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Guest Article

Deloitte logo

(From the October 28, 2002 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

PWBA Issues Guidance on Refinancing ESOP Loans


An ERISA fiduciary's obligations with respect to deciding whether to refinance an ESOP securities acquisition loan is the subject of the Pension and Welfare Benefits Administration's first Field Assistance Bulletin, FAB 2002-1. The FAB is a new compliance tool that PWBA will use to make public the technical guidance it provides to its field enforcement staff. FAB 2002-1 is available on the PWBA's Web site, at www.dol.gov/pwba.

ESOP loan refinancings-- which became a high-profile topic during the late 1990s due to rising stock prices-- raise a number of tax and ERISA issues. The Internal Revenue Service has addressed many of the tax issues, including the Internal Revenue Code's prohibited transactions provisions, in a series of private letter rulings. See, e.g., PLR 9704030 (October 31, 1996). However, FAB 2002-1 is the PWBA's first public guidance on the relevant ERISA issues.

Background on Leveraged ESOPs

An employee stock ownership plan (ESOP) is a defined contribution pension plan that invests primarily in the sponsoring employer's stock. In general, a leveraged ESOP is one that borrows the money needed to purchase the employer stock, either from the employer or a third-party lender. (If the plan borrows from a third-party lender, the employer often guarantees the loan.) The lender uses the stock as collateral for the loan.

Leveraged ESOPs use suspense accounts to hold shares while they are subject to the lender's security interest. Each time the plan makes a loan payment, the lender releases its security interest on a proportionate number of shares, and those shares are then allocated to participants' accounts. For example, if the loan is secured by 100 shares of stock, and the loan (plus interest) is to be repaid in 10 equal installments, then each payment causes the lender to release its security interest on 10 shares.

Usually, these loan repayment schedules are designed so that stock will be released from the ESOP suspense account-- and thus allocated to participants' accounts-- according to a schedule that roughly coincides with a certain level of benefits. However, the release and allocation schedule may cease to coincide with expected benefit levels if, for example, the value of the employer's stock significantly increases or the number of participants significantly decreases before the loan is repaid.

ESOP Refinancings

A number of ESOP plan sponsors have responded to this problem by refinancing the plan's loan. The new loan usually has a longer repayment schedule, causing the stock to be released from the suspense account at a slower pace-- a pace that, due to the change in circumstances, is more in line with intended benefit levels.

However, a plan fiduciary must consider several ERISA issues before agreeing to accept a plan to refinance the ESOP's loan. For example, ERISA's basic fiduciary standards require fiduciaries to discharge their duties solely in the interest of the plan's participants and beneficiaries. ERISA sec. 404(a)(1)(A). Additionally, ERISA fiduciaries must act with the care, skill, prudence, and diligence under the prevailing circumstances that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. ERISA sec. 404(a)(1)(B).

ERISA also places specific limits on the uses of plan assets. Specifically, an ERISA plan's assets can never inure to the benefit of any employer and must be held for the exclusive purpose of providing benefits to participants and beneficiaries and defraying reasonable expenses of administering the plan. ERISA sec. 403(c)(1). ERISA plan fiduciaries also may not cause the plan to engage in certain prohibited transactions. In particular, "A fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect ... lending of money or other extension of credit between the plan and a party in interest." ERISA sec. 406(a)(1)(B). A party in interest is almost anyone connected with the plan, including the plan sponsor.

There is a specific exception to the ERISA sec. 406(a)(1)(B) loan prohibition for ESOP loans. Under ERISA sec. 408(b)(3), the loan prohibition does not apply to "A loan to an employee stock ownership plan ..., if-- (A) such loan is primarily for the benefit of participants and beneficiaries of the plan, and (B) such loan is at an interest rate which is not in excess of a reasonable rate. According to DOL regulations, whether a loan satisfies the "primary benefit" requirement is a facts and circumstances determination. See DOL Reg. Sec. 2550.408b-3(c)(1).

How Can ERISA Fiduciaries Cause the Plan to Engage in ESOP Refinancings Without Violating These Requirements?

If the ESOP refinancing satisfies the "primary benefit" requirement, the FAB indicates the fiduciary's obligations under ERISA 404(a) typically would be satisfied as well. The fiduciary bears the burden of establishing compliance with these requirements. The question, of course, is how to comply.

According to FAB 2002-1, before causing an ESOP to engage in a refinancing, an ERISA fiduciary must at a minimum "make a careful assessment of the costs and benefits conferred upon the ESOP and the likely consequences of a failure to refinance, and ensure that the transaction is 'arranged primarily in the interest of participants and beneficiaries.'" If the refinancing is designed to slow down the rate at which stock is allocated to participants' accounts, FAB 2002-1 says the fiduciary must "assess the extent to which the refinancing is consistent with the documents and instruments governing the plan, including loan and related agreements." Further, the fiduciary should "assess the extent to which such an extension is consistent with the reasonable expectations of the plan's participants and beneficiaries, as might be determined by reference to the plan's summary plan description or other disclosures relating to the funding and benefits of the plan."

In many cases, the plan sponsor will benefit from an ESOP refinancing. However, the FAB admonishes, the fiduciary deciding whether to engage in the refinancing must act with "undivided loyalty" to the plan's participants and beneficiaries in order to satisfy ERISA sections 404(a)(1)(A) and 408(b)(3). Thus, the fiduciary must analyze the costs and benefits of the transaction and agree to go forward only if--

  • the fiduciary reasonably concludes the transaction is advantageous to participants and beneficiaries; and

  • the terms of the refinancing are at least as favorable as an arm's-length transaction between independent parties.

In order to ensure that the primary benefit requirement is satisfied, the plan sponsor might offer any of a number of inducements to the plan to engage in the refinancing. Examples include:

  • making a commitment that shares held in the suspense account will not be used to repay any outstanding loan balance if the ESOP is terminated ("event protection");

  • providing additional diversification rights for participants;

  • increasing the matching contribution; and

  • paying a "dividend make-whole" to compensate participants and beneficiaries for increased use of dividends for loan repayment.

The presence of any (or all) of these and other inducements is not, in and of itself, dispositive with respect to the primary benefit requirement.

A particularly important issue, according to the FAB, is whether the plan sponsor has made an enforceable commitment to make all of the contributions needed to retire the loan. If so, the plan sponsor may have a great deal to gain from the refinancing unless it is providing additional inducements to the ESOP to accept the transaction.

With respect to an ESOP fiduciary's duty of impartiality to all of the plan's participants, in an ESOP refinancing decision-making process, the FAB states, "the fiduciary cannot satisfy the duty of impartiality solely by considering the asserted benefits of the refinancing to future participants (e.g., more generous benefits in later years than the employer would otherwise provide), but must also consider the interests of current participants and beneficiaries." The fact an ESOP refinancing might be a good deal for future participants must be weighed against the sacrifices being made by current participants.


Deloitte logoThe information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances.

If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094).

Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207.

Copyright 2002, Deloitte.


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