Freeze Share Value for Term'd Employees?

[SadieJane]

A client claims that some ESOPs freeze the share value on termination of employment for the terminating participant. That participant's share value/account balance would not change in the future, regardless of how long the participant waits to receive distribution. There would also be no interest credit or any other adjustment to the account balance at termination. The purported rationale is that a terminated participant should neither share in the upside of future stock increases nor bear the potential risk of share price decline in the future.  I can find nothing on this. Seems dubious to me. Has anyone heard of this? 

[Paul I]

I have had clients comment that it seemed unfair for terminated participants to benefit from future increases in share value since the terminated participants were not adding value to the company.  Almost all of them put in place a mechanism to replace the shares of terminated participants with cash.  The rest have gone the route of replacing the shares with a secured note.  I have not heard anyone just freezing the price.

Keeping shares in the accounts of terminated participants but not allowing the share value to fluctuate is treating these shares differently from the shares held in other participants' accounts.  This sounds to me like a problem.

Assuming the shares are not publicly traded, it would be interesting to see if the independent appraiser has commented on this policy.

[MoJo]

Fundamentally, not allowing a participant to share in future growth in the INVESTMENTS held in the plan would be a serious fiduciary breach.  We can have all kinds of discussion about what contribution any OWNER of a company makes to it's on-going success (and I can assure you I make no contribution whatsoever to AAPL's success - don't use it's products at all, but still own shares and there is value to them in using my "capital") but all of that becomes irrelevant in the context of plan.  The trustee MUST make the assets productive.  Now, I've seen ESOPs where by the corporate by-laws only current employees can be shareholder or beneficial shareholders (engineers, doctors, lawyers, accountants, etc.) where usually by law only licensed individuals can ne owners of a practice requiring their license, so that is a possible exception.  In any event, just to "freeze" the share price or to put them in a non-productive investment in my mind is buying a lawsuit - and one that could be costly....

[EBECatty]

This is very common in private-company ESOPs. As Paul notes, typically the shares are replaced with cash. Once replaced, the participant generally is offered various investments (other than employer securities). 

There's IRS guidance on common issues that arise in the arrangement: 

Response to Technical Assistance Request (#4) (irs.gov)

[Degrand]

Segregation is common only when the stock is replaced with cash.  The cash will need to be prudently invested. If you question is whether a company can keep a terminated employee invested in shares and freeze their value to a set price, there is no legal way to accomplishing that result.  Stock held in an ESOP is required to be valued at least annually.  

[ESOPMomma]

Degrand is spot on.  If the plan sponsor does not want former participants to share in the increase or decrease in the value of the company's stock, then it must liquidate those shares via segregation (replacing the shares at the most recent FMV) with cash assets that are prudently invested.  As long as a participant has shares of stock in their ESOP account, those shares must be subject to the required valuation process. 

[ESOP Guy]

Someone out there must be saying this.  This is the 2nd time I have heard someone say, "I just heard I can freeze the value of the ESOP account to the value of the year they terminated" in about a week.   And I doubt my client is coming here to get a 2nd opinion after I talked about segregation.  

I don't know who is doing this but I am prepared to slap them upside of the head. 

The replies capture the correct answer.  

[QDROphile]

Long ago, a big name, but very aggressive, ESOP consulting/promoting company sold a design (and related services) that provided for terminated employees to keep their share-designated ESOP accounts, but instead of investment results of share ownership, the accounts got a fixed rate of return (I recall something like 3%), which was a way of limiting participation in post-employment appreciation because the company was “sure” of appreciation of 6% or more). The accounting got pretty wacky if your perspective is hidebound by compliance with applicable rules and conventions.  The IRS gave determination letters on the plan documents, but the neither the IRS nor the DOL approved the concept in practice (among other things it is inconsistent with the definition of a DC plan) as far as I know and I have seen the operation challenged by the authorities as well as litigants. Never have I seen it vindicated by any agency or court. 

[QDROphile]

I also approve of dope slapping, in addition to slapping with a class action lawsuit.

[Peter Gulia]

Do we concur that someone in the circumstances SadieJane describes should give one’s client correct information, then let the client decide what it will do?

Or is there anything else a practitioner ought to do?

[Nate S]

2 hours ago, Peter Gulia said:

Or is there anything else a practitioner ought to do?

we all safeguard our industry, to the extent bad information is being promulgated, it should be traced and if possible re-educated.  I've had clients/referral sources come to me with strange/bad ideas and been able to correct them before it went further.  Other times I've read articles/trustee minutes/investment committee reports and asked our sales group to make contact and setup meetings with the author.  If widespread it became a topic in our client/advisor newsletter.  This just sounds like a misunderstanding/over-simplification of segregation, but it gains traction in this abrogated form then someone at NCEO, ASPPA, or ESOP Association should be made aware of the issue.

[Roycal]

From quite a long time ago, when I was an "ERISA attorney," I recall running into a situation where a client had bought an ESOP plan product from a company that specialized in selling ESOPs with this sort of feature.  Although I don't recall the details, I do remember that a "mess" had arisen, which is why the employer came to me.  I contacted the ESOP product provider and questioned the design, which they admitted was, possibly, over the line.  I in turn sent the employer back to ESOP provider for a solution.  I didn't see the sense in my trying to help them out of what I thought was an impossible situation.  This was well before the technical advice mentioned above, and even before the diversification option was enacted, I'm pretty sure.  Did I do the right thing?  (Don't answer that.)  I never heard from the client again.  I've always wondered why the IRS and/or DOL didn't pay attention to some of weird things going on in the ESOP world.  Buyer beware.