Question relating to ERISA 404(c) and company stock

[Guest ERISAGuy]

Situation: A privately held company makes its match in company stock and gives its employees the right to sell the stock and to move the proceeds into any one of a variety of other choices (which presumably qualify under 404©). The company does not allow the employees to reinvest the funds in the company stock account, however. Does the plan qualify under ERISA 404©? I need any assistance. Thanks.

[QDROphile]

The 404© regulations have detailed provisions specific to employer security investment options, which must be followed. I don't see anything that requires that a participant be able to direct funds into the employer security option.

[Erik Read]

Only exception I would have is if the employer stock is publically traded and the particpants are given access to trade any public company. I'm not sure it would qualify if the plan said that a participant cannot select XYZ Corp as an option.

Are you asking if by limiting the participants so they cannot get back into the stock the plan does not comply with 404© or are you asking if by forcing the contributions to the company stock in the first place does not comply with 404©?

Thanks.

[Jon Chambers]

Couple of quick comments. First, 404© relief from fiduciary liability for investment decisions is transactional in nature, and you don't really "qualify" in the traditional sense of the term. You either get the transactional relief or you don't. With that background, consider the question further. Employer chooses to fund the matching contribution in employer stock. That's an employer election--clearly no 404© relief relating to the contribution transaction. Once the contributions are made in the form of stock, participants can elect to sell. What the client is hoping for is that this permissible election provides 404© relief. The answer to that is maybe. It depends on many more facts than you have presented. The really quick answer is that having non-publicly traded employer stock in a qualified plan (other than an ESOP) introduces numerous fiduciary and securities law issues, and should be avoided at almost any cost. I doubt that 404© is likely to be your main problem.

[RLL]

ERISAGuy ---

I think 404© protection is available for this arrangement, so long as participants can freely direct the sale of employer stock, but only with respect to the other investments.

But in a closely-held company, can such sales really be readily effected? If the sale is to the employer or to another party in interest, ERISA sections 408(e) and 3(18) require an independent appraisal as of the date of each sale.

Jon Chambers ---

Your "really quick answer" regarding the use of closely-held company stock is not sound objective advice regarding the ERISA fiduciary rules. With the exception of the "ESOP loan exemption," the ERISA fiduciary provisions that apply to investments in employer stock are very similar for ESOPs and non-ESOP plans which are specifically designed to invest in employer stock. There are thousands of non-ESOP qualified plans which invest successfully in closely-held employer stock. The securities law issues can be dealt with...particularly when employee contributions and investment directions are not permitted with respect to employer stock. Saying that this "should be avoided at any cost" sounds like the pitch of a conventional investment adviser seeking to protect his turf.

[Guest ERISAGuy]

Thank you for your responses - they have been very helpful.

In this situation, the privately-held company has independent appraisal of its shares quarterly for many years - and uses the latest appraisal price in determining any sale or transfer of its stock, regardless of the situation. My read of ERISA 408(e) and 3(18) leads me to believe that this strategy could work.

[Jon Chambers]

RLL--

Don't intend to get into a shouting match, but if you read your own reply, you indicate that "The securities law issues can be dealt with...particularly when employee contributions and investment directions are not permitted with respect to employer stock." In this case, it's clear that investment directions would be permitted on the employer stock. I don't purport to be an expert on securities law issues, but I am passingly familiar with the registration and filing requirements, which are quite onerous and often overlooked. Perhaps "should be avoided at any cost" was a little strong. Let me rephrase to "should only be entered into after all the direct and indirect costs of the transaction have been fully considered."

I don't consider myself to be a conventional investment adviser, and I'm not in the slightest concerned with defending my turf. I am very concerned with self-dealing in qualified plans, which, in my experience, is the typical underlying rationale for including non-public employer securities in a plan. I'm well aware that qualified securities attorneys can deal with the securities laws, and that they are usually well-paid to do so. However, most securities lawyers that I have worked with can't deal with the ethics of using a retirement benefit plan as the vehicle for funding a speculative, illiquid investment in employer stock. By their very nature, retirement plans must cover rank and file employees who don't understand the risks implicit in non-public stock. If the intent of using stock is to promote broad-based employee ownership, there are typically better methods than a 401(k) match. It sounds to me like the company is looking for a way to duck what would otherwise be a cash obligation, and I think that that is wrong. Of course, I don't have all the facts, and I may be rushing to judgement. But I don't appreciate having my motivations questioned.

[Kirk Maldonado]

A bit of clarification, a bit off-point perhaps.

My recollection of the applicable regulations is that you do not have Section 404© for participant-directed investments in privately held employer stock.

[RLL]

Hi Kirk ---

You are correct with respect to the DOL regulations....whether the statute would provide 404© protection under certain circumstances may be another matter.

In this situation, however, there are no participant directed investments into employer stock.

[QDROphile]

Could you specify how investment in private employer securities is contrary to the 404© regulations?

[RLL]

QDROphile ---

An investment in closely-held employer stock actually is not "contrary to the 404© regulations," but is available only under extremely limited circumstances. See Reg. Sec. 2550.404c-1(d)(2)(ii)(E)(4)(iii), which denies 404© protection in connection with any transaction (involving employer stock) between the plan and the plan sponsor or an "affiliate" unless certain conditions, including a public market for the stock, are met.

The 404© protection specified in the regulations would be available only if the employer stock (that is subject to the participant's investment direction) can be acquired from or sold to a party other than the employer or an "affiliate" of the employer (the definition of "affiliate" for this purpose is fairly broad). This may be possible in some situations involving closely-held companies, but very few.

[QDROphile]

Thanks for focus.

So what we have is a difference between (i) securities law, which generally does not require registration of the stock acquired through a matching contribution or other nonelective emplyer contribution simply because the participant my elect to divest, and (i) ERISA, which does not afford the protection of the 404© regulations when the participant chooses to divest. As you observe, that is not the end of the matter, but for those who don't want to go outside of the 404© regulations, ERISA encourages plans to lock participants into the employer stock.

In the battle between the policies that encourage ownership of employer stock and that allow particpants to have contol over investment of their accounts, ownership of employer stock wins unless the employer is a public company. Wait until the popular financial press catches on! Or maybe it is just another warning signal against having private employer securities in a plan.

[Jon Chambers]

I've clipped from the 404© regs below. Briefly, the 404© regs don't apply to employer securities, unless they meet the exceptions listed below. Note subpoints (iii) and (iv), which, when read in the double negative form, says that employer securities must be publicly traded in order for 404© relief to apply.

"(ii) Paragraph (d)(2)(i) does not apply (added by me--this is the section under which 404c provides transactional relief) with respect to any

instruction, which if implemented--....

(E) Would result in a direct or indirect:...

(4) Acquisition or sale of any employer security except to the

extent that:

(i) Such securities are qualifying employer securities (as defined

in section 407(d)(5) of the Act);

(ii) Such securities are stock or an equity interest in a publicly

traded partnership (as defined in section 7704(B) of the Internal

Revenue Code of 1986), but only if such partnership is an existing

partnership as defined in section 10211©(2)(A) of the Revenue Act of

1987 (Public Law 100-203);

(iii) Such securities are publicly traded on a national exchange or

other generally recognized market;

(iv) Such securities are traded with sufficient frequency and in

sufficient volume to assure that participant and beneficiary directions

to buy or sell the security may be acted upon promptly and efficiently;

(v) Information provided to shareholders of such securities is

provided to participants and beneficiaries with accounts holding such

securities;

(vi) Voting, tender and similar rights with respect to such

securities are passed through to participants and beneficiaries with

accounts holding such securities;

(vii) Information relating to the purchase, holding, and sale of

securities, and the exercise of voting, tender and similar rights with

respect to such securities by participants and beneficiaries, is

maintained in accordance with procedures which are designed to safeguard

the confidentiality of such information, except to the extent necessary

to comply with Federal laws or state laws not preempted by the Act;

(viii) The plan designates a fiduciary who is responsible for

ensuring that: The procedures required under subparagraph

(d)(2)(ii)(E)(4)(vii) are sufficient to safeguard the confidentiality of

the information described in that subparagraph, such procedures are

being followed, and the independent fiduciary required by subparagraph

(d)(2)(ii)(E)(4)(ix) is appointed; and

(ix) An independent fiduciary is appointed to carry out activities

relating to any situations which the fiduciary designated by the plan

for purposes of subparagraph (d)(2)(ii)(E)(4)(viii) determines involve a

potential for undue employer influence upon participants and

beneficiaries with regard to the direct or indirect exercise of

shareholder rights. For purposes of this subparagraph, a fiduciary is

not independent if the fiduciary is affiliated with any sponsor of the

plan."

Hope this helps,