ESOP Law Blog

ESOP Benefit Distributions - A Little Guidance on Financial Disclosure

Sheppard Mullin — Mon, 01 Feb 2010 17:30:25 -0500

In a recent California case, Balsley v. Delta Star Employee Stock Ownership Plan, the U.S. District Court in San Francisco added a little flesh to the bare bones questions of what if any financial disclosure must a company make to ESOP participants in connection with their benefit distributions.

The plaintiff sued the ESOP and its fiduciaries for (i) a breach of ERISA fiduciary duty and (ii) failure to provide information required under Section 502(c) of ERISA. The motion to dismiss only addressed the breach of fiduciary duty claim.

Some facts: The plaintiff alleged that after his termination of service in November, 2007, he was offered a lump sum distribution of his ESOP account using the fair market value of the stock as of December 31, 2006. At that time the stock was worth $22.38 per share. The Company's chief financial officer ("CFO") allegedly told the plaintiff that "cash may not be available in the future to buy back Balsely's [plaintiff's] shares, and that the lump sum offer would not remain open." The plaintiff stated he relied on these two representations of the CFO. The plaintiff accepted the lump sum. He later learned that the December 31, 2007 valuation was $142.45. Apparently, the Company was a having a very strong financial year that resulted in a substantially higher stock value.

The fiduciary defendants made the following arguments:

First, the defendants argued the plaintiff lacked legal standing to bring the case. The fiduciaries argued that Section 502(a)(2) of ERISA does not provide a remedy for individual damages and that plaintiff would have to show an injury to the ESOP generally that impacted the value of his account. (See our prior blog on the LaRue decision of the U.S. Supreme Court on this point). The Court granted the defendant's motion to dismiss, although it noted that the plaintiff could pursue the breach of fiduciary claim under Section 502(a)(3) of ERISA. (Again, see LaRue).

Second, the Court then addressed the plaintiff's fiduciary claims, presumably because the claims will be resubmitted under Section 502(a)(3). The Court began by noting the rule in Varity Corp. v. Howe, 516 U.S. 489, 506 (1996) in which the U.S. Supreme Court held that: " . . .to participate knowingly and significantly in deceiving a plan's beneficiaries in order to save the employer money at the beneficiaries' expense is not to act 'solely in the interest of the participants and beneficiaries.'" The Varity case stands for the proposition that a fiduciary that deceives participants can be liable, even though the fiduciary provides the minimum information required under ERISA. Here, the plaintiff alleges the deception came in the form of both "omissions" and "affirmative misrepresentations."

As to the omissions, the plaintiff claims that the CFO had knowledge the Company was having a record sales year, and that the stock value had increased. Defendants argued that Section 404(a) of ERISA only creates duties "with respect to the plan" and so an omission of information about the company is not actionable. However, the Court compared this situation to Varity and found the statements about the limited availability of the lump sum distribution could be connected to the offering and may have created grounds for asserting the omission related to the administration of the plan. The court found that plaintiff's arguments were sufficient to survive a motion to dismiss.

If the court finds this omission of information constitutes a breach of fiduciary duty (at this point, it is just a decision on a motion to dismiss) the district court may cause ESOP companies to consider whether any material financial information about the company needs to be disclosed to participants who are assessing whether to elect to receive a current benefit distribution. Of course, it is possible the plaintiff will not prevail on this point at trial, as the burden shifts to the plaintiff to prove the misleading nature of the omission and the connection to plan administration under Varity.

As to the affirmative misrepresentations, plaintiff claims he was told (i) cash may not be available in the future to buy plaintiff's shares and (ii) the lump sum offer would not remain open. The court found for the defendants on the first statement. The court felt a company could have strong revenues and profits but still not have sufficient cash available to make benefit distributions. On the second statement, the court found for the plaintiff on the ground that plaintiff may be able to show that the ESOP trustees would again consider in the future whether to offer lump sum distributions.

Finally, the court found that neither the Company nor the ESOP trustees could be held liable as fiduciaries for the omissions or misleading statements made by the CFO. For this reason, the fiduciary breach claims against the Company and the ESOP trustees were dismissed. Only the fiduciary claim against the CFO remains. (The CFO did not contest his status as a plan fiduciary).

Final scorecard on the motion to dismiss: the plaintiff will have to resubmit his fiduciary claims under Section 502(a)(3); the claim based on omission of disclosure of company financial performance may go forward against the CFO (but not the company or trustees); the misrepresentation claim based on the possible lack of cash in the future is dismissed; the misrepresentation claim based on availability of a lump sum option in the future remains against the CFO.

Since the decision of the court is only on a motion to dismiss and not a trial on the merits, it would be a mistake to read too much into the decision at this point. Tow observations to keep in mind: first, the court seemed to recognize there is no general ERISA fiduciary duty for ESOP trustees to provide financial information about the company' performance in connection with benefit distributions; second, under the court's Varity approach, it is important for the fiduciaries of an ESOP to ensure that information is not provided to distributees that could be misleading.

Pitfalls In Selling Stock To Fund ESOP Repurchase Obligations - Part II

Sheppard Mullin — Mon, 07 Apr 2008 15:44:17 -0500

In the first article on this subject that we recently posted, we considered the administrative and fiduciary issues that arise when an ESOP sells company stock to the company to fund its benefit distributions. The fiduciary issues under the Employee Retirement Income Security Act of 1974, as amended ("ERISA") include the need to obtain a new valuation opinion letter from the ESOP's appraiser updated to the date of the sale. This updated opinion letter is required for the sale to be exempt from the prohibited transaction rules of under Section 4975(c)(1)(A) of the Internal Revenue Code of 1986, as amended ("Code") and Section 406(a)(1)(A) of ERISA. In this second article, we consider alternative methods for handling benefit distributions which avoid (or at least reduce) the administrative and fiduciary issues associated with the sale of company stock and the updated valuation opinion. We assume the company's objectives are: (1) to make ESOP distributions in the form of cash in order to avoid having former employees retain stock in the company, (2) to make no additional ESOP contributions to fund this obligation and (3) to preserve stock ownership for ESOP participants who are active employees.

Stock Distributions with Mandatory Company Buyback

If the ESOP sponsor is a company that restricts ownership of substantially all of its stock to active employees and the ESOP (as contemplated by Section 409(h)(2) of the Code) through its Articles of Incorporation or By-laws, or for a company that is an S corporation for federal tax purposes, the ESOP may distribute shares to ESOP participants subject to the requirement that the shares be immediately and automatically resold to the company. The Treasury regulations that define an ESOP would permit this repurchase to occur at the most recent prior year end value. An updated valuation would not be needed (unless the distributee was a "party-in-interest" under Section 3(14) of ERISA).

If the ESOP sponsor does not have an ownership restriction on its stock and is not an S corporation, then an ESOP participant who receives company stock in a distribution is not obligated to sell the shares to the company. He may retain the shares and become a long term shareholder.

Use of Secured Promissory Notes

If an ESOP sponsor is an S corporation or has a stock ownership restriction as described above, the ESOP could make distributions in a lump sum in the form of company stock. The purchase price for the mandatory buyback of the stock could be made in installments using a secured promissory note, as contemplated under Section 409(h)(5) of the Code. Former employees would then become creditors rather than shareholders of the company. The company's future payments on the promissory notes would not be contributions.

By following this procedure, the company could prevent former employees from becoming shareholders. Also, the company would avoid making additional contributions into the ESOP. Note that the IRS has made clear that momentary ownership of S corporation stock through ESOP distributions to an ineligible person or individual will not affect the company's S election.

Temporary Suspension of New Contributions

If the desire to avoid additional contributions is temporary, the ESOP could make distributions in the form of company stock and repurchase the shares from participants using the proceeds of a new ESOP loan from the company at the prior year-end fair market value. (However, if the former employee is a party in interest under Section 3(14) of ERISA an updated valuation may be needed). The shares acquired by the ESOP would be credited to an ESOP loan suspense account, and would be released only as payments are made on the ESOP loan. Contributions to the ESOP to repay the loan could be minimized (using an interest-only loan for awhile), with principal amortization to begin once the company can again begin making substantial contributions to the ESOP. This alternative would defer, but not eliminate the need for future ESOP contributions. Also, distributions of stock could be subject to an immediate and automatic repurchase by the company so long as the company had an ownership restriction on its stock or is an S corporation.

Alternatively, the company could assist the ESOP in funding cash distributions by using an interest free loan, as contemplated under DOL Prohibited Transaction Class Exemption 80-26. The ESOP would use the proceeds of the interest-free to make benefit distributions. Then, in the next year or two, the company would make contributions large enough to allow the ESOP to repay the principal balance of the loan.

Installment Distributions

A company may find that it is willing and able to make continuing cash contributions into the ESOP, but not contributions which are large enough to fund all benefit distributions. In this case, the ESOP could choose to make cash distributions in annual installments from the ESOP over a period of up to five years (see Section 409(o)(1)(C) of the Code), reducing the amount of new cash needed each year by the ESOP (relative to the cash needed to make lump sum distributions). So long as the company maintained an ownership restriction on its stock or was an S corporation, all distributions could be made in cash and not in company stock. Under this approach, participants would retain a declining balance of equity in the company over the installment period. Therefore, two of the objectives stated above of (i) avoiding distributions in company stock and (ii) avoiding additional contributions to the ESOP are met. However, former employees remain partially invested in company stock during the installment period (although they do not receive distributions of stock) and additional contributions are required in order to fund the installment payments.

Conclusion

A company may wish to fund ESOP benefit distributions without allowing former employees to remain invested in company stock and without permitting former employees to become long-term shareholders. If the company does not wish to make current cash contributions to the ESOP to fund these distributions, the company and the ESOP should consider a distribution policy that avoids the need to have the ESOP regularly sell company stock back to the company. These sales create both administrative and fiduciary issues that may be avoided by choosing one of the alternative methods of distributions described in this article.

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.

Pitfalls In Selling Stock To Fund ESOP Repurchase Obligations - Part I

Sheppard Mullin — Thu, 27 Mar 2008 15:28:07 -0500

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.

ESOPs Impacted by Landmark U.S. Supreme Court Case

Sheppard Mullin — Tue, 26 Feb 2008 15:09:52 -0500

The pension plan world is abuzz with last week's U.S. Supreme Court (the "Court") decision in a pension plan case, LaRue v. DeWolff, 552 U.S. ____ (2008). We don't get many decisions by the Supremes in the pension area, so it's worth some focus. We will give just a brief summary of the case (more detailed reviews available all over the Internet) and then focus on the ways the decision might impact ESOPs.

Case Summary

The company sponsored a 401(k) plan and investment decisions were controlled by plan participants. Mr. LaRue was a participant and he claimed that the plan's fiduciaries failed to follow his investment instruction to sell securities in his account and this failure resulted in a loss of $150,000 in the value of his account . He sued the plan's fiduciaries under Section 502(a)(2) of ERISA. This section gives a plan participant the right to bring a lawsuit for "appropriate relief" under Section 409 of ERISA. Section 409 of ERISA provides:

"Any person who is a fiduciary with respect to a plan who breaches any of the responsibilities, obligations, or duties imposed upon fiduciaries by this subchapter shall be personally liable to make good to such plan any losses to the plan resulting from each such breach, and to restore to such plan any profits of such fiduciary which have been made through use of assets of the plan by the fiduciary, and shall be subject to such other equitable or remedial relief as the court may deem appropriate, including removal of such fiduciary. A fiduciary may also be removed for a violation of section 1111 of this title."

The circuit courts of appeals around the country had split over the interpretation of this section. Some circuits held that the references in Section 409 to "losses to the plan" and "restore to such plan" meant that only a loss suffered by the "entire plan" was subject to a remedy under Section 502(a)(2). Other courts found that an individual participant could bring a fiduciary breach claim for losses suffered by his individual plan account without any other loss to the plan as a whole.

In resolving this circuit court split in favor of permitting lawsuits on behalf of individual participants, the LaRue opinion contains the following highlights:

1. The Court reexamined its opinion in Massachusetts Mut. Life Ins. Co. v. Russell, 473 U.S. 134 (1985). In Russell, the Court found that Section 502(a)(2) authorized recovery for a breach of fiduciary duty under Section 409 only for the plan as an entity, and did not permit individuals to bring suit when they did not seek relief on behalf of the plan as a whole. Russell involved a participant in a disability plan who received his benefits but claimed consequential damages relating to the delay in the startup of the payments.

In LaRue, the Court found the "entire plan" concept should be restricted to defined benefit plan cases (the Court included long term disability plans in this category). The Court found the concept inapplicable to defined contribution plans (like and ESOP) in which benefits are determined on an individual account balance basis.

2. Justices Roberts and Kennedy concurred in the result in favor of LaRue, but they wrote a separate concurrence in which they suggested that LaRue's remedy is under Section 502(a)(1)(B) rather than under Section 502(a)(2). Section 502(a)(1)(B) allows a participant to sue " . . . to recover benefits due to him under the terms of his plan, to enforce his rights under the terms of the plan, or to clarify his rights to future benefits under the terms of the plan." It is possible that LaRue might win his case under either section; however, forcing participants to sue under 502(a)(1)(B) provides employers with some additional procedural defenses that would not be available in a breach of fiduciary duty case under Section 502(a)(2).

3. Justices Thomas and Scalia filed an additional concurring opinion. They made the point that the loss to LaRue's account was a "loss to the plan" even if it did not affect all accounts within the plan. They saw no reason to distinguish defined benefit plans from defined contribution plans for this purpose.

Impact on ESOPs

So, how does this case impact ESOPs? First, let's consider ESOPs in closely held companies.

Generally, all of the participants in the plan are collectively invested in company stock. A claim that a fiduciary breached his duties in a manner that impacted the company stock value would likely impact all ESOP participants. Therefore, a claim against the fiduciaries could be brought under Section 502(a)(2) by a single affected participant, or by a class that includes one or all of the participants. This would have been true before the LaRue decision.

The LaRue decision has greater significance where a fiduciary breach may have affected only a portion of the ESOP's participants. Here are a few examples:

1. Age 55 and 10 Statutory Diversification. Suppose the limited group of participants eligible for diversification in a year (under Section 401(a)(28) of the Code) made a claim that the stock value was incorrectly determined. If those participants sued for a breach of fiduciary duty, prior to LaRue, a court might have held that the entire plan was not impacted by the breach, but only a small group of participants. The claim might have been dismissed. Under the majority opinion in LaRue, the participants would have a right to bring the fiduciary case under Section 502(a)(2). Note that under Justice Roberts concurrence, it is possible the participants would be required to make a claim for benefits under Section 502(a)(1)(B), rather than a fiduciary claim. That result would create a longer and tougher road for the participants.

2. Benefit Distributions. Similarly, a claim of undervaluation of stock made just by the participants receiving benefit distributions in a particular year would affect only a subset of the ESOP's participants. The before and after analysis of LaRue relating to a diversification election would apply equally to benefit distributions.

3. KSOP - In a KSOP, participants make individual elections to invest some or all of their salary deferral contributions into company stock. If those participants who invest in the company stock fund later sue the fiduciaries, the group would represent a subset of plan participants, rather than the plan as a whole. The LaRue decision would permit the affected group to bring the fiduciary claim. See discussion below on public company KSOPs.

Publicly-Traded Companies with KSOPs

Much of the ERISA-related stock drop litigation since Enron has involved participants' claims that the company stock fund in the 401(k) plan was an imprudent investment choice and that the fiduciaries are liable to any participants who invested in the fund. Prior to LaRue, some of these cases were dismissed by courts because only some of the KSOP's participants chose to invest in the company stock fund. Since others elected not to invest in company stock, some courts said there was no loss to the "entire plan" but rather individual losses to affected participants. After LaRue, this sort of defense will no longer be available. The affected participants should be able to maintain their claims. Under Justice Roberts' concurrence, it is possible that participants will need to bring these claims under Section 502(a)(1)(B) as a benefit claim rather than as a 502(a)(2) fiduciary breach case.

Summary

The LaRue decision undoubtedly expands the universe of possible fiduciary breach cases. For ESOPs in closely held companies, the impact may be limited to a handful of situations in which one or more individual participants have a particular right under the ESOP that is not enjoyed by all participants. For ESOPs in publicly traded companies, the LaRue decision will allow many more plaintiffs to avoid an early stage dismissal of their case and increase the likelihood of getting to a trial on the merits of the underlying fiduciary claim. With so many public company cases pending in the courts, it will be an interesting year.

Treasury Proposes New ESOP Regulations And Invites Public Comment

Sheppard Mullin — Fri, 15 Feb 2008 14:54:21 -0500

In January 2008, the IRS published proposed regulations ("Proposed Regulations") under the new ESOP diversification rules of Section 401(a)(35) of the Internal Revenue Code ("Code"). The Proposed Regulations could impact several ESOP provisions of the Code, including: the independent appraiser requirement of Section 401(a)(28)(C), the put option rules of Section 409(h)(1)(B), the definition of employer securities under Section 409(l)(1), and the eligibility for a tax deferred sale to an ESOP under Section 1042, all of which apply to employer stock that is not publicly-traded.

Since the applicability of these four Code provisions turns on whether the ESOP plan sponsor has publicly-traded stock, the Proposed Regulations suggest a test for determining when stock is publicly-traded for ESOP purposes. The IRS has invited public comments on this matter.

Existing IRS Position on the Meaning of "Publicly-Traded"

Since 1977, the Treasury Regulation Section 54.4975-7(b)(1)(iv) (the "Prohibited Transaction Regulations") has provided that an employer security is treated as publicly traded for ESOP purposes if it is listed on a national securities exchange registered under section 6 of the Securities Exchange Act of 1934 (the '34 Act") or is quoted on a system sponsored by a national securities association registered under Section 15A(b) of the Securities Exchange Act. For many years, this definition effectively meant that a stock needed to be either quoted on one of the U.S. stock exchanges or quoted on the NASDAQ National Market System to be publicly traded.

When the Code was amended after 1977 to add new ESOP benefits (and requirements), Congress used the term "readily traded on an established securities market" rather than "publicly-traded." However, the IRS in several private letter rulings ("PLRs") confirmed that the term "readily traded on an established securities market" would be defined by reference to the term "publicly traded" in the Prohibited Transaction Regulations until further guidance was published.

Clearly, all stocks traded on the New York and regional stock exchanges (that are registered) and stocks traded on NASDAQ would be publicly-traded for this purpose.

In 1990, NASD created the Over The Counter Bulletin Board ("OTCBB"). The OTCBB was essentially an automated version of the 'pink sheet' quotation system. A question arose as to whether the OTCBB, having been created by NASD, could be said to be a system "sponsored by a national securities association." In PLR 200052014, a taxpayer seeking to complete a Section 1042 transaction using stock quoted on the OTCBB requested a ruling on the matter. In the PLR, the IRS found that the Section Prohibited Transaction Regulations were written based on an assumption that the qualifying quotation systems would have "comprehensive standards" and broad powers which would be protective of the interests of participants and provide for enhanced marketability of quoted securities. In the PLR, the IRS ruled that the OTCBB did not offer these benefits and protections and held accordingly that a stock quoted only on the OTCBB is not publicly-traded for ESOP purposes.

Stocks quoted only on foreign stock exchanges would not qualify as publicly-traded, since those exchanges are not registered under Section 6 of the '34 Act.

Proposed Regulations Definition

Under the Proposed Regulations, the IRS has continued its position that stock quoted on a Section 6 stock exchange is publicly-traded. The Proposed Regulations note that NASDAQ is now itself an exchange and falls under that definition. In addition, the IRS appears to have confirmed its position in PLR 200052014 that a stock quoted on the OTCBB is not public-traded. However, the IRS has taken the position, at least for the diversification rule of Section 401(a)(35), that a stock quoted on a foreign stock exchange that is regulated by its local government will be treated as publicly-traded, even though the foreign exchange is clearly not registered under the '34 Act.

The IRS has invited public comments on the question of whether the final definition under Section 401(a)(35) should be applied to the four other ESOP requirements that use the term "publicly-traded." Some thoughts on the extension of the regulation follow:

Practical Considerations

Desire for Certainty in Legal Compliance. First and foremost, ESOP sponsors need to know whether they are subject to the requirements to arrange for an independent appraisal of the stock in the ESOP each year and whether ESOP participants must be given a "put option" in connection with ESOP benefit distributions of stock. For these reasons, it seems best to draw a bright line between what stock is and what stock is not publicly-traded. Moreover, a shareholder who intends to make a Section 1042 election in connection with a sale of stock to an ESOP needs to know with certainty that he or she is eligible to make the election.

The Two Value Problem. The "bright-line" approach could create some difficulty for an OTCBB company with a relatively liquid market by requiring it to obtain an annual stock valuation. The Company and the ESOP may believe that the quoted price for the stock properly reflects the stock's fair market value. Nevertheless, the Company's ESOP would need to obtain an annual valuation. Further, the exercise of a "put option" by a participant at a time when the market price is substantially lower than the prior year-end ESOP valuation could create difficulties for the ESOP and plan sponsor.

Coordination with the Adequate Consideration Definition. Section 3(18) of ERISA provides a definition of the term "adequate consideration" for purposes of determining whether a purchase or sale of stock by an ESOP is exempt from the prohibited transaction rules by reason of Section 408 of ERISA. Under Section 3(18) of ERISA, stock for which there is a "generally recognized market" can be bought and sold by an ESOP based on either: (1) the price prevailing on the Section 6 registered exchange on which it trades, or (2) if the stock is not quoted on a registered exchange, then at the bid/ask price established by "persons independent of the issuer." If there is no "generally recognized market" for the stock, then the Department of Labor proposed regulations require an independent appraisal to establish value. It is possible that an OTCBB quoted stock could have a "generally recognized market" if it is traded frequently, but would not meet the publicly-traded definition in the regulations proposed under Section 401(a)(35) of the Code. It would be helpful if the Department of Labor could coordinate its position under Section 3(18) of ERISA with any final regulations published by IRS.

We expect to work with the Legislative & Regulatory Committee of The ESOP Association to develop appropriate comments for the IRS on the Proposed Regulations.

House Ways and Means Proposes New Restrictions on S Corporation ESOPs

Sheppard Mullin — Thu, 29 Nov 2007 13:55:49 -0500

H.R. 3970 introduced by Hon. Charles Rangel on October 25, 2007, includes a Section 3701 that would add Section 409B to the Internal Revenue Code. The new provision would create an additional income tax on the holder of synthetic equity (as defined in Section 409(p)). The new rule would provide that when the holder "exercises" the synthetic equity, in addition to any taxable gain he may recognize from the exercise of the instrument, he must also recognize a new taxable amount. That amount is calculated by determining the amount of S corporation income the holder would have recognized each year, had he held actual stock instead of synthetic equity. In addition, once that amount of additional tax liability is calculated, Section 409B imposes an interest charge on the amount at the underpayment interest rates.

Under the proposed rule, it appears that the effective federal tax rates on employee stock options could exceed 100% and the rate on employee stock appreciation rights could exceed 70%. For warrant holders, the effective federal tax rate could exceed 80%. These effective federal rates do not include state income tax.

Here are three examples of how this would work.

Executive Compensation

Stock Options – Assume a company has $10 million in pre-tax income and the company is worth 5x income, or $50 million. It grants an employee an option to acquire 5% of its stock. The exercise price is set at $2,500,000, using the current FMV. Assume the company continues to earn $10 million per year for the next 5 years, and the company is worth $80 million at the end of 5 years. When the employee exercises his option, he is entitled to pay the $2,500,000 exercise price and receives $4,000,000 of stock (5% of $80 million). Under current law, he has ordinary income equal to the spread of $1,500,000 and, at a 35% effective federal tax rate, he owes $525,000 in federal income tax. Under the proposed law, he would also have to include 5% of the company's annual $10 million, or $500,000, in his taxable income. The $500,000 per year for 5 years is $2,500,000. At a 35% federal tax rate, he would owe an additional $875,000 plus the interest charge for the 5-year period.

The employee ends up with a $1.5 million economic gain in the option for which he pays $1,400,000 ($525,000 + $875,000) in income taxes plus the substantial interest charge (approximately $175,000 depending on interest rates).

Stock Appreciation Rights – Assume the same facts as above, except the company uses stock appreciation rights ("SARs") instead of stock options to compensate executives. The original strike price for the SAR is set at $2.5 million (5% of the $50 million company value). When the employee is eligible to exercise the SAR in 5 years, he is eligible to receive in cash the excess of $4 million (5% of $80 million) over the $2.5 million strike price. Under current law, he has ordinary income equal to the spread of $1,500,000 and, at a 35% effective federal tax rate, he owes $525,000 in income tax. Under the proposed law, the employee would also have to include up to 5% of the company's annual income of $10 million, or $500,000, in his taxable income for each of the 5 years the SAR is outstanding. The actual amount would be somewhat less because the proposed Section 409B appears to use the concept in Section 409(p) that the amount of synthetic equity owned by a SAR holder is equal to the fair market value of the spread in the SAR at a given time divided by the per share price of the company's stock. So, the SAR holder's share of the S corporation income in the first year might be relatively small, and would grow as the value of the SAR "spread" grows. Assume the value grows ratably over the 5-year period. The employee's portion of the S corporation's taxable income that would be subject to Section 409B over the 5-year period would be $1.25 million, determined as follows: $10 million (annual S corporation income) x 5 years x 5% (SAR ownership level) x 50% (reflecting ratable growth). At a 35% federal tax rate, the employee would owe an additional $437,500. With the $525,000 of federal income tax under current law, the liability on the $1.5 million profit would be $962,500 in income taxes plus the substantial interest charge (approximately $87,500 depending on interest rates).

Mezzanine Lender with Warrants –

Assume the same facts as above. In addition, X Corp agrees to lend the Company $10 million on a subordinated basis. The loan provides for 6% annual interest rate, plus a warrant to acquire 20% of the stock of the Company. The original strike price for the warrant is set at $10 million (20% of the $50 million company value). When X Corp is eligible to have its warrant redeemed by the Company in 5 years, it is eligible to receive in cash the excess of $16 million (20% of $80 million) over the $10 million strike price. This leaves X Corp with a $6 million economic value in the warrant. That amount would be subject to federal capital gains at 15%. Under the proposed law, X Corp would also have to include up to 20% of the company's annual income of $10 million, or $2 million, in its taxable income for each of the 5 years the warrant is outstanding. X Corp's portion of the S corporation's taxable income that would be subject to Section 409B over the 5?year period would be $10 million, determined as follows: $10 million (annual S corporation income) x 5 years x 20% (warrant ownership level). At a 35% federal income tax rate, X Corp would owe an additional $3.5 million in taxes plus the interest charge for the 5-year period. With the $900,000 or so of federal capital gains tax, plus the $3.5 million of new taxes, the liability on the $6 million profit would likely exceed $4.4 million. In addition, the warrant holder would owe approximately $700,000 in interest charges.

Timing Problems and Solutions for ESOP Diversification Elections

Sheppard Mullin — Tue, 20 Feb 2007 12:34:19 -0500

ESOP Diversification

The January 1, 2007 effective date of the new investment diversification rules for ESOPs with publicly traded stock got us thinking about the diversification rules that extend to companies whose stock is not publicly traded. These rules include some rather difficult timing requirements for most ESOP companies.

The Internal Revenue Code (“IRC”) requires that “Eligible Participants” be given an election to diversify up to 25% of their Company Stock Account balances each year during a five year “Election Period” and up to 50% of their Company Stock Account balance in the 6^th and final year of the Election Period. An Eligible Participant is one who is at least age 55 and has completed at least 10 years of participation in the ESOP.

The IRC requires that Eligible Participants be given an election to diversify during the first 90 days of the plan year. In addition, the IRC requires that any elections to diversify in the first 90 days be implemented, that is, the change in investment or the distribution, must occur, within a second 90-day period.

Two problems will arise for most ESOP companies:

First, the Company will likely not have completed its allocations for the prior year and the Trustee will not have received the new annual valuation from the appraiser before the end of the first 90-day period. So, an election form that is sent to Eligible Participants asking for their investment instructions will not inform them of: (a) the number of shares eligible for the diversification election, or (b) the fair market value that will be used to convert shares to cash. Two critical pieces of information needed for an informed decision!

Second, a significant number of ESOP companies will not have completed their annual valuations even by the end of the second 90-day period, and will not be able to convert electing participants’ accounts to cash in time to meet the second deadline.

What to do?

Let’s say your calendar year company’s December 31 valuation is not ready until July 15 of the following year. You’ve sent the first revocable notice out as described above. Now, the Company sends a second notice out around July 31, giving participants 30 days to elect a distribution. The ESOP is now in technical violation of IRC 401(a)(28)(B). For a possible solution, we look to the IRS correction program, known as the Employee Plans Compliance Resolution System ("EPCRS"). EPCRS provides taxpayers with the ability to self correct qualification defects in their plans without risking loss of the plan’s tax-qualified status under Section 401(a) of the IRC.

The correction principles of EPCRS would first look to place participants into the position they would have been in had the qualification defect not occurred. That is, as if the company had followed the terms of the ESOP plan document requiring implementation of elections by June 30^th (for a calendar year company). Since the company’s stock value is determined only once per year, the amount of the distribution the participant should have received on or before June 30^th is the same as the actual distribution he received on August 31^st. One could argue that the only additional action required of the company is to provide the participant with the lost earnings opportunity for the period from July 1^st to August 31^st. While EPCRS does not specifically address, the situation, it does provide guidance on determining lost earnings for other purposes.

EPCRS does not provide a complete solution, because EPCRS looks to address inadvertent or unintentional errors that occurred for a plan, despite the plan having in place adequate procedures to guard against such errors. In the case of ESOP diversification, the IRS might take the position that the lateness of the election is not inadvertent or a violation of the plan’s regular operating rules. The good news, however, is that the violation does not appear to be one that is specifically excluded from EPCRS. For example, EPCRS specifically states that it is not available for egregious violations, such as for a plan that is providing excessive benefits to the highly compensated employees.

Conclusion

The first timing problem identified above can readily be addressed by using a two-step revocable election form process. The second timing problem can also readily be solved by completing the stock valuation within the first 4 to 5 months of the new year. For companies unable to work within that time frame, the ESOP company can look to the EPCRS model for a workable resolution. Perhaps, given the commonality of this problem, the IRS will one day provide additional guidance to ESOP companies.

Thoughts on the Final 409(p) Regulations

Sheppard Mullin — Mon, 05 Feb 2007 17:58:25 -0500

In December, the IRS published in final form the long-awaited regulations (“Final Regs”) under Internal Revenue Code (“IRC”) Section 409(p). These regulations were first published in proposed form in 2003, and then again as proposed and temporary regulations in 2004. The Final Regs largely follow the 2004 temporary regulations. We thought it would be helpful to discuss the issues the IRS considered in finalizing the regulations and the conclusions reached. In a future ESOP Blog, we will explore some of the difficult and unresolved 409(p) issues that remain in the Final Regs

I. Threat of Plan Disqualification

The Final Regs really bring the hammer down on a 409(p) violation. In addition to the onerous 409(p) related excise tax for the plan sponsor and the ugly income inclusion problem for the employee, the Final Regs make clear that a 409(p) violation will constitute a qualification defect under IRC Section 401(a). The IRS takes the position that operating a plan in violation of its terms is a disqualifying event. As a result, the IRS adds plan disqualification to the list of negative consequences of a 409(p) violation.

As the Final Regs point out, if the ESOP is disqualified, then it becomes a trust that is not an eligible shareholder for S corporation purposes. So, in addition to having to pay penalties associated with the loss of qualified plan status, the Final Regs make clear that the S corporation sponsor will lose its S corporation tax benefits.

Any silver lining? Since the IRS will treat the 409(p) violation as a qualification defect, the defect should be correctable under EPCRS (the IRS voluntary correction program). Under EPCRS, the IRS will not waive an excise tax. However, the IRS would have the authority to negotiate over the income inclusion suffered by the disqualified person (“DQP”), as well as the retroactive restoration of the ESOP's qualified status, which would retroactively restore the S corporation status. I guess that's more of a brass lining than silver.

II. 409(p) Avoidance Methods – Profit Sharing Plan Transfer Clarified

The proposed regulations provided that a 409(p) violation could be avoided if an ESOP transferred sufficient shares to a non-ESOP portion of the plan. However, the shares then held in the non-ESOP would be subject to the Unrelated Business Income Tax (UBIT). The tax from this approach could be an acceptable expense in some cases. It seems the IRS position is that the ESOP cannot merely provide for an automatic transfer of ownership of shares when a problem is detected after the close of the plan year. The Final Regs state that any such transfer of shares must be " . . . effectuated by an affirmative action taken no later than the date of the transfer . . " While the IRS is clearly not satisfied with plan language triggering an automatic transfer of stock, ESOP plan sponsors should consider the possible benefits of such a provision in the event a 409(p) violation is not detected until after the close of the plan year.

III. Reshuffling Slammed Down

The Final Regs appear to have killed the use of "targeted reshuffling" to solve a 409(p) violation. Practitioners had hoped that the IRS might permit an ESOP to convert a portion of a participant's stock account to other investments before a nonallocation year occurs. The IRS has taken the position that such targeted investment conversion would likely result in impermissible discrimination in favor of highly compensated employees. By converting the company stock account of an HCE into other investments, the HCE would be getting an investment opportunity that the non-HCEs could not have.

IV. IRS Suggests Alternatives to Targeted Reshuffling

While the folks from IRS shot down targeted reshuffling, they did suggest some alternatives. First, they suggest that HCEs who are, or are at risk of becoming, DQPs could just be cut out of new allocations for the year. This method won't be popular with senior folks at most companies who are impacted. In addition, this approach may not be sufficient to solve a problem that is being driven by synthetic equity build up. Second, the IRS suggested making disproportionately large contributions for just the non-HCEs who are not DQPs. Again, a nice egalitarian solution but it could be unpopular with senior folks who will perceive a hit to their benefits.

Finally the IRS suggests "mandating diversification" under IRC Section 401(a)(28)(B). The preamble to the Final Regs seems to say that an ESOP could force the diversification of the account of a participant who is eligible to diversify (that is, participants who are age 55 with at least 10 years of ESOP participation). However, a forced election is clearly not intended. It appears that the IRS intended to suggest simply that a "reshuffling" or "rebalancing" of the ESOP through cash contributions to the ESOP would be an acceptable means to reduce the amount of company stock in the accounts of DQPs or potential DQPs. So, while IRS is clearly opposed to targeted reshuffling, a reshuffling approach that treats all participants' accounts equally would be acceptable.

V. Family Attribution and Deferred Compensation Plans

The Final Regs provide some clarification on the application of family attribution rules under 409(p). In a future ESOP Blog, we will consider these rules in detail. For now, let us say that you will need to drill down into these rules if you have in-laws. (pun intended). The IRS also tinkered with the 3-year calculation rule for deferred comp plans but refused to provide guidance on what would be a "reasonable" discount rate for calculations.

VI. Right of First Refusal

The Final Regs except from the definition of synthetic equity a right of first refusal held by a shareholder over shares owned by the ESOP. To qualify for the exception, the right of first refusal must have terms that meet both the ESOP loan regulations and the S corporation second class of stock rules.

Sheppard Mullin Announces New ESOP Blog

Sheppard Mullin — Thu, 19 Oct 2006 08:26:17 -0500

We are pleased to announce that Sheppard Mullin and Larry Goldberg have launched a new blog on Employee Stock Ownership Plans (ESOPs). You can access it at http://www.esoplawblog.com. A blog is an online web journal. You will now be able to access up-to-date information on ESOP Law.

ESOP Blog updates will come from updates@esoplawblog.com. You may wish to enter this address into your spam filter so that you will continue to receive notifications when new content is posted. If you do not wish to receive e-mail updates when new content is posted to the Blog, please let us know by clicking the "Unsubscribe" link below. We apologize for any confusion caused by an email sent to you yesterday.

We hope that this Blog is useful to you. If you know others who might like to be added to our distribution list, please forward the link to them so they can subscribe online. Thank you.

Pension Protection Act of 2006 ("PPA")

Sheppard Mullin — Tue, 17 Oct 2006 20:00:00 -0500

While you may have already seen general descriptions of the PPA, this ESOP Blog focuses on the PPA provisions that relate to ESOPs, and provides some planning considerations for ESOP companies.

1. New, Faster Vesting for ESOPs – Contributions made to a defined contribution plan for plan years beginning after December 31, 2006 will now be subject to an accelerated 3-year "cliff" or 6-year "graded" vesting schedule. These alternatives replace the existing 5-year cliff and 7-year graded alternatives.

Special ESOP transition Rule – For an ESOP which had a loan outstanding on September 26, 2005, which was used to acquire employer stock, the new, faster vesting rules will not apply until the earlier of (a) the date the loan is fully repaid or (b) the date the loan was (as of September 26, 2005) scheduled to be fully repaid.

ESOP Planning Note – ESOP sponsors will want to review their outstanding loan documents to determine the first year in which the new vesting schedules will apply. Also, employers do not have to keep two sets of vesting records, and may choose to apply the new vesting rules to all ESOP shares, including amounts contributed prior to 2007.

2. 401(k) Auto Enrollment – A new safe-harbor for the ADP and ACP test is created for plans that meet 3 requirements: (a) automatic enrollment for salary deferrals; (b) matching or non-elective contributions and (c) notice to employees. The automatic deferral requires a deduction of salary of 3% in the first year, 4% in the second year, 5% in the third year and 6% thereafter. This only need apply to new 401(k) Plan participants. In addition, the matching requirement is 100% on the first 1% of deferrals and then 50% on the next 5% of deferrals for all eligible non-highly compensated employees. As an alternative to the match, a non-elective contribution of 3% of compensation can be made for all eligible employees. These safe harbor contributions must fully vest after two years of service. The notice requirement is similar to the existing safe harbor match notice, and must explain how the contributions will be invested and the participant's right to elect to not participate. The new safe harbor is effective for plan years beginning after December 31, 2007.

ESOP Planning Note - If your ESOP is currently being used to meet the 401(k) safe harbor, you may wish to consider switching to the PPA safe harbor in order to use the two year vesting schedule and avoid the immediate full vesting required under current law. Depending on deferral patterns in your 401(k) plan, the new PPA safe harbor may save you money on your company match.

3. Expanded Diversification For Employer Securities –

First thing to know: the expanded diversification election does not apply to an ESOP or a profit sharing plan that invests in employer stock if the employer's stock is closely-held. In addition, ESOPs are excepted from the new diversification requirement even if the employer's stock is publicly traded if: (a) the ESOP does not have contributions that are subject to 401(k) or matching contribution rules and (b) the ESOP is a stand alone plan.

The new rule generally applies to: (a) 401(k) salary deferral contributions, matching contributions and discretionary employer contributions; (b) that are invested in employer stock in a profit sharing plan ; and (c) the employer (or a member of its controlled group) has outstanding a class of stock that is publicly traded.

Slightly gray area: The new diversification rule applies to an ESOP that has a 401(k) feature, but it is unclear if it applies to an ESOP which merely accepts a transfer of 401(k) salary deferral contributions. Employers who previously converted their 401(k) Plans to ESOPs to qualify for the dividend deduction under Section 404(k) should check their plan terms to see if they are exempt from the new diversification rule.

What is the new rule? The defined contribution plan must permit immediate diversification of all salary deferral contributions invested in employer stock. For matching contributions (or any discretionary employer contributions) invested in employer stock, diversification is required to be offered after the participant has at least three years of service. Notice must be given to participants 30 days prior to the date on which they will have the right to divest employer stock.

Transition Rule - (1) Employee's Salary Deferral Contributions – If invested in employer stock, there is no transition rule. Diversification is effective in the first plan year beginning after December 31, 2006.

(2) Company Contributions – For employer stock acquired by the plan prior to January 1, 2007, the new diversification election is phased in 1/3 per year in 2007, 2008 and 2009. However, for a participant who had attained age 55 and completed 3 years of service before the first plan year beginning after December 31, 2005, this transition rule does not apply and the new diversification rule is effective in the first plan year beginning after December 31, 2006.

4. Benefit statements – Benefit statements must now be distributed at least annually. ERISA did not previously require an automatic annual statement. Most ESOP companies have provided automatic annual statements anyway. In addition, the new law requires quarterly statements if the participant can direct the investment of his account. ESOPs that have satisfied the age 55 and 10 years of participation requirement by creating investment funds in the ESOP will be subject to this rule. This new quarterly notice must also provide investment information on diversification strategy. The benefit statement rules apply for plan years beginning after December 31, 2006.

5. Bonding – The fidelity bond maximum is increased from $500,000 to $1 million. This requirement is only for Plans holding employer securities. It is effective for plan years beginning after December 31, 2007. We suppose Congress was especially concerned with fiduciaries running off with stock certificates in closely-held companies. (Hard to pay your bills while on the lam with those illiquid stock certificates!).

6. Permits in-service distributions from pension plans after age 62 – For ESOPs that have included a money purchase pension feature (MPP), in-service distributions prior to normal retirement age have been impermissible under ERISA. Under the new law, beginning in 2007, in-service distributions may be made from a MPP so long as the participant has attained at least age 62. This may be useful to MPP ESOPs, particularly in connection with the implementation of diversification elections where some of the funds to be distributed would have come from the MPP account.

Authored by:

Larry Goldberg

(415) 774 2927

lgoldberg@sheppardmullin.com