Labor Department Pushes Intensified Scrutiny of Employee Stock Ownership Plan Fiduciaries

Darlene Brown has been a trustee to her company’s employee stock ownership plan since 1997. The company’s chief financial officer, Brown is one of nearly 800 employees and retirees who, through their retirement plan, own 100 percent of Parametrix, an Auburn, Washington-based consulting firm specializing in environmental services.

So far, Brown thinks she is on track to retire in 14 years with the savings from this plan combined with the assets she has accumulated in the company’s 401(k) plan. But a recent proposal from the Department of Labor that changes a 35-year-old regulation redefining fiduciaries to plans has Brown concerned that the potential cost of the employee stock ownership plan, also known as an ESOP, will dramatically increase, in turn hurting her ability to save enough to retire on time.

“If I used the average for our accounts this would mean $31 per account each year,” if the cost to appraise the plan doubles, Brown says. “This $31 could have gone to purchase stock in the company which has generally grown, so it is not the amount of money, but the opportunity for growing the account that is diminished by these annual expenses.”

Brown adds Parametrix has “no plans to change our ESOP, although this proposed regulation scares us in terms of increasing the cost to our plan.”

ESOPs are defined contribution retirement plans, where the assets are primarily company stock. Because ESOPs are required by law to invest mostly in company stock, participants share ownership of the business that is equal to the proportion of stock in the plan.

There are about 11,500 ESOPs in the United States covering 10 million employees with $901 billion in assets, according to the ESOP Association. It’s hard to get the exact number of ESOPs because most are privately held, and although it’s required to have company stock appraised annually, plan trustees aren’t required to file that information publicly.

Currently, ESOP trustees are the primary fiduciaries and can be held liable if they knowingly participate in certain kinds of transactions, including signing off on bad valuations of the company stock. In general, advisers to all kinds of retirement plans become fiduciaries primarily when they get paid for guidance.

The proposed rule extends fiduciary liability to ESOP valuation firms and significantly strengthens the Labor Department’s ability to file lawsuits against them for faulty appraisals.

“This (proposed) regulation helps us more fairly allocate the responsibility and hold accountable the person who really is the responsible party if a fiduciary breach occurs,” said Assistant Secretary of Labor for the Employee Benefits Security Administration Phyllis Borzi in a conference call to reporters. “We want fiduciaries to have good, solid, quality advice that’s consistent with the duties of prudence and loyalty.

“If it dries up the schlocky advice, I don’t have a problem with that.”

The Department of Labor says the proposed regulation is designed to clarify which adviser roles carry fiduciary responsibility under federal law. The department’s main complaint is that the current rule is old and doesn’t work considering the significant changes in the financial industry as well as the massive shift to defined contribution plans.

“These rules have really become a barrier for the department’s ability to protect participants and beneficiaries,” Borzi says.

But the proposed rule, as it relates to ESOPs, may do more harm than good, says Michael Keeling, president of the Washington, D.C.-based ESOP Association.

Keeling and other ESOP experts agree that making valuation firms fiduciaries will reduce the number of firms willing to perform the service. The risk to the firm will be too high and firms can turn to other lines of business, such as estate valuation, which don’t require any fiduciary responsibility, Keeling says.

“There are opportunities for people valuing privately held stock other than valuing ESOPs,” Keeling says. “The impact will be a hindrance on ESOP creation and operation.”

Keeling predicts a domino effect. Valuation firms that remain in the ESOP business will need fiduciary insurance, and that cost will be passed onto their clients.

Columbia Financial Advisors Inc., one of the nation’s largest business valuation firms, is analyzing the cost of purchasing fiduciary insurance, says Kathryn Daly, principal. Because they are still working on that figure, Daly couldn’t say exactly how much costs would rise, but said because of the risk involved, it wouldn’t be a surprise to see ESOP valuations double.

Some firms may not think the new risk is worth it, she says.

“I think the qualified ESOP appraisal firms will exit the market,” Daly says. “Who is left will be the firms not as qualified. If our costs go up, it will make the cost of putting an ESOP in a smaller company cost-prohibitive.”

Parametrix pays about $25,000 annually for Portland, Oregon-based Columbia Financial Advisors to appraise its company stock, Brown says. Valuation fees are included in the expenses of the plan, so if that cost goes up, there is less money for each plan participant.

“It would not deflate the value of the stock but would impact overall account balances,” Brown says.

Dave Fitz-Gerald, chief financial officer and ESOP trustee at manufacturer Carris Reels Inc. in Proctor, Vermont, agrees, adding the proposed rule may end up hurting the participants the Labor Department is trying to protect.

“As a 100 percent employee-owned company, the more the company spends, the less it is worth,” he says. “The more we spend on administering benefits the less we spend on other things like payroll and benefits.”

Karl Huish, chief retirement specialist with investment consulting firm Loring Ward of San Jose, California, says the Labor Department needs to update fiduciary requirements for ESOP valuation firms so it can better protect beneficiaries, but it should also provide guidance to valuation firms to help avoid making bad appraisals.

“It’s going to be tricky,” Huish says. “All these (ESOP) companies are so different. How you create guidelines that help and not hurt (valuation firms) is going to take some careful thought.”

Under the proposed rule, certain providers that give advice only once would become fiduciaries to plans. The Labor Department needs the ability to go after these providers, because oftentimes their advice is crucial to the future benefit participants will receive, Borzi says.

“Certain decisions are only going to go forward based on what that appraiser says and yet we have no claim against the appraiser,” Borzi says.

ESOP experts agreed there are bad valuation firms in the community. Daly said she hopes the Labor Department holds hearings on the proposed regulation and suggested that requiring trustees to pass a certification test might be a more appropriate way to protect participants without significantly adding more costs.

“We want to keep the system working for all of us, even the Labor Department,” Daly says.

The Labor Department will take comments on the proposed regulation until January 20.

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