The Rise and Fall of the DOL's Long-Anticipated Proposed Regulation on "Adequate Consideration"

The U.S. Department of Labor (DOL) on Jan. 16, 2025, released a pair of proposed regulations impacting private company employee stock ownership plan (ESOP) transactions. The first was its long-anticipated proposed regulation interpreting the definition of "adequate consideration," the standard that exempts ESOP stock purchase and sale transactions from prohibited transaction rules in the Employee Retirement Income Security Act of 1974 (ERISA). The second was a class exemption, or prohibited transaction exemption (PTE), for initial acquisition of employer stock by an ESOP from selling shareholders. If finalized in their proposed forms, the regulations could have dramatically changed the landscape for private company ESOP transactions. The adoption of any such regulations has been halted, however, due to the Trump Administration's issuance of an executive order (EO) freezing all pending proposals on Jan. 20, 2025. The proposed regulations were not published in the Federal Register prior to the Jan. 20, 2025 EO, meaning that they were not considered officially "proposed." They have now been withdrawn. Whether new or revised proposed regulations will be published under the Trump Administration is yet to be seen.

Background on the Adequate Consideration Exemption for ESOP Transactions

ERISA's prohibited transaction rules are structured in a way to bar transactions between ERISA plans and "parties in interest," such as company officers, directors and certain shareholders, unless an exemption applies. One of those exemptions permits an ESOP's purchase of company stock for no more than "adequate consideration." Most private company ESOP transactions would be prohibited absent this exemption. ERISA defines "adequate consideration" as "the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary [of Labor]." 29 U.S.C. § 1002(18). The DOL, however, never finalized or promulgated any final regulations interpreting or clarifying this vague definition of "adequate consideration," despite a long history of repeated calls for guidance from the DOL by Congress and ESOP professionals.

Congress first instructed the DOL to promulgate a regulation interpreting the adequate consideration definition nearly 50 years ago. The DOL issued a proposed regulation in 1988 but never finalized or withdrew it. In 2022, Congress once again, through the 2022 SECURE 2.0 Act, mandated that the Labor Secretary issue formal guidance on the standards and procedures that are acceptable when establishing good faith fair market value for shares of a business to be acquired by an ESOP. On Jan. 20, 2025, in the final days of the Biden Administration, the DOL released two proposed regulations: the long-awaited "adequate consideration" regulation and a class exemption for certain ESOP transactions.

The Proposed Adequate Consideration Regulation

The DOL's proposed regulation outlined the process to analyze whether there was a good faith determination of fair market value under ERISA's definition of "adequate consideration." The proposed regulation essentially created a two-part test to determine adequate consideration: 1) whether the value assigned to the stock reflects the stock's fair market value and 2) whether that value is the result of a good faith determination and process by the plan trustee or named fiduciary. Both parts must be met to satisfy the definition of "fair market value."

Fair Market Value

The proposed regulation defined "fair market value" as the price at which the employer stock would change hands in an arm's length transaction between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell and both parties are willing and able to trade and have reasonable knowledge of the facts relevant to the stock's value.

The regulation specified that fair market value is determined on the date of the transaction and must reflect consideration of all known or reasonably knowable information related to the value of the stock as of that date. The regulation further specified that fair market value is determined on the same basis as if the ESOP were purchasing the stock on a cash or cash equivalent basis, without any increase in the purchase price based on consideration of the terms of any debt, direct or indirect, used to finance the acquisition.

Good Faith Process

The proposed regulation included a detailed provision focusing on the second component of the two-part inquiry and outlines the process a trustee or named fiduciary must follow to ensure the value assigned to the stock was determined in good faith. The components of that process included, among other things, that the fiduciary prudently:

• choose and engage a qualified independent appraiser to value the stock and prepare a written valuation report
• oversee production of the independent appraiser's written valuation report based on generally accepted professional standards for performance of valuations and based on complete, current and accurate information
• review the written valuation report to ensure that it may reasonably be relied upon

The proposed regulation further specified the details of these components. Among other things, the proposed regulation imposed requirements targeted at a trustee or named fiduciary's obligation to select and monitor "trustworthy service providers" for ESOP transactions.

The proposed regulation also addressed ESOP transactions involving warrants. Warrants grant their holders the right to purchase a certain number of shares at a future date for a specified price. Warrants are often used in leveraged ESOP transactions, as lenders, often the selling shareholders, will take warrants in exchange for accepting a below-market cash interest rate on the loan used to finance the ESOP transaction. In recent years, however, the DOL has taken the position that warrants necessarily reduce the fair market value of a company's equity in an ESOP transaction. Consistent with this position, the proposed regulation states the independent appraiser's valuation report must account for the impact of the grant or assignment of any interests or rights to potential income streams or assets, including warrants:

"If, for example, in a stock purchase transaction, the sellers have been granted warrants with strike prices below the price paid per share by the ESOP, which are expected to result in the seller's retention of a significant equity stake in the company, the dilutive impact of the warrants must be reflected in an appropriate reduction of the fair market value and associated purchase price."

The DOL likewise stated that "[s]tock warrants are often referred to as dilutive securities" in its regulatory impact analysis, evidencing the DOL's negative view on warrants.

The Proposed Safe Harbor Class Exemption

Along with the proposed adequate consideration regulation, the DOL also published a PTE that would apply to certain private company ESOP transactions. As the proposed rule explained, the DOL's objective in proposing the PTE was "to promote ESOP transactions that comply with ERISA, protect the interest of plan participants and beneficiaries in paying no more than fair market value for stock, and provide clarity to the parties so they can have confidence in the legality of the transactions covered." However, in order to satisfy the PTE, the transaction would need to satisfy a number of requirements that fail to consider the practicalities involved in private company ESOP transactions.

Among other requirements, the proposed PTE would require that any seller financing be on the same terms and conditions as the internal loan between the ESOP and company in a leveraged ESOP transaction. Yet, at the same time, the class exemption prohibits any selling shareholder from receiving warrants or other synthetic equity, the granting of which is typically used to account for the fact that seller debt is subordinated and presents greater risk to the seller. These restrictions greatly limit the type of financing options available to support the ESOP transaction and would essentially steer companies into mezzanine financing to cover the amount that cannot be financed with senior bank debt. Mezzanine financing typically involves much higher interest rates and, ironically, stock warrants issued to the lenders.

Another issue raised by the proposed PTE is the insurance requirements for the independent fiduciary. The proposed PTE would require that the independent trustee have fiduciary liability insurance sufficient to cover losses equaling at least 20 percent of the purchase price. Given the hardening of the fiduciary insurance market for trustees – which has severely limited the ability for trustees to get fiduciary insurance – the requirement that a trustee to carry this level of insurance would make any larger ESOP transactions almost impossible to pursue, to the detriment of potential participants.

The exemption also prohibits any contractual provision providing for the indemnification of the independent trustee by the employer. There is a carve-out allowing for the advancement of fees for the defense of a fiduciary breach claim, but only where the independent trustee posts "adequate security" for those funds. Thus, even absent the insurance requirements, the limitations on indemnification would severely restrict, if not entirely eliminate, the available pool of qualified independent trustees.

ESOP Industry Response

ESOP professionals were initially encouraged by the DOL's decision to finally promulgate a modern regulation interpreting the definition of "adequate consideration." But, upon release of the adequate consideration and PTE regulations, many ESOP professionals raised issues and uncertainties concerning the proposed regulation. For example, the ESOP Association stated the DOL's proposed adequate consideration regulation "risks introducing further confusion to an already unclear standard," and, therefore, would require "substantial modification." Among many issues raised, the ESOP Association raised concerns about the proposed adequate consideration regulation's focus on the accuracy of the trustee's fair market value determination, rather than on the trustee's good faith process in determining value and the proposed adequate consideration regulation's treatment of warrants and control rights.

Trump Administration Rescinds Proposed Regulations

The proposed adequate consideration regulation and PTE were scheduled to be published in the Federal Register on Jan. 22, 2025, followed by a comment period ending on April 7, 2025. Under the Administrative Procedure Act, a new regulation is not considered officially proposed until it has been published in the Federal Register. Shortly before the regulation was scheduled to be published, however, the Trump Administration issued on Jan. 20, 2025, an EO pausing all pending proposals, including the proposed regulation on adequate consideration. The DOL's proposed guidance on adequate consideration and the PTE regulation have now been withdrawn, and their unpublished versions were removed from the Federal Register website.

Potential Impact

If finalized, the proposed adequate consideration regulation and PTE could have dramatically changed the landscape and viability of private company ESOP transactions. But because the proposed regulations have been withdrawn, they have no force or effect.

On Feb. 11, 2025, President Donald Trump nominated Daniel Aronowitz to be DOL assistant secretary and head of the DOL's Employee Benefits Security Administration, the arm of the DOL charged with enforcement of ERISA. His confirmation hearing is expected to be scheduled soon, followed by a Senate vote. Aronowitz comes from a background that many would say is more practical and supportive of plan sponsors, fiduciaries and service providers. Whether the DOL under a Trump nominee's leadership decides to modify what was proposed, propose something entirely new or issue no new regulations remains to be seen.

For more information or questions, please contact the authors or any member of Holland & Knight's ERISA Litigation Team or ESOP Group.

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