John C. Schumacher, CFA
Analysis of Latest DOL Process Agreement over ESOPs
John C. Schumacher, CFA
On February 28, 2020, the U.S. Department of Labor entered into an agreement with The Farmers National Bank of Danville d/b/a WealthSouth, in connection with a Consent Order and Judgment by a U.S. District Court, in a case brought by the DOL against WealthSouth, in its role as trustee of the Weddle Bros. Construction Co., Inc. ESOP. This process agreement with WealthSouth is the sixth process agreement obtained by the DOL, each of which provides a proscriptive list of process requirements that each of six different trustees have now agreed to perform indefinitely, in their role as trustee of any employee stock ownership plan.
This process agreement (the “WealthSouth Process Agreement”)1 between the U.S. DOL (“DOL”) and The Farmers National Bank of Danville d/b/a WealthSouth (“WealthSouth”) is now the sixth process agreement the DOL has obtained from a trustee of an employee stock ownership plan (“ESOP”). The first process agreement dates back to June of 2014, and the most recent agreement prior to this one was executed in May of 2018. Across these six agreements, the overwhelming majority of the process requirements are consistent from agreement to agreement, with the notable exceptions of this latest agreement adding two new subsets of requirements under the titles of “Indemnification” and “Control,” respectively. The primary focus of this article is on the process requirements captured under Control.
Process Requirements for Control in the WealthSouth Process Agreement
Based on prior DOL litigation of ESOPs, it should come as little surprise that this latest process agreement now proscribes process requirements regarding Control. This is due to the fact that the attribute of Control in a transaction involving an ESOP has been one of the primary topics litigated over on over a dozen cases brought by the DOL in recent years, with the decision in Vinoskey/Sentry Equipment case2 being the most recent prior to this case with WealthSouth. In fact, informal studies of ESOP litigation indicate the attribute of Control is the second or third most prevalent litigated issue.3,4
The WealthSouth Process Agreement under the section of Control starts off by noting that these requirements apply only when the “ESOP intends to buy a controlling interest in the company.” Thus, it appears these requirements do not apply in a partial ESOP implementation transaction involving less than 50 percent ownership, and assuming full consideration was given in the valuation for the lack of control.
For those ESOP transactions that are over this 50 percent ownership threshold, the over-arching requirement per the WealthSouth Process Agreement is captured in the following:
To the extent permissible under state and federal law, FNB will only approve a Transaction [SIC] where the ESOP pays for a controlling interest if, in fact, the ESOP obtains the right to control the company whose stock it acquires. The right to control the company includes all of the unencumbered rights that a shareholder would have that acquired the shares to be purchased by the ESOP, and the right to control the company’s direction.
In addition, and more specifically, the WealthSouth Process Agreement provides a non-exhaustive list of 12 examples of control, including;
- the ability to appoint and remove the company’s officers;
- the ability to appoint and remove the majority of the members of the company’s board of directors;
- the ability to set management compensation and perquisites;
- The ability to modify or amend the company’s articles of incorporation or bylaws.
If “the ESOP does not acquire the degree of control of the company commensurate with the ownership interest it is acquiring, or that restrictions are placed on the ESOP’s ability to exercise its right to control the company, [WealthSouth] will ensure that the purchase price paid by the ESOP will reflect the ESOP’s lack of control.”
- In such instances, WealthSouth “will ensure that the valuation of the stock the ESOP is purchasing does not include a control premium, and includes an appropriate lack of control discount,…”
- Additionally, in such instances, WealthSouth will also “ensure that the normalized earning of the subject company does not include adjustments based on anticipated actions that only a controlling, unencumbered, shareholder can execute.”
From a documentation perspective, WealthSouth will document:
- its determination of whether and to what extent the ESOP has obtained the right to control the company
- how and to what degree those rights may be limited…and
- how that determination affects the valuation of the stock,…the price the ESOP is paying for the stock and why that price is fair…
The WealthSouth Process Agreement is similar to the prior five process agreements with the DOL, with the notable exception of the addition of requirements on the topic of Control (and Indemnification), in ESOP transactions of greater than 50 percent of the ownership. These requirements are generally consistent with positions the DOL has taken or signaled in prior ESOP litigation cases.
When applied to a 100 percent ESOP implementation transaction and viewed at a conceptual level, these requirements for Control are problematic and controversial. It appears the DOL contemplates the ESOP assuming a role far beyond its primary function as an employee benefits plan, and on to the role of financial sponsor/active investor/de-facto board of directors of the sponsor of the ESOP. ESOP trustees are not designed nor equipped for taking on such a drastically different and consequential role in setting and managing the strategic direction of the sponsor of the ESOP.
Alternatively, the DOL may argue that the aforementioned issues at the conceptual level can all be avoided by having the ESOP pay a minority interest price, despite acquiring all of the equity. This then raises the question of how significant is that minority interest discount. Is it so significant that the DOL is satisfied but leaves sellers electing to no longer sell to an ESOP and instead electing to sell in the traditional merger and acquisition market to either a true financial sponsor/private equity firm or a strategic investor.
In our judgment, there is reasonable ground to be found in between these two extremes where an ESOP buyer and seller can meet on mutually beneficial terms. Additionally, it may be unlikely for the ESOP community at large to treat this process agreement as settled science. If you would like to discuss and explore in more detail what this means to your future or existing ESOP, please contact John Schumacher or Nick Adamy.
1 Scalia v. The Farmers National Bank of Danville, U.S. District Court (S.D. Ind.), Case No. 1:20-cv-674 (Feb. 28, 2020)
2 Pizella v. Adam Vinoskey, et al., U.S. District Court (W.D. Vir.), Case No. 6:16-cv-0062 (Aug. 2, 2019)
3 Rillo C, Golumbic L, and Mikula C, “ESOP Litigation Trends,” presented at the annual conference of the National Center for Employee Ownership, April 2019.
4 Bornino B, Stitt S, and Flesch M, “Analyzing the Valuation Issues in Recent ESOP Lawsuits” presented at the annual conference of the National Center for Employee Ownership, April 2019.