An ESOP Top Ten List

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Issues for ESOP Companies, Trustees, and Other Fiduciaries to Consider in Connection with the Creation and Administration of an ESOP

On one level, an employee stock ownership plan (“ESOP”) is nothing more than a tax-qualified, defined contribution plan designed to invest primarily in qualifying employer securities, generally the common stock of the plan sponsor. ESOPs can be used by both publicly traded and privately held companies in any number of ways, including a tax- advantaged method for the sponsor to raise new capital, a tax-advantaged way for one or more existing shareholder(s) to dispose of some or all of their stock in the plan sponsor, or even as part of a divestiture of a division or subsidiary of the plan sponsor. Regardless of how an ESOP is used, there are some unique concerns that plan sponsors, trustees, and other fiduciaries of such plans should consider in connection with the creation and ongoing administration of the ESOP. With apologies to a certain late-night talk show host, we humbly submit the following list of ten such issues (really nine, but one is so important that it should be considered twice).

1. It’s the valuation, Dummy!

Without question, the most important step in implementing an ESOP for a closely held company (or the rare publicly traded company whose trading price does not necessarily reflect the current value of the company stock) is the determination of the fair market value (“FMV”) of the stock to be purchased by the ESOP. For most publicly traded companies, this is not a concern because the shares trade actively in the open and active market. However, for closely held companies and publicly traded companies without an open and active market, the law requires that an independent, qualified appraiser perform a valuation on an annual basis to determine the FMV of the stock. A valuation is also required as of the specific date of any purchase of company stock by an ESOP in order for such purchase to satisfy the prohibited transaction exemption in Section 408(e) of the Employee Retirement Income Security Act (“ERISA”). The valuation must be reflected in a written document that should reflect the basis on which the value is determined.

The ESOP fiduciaries charged with the responsibility of approving a purchase of company stock, usually the ESOP trustee, must review the valuation, conducting a thorough and prudent investigation regarding the circumstances of the valuation and the application of sound business valuation principles. The Courts have made clear that ESOP fiduciaries cannot merely “rubber stamp” the valuation determined by the appraiser and must form an independent, good faith opinion as to the value of the stock in question based on all relevant factors, including the valuation report. Such determination of value in connection with the approval of a purchase of company stock is, without question, the single most likely action taken by an ESOP fiduciary that would be challenged in any later litigation resulting from a failed or troubled ESOP company. Even after the initial purchase of company stock by an ESOP, it is imperative that the ESOP fiduciaries continue to monitor and understand the valuation determined by the appraiser, especially in situations where the ESOP sponsor is encountering financial difficulty with a resulting loss of value in the company stock in the ESOP.

In light of the importance of the valuation of the company stock in an ESOP, most ESOP fiduciaries select appraisers with experience in preparing ESOP valuations and, when possible, valuations for companies involved in the same industry as the plan sponsor. While it would not be a per se violation of ERISA for the ESOP fiduciaries to select an appraisal firm without such experience, the work product of such a firm would seemingly be subject to greater scrutiny by a Court in the event of a dispute than the work of a more experienced firm. Further, if the valuation prepared by an inexperienced appraiser is determined to contain errors or otherwise not be persuasive, the selection of an inexperienced appraiser could be cited by the Court as evidence of a breach of the duties imposed on the fiduciary making the selection.

Even for established ESOP companies, the fiduciaries should, to the extent possible, have a continuing dialog with the appraisal firm regarding the company operations and, especially, any changes that could later affect the valuation of the company stock. It is imperative that, in order for the ESOP fiduciaries to be to rely on a valuation report, the appraiser preparing the report understand both the past financial results and any impending changes or challenges that may be faced by the ESOP sponsor in the future.

2. About that debt service!

Many ESOPs are leveraged. In such an arrangement, the ESOP has borrowed funds to purchase the shares of the company stock either in a direct loan from a lender or, more commonly, an indirect loan to the company and a separate loan from the company to the ESOP. Leveraged ESOPs are advantageous for the sponsor because both the interest portion and, within certain limits, the principal portion of the loan repayments are tax deductible. However, as with any other loan, an ESOP loan must be repaid on a timely basis. In the usual case, the lender will have obtained collateral for the loan from the company and the ESOP will likely have pledged the company stock acquired with loan proceeds. With a direct loan, the ESOP will not have funds to repay the loan unless the company makes contributions in sufficient amounts to service such payments. If the loan is indirect (one loan from the lender to the company and separate loan from the company to the ESOP), the company must make contributions to the ESOP sufficient for the ESOP to repay the loan to the company; in turn, the company can then repay the outside lender. Apart from the contributions, the ESOP trustee can repay the ESOP loan with dividends, if made, and earnings from other investments of the ESOP trust. ESOP companies generally have low rates of default. However, if the company is in distress and cannot make contributions, a related default on the loan will be disastrous for the ESOP.

It is imperative that the ESOP trustee, in entering into any leverage ESOP transaction, determine not only that the price being paid for the company’s stock is not in excess of the FMV of such stock on the date of the transaction but, in addition, that the company’s projected income stream will be adequate to retire any debt payments that will be required as a result of the loan transactions entered into as part of the purchase. This determination, in the usual case, requires careful consideration of both the company’s past and projected results, taking into account the impact of the new debt brought about by the leverage ESOP transaction. Careful consideration should also be given to the loan covenants in not only any new ESOP debt but, in addition, any existing loan documents affecting the ESOP’s sponsor. Most ESOP trustees also require that the ESOP document itself expressly require the sponsor to make sufficient contributions in amounts necessary to service any outstanding ESOP loans.

3. Who is going to run this Company and how are they going to get paid?

Another issue for the ESOP fiduciaries to consider in connection with the implementation of any new ESOP is both the identity of and the compensation to be paid to the senior managers of the company. As a pure financial buyer, it is important to an ESOP that, after any proposed transaction, there be a sustained and consistent earnings history, even after taking into account any required payments to senior managers. If all of the members of the senior management team are under contract and 100% of the compensation that they could possibly receive (including any contractual and/or discretionary bonuses) are set forth in the existing contracts, this should not be an issue. However, in many leveraged ESOP transactions, and especially those that involve the buyout of one or more controlling shareholders, the selling shareholder(s) desire to depart the company (or at least assume a much less significant role), leaving the management of the company to a different group of individuals. If those individuals are not under contract, or if contracts are in place but the managers receive a large portion of their compensation in the form of discretionary bonuses, it is important that agreement be reached (and, in the usual case, contractual arrangements be made) and that all such arrangements be provided to the appraiser so that the future impact of such payments be taken into account in the valuation of the company stock, both in the initial transaction and in future annual updates.

4. You mean we have to pay for the stock again?

Generally, in the case of employer securities that are not readily tradable on an established market, a participant who receives a distribution from an ESOP has a legally enforceable right to require that the company repurchase his or her employer securities under a fair valuation formula. This is referred to as a “put option.” As a related matter, the company generally has a legal obligation to redeem the distributed shares from the participants who receive a distribution and elect to put their shares back to the company. Sometimes, the plan sponsor will make additional contributions to the ESOP and ask the ESOP trustee to satisfy the plan sponsor’s repurchase obligation by cashing out the terminated participants who have elected a distribution, which effectively “recycles” the stock in question for reallocation under the ESOP. If the ESOP so provides, the put option does not apply in certain situations such as S-corporations or corporations in which the charter or bylaws restrict ownership of stock to employees. However, there must ultimately be sufficient cash to make any distributions and/or redemptions necessary to satisfy the put option obligations of the ESOP sponsor. It is, therefore, important for ESOP companies to understand and manage their repurchase obligations.

5. Will the ESOP participants be treated like mushrooms or owners?

ESOPs are fundamentally retirement plans that result in stock ownership, but, to increase the chances for success, the company generally needs to create an ownership culture. With an ESOP, the company needs to communicate the benefits of the ESOP to its employees, particularly if the company will make contributions to the ESOP in lieu of other retirement plan contributions that the employees may have previously received. ESOP companies must sometimes overcome the employees’ belief that the ESOP was established solely for the benefit of the original owners or management and explain how--even when that was a motivating factor--the ESOP provides an opportunity for the employees to create personal wealth through their contributions to the success of the ESOP sponsor. However, employees must also understand the ups and downs of the company and the resulting effect on the valuation of the company stock. If employees learn to understand the company and have an interest in its growth, the company will likely benefit.

6. Does the Company have a “Chicken Little” concern?

History has shown that even the best managed companies have been unable to cope with unanticipated changes in the business environment, many brought about by the impact of technological developments. As a result, even when an established ESOP company is moving forward, growing its profits and retiring its ESOP debt, its managers, including the ESOP fiduciaries, should be on the lookout for those issues that could result in a “The sky is falling!” problem for the company. Examples? Is the company overly dependent on one or a small handful of clients? Could the loss of one of those clients, or a change in the buying pattern of those clients, result in substantial harm to the company? Are there any new technological developments emerging that could impact the company’s financial model? (100 years ago the Carriage Builder’s National Association was a thriving trade group, with numerous members engaged in the manufacturer of horse-drawn carriages. By 1926, the Association met for the last time, signaling the triumph of the automobile over horse-drawn transportation. Does your ESOP sponsor have any similar technological risk?) While certainly not a technical legal obligation of ESOP fiduciaries to be concerned about, it cannot hurt if the fiduciaries question the company management team concerning any such risks and any plans that may be in placed to deal with such issues in the future.

7. Do (or will) the participants have too many “eggs” in the ESOP “basket”?

Allocations of company stock to an ESOP participant’s account count toward the maximum allocation limits under Internal Revenue Code (“Code”) Section 415(c). In some leveraged ESOPs, the plan sponsor curtails or discontinues all other employer-provided retirement benefits other than the ESOP allocations in order to free up cash for debt service payments. In some cases (though, in fairness, less so since the increase in the 415(c) limits beyond the long-time $30,000 threshold), the result is that the only allocations that the participants receive each year are under the ESOP. While technically not a violation of either tax-qualifications rules under the Code or the fiduciary provisions of ERISA, the potential lack of diversification presented by such an arrangement is something that should be carefully considered with company management. Several years of the participants receiving only allocations under an ESOP could result in a significant portion of their retirement assets being invested in the company’s stock. Such a lack of diversification could pose a potential problem for the participants in the event that the company faces financial difficulty.

8. What does happen after all the ESOP stock gets allocated?

For most leverage ESOPs, the time period between the initial ESOP transaction and the date on which the ESOP loan is repaid is marked by the plan making distributions only to those participants who die, become disabled, or attain normal retirement age, with the rest of the terminated vested participants being told that they will not be eligible to receive a termination distribution until the ESOP loan has been fully repaid. Planning for the time period after eventual repayment of such loan is important for two reasons. First, the ESOP sponsor and the ESOP trustee need to plan carefully to ensure that the plan sponsor has sufficient liquidity on hand to make the accumulated termination distributions to those participants who leave the company while the ESOP loan is being repaid, in whatever form is determined under the policy established by the fiduciaries. Second, the ESOP fiduciaries should consult with the ESOP sponsor regarding what benefits, if any, will be provided to the company employees under the ESOP after the loan is repaid. For some companies, the tax advantages of making additional contributions to the ESOP will result in the “recycling” of the company’s stock for allocation to the participants in years after the ESOP loan is repaid, as a result of additional ESOP contributions or later sales of stock to the ESOP. Other companies will choose to redeem all of the ESOP shares as participants terminate and provide other retirement benefits, such as those provided through a separate 401(k) plan.

9. What is required diversification and why does it matter?

The Code requires ESOPs to provide qualified participants with the right to diversify their (post-1986) stock account during a six-year election period, generally beginning once the participant has attained age 55 with ten years of participation in the ESOP. Such participants are permitted to diversify up to 25 percent of the employer stock in their ESOP accounts during the first five years of the six-year election period and increase the amount of diversification permitted up to 50 percent during the final year of the election period. This required diversification can be implemented as a result of transfers to other investment options available under the ESOP or through in-service distributions. The failure to provide the required diversification right would be a potential qualification failure of the ESOP, requiring the ESOP sponsor to consider correction of such failure under the Employee Plans Compliance Resolution System (“EPCRS”). The failure to voluntary correct such a failure could result in substantial penalties under the Audit CAP provisions in EPCRS.

10. See Issue #1

In case our brief mention of the ESOP put option rules, concerns about what the ESOP sponsor managers get paid and, of all things, Chicken Little, has caused you to forget where we started this discussion, please go back and review our comments on the importance of the valuation of the company stock in the ESOP. In any sort of fair weighting of the issues described herein, it would count at least twice!

Finally, why are all these issues important? In short, an ESOP fiduciary who breaches the fiduciary requirements under ERISA can be determined to be personally liable for any losses to the plan resulting from such breach. ESOP fiduciaries are subject to a lawsuit brought by participants, other fiduciaries, or the U.S. Department of Labor. The Department of Labor may seek a penalty of up to 20% of the amount involved. Courts may impose equitable relief including removal of a fiduciary and can even assess criminal liability for willful violations. As a result, anyone (or any entity) that is considering serving as a fiduciary of an ESOP should give careful consideration to all of the issues discussed above.

For more information on this topic, please contact B. David Joffe at 615.252.2368 or or Gordon E. Nichols at 615.252.2387 or

This article originally appeared in the quarterly newsletter for the members of the New South Chapter of the ESOP Association.