Diversification Requirement

[Scott]

A private company maintains an ESOP. The ESOP portion of the plan is frozen (i.e., participants are no longer able to invest in company stock), and the plan becomes a 401(k) plan with several other investment alternatives. The plan continues the diversification requirement under Code Section 401(a)(28(B) with respect to the company stock fund.

Subsequently, the sponsor of the plan is acquired by a publicly-traded company, and the sponsor's stock held by the plan is exchanged for cash and stock of the acquiror. The plan will be continued, and participants will be able to exchange between any of the investment funds, including the publicly-traded stock. Must the plan continue to apply Code Section 401(a)(28)(B)?

[RLL]

To the extent that there remains stock of the new employer allocated to participants' accounts under the frozen ESOP portion, the diversification requirement of IRC Sec. 401(a)(28)(B) continues to apply.

[Scott]

Thanks. That brings up a follow-up question. I realize that the ESOP requirements, such as 401(a)(28)(B) and the right to demand a distribution in stock, must be continued in the plan. If participants are allowed to freely exchange between investment funds, including the company stock account, how is this accounted for?

For example, suppose a participant who has original ESOP stock in his account elects to "sell" all of his company stock and invest in another fund. He later reinvests a portion of his account in company stock. When he retires, is he entitled to demand a distribution in company stock? If so, to what extent?

[RLL]

Your original question stated that the ESOP portion would be "frozen" and there would be no additional investments in company stock. Now there is a change....you're allowing participants to reinvest in company stock.

Is the reinvestment in company stock under the (now "unfrozen") ESOP portion? If so, the requirements for diversification under IRC Sec. 401(a)(28)(B) and the right to demand distribution in company stock under IRC Sec. 409(h)(1) apply to the new shares. If the reinvestment in company stock is under a non-ESOP portion, such requirements do not apply. On the other hand, it is common for a 401(k) plan of a publicly-traded company to permit participants to receive distributions of company stock from a company stock fund (to the extent their accounts are so invested). What does the plan document say?

To the extent that participants elect to "sell" company stock from the ESOP portion of the plan, the amounts reinvested in other funds would be under a non-ESOP portion and would not be subject to the special ESOP rules (unless the entire plan was designated as an ESOP).

Scott.....have you yet joined The ESOP Association or the NCEO ?

[This message has been edited by RLL (edited 09-24-1999).]

[Scott]

Perhaps I didn't do a good job of setting forth the facts in my first post, because the facts shouldn't have changed. I'll try again.

The plan started out as an ESOP, with employee after-tax contributions and employer matching contributions. Later, the plan was amended to (a) add a 401(k) feature, (B) cease after-tax contributions, and © "freeze" the employer stock fund (no more investments in employer stock, and (except as required under 401(a)(28)(B)) no reinvestment of funds held in the employer stock account into other investment alternatives).

The plan continued under that structure until recently, when all of the stock of the employer was purchased by a publicly-traded corporation, in exchange for cash and shares of the publicly-traded corporation. Participants were given the opportunity to direct the investment of the cash received for their shares of stock. The publicly-traded stock replaced the original employer's stock in the employer stock fund.

From here on out, participants will be allowed to direct the investment of contributions into any investment fund, including the publicly-traded stock, and to freely exchange among all of the funds, including the publicly-traded stock. I'm trying to get a handle on how to preserve the requirements attached to the "old" ESOP under this new arrangement.

RLL, you indicate that the ESOP requirements must continue with respect to the "ESOP" portion of the plan, from which I infer that it is necessary to distinguish between the "ESOP" and "non-ESOP" portions of the plan. What I'm having difficulty with is how to make that distinction under the new arrangement, where participants will be able to buy and sell stock within the plan, and stock will be purchased and sold by the plan on the open market as the demand for investments in the stock under the plan changes.

Sorry for the long post, and for possibly making a mountain out of a molehill, but I want to make sure the facts are clear, and I would really appreciate any guidance.

RLL, I have not had a chance to investigate either of those organizations yet, but I will look into them. Thanks.

[RLL]

Is the current company stock fund (under the plan) designated as an ESOP? If so, it's subject to the special ESOP rules.

With regard to stock attributable to the former (frozen) ESOP, did the plan continue to designate that portion of the plan as an ESOP? If so, the ESOP rules continue to apply.