401(k) Plan "spin-off" to facilitate ESOP

[Guest Doug Johnston]

Our client has $1.8 million in a 401(k) plan and is in the process of establishing an ESOP. To facilitate the ESOP purchase, the client proposes to "spin-off" about $300,000 in participant matching and profit-sharing contribution accounts from the 401(k) plan to the newly formed ESOP. The spin-off would be based on a formula developed by management, and would not be elective on the part of the participant. The participant account balances in the two plans after the spin-off would be the same as the 401(k) balances immediately before the spin-off, and participants would be 100% vested in the balances transferred to the ESOP.

The client understands the fiduciary issues related to converting a portion of the 401(k) plan assets to an ESOP. Are there any statutory, regulatory, or administrative guidelines on the appropriate conditions and/or methods for a plan spin-off? Are there other potential pitfalls with the proposed spin-off?

As usual, the client's timetable for the ESOP purchase makes it impractical to request a PLR.

[Kirk Maldonado]

Have you considered the federal and state securities laws implications as well as the accounting consequences?

[Dawn Hafner]

Why even do the spin off to two plans? Why not restate the 401(k) plan to be an ESOP with 401(k) provisions with the same vesting schedule?

How are participants being given the opportunity to invest in employer stock? What kind of formula? Could the formula be discriminatory?

Securities law issues are a biggie here. The SEC views allowing employees to invest in employer stock on a volutary basis as purchasing a security that must be registerd, absent an exemption. Given that, an exemption can often be found. Even if an exemption is found, anti-fraud provisions of securities law would require a detailed disclosure statement to participants so that they have the information necessary to make an informed investment decision.

[Guest Doug Johnston]

The spin-off is considered necessary because the combined KSOP would not be "primarily invested" in Company stock. After the stock purchase of about $1 million, only 1/3 of the combined plan assets will be invested in Company stock. In addition, the Trustee of the 401(k) Plan will be the lender on the ESOP debt, so it can't serve as the Trustee on the ESOP. The spin-off allows for separate Trustees.

I'm not sure how the securities laws apply. The investment in Company stock would not be voluntary. Once the spin-off is completed, all of the ESOP assets will be used to purchase Company stock. Managements' philosophy is that they have the power to dictate how the balances are invested in the 401(k) plan, so it follows that they have the power to spin-off a portion of the assets into a separate plan and dictate that the balances be invested in Company stock. Some employees may not like it but many employees will, and management is willing to accept the fiduciary risks.

[Kirk Maldonado]

I disagree with your analysis about primarily invested. The rule is that the plan must be designed to be primarily invested in employer stock. It does not say that the plan assets must actually be primarily invested in employer stock.

[Guest Doug Johnston]

I understand that there is some flexibility in determining whether a plan is "primarily invested" in Company stock. However, I disagree that the an ESOP sponsor can avoid the substance of this principle simply because the plan document semantics are correct. Am I missing something? How can a plan be "designed" to invest primarily in Company stock and not follow the plan terms?

Interestingly, in its ESOP audit guidelines, I believe the IRS simply states "An ESOP must invest primarily in qualifying employer securities".

In any case, our trustee issue precludes converting the 401(k) to an ESOP.

[RLL]

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.

[IRC401]

Deloitte & Touche has been telling large publicly traded companies to merge all or part of their 401(k) plans into ESOPs for years (although they are interested in the part of the 401(k) plan already invested in employer stock). I doubt that you have any qualification problems, but you do have fiduciary issues and securities law issues.

I also doubt whether hiring an independent fiduciary makes much of a difference. If the stock tanks (or even significantly underperforms the 401(k) plan), be prepared for a class action suit.

Could the client get to where it wants to be by making future matching contributions in employer stock?