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Termination of Leveraged ESOP before the loan is paid off.


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An employer established a leveraged ESOP. The loan was for 15 years. After 10 years, the employer merely desires to terminate the ESOP. Does the employer have a PT problem under 4975(d)(3)? Assume that the employer is not in any financial trouble nor has any acquisition transaction occurred.

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The big issue is what will happen to the unallocated ESOP suspense account shares. The employer cannot unilaterally decide to "unwind" the ESOP loan, even if the ESOP is terminated. An ESOP fiduciary, who is acting independently on behalf of the ESOP participants, must agree to the "unwinding" process. It's important to review the terms of the ESOP and the ESOP loan documents in this regard. How much of the suspense account shares will be "released" and allocated to ESOP participants' accounts, etc. ?

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Then why would an ESOP fiduciary agree to now pay off the loan using the suspense account shares?

With five years left under the ESOP loan, there may be potential for significant increase in the value of the suspense account shares. This could provide additional value for ESOP participants even if the employer decides to terminate the ESOP and make no additional contributions.

Also, do the terms of the ESOP or the ESOP loan documents include a commitment by the employer to make contributions to the ESOP sufficient to allow the ESOP to make loan payments?

The ESOP must be compensated if it agrees to "unwind" the loan prematurely. Otherwise, the participants are losing the opportunity for the accumulation of additional ESOP benefits. There are significant problems here. An independent fiduciary should be engaged to represent the ESOP.

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RLL:

Would you feel that an independent fiduciary would be necessary [/i] (as opposed to being merely advisable) if the employer were to pay a big premium over what the stock is currently worth? For example, assume that the ESOP bought the stock for $10, but it is only worth $3 today. What if the employer were willing to cancel the entire debt of $10 per share if the plan surrendered the stock currently worth only $3 per share. Would you still feel an independent fiduciary is necessary or is merely advisable under these facts?

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Hi Kirk!

Your proposal may eliminate the need for an independent fiduciary. But it raises a significant Section 415© problem. As you know, under the 415© regs., the IRS reserves the right to recharacterize a transaction between an employer and a plan to generate "annual additions." A "purchase" of employer stock by an employer from its ESOP at a price substantially in excess of current fair market value certainly may be vulnerable to such recharacterization.

A way to avoid that result may be to have the deal negotiated by an independent fiduciary on behalf of the ESOP, rather than having the employer propose the transaction which you describe.

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If the employer is under no obligation to make contributions, why can't it just stop contributing and foreclose on the loan (assuming that the ESOP doesn't hold a majority of the voting rights)?

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Under both the DOL and IRS Regs on ESOP loans, a party in interest (or disqualified person) may not foreclose on an "accelerated" basis against the employer stock held as collateral for an ESOP loan. Foreclosure would be limited to the value of shares equal to the current amount due under the loan (prior to acceleration upon default). Accordingly, it may take as long as five years under these facts for the employer to fully "unwind" the ESOP loan unless the ESOP fiduciary agrees to some other arrangement.

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While the IRS can be unpredictable, I think that the likelihood of an imputed annual additions challenge is slim, in my particular situation.

Before the transaction, the ESOP had stock worth $3 burdened with a debt of $10 per share. Afterwards, the ESOP had nothing (attributable to those shares). This is very different from the situation where the employer pays too much for the stock and the excess cash proceeds get allocated to participants' accounts.

In that regard, I think two points are worth noting. First, the employer could have written down the debt to $3 per share. That would certainly mitigate the imputed annual additions problem. Second, if the employer had actually contributed the $3 per share to the plan, that would have definitely caused annual additions in that amount, but the participants would have received stock equal to that amount. In my situation they receive nothing (attributable to those shares).

Also, while I agree that having an independent fiduciary negotiate the arrangement minimizes the risk of imputed annual additions, I don't think that the presence of the independent fiduciary completely eliminates it.

As a result of good negotiating position, it is possible that an independent fiduciary could get the employer to pay more than the fair market value of the stock. I have seen that happen before.

[This message has been edited by Kirk Maldonado (edited 05-01-2000).]

[This message has been edited by Kirk Maldonado (edited 05-01-2000).]

[This message has been edited by Kirk Maldonado (edited 05-01-2000).]

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Kirk.....

Why would an ESOP fiduciary agree to a "write-off" of the loan in exchange for the shares? The ESOP participants would get nothing!

Under these circumstances, the ESOP would be much better off waiting to see what happens to the value of the stock over the next five years. Why accept the equivalent of $-0- today? The write-off of the loan does nothing for the participants unless the employer agrees to give something in return.

The "burden" of $10/share debt does not affect the participants'accounts....they benefit only if the debt gets repaid AND shares are released and allocated to accounts. A repayment using only the value of the suspense account shares does not release shares and does not at all benefit participants. How can any fiduciary agree to that under ERISA Section 404(a)(1)?

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RLL:

I think that you are assuming that, as is usually the case, the employer is obligated to make contributions to the plan to amortize the loan. However, I've seen many ESOP transactions where the employer did not undertake any such amortization obligation.

If the employer is not obligated to and does not make any additiopnal contributions, the rest of the shares will not be released (at any time). Thus, in this case, the participants would not receive any additional shares.

Accordingly, in this situation, whether the plan is terminated currently or kept alive on life support, the employees do not get any more allocations.

However, when the shares are sold for the amount of the debt, the plan can be terminated currently. Otherwise, in most situations, the plan will need to be continued until the expiration of the loan repayment period.

The ability of participants to receive a distribution in the near future, as opposed to having to wait at least 5 years in the future, seems to be in the interest of the employer.

Also, in most of these situations that I've been involved in, the employer's financial (and perhaps physical) health is deteriorating, often at a rapid pace. Shutting down the ESOP now, while the stock still has some value, may be more favorable to the participants than waiting for five years, at which time the employer may be insolvent so that participants get nothing for the shares in their accounts.

To say the very least, these are not pretty pictures. However, sometimes you have to try to salvage something for the participants. Simply terminating the plan and accelerating the repurchse obligation is a benefit to the participants. The financially strapped employer would prefer not to expend its scarce financial resources buying its stock back from the ESOP participants. The employer would rather gamble, hoping that either (1) the situation will improve, so that it will be in a better position to fund the repurchase obligation, or (2) the employer goes bankrupt, so that the repurchae obligation goes away entirely.

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I'll let you in on a few more facts: (i) Leveraged ESOP owns publicly traded common stock so that FMV is determinable, (ii) under the plan, trust, loan agreement, note, pledge agreement and other related documents, the Employer has no affirmative obligation to contribute to plan, (iii) in accordance with documents, Trustee is under NO obligation to pursue contributions, (iv) recitals to plan document state LESOP is to assure availability of stock for EEs, and (v) loan, pledge and note do provide parenthetically that the right to "earnings" attributable to collateral may include proceeds from sale of stock to the extent permitted by law.

Any additional thoughts?

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If the ESOP fiduciary does not agree to "give back" the pledged shares, the employer can recover them only over the 5 year remaining term of the loan as payments are due and not made by the ESOP. If the shares appreciate in value over that period, there will be shares remaining after the repayment of the loan in full. Those shares will then be allocated to participants accounts.

There is no benefit to the ESOP participants to currently repay the ESOP loan with all the remaining pledged shares. That action would assure that none of the shares will get allocated, while waiting and "losing" the shares over the 5 year period at least creates the potential for additional benefits.

Under these circumstances an ESOP fiduciary is certainly violating ERISA by giving up the potential appreciation in value of the remaining pledged shares in exchange for satisfaction of the ESOP's non-recourse debt (which nets nothing for the participants).

Mr. Maldonado must be certain that there will be no appreciation in value of the employer stock over the 5-year period. Otherwise, he is willing to give up potential participant benefits for nothing...a result that cannot be justified under ERISA's fiduciary rules. Or maybe he thinks that no one will ever find out.

This situation begs for an independent fiduciary who can negotiate with the employer for a deal that's satisfactory to both the employer and the ESOP.

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In response to RLL, I agree that if the stock does appreciate, then the fiduciary would be vulnerable to criticism using 20-20 hindsight.

However, the other opposite scenario needs to be considered. If the employer goes bankrupt before the end of the term of the loan, the participants get nothing. In this situation, the participants would have been better off if the stock had been sold in satisfaction of the debt, and the ESOP terminated at that time. At least they would get the value of the shares that were allocated to their accounts at the time of the termination of the ESOP, which is better than what they would get if the ESOP is continued and the employer goes bankrupt (i.e., nothing).

I guess my position isn't quite as different than RLL's than might appear at first. For one thing, I don't disagree that it is best to use an independent fiduciary in these circumstances. My quarrel is that I can rationalize a fiduciary deciding to sell the stock held by an ESOP sponsored by an employer that is rapidly imploding.

In my scenario, in exchange for agreeing to sell the stock in satisfaction of the debt, the ESOP participants get (1) full vesting and (2) payment of the fair market value of the stock at that time. Given the fact that it is entirely possible that the employer may go bankrupt before the loan would otherwise be paid off, I think it is better to get something for the ESOP participants (by terminating the ESOP now) rather than having them be exposed to the real risk that they may lose everything if the employer goes bankrupt.

Finally, I want to emphasize that the facts that I am positing are quite different than the original message posted here.

[This message has been edited by Kirk Maldonado (edited 05-02-2000).]

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