RLL

Kirk --- Please confirm that the sale by a shareholder to the ESOP, rather than by the issuer (employer), does not prevent use of Rule 701. Isn't it also possible that the intrastate exemption under the '33 Act will be available if all the participants reside in the state where the employer is located? By the way, isn't there a policy here against "shameless self-promotion" ? Especially for message board guides!

Not a problem so long as there are no partipant contributions (inc. 401(k) elective contributions) or investment elections. It's likely that the sale will qualify under the private placement exemption, as the purchaser is the fiduciary that makes the ESOP's investment decision. Kirk probably knows the specifics, citations, etc.

Dawn ---- IRC Section 1042 requires a sale by the shareholder directly to the ESOP. If the shareholder sells to the employer, which then sells the shares to the ESOP, the sale does not qualify for the 1042 tax-deferred election.

I think Kirk is overstating the risks in permitting participants to direct the investment of their 401(k) elective contributions into closely-held employer stock. The risks can be minimized (1) by using one or more experienced, qualified appraisers to determine the fair market value of employer stock; (2) by having an independent fiduciary monitor the periodic investments in employer stock; (3) and by providing participants with sufficient disclosure appropriate to comply with both ERISA standards and federal/state securities laws requirements. Note that an independent appraisal will be required as of each date (not just annually) on which employer stock is purchased by the ESOP from the employer or another party in interest. If it's important to the employer and the participants to have an employer stock investment option in the 401(k)/ESOP, the employer and ESOP fiduciaries may want to proceed on this basis. It's very easy for advisers to just say "no" when they have pre-conceived notions as to ERISA fiduciary risks. Why not be more objective and show the client how to do what they want in a risk-minimizing manner and then let the client decide whether or not to proceed?

An employer clearly may make cash contributions to an ESOP if the provisions of the ESOP plan documents permit cash contributions. I don't know where the Internal Revenue Code or regulations specify that this is permissible....it is so obvious that I've never looked for it. However, there may other agreements (such as loan covenants) that limit or restrict the employer's ability to make cash contributions to the ESOP. The ESOP plan documents may require or permit the appropriate ESOP fiduciary to use cash contributions from the employer to make benefit distributions to participants. There may be circumstances, however, when it could violate ERISA fiduciary responsibility for an ESOP fiduciary to use cash contributions for benefit distributions. For example, using cash contributions allocated to all participants for making cash distributions with respect to employer stock allocated to a few participants may involve a fiduciary decision equivalent to buying shares of employer stock for the remaining participants.....which sometimes may be imprudent. Note that the ESOP fiduciary may be able to distribute benefits in shares of employer stock. If the stock is not readily tradable, it is the obligation of the employer, not the ESOP, to offer a put option and make cash available to the distributee. Under a DOL class exemption from the prohibited transaction restrictions, it is permissible for an employer to make an interest-free loan to an ESOP to fund benefit distributions....so long as the appropriate ESOP fiduciary agrees to receive such a loan. Whether it is prudent at any particular time to use this alternative method for funding benefit distributions depends on the then prevailing facts and circumstances

Correct ASAP under one of the IRS plan qualification defect correction programs. These are applicable to ESOP diversification, as compliance with IRC Section 401(a)28)(B) is a qualification requirement for ESOPs. Manner of correction will depend on specifics; how many years are involved? has stock value increased or decreased? how many participants involved? etc., etc. But you must make the eligible participants "whole" in order for there to be an appropriate correction. [This message has been edited by RLL (edited 05-26-2000).]

Kirk --- I think that the so-called "glitch" in the regulations for the "ESOP exception" in IRC Section 411(d)(6)© was clearly intentional on the part of the IRS. There are several aspects of those regulations that narrow the "ESOP exception" well beyond what was contemplated by the statutory language and the Senate Finance Committee Report under the Tax Reform Act of 1986. If it were merely an "unintentional technical glitch" the IRS National Office could easily have taken steps over the past decade to fix the problems (that have repeatedly been pointed out) in the regulations, most recently in connection with the pending proposed changes to the Section 411(d)(6) regulations. Fortunately, the IRS district and regional offices have been administering the "ESOP exception" in a manner which generally conforms to the legislative history of Section 411(d)(6)©, rather than by strictly applying these defective & inappropriate regulations. But we shouldn't assume anything other than the obvious fact that the IRS continues to be skeptical about ESOPs and frequently applies the rules applicable to ESOPs in a manner that is far more restrictive than what is a reasonable interpretation of the statutory provisions. This has been the case for the 25+ years since the enactment of ERISA.

In order for an employer contribution to be deductible (under the Internal Revenue Code) for a taxable year, it must be paid to the ESOP not later than the due date (including any extension) for filing the employer's federal income tax return for that taxable year. The contribution must be treated under the ESOP as though it had been made on the last day of the taxable year. In the case of an employer with a taxable year endiing on Feb. 28th, the due date would be May 15th....November 15th if the employer has an extension for filing the return. There is no specific time by which the ESOP is required to use a cash contribution to purchase employer stock. The employer is not required to purchase stock....it's contribution to the ESOP may be in cash or stock. Stock under a Section 1042 election is purchased by the ESOP (not by the employer) from a shareholder. 1042 stock cannot be contributed by the employer to the ESOP. The ESOP would use cash or borrowed funds or a note (to the seller) to pay for such stock.

Dawn ---- The employer cannot "simply" buy all of the ESOP's employer stock. An ESOP fiduciary (hopefully, an independent fiduciary) must agree to sell the ESOP's employer stock to the employer for a price not less than fair market value (the fiduciary may negotiate for a price in excess of appraised fair market value). Upon termination of an ESOP, the participants have the right to receive benefit distributions in shares of employer stock (accompanied by a put option if the stock is not readily tradable), unless the ESOP provides for only cash distributions under one of the exceptions in IRC Sec. 409(h)(2) applies. As an alternative, it may be possible under IRC Sec. 411(d)(6)© to amend the ESOP (upon its termination) to provide for all cash distributions.

(1) yes (2) yes

I understand that the IRS has recently raised questions about such a transaction, even after the change in the "continuity of interest" regulations. I'd check with folks at the IRS National Office before proceeding. Also, note that Section 1042 requires a sale of shares of the company which maintains the ESOP. If the sale of stock is to the Acquiring Company ESOP, the Target shares must be exchanged for Acquiring Company shares prior to the sale to the ESOP. [This message has been edited by RLL (edited 05-15-2000).]

IRC401 ---- It's a Sec. 411(d)(6)© issue.....the extent to which benefit distribution options may be changed under an ESOP. Sec. 409(h)(5) relates to put options with respect to non-tradable shares of employer stock that are distributed by an ESOP. "grimmace" appears to have said that the ESOP distribution options are being changed.

Your counsel is correct that the ESOP must receive not less than "fair market value" as of the transaction date if it sells shares to the company. An alternative would be for the ESOP to distribute the shares to the terminated participant and for the company to give a "put option" (offering to repurchase the shares from the terminated participant) at the 12/31 appraised fair market value. This is permitted under Section 409(h) of the Internal Revenue Code and would avoid having to get an updated valuation. [This message has been edited by RLL (edited 05-12-2000).]

I believe that both "hapa123" and "IRC401" may be confusing the issue. An important factor here is whether the shares were acquired by the Amsted ESOP before January 1, 1987. Also, what are the specific provisions of the Amsted ESOP relating to the timing of benefit distributions and changes thereto? Whether or not the company has an ownership restriction in its bylaws or is an "S corporation" is likely irrelevant to this issue. The issue posed by "grimmace" appears to involve a change in the timing of ESOP benefit distributions, under IRC (Internal Revenue Code) Sections 409(h) and (o) and 411(d)(6)©, not the form of distributions (cash v. stock). The relevant IRC provisions, as well as a corresponding provision of ERISA, were added/amended by the Tax Reform Act of 1986, so that different rules apply to shares acquired by the ESOP prior to 1987. Also, the age 55 and ten years of participation ESOP "diversification" rule under IRC Section 401(a)(28)(B) is required to apply only to shares acquired by an ESOP after 1986. [This message has been edited by RLL (edited 05-08-2000).]

Depending on the details of the transaction, a prohibited transaction may be involved. If not, it may be possible but is probably foolish.

Many closely-held company ESOPs (approximately 64.7%) have a Board of Trustees composed of one or more individuals appointed by the Board of Directors. The Board of Trustees very often also has the responsibilities which might otherwise be assigned to an Administrative Committee if there were an institutional trustee. When a transaction (which affects the ESOP) is proposed and which might cause the individual trustees to have a possible (or perceived) conflict of interest, it is very common to engage an independent fiduciary to represent the ESOP in that transaction. [This message has been edited by RLL (edited 05-08-2000).]

Kirk..... This is a publicly-traded company that Tot is talking about. Doesn't the stock market always go up?

Did beth expect to wait two months to get an answer ???

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.

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)?

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.

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.

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.

Hi Doug..... I think whjat your client wants to do is OK, subject to the ERISA fiduciary issues that the client "understands." I suggest that an independent fiduciary ought to be involved in the decision to use the transferred assets to invest in employer stock. Inasmuch as no employee contributions (including elective deferrals) are going to be transferred to the ESOP and participants presumably will have no investment election under the ESOP, there are available exemptions under the Securities Act of 1933 to cover this situation (and probably also under applicable state securities laws). You mentioned that part of the matching contribution accounts will be transferred to the ESOP. Did the 401(k) participants have investment direction of those accounts? That would certainly raise some concerns here. Along with using an independent fiduciary, I'd strongly recommend that great efforts be put into an effective employee communications program in connection with this proposal. You are "changing the ground rules" with respect to funds already allocated under the 401(k) plan, and this always raises concerns among employees who contributed to the plan under the prior rules.

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. ?