Using a preferred class of stock for ESOP

[Guest svatty]

I’ve heard recently about a technique whereby a leveraged ESOP would be used to acquire preferred stock in a company, where the value of the preferred stock was tied to a fund of assets set aside by such company. The ESOP debt would also be assigned to that fund. The net result would be that the preferred stock would have a lower value post transaction than it did pretransaction, similar to a traditional leveraged buyout situation. Has anybody seen this preferred stock technique used? If so, by any public company?

This would seem to raise a whole host of issues, for example, could a “security” (preferred stock convertible into common stock of the company, but where the conversion is based on the value of the fund) be structured so as to be a qualifying employer security for the purposes of the Code and ERISA? Could such a conversion scheme be “reasonable” within the meaning of Section 409(l) of the Code?

[RLL]

I've seen it, and I don't like it.

This is an area where employee ownership intersects with abusive corporate tax shelter. Upon audit, the IRS is likely to "look through" and disallow such a scheme. There are also significant issues under ERISA's fiduciary rules.

The folks promoting this kind of arrangement are not friends of employee ownership. This is the kind of abuse that can lead to anti-ESOP regulatory actions and legislation.

[Guest svatty]

RLL, thanks for your comment. Maybe that is why there appears to be no PLR's dealing with these issues.

If the IRS were to "look through" this arrangement on audit, what do you think would be the basis be for disallowance? Would it likely be on a technical basis, such as the failure of these securities to meet Code Section 409(l) requirements, or would it be a broader attack, such as a failure of this arrangement to be for the sole benefit of participants?

Any thoughts or insights would be appreciated.

Thanks

[RLL]

The preferred "tracking" stock arrangement might be treated by the IRS as having no substance other than for tax savings (as it is designed to generate tax deductions greatly in excess of the benefits being provided to ESOP participants). The preferred stock might be treated as not having a "reasonable conversion price," as required under IRC Sec. 409(l). The ESOP loan might be treated as not being "primarily for the benefit of participants," as required under IRC Sec. 4975(d)(3) and ERISA Sec. 408(B)(3).

I could go on and on about this....... Bottom line is that it's using an ESOP primarily as an abusive corporate tax shelter rather than as a vehicle for providing employee stock ownership.

[This message has been edited by RLL (edited 12-29-1999).]

[Guest TAV]

SVATTY

I have read the insightful questions you have posted regarding using a preferred class of stock for ESOPs. I am a consultant interested in defined contribution strategies. I currently am reviewing a proposal for a leveraged ESOP and could use someone like you in my camp. Is there any way I could contact you directly for advice on that proposal? I look forward to hearing from you.