EMPLOYEE STOCK OWNERSHIP PLANS
(“ESOPs”)
Why Private Companies Offer Them
And The Issues They Create
ESOPs
 Created in 1974 with the passage of ERISA.
 Purpose is to encourage employee stock
ownership.
 More than 10,000 ESOPs have been
established covering some 10 million employees
 ESOPs used in smallest private companies as
well as America's largest corporations.
ESOPs –
What are they?
An ESOP is a qualified, defined
contribution employee benefit plan
required to invest primarily in the
company’s securities.
ESOPs – Dual and Conflicting Purposes
ESOPs function as both an employee
retirement benefit plan and a technique of
corporate finance intended to encourage
employee ownership of a company.
ESOPs are not intended to guarantee
retirement funds, and they place employee
retirement assets at a greater risk than the
typical diversified, ERISA-regulated plan.
ESOPs – Who are ESOPs to benefit?
ESOPs are supposed to be primarily for
the benefit of the ESOP participants
(rather than the selling shareholder).
Conflict exists because the ESOP is
typically created by the company for
reasons that would benefit the company.
ESOPs –
How are they created?
Company creates a trust for benefit of
company’s employees.
Corporation or corporation's shareholders
sell stock to the trust.
Employees are allocated stock each year
based on plan's vesting schedule.
Employee receives shares (or cash
equivalent) after leaving the company.
ESOPs - Non-Tax Advantages
 Allow owner of closely held business to sell
interest.
 Raise capital by selling newly issued shares.
 Improve company’s cash flow because sponsor
contributes company shares, rather than cash.
 Provides employees with both retirement
benefits and added incentives from having an
ownership interest.
 Trade stock for wage or other benefit
concessions from employees.
ESOPs - Tax Advantages
 Sellers of stock to ESOP can defer any capital
gains tax, under certain circumstances.
 Interest and principal is potentially tax
deductible.
 Dividends paid on ESOP shares are tax
deductible when passed through directly to
employees.
 Participants are not subject to tax until the
benefit is actually distributed, when participants
often are in lower tax brackets.
ESOPs – Disadvantages
If newly issued shares are sold to the
ESOP, the issuance of new stock dilutes
the value of the existing stock.
It costs time and money to comply with
complicated ESOP rules and regulations.
Legal liability for sponsor, fiduciary and
trustees
ESOPs – Use by Private Companies
Provide a mechanism for owner of private
company to sell interest.
Sell interest in company with little or no market.
 Sell minority interest in company while
retaining control of business.
Estate Planning Tool.
Raise Capital.
ESOPs – Sale of Ownership Interest
 Wealth of owners of closely held business often
tied up in closely held, illiquid business.
 ESOPs are attractive way for owners of closely
held businesses to achieve a cash flow
equivalent to past salary and other perquisites.
 ESOP allows a business owner to receive
maximum value on the sale of a business
through "tax-free" sale.
 Sale may be of total interest or a minority
interest only.
ESOPs – Estate Planning Tool
Leaving a closely held business to an
untrained family is unattractive.
ESOP allows family to move into business
of managing a portfolio of liquid
investments rather than a business.
ESOP can be used in transitioning
ownership of the business to the next
generation with minimum tax cost.
ESOPs – Raising Capital
Company can take advantage of tax
benefits of ESOP to raise capital at
reduced cost.
Company can use stock to raise capital
even though stock not readily traded.
Capital can be used for any business
purpose.
ESOPs – Underwriting Issues
Determine the reason for the creation of
the ESOP and any subsequent purchase
transactions by ESOP.
Sale of business in its entirety may
present less risk than sale of minority
interest by owner seeking to retain control
or capital raising transaction.
ESOPs – ESOP Structure
 Typically, the decisions of the ESOP will be
made by the ESOP committee, which is created
by the company and populated by the
company’s officers, directors or family members.
 Trustee will typically be a directed trustee
required to discharge the instructions of the
ESOP committee.
 Occasionally, trustee may be an independent
trustee or an uninformed trustee.
ESOPs –
ESOP Committee
Trend in the public company environment
to remove executives with inside financial
information of the company from the
ESOP committee.
Private companies may seek to avoid the
expense and loss of control associated
with an independent, outside fiduciary.
ESOPs – Underwriting Issues
Identify the members of the ESOP
committee and determine how they relate
to the company or the owner.
The more incestuous the ESOP
committee, the greater the risk of liability.
Determine whether any of the members of
the ESOP committee have sold stock to
the ESOP.
ESOPs – Underwriting Issues
Determine whether the trustee is a
directed trustee or an independent trustee.
 An independent trustee entails less risk
than a directed trustee.
If a directed trustee is involved, is it a
reputable, independent company or a
company insider or hand-picked service
provider.
ESOPs – Leveraged ESOP
 Bank lends money to company, which in turns
loans money to ESOP.
 ESOP used cash to purchase company’s stock.
 ESOP repays the loan by virtue of tax free
contributions from company and stock dividends.
 Stock used as security for the loan; As loan
repaid, stock is released from suspense account
and allocated to individual employee accounts.
ESOPs – Leveraged ESOPs
At the time the loan is made, the interest
rate for the loan and the price of securities
should not be such that plan assets might
be drained off; and
The terms of the loan must be at least as
favorable to the ESOP as the terms of a
comparable loan resulting from armslength negotiations between independent
parties
ESOPs – Underwriting Issues
Determine whether loan between ESOP
and Company is consistent with the loan
rate between the Company and the
commercial lender.
Determine whether the loan between the
ESOP and the Company has been
refinanced or whether there has been a
change in terms.
ESOPs – Purchase of Sponsor’s Stock
 The key transaction in establishing an ESOP is
the purchase of stock from the company or the
owner.
 The ESOP can never pay more than the fair
market value for the stock.
 In private companies with stock that is not
readily traded, there is no existing market
valuation.
 ESOP should obtain an independent appraisal of
stock’s value.
ESOPs – Purchase of Sponsor’s Stock
Many ESOPs involve the sale of a minority
interest by the owner of the company.
Typically owner seek to retain control of
the company, but wishes to convert illiquid
stock into cash.
Value of minority stock interest in a private
company is very difficult to ascertain.
Owner’s interest will be to maximize stock
price.
ESOPs – Purchase of Sponsor’s Stock
Except for company securities that are
readily tradable on an established
securities market, all valuations of
company securities contributed to or
purchased by an ESOP must be made by
an independent appraiser.
ESOPs – Purchase of Sponsor’s Stock
 Duty of prudence requires that the fiduciary
conduct an independent investigation that a
purchase of the company stock is fair.
 Fiduciary’s reliance on experts' advice must be
reasonably justified.
 A fiduciary should therefore:
Retain independent expert;
 Investigate expert‘s qualifications;
 Provide expert with complete and accurate information;
Scrutinize expert’s conclusions.
ESOPs – Breach of Fiduciary Duty
 Trustee breached fiduciary duty by failing to prudently
investigate value of company stock purchased by the
ESOP.
 Trustee motivated primarily in retaining control of the
ESOP sponsor.
 Acquisition was based upon a selling price determined
without negotiation and upon a deadline set by the
selling shareholder.
 Trustee violated prohibited transaction provisions of
ERISA § 406 by causing ESOP to make the purchase
for more than adequate consideration.
Horn v. McQueen,
215 F. Supp. 2d 867 (W.D.Ky. 2002)
ESOPs – Breach of Fiduciary Duty
 The members of an ESOP committee not
fiduciaries before their appointment.
 Accordingly, committee members not liable for
ESOP's acquisition of company securities before
the date of their appointment.
 Committee members could be liable for breach
of fiduciary duty by allowing ESOP assets to
decline in value without undertaking
investigation into the cause of the decline or
possible recourse.
Keach v. U.S. Trust Co., 240 F. Supp. 2d 840 (C.D. Ill. 2002)
ESOPs – Underwriting Issues
 Determine who sold stock to the ESOP.
 Obtain copy of appraisal for all stock purchases
by ESOP.
 Determine whether appraisal done by reputable,
independent appraisal firm.
 Obtain due diligence file of ESOP committee or
trustee with regard to appraisal firm.
 Review appraisal to evaluate whether it was
thorough and supported by comparables.
 Determine whether ESOP has sold stock and if
so, what the sales price was.
ESOPs – Liability Concerns
Because an ESOP invests in the stock of
the sponsoring company, if the company
suffers a decline, the wisdom of the
investment will be brought into question.
ESOPs – Underwriting Issues
 Evaluating the financial health of the company
could be critical.
 Evaluating the company’s financial health
pertains to both avoiding suits over the stock
price and control issues as well as the potential
inability of the Company to repurchase shares.
 Obtain copies of recent annual independent
valuations.
 Evaluate history of ESOPs purchase of stock
and Company’s history of repurchase of stock.
ESOPs –
Issues of Economic Decline
Difficult decisions faced by fiduciaries in
times of economic troubles:
 Whether to support management when the
company is in economic difficulty.
whether to remain invested in company
securities when the company is in distress.
ESOPs – Issues of Economic Decline
Falling stock price may trigger suits
alleging:
 ESOP paid more than fair market value for the
stock initially purchased.
ESOP should not have continued to buy
company’s stock as price fell.
ESOP should have divested itself of company’s
stock.
Fiduciaries should have voted unallocated and
uninstructed shares to change management.
ESOPs – Issues of Economic Decline
Trustee or ESOP committee may include
members of Company’s management with
information they have an obligation to use
to avoid ESOP’s loss in the Company
stock.
Management has conflict of interest
between supporting stock price and
avoiding loss for ESOP.
ESOPs –
Duty of Prudence
General presumption that an ESOP
fiduciary who invested in company’s stock
acted consistently with ERISA.
Plaintiff can overcome presumption by
establishing that the fiduciary abused its
discretion by investing in company
securities.
ESOPs –
Duty of Prudence
Investment in company securities may
violate fiduciary duty requirements even
where plan documents require all
investments to be in company securities.
Courts have held that fiduciaries investing
in stock of a failing company or fail to
diversify out of company securities may
violate ERISA's fiduciary duties.
ESOPs – Fiduciary Duty to Divest
 Presumption that an investment in company securities is appropriate
overcome by establishing that fiduciary abused discretion.
 ESOP committee had knowledge of the company's financial decline
and situation through its members who were on the company's
board
 Committee continued investment until stock almost worthless.
 ESOP committee breached its fiduciary obligations by failing to
disclose and misrepresenting pertinent information regarding the
company's condition.
 ESOP did not absolutely require the committee to invest exclusively
in company stock without regard to the financial condition of the
company.
Moench v. Robertson,
62 F.3d 553 (3d Cir. 1995)
ESOPs – Fiduciary Duty to Divest
ERISA could require a fiduciary to diversify
ESOP assets if:
Most of the plan participants are near
retirement age;
ESOP is the principal retirement vehicle for the
participants;
ESOP is entirely invested in company stock;
ESOP is assumed by a company that
demonstrates a bankruptcy risk.
Steinman v. Hicks, 352 F.3d 1101 (7th Cir. 2003)
ESOPs – Fiduciary Duty to Divest
 ESOP fiduciary not breach duty by failing to
reduce company stock holdings during an 18month period in which the value declined by
80%.
 ESOP fiduciary presumed to have acted
reasonably in following the terms of the ESOP.
 Fiduciary’s awareness of company's financial
problems, and failure to investigate
diversification, insufficient to overcome this
presumption.
Kuper v. Iovenko,
66 F.3d 1447 (6th Cir. 1995)
ESOPs – Fiduciary Duty to Divest
No breach of fiduciary duty where trustee
had no knowledge of any malfeasance
within company, but, at most, learned only
as events were unfolding that company's
stock price and profits were declining and
that company was undergoing
restructuring.
Lalonde v. Textron, Inc.
369 F.3d 1
C.A.1 (R.I.), May 7, 2004
ESOPs – Repurchase Obligation
If the securities are not readily tradable on
an established market, ESOP participants
must be given the right to put the
securities to the company at the price
determined under a fair valuation formula.
ESOPs – Repurchase Obligation
With private company stock, only the
company or ESOP will be available to
purchase participant stock.
Purchase must be for fair market value
and will be based upon annual
independent appraisal.
ESOPs – Repurchase Obligation
Fiduciary likely has duty to ensure that
repurchase is for fair market value.
Fiduciary likely has duty to ensure that
company can meet its repurchase
obligations.
Fiduciary likely has duty to ensure that
company provides adequate security for
repurchase of stock over time.
ESOPs – Repurchase Obligation
Private companies have independent
appraisals performed on an annual basis.
Private companies may also have
repurchase obligation studies performed.
Private companies may also fund ESOP
with cash to repurchase participant
shares.
ESOPs – Underwriting Issues
 Evaluate repurchases valuation mechanism and
recently conducted repurchases.
 Look for drop in repurchase price.
 Determine whether repurchase obligation study
conducted and if so, evaluate the same.
 If no repurchase obligation study, examine
repurchase liability and company’s ability to
meet liability.
 Evaluate source of funds for repurchases.
 Examine ESOP’s cash position.
ESOPs –
Change of Control Issues
Voting decisions taking into account nonfinancial factors may violate exclusive
benefit rule:
 continuing job security of participants;
 conditions of employment;
employment opportunities; and
prospect of participants for future benefits under
the plan.
ESOPs – Voting Allocated Shares
 IRS rules require that participants and
beneficiaries be entitled to direct the voting
rights with respect to:
any corporate merger or consolidation,
Recapitalization or reclassification,
Liquidation or dissolution,
asset sale,
or any similar transaction
but only as to securities that are allocated to the
participant.
ESOPs – Voting Allocated Shares
 DOL’s position is that trustee has responsibility
to ensure that the participants are fully informed
with correct information when they vote their
shares.
 Trustee protected if it assures that ESOP is fairly
implemented, that participants have not been
coerced, participants received all necessary
information, and not receive any false or
misleading information.
ESOPs – Voting Unallocated Shares
 Trustee is entitled to vote all unallocated shares
and uninstructed shares.
 Directed trustee will vote as directed by ESOP
committee, which will likely reflect the interests
of management or the owners.
 As an alternative, plan may provide that
unallocated and undirected shares are to be
voted in the same proportion as directed shares.
ESOPs – Voting Unallocated Shares
Voting unallocated shares strictly in
accordance with allocated shares
breached fiduciary duty,
Votes of current participants not reflect
interests of future participants.
Danaher Corp. v. Chicago Pneumatic Tool Co.,
635 F. Supp. 246, 250 (S.D.N.Y. 1986)
ESOPs – Voting Unallocated Shares
 ESOP committee, composed of a majority of
management, breached fiduciary duty by
abstaining from voting unallocated shares where
participants voted against management.
 Committee failed to conduct an independent
investigation.
 Committee also not obligated to implement
mirrored voting and to do so would itself
constitute a breach of fiduciary duty.
Newton v. Van Otterloo,
756 F. Supp. 1121 (N.D. Ind. 1991)
ESOPs – Voting Unallocated Shares
Mirrored voting is when the trustee votes
all unallocated and uninstructed shares in
the same proportion as the allocated
shares.
Some ESOP agreements require mirrored
voting.
DOL initially frowned on mirrored voting,
but has recently appeared more tolerant of
the mirrored voting provisions.
ESOPs – Underwriting Issues
 Determine whether ESOP Agreement provides
for pass-through voting rights on all issues.
 Pass-through voting rights for all issues entail
less risk than limited pass through voting rights.
 Determine whether the ESOP Agreement makes
provisions for voting unallocated and
uninstructed shares.
 Mirrored or trustee directed voting of unallocated
and uninstructed shares entails less risk than
voting that can be directed by the ESOP
Committee.
ESOPs –
Termination of ESOP
Company’s repurchase of ESOP stock
may create risk for fiduciaries.
Same concerns that exist with original
creation of ESOP exist here.
Sale frequently involves transaction
between fiduciaries or at least insiders.