ESOPs often choose to make benefit distributions in the form of
cash, rather than in company stock. Some of these ESOPs obtain the
necessary cash by selling company stock to the company. This sale
transaction raises two fiduciary issues under the Employee Retirement
Income Security Act of 1974, as amended ("ERISA"). First, the sale is a
prohibited transaction under Section 4975(c)(1)(A) of the Internal
Revenue Code of 1986, as amended ("Code"), and Section 406(a)(1)(A) of
ERISA, unless the sale meets the exemption in Section 408(e) of ERISA.
Second, under Section 404(a)(1) of ERISA, the fiduciary must satisfy
itself that the decision to sell company stock is in the best interests
of the ESOP's participants.
To satisfy
the prohibited transaction exemption, the fiduciary must obtain a
valuation opinion letter from the ESOP's independent appraiser, dated as of the sale date,
that states that the purchase price paid to the ESOP is not less than
the fair market value of the company stock. The ESOP cannot rely on the
prior year end appraisal to satisfy this requirement. While the updated
stock valuation from the appraiser solves the prohibited transaction
problem, it may create additional administrative issues for the ESOP,
discussed below. In addition, while the sale of company stock may
achieve the company's objectives, the fiduciary may only sell company
stock if the sale is in the best interests of the ESOP participants.
The first part of this Article will address the administrative and
fiduciary issues associated with obtaining the updated valuation
opinion letter. The second part of this Article (to be published
shortly) will discuss methods to fund repurchase liability without
involving a sale of company stock by the ESOP.
Administrative and Fiduciary Concerns
Although a company and its ESOP may prefer to make distributions in
cash, an ESOP is generally required to offer benefit distributions in
the form of company stock, unless the company is an S corporation or
the company restricts ownership of its stock to employees and the ESOP
in accordance with Code Section 409(h)(2).
Rarely will an ESOP have sufficient cash to fund all benefit
distributions indefinitely. Since the assets of the ESOP are invested
largely in company stock, an ESOP may find it difficult to obtain the
cash needed to fund benefit distributions. For example, the company may
have concluded that it does not want to make additional tax deductible
contributions to the ESOP, or the company may already be making
contributions up to the limits permitted under the Code, in which case
it would not be able to make any additional annual contributions to
fund the benefit distributions.
To achieve the objectives of (1) making ESOP distributions in the
form of cash, and (2) making no additional contributions to fund this
obligation, the ESOP may be led to conclude that it should sell company
stock to obtain cash. The stock sale provides the ESOP with cash but
avoids any additional contributions, since the payment of the purchase
price to the ESOP is not a contribution.
As previously mentioned, the ESOP fiduciary must obtain an updated
valuation opinion letter from the ESOP's independent appraiser, as to
the fair market value of company stock. The ESOP cannot rely on the
fair market value determined as of the prior year-end. This is the
position of the Department of Labor ("DOL") in DOL Prop. Reg.
2510.3-18(b).
Although the updated valuation is required under ERISA, the
existence of this additional valuation raises other concerns for the
fiduciary. Let's assume that the company's fair market value is higher
at the time of the update than at the prior year-end. The ESOP cannot
legally sell shares to the company for less than the updated fair
market value. If the ESOP sells at the higher current price, who is
entitled to the increased value? The former employee may only be
expecting to receive the prior year-end value that appeared on his last
annual statement (and the ESOP document may state explicitly that this
is the value used for all distributions). The ESOP could provide that
the former employee would only receive the prior year-end value, and
that the excess value would be allocated to all other participants as
an item of net income of the trust for the year. Alternatively, the
ESOP fiduciary could decide to pay the increased value to the former
employee, resulting in a "windfall" to the former employee.
If the ESOP does not pay the former employee the higher updated
price, the former employee could assert he is entitled to the excess
sales proceeds, since the shares sold were from his account. On the
other hand, active employees could assert that the former employee is
only entitled to the prior year-end value and that the additional
purchase price should be allocated to all ESOP participants.
What if the updated value is lower than the prior year-end
fair market value? The ESOP could sell the stock to the company for the
higher price determined as of the prior year-end, since Section 408(e)
of ERISA would permit the ESOP to sell the stock for more than its fair
market value. However, the issue of who is entitled to this premium
presents itself again. If the ESOP document permits interim valuations,
the active employees may have a superior claim to the premium. The
former employee may argue that the fiduciaries breached their ERISA
duties by obtaining the interim valuation which resulted in a reduction
in his benefits. If the company pays the lower interim value, then the
former employee would only receive the lower, updated amount for his
shares. He might argue that obtaining the interim valuation was itself
a violation of ERISA by the ESOP's fiduciaries.
In addition to the foregoing administrative and fiduciary issues,
the fiduciary of the ESOP must consider whether his decision to sell
Company stock is in the best interests of ESOP participants. The mere
existence of the updated valuation opinion does not fully discharge the
fiduciary's responsibilities under ERISA. Courts have established a
presumption in favor of an ESOP fiduciary that is buying company stock.
However, no such presumption protects a fiduciary that is selling
company stock. Often, the reasons to sell company stock to fund benefit
distributions (as identified above) are to further the interests of the
company, but not necessarily the interests of the ESOP. If the ESOP
owns all of the stock of the Company, it may be easier for the ESOP
fiduciary to conclude that actions which are in the best interest of
the company are also in the best interests of the ESOP participants.
Otherwise, the ESOP fiduciary must consider the drop in the ESOP's
percentage ownership in the company as a factor in agreeing to sell
company stock.
A fiduciary who does not wish to sell company stock to raise cash
could consider simply distributing shares of stock to participants.
However, if the company is an S corporation, such an action could
result in the loss of its S corporation status if an ineligible person
thereby becomes a shareholder. Also, if the company is a C corporation
and does not have an ownership restriction in its certificate of
incorporation or by-laws, the distribution of shares could result in
permanent share ownership by former employees.
Conclusion
Because the prohibited transaction rules require the ESOP to obtain
an updated valuation, the stock sale may create a dilemma for the
ESOP's fiduciaries. Whether the fair market value is higher or lower
than the prior year-end fair market value, the company and ESOP may
find themselves in a position of having to take actions that harm
either former employees or active employees. Moreover, the fiduciary of
the ESOP may have difficulty demonstrating that a sale of company stock
was in the best interests of the ESOP participants under ERISA.
The second installment of this article will describe alternative methods for funding benefit distributions.
Editor's note: this posting is based in part on an article that
appeared in The ESOP Report of The ESOP Association several years ago.
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