basis, it may be possible to set an interim valuation date to be used for purposes of calculating the amounts of participant distributions in 2020. A word of caution here though: Interim valuations may sound tempting, but before doing that, ESOP sponsors should thoroughly consider the following issues:
- Does the plan allow interim valuations, or is an amendment needed? Many ESOPs give plan administrators the ability to set a special interim valuation date for extraordinary situations to protect the interests of participants in the ESOP. If the ESOP does not contain language that allows for interim valuations, an amendment would be needed to add such a provision. Caution is advised before rushing to amend the plan though. Courts historically have prohibited such amendments from being applied retroactively, meaning that the interim valuation probably may apply only to participants who terminate employment and become entitled to a distribution after the date of the amendment. Employees who terminated service before the date of the amendment probably must have their distributions based on the terms of the plan in effect at the time of their termination, and, therefore, a Dec. 31, 2019 valuation date.
- Is the decision to establish a special valuation date consistent with the ERISA fiduciary duties? The decision to declare an interim valuation date is a fiduciary decision, meaning that the decision must be one that both (a) a prudent financial expert would make and (b) would be in the best interest of plan participants and beneficiaries. Like many fiduciary decisions, the process used to arrive at the decision may be more important than the result. Fiduciaries should evaluate whether interim valuation dates have been established in the past, both in good times and bad. Is this decision consistent with past practice? If not, why is this time different? Further, how will this valuation affect distributions and the sustainability of the ESOP? Fiduciaries should document this process and how they arrived at their conclusion.
- Are the time and costs involved with another appraisal worth the projected cash savings? Appraisals take time, and that time comes with a cost, even when the appraiser is familiar with the company. The ESOP company will want to discuss how much additional time and expense an interim valuation will take before making a decision. A key question will be whether the ESOP trustee will request additional information from the appraiser or rely mostly on the 2019 information.
Managing cash needs for both the company and employees
Both employers and employees are evaluating strategies to manage cash during this economic disruption. To manage cash, companies may want to consider amending their distribution policies to delay or spread out the period of making distributions under their ESOP. Before doing so, companies should realize that such a decision is a fiduciary one. In a recent letter to the Department of Labor (DOL), the ESOP Association asked for relief on this front.
Alternatively, if companies have excess cash, they may want to consider amending their plans to provide for a one-time in-service distribution to participants. Many employees are looking for ways to accelerate distributions from their qualified retirement plans, especially if their salaries have been reduced. An in-service distribution may help cushion that loss. Of course, employers should consider how such an amendment would affect the long-term sustainability of the ESOP and the retirement readiness of its participants.
Other relief items requested
In addition to requesting relief with respect to the previously-described items, the ESOP Association asked the DOL for relief on two other fronts. One was to request that the DOL refrain from launching any new routine audits and investigations and to pause any current routine investigations. In essence, ESOP companies are trying to do more with less, and as such, now is not the time to add the time and expense of an audit. Additionally, the ESOP Association asked the DOL to grant a 3-month extension for filing Forms 5500. It will be interesting to see if the DOL is amenable to either or both of these items.
In short, ESOP companies do not need to panic. Instead, they should plan ahead. In particular, they should consider whether an interim valuation and a change to their distribution policies are prudent and in the best interest of participants. Doing so could help these companies manage cash. Further, ESOP companies should communicate any changes to employees, explain why any changes were made, and continue to provide employees with the resources they need to thrive in their jobs. It is important to preserve that culture that made the company successful. Doing so can help companies navigate the disruption and emerge stronger than they were before. If the DOL grants the regulatory relief that the ESOP Association has requested, that will make these companies even stronger.
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