ESOP Stock Price Drops in the Current Pandemic

April 13, 2020

In January of 2019 we published an article titled "Post Transaction Dip in ESOP Stock Purchases".  That article discussed that there has been an increased level of activity by plaintiffs' attorneys looking for price dips in employee stock ownership plan (ESOP) owned stock. The technique used by plaintiff's attorneys is to pay a law firm to compare Form 5500s submitted by ESOP trusts and look for a drop in the value of the stock held by the trust. In that article we discussed techniques being developed to minimize or eliminate ESOP stock price drops found after an ESOP stock purchase with debt, in which the debt from the stock purchase reduces the value of the sponsoring company's equity and, thus, reduces the value of the shares held by the ESOP.

We now are in a unique situation with the current pandemic and resulting economic chaos in the world that we may well see a repeat of conditions experienced in 2008 when there were broad declines in market values of ESOP stock that are not related to the transaction costs and debt associated with ESOP stock purchases. Time will tell if the plaintiff's attorneys follow this economic downturn with the same approach that they have used to file lawsuits as discussed in the next paragraph.

Plaintiff's attorneys will place advertisements in local newspapers that start off with a law firm name, then ask the reader if they have an "investment" in the XYZ Employee Stock Ownership Plan. The advertisement goes on to say who the Trustee of the plan is and that the firm is "investigating" the stock purchase by the ESOP, including the valuation of the XYZ stock at that time (presumably the time of the stock purchase by the ESOP trustee). There are several problems with this advertisement, not the least of which is that an ESOP plan is not a contributory plan. Plan participants do not make "investments" in the plan. It appears that the firm is looking for a volunteer from the plan participants to file a class action lawsuit on their behalf.

Now we will find stock price drops that have nothing to do with ESOP stock purchases but are related to the Pandemic. Companies are taking two courses of action in response to the current unusual circumstances. One is to prepare an updated forecast, using the better knowledge of how the current crisis will impact their business. These impacts include employee pay extensions for time not worked, healthcare coverage while employees are laid off or on furlough, and tax benefits from the CARES Act and other similar stimulus efforts by governments.  The second consideration by employers sponsoring ESOPs is to consider using an alternative valuation date.  This article will discuss both such efforts so that you can assist your clients during this difficult time.

As the impact of the pandemic on the operations of businesses became clearer in March, we began to have discussions with our clients, by phone or computer of course, discussing the initial five year forecast that the client prepared for their companies for the years 2020 through 2024.  We found a surprising array of radical differences in the year to date performance of the company compared with the forecast for 2020 and the historical financial performance for the same period in 2019, let alone how that unexpected difference might impact the operations of the client in years past 2020. For instance, while food retail revenue was much higher than expected, so were costs. And, the delivery systems for retail grocers, warehouses and suppliers were all much busier than expected. But while it is nice to be successful for a time, what happens when the crisis has passed and the consumer realizes they do not need a year's supply of toilet paper in their closet? In this industry, the over-riding concern is to avoid fixed costs that can't be shed once the consumer buying boom becomes a bust.  This has caused most of our food retail related clients to revamp not only the revenue and expense estimates for the 2020 forecast, but also change the capital expenditure forecast and the likely debt levels, not just for 2020 but for the estimated two year impact past the current crisis.

At the same time, clients in industries like laboratory supplies are finding the current boom is putting some big numbers on the income statement with some big problems with suppliers meeting demand.  The concern is one of not over stating the value of ESOP stock for 2019 and 2020 only to watch it fall in later years as their part of the economy cools off.  We are getting revised forecasts from most every industry and every client, with the occasional exception found in the construction industry.  The construction industry seems relatively resistant to the "stay at home" orders found in most cities and states, and for the time being seems well funded with a steady backlog of work.

For those clients in industries where there will be a detrimental impact from the pandemic, companies are considering using an alternative valuation date. IRS Revenue ruling 80-155 requires that all ESOP assets be valued at least once a year. We are finding the values using public company data at year end 2019 appear to be inflated by an over-heated stock market. This has been discussed at length in articles from practitioners discussing whether the discount rates are too low, and not reflecting an adequate return on equity, and debt, considering the risks assumed by shareholders and debtholders in privately held companies.  We generally agree with this analysis, and struggle to employ best practices in our valuations.  Now, 90 days later, the public market returns are exceptionally low compared to historical returns.  How much of this price drop is investor hysteria caused by the crisis and how much is a permanent loss of economic value from future cash flows? Our clients are considering delaying year-end valuations to say June 30, 2020, thinking that they will use the later date to allow the market indications of value to return to more stable levels.

This alternative valuation date is almost always allowed in ESOP plan documents at the discretion of the Administrator of the plan. This is not a decision for the ESOP Trustee, and is not part of the Trustee's fiduciary responsibilities. If such an approach is elected, then it is likely that all benefits due to terminated employees would have to be paid out using the prior valuation. The participants in the ESOP must be told that there will be an alternate valuation, and they must be told why and for how long. The need to document and disclose the Administrators' actions is critical as it is when the valuation report is reviewed and criticized each year. These actions must be documented to demonstrate that appropriate fiduciary actions were taken that were in the best interests of the participants in the ESOP plan.

As valuation experts, there are things we advise our clients to consider when we are retained by the Trustee and the Administrator of the ESOP to help assure the best possible outcomes for the participants of the ESOP. An experienced ESOP valuation expert knows that they are retained by an ESOP trustee as a financial adviser, not just a valuation expert. In addition, it is best practice to have our engagement letter also signed by the Administrator of the ESOP plan. This will allow practitioners to withstand scrutiny from outside interests, but more importantly, provide much needed analysis and financial advice to the fiduciaries to assist with data needed to provide fair plan administration that is in the best interests for the participants of the ESOP.

Steven York, CPA/ABV/CEIV, ASA, CBA, CGMA

Senior Vice President, Stern Brothers Valuation Advisors

Steve is an Executive Vice President of Stern Brothers Valuation Advisors. He specializes in valuing businesses, intangible asset purchase price allocations, impairment testing, ESOP valuations, litigation support and expert witness on business valuation. He is a member of the AICPA’s Business Valuations Committee.