Securities law & registration exemptions - 1042 sales

[Dawn Hafner]

Under the commonly used registration exemptions the sale from an employer to participants is exempt from registration. How does a 1042 transaction fit into this? Is this considered a sale directly from the selling shareholder to the participants and therefore not eligible for an exemption? Or is the employer considered to be offering the securities to the plan by permitting the 1042 sale? Can the selling shareholder sell to the employer who in turn sells to the ESOP and still be eligible for 1042 and the exemption?

[Kirk Maldonado]

The sale is to the plan, not to the participants. Most (but not all) state securities laws have an exemption for sales to a tax-qualified retirement plan.

[Dawn Hafner]

I agree that the sale is to the plan, but within the plan the participants will be given the opportunity to elect to invest in some of the employer securities. My understanding of the SEC's position is that voluntary investment in a contributory plan (401(k)/ESOP) subjects the transaction to registration absent an exemption.

[Kirk Maldonado]

That's a very major point that you neglected to mention before.

Allowing participants to buy privately held employer stock is very, very risky. I've only had one client do that in my career, and they did that only because that was their only alternative other than bankruptcy (which was imminent). They are now being audited by the DOL on that issue.

If I were you, I'd stay as far away from that deal as possible. I've had literally dozens of clients suggest it, but when I explained all of the risks everyone but that one decided not to risk it.

[RLL]

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?

[RLL]

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.

[Kirk Maldonado]

I don't disagree with RLL.

However, I have never seen a single case where my client was willing to give sufficient disclosure (even in the one case where the employer did permit the investment election). To satisfy the dislosure requirements, I believe that you would have to give basically all of the disclosure that you would give if the employer went public.

I must confess that some companies that already sponsor ESOPs tend to be more open about their finances, salaries paid to executives, etc. However, none of my ESOP clients have been interested in allowing employees to invest, and I have never encountered an non-ESOP company that was willing to give full disclosure.

However, as RLL posits, I could easily imagine a company that already sponsors an ESOP that subscribes to the "open book" philosophy, being willing to make an adequate amount of disclosure.

[Dawn Hafner]

So, are there any exemptions from SEC registration that would apply to a 1042 transaction? I read the exemptions to only apply on sales from the "issuer", or is the issuer involved as the fiduciary (employer) of the plan. I am concerned that a transaction that would normally fall under a exemption could lose the exemption because the sale is from the 1042 seller, not the issuer.

[RLL]

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 Hafner]

In this case there will likley be participant elections to some extent, so if there are participant elections and/or 401(k) funds involved and the sale is from the shareholder selling under 1042 are there any registration exemtpions?

If the stock is sold from the employer to the plan and there are participant elections Rule 701 works, but without the sale coming from the issuer I don't see an exemption.

[Kirk Maldonado]

The first hurdle is whether the employer will willing to give all of the disclosures that it would have to give if the employer went public. If they aren't, I wouldn't allow any participants to purchase the stock. Thus, if you don't pass this first hurdle, everything else is relevant.

As I mentioned before, I am very skeptical that the employer would be willing to give that level of detail to its employees. One reason for that is that many employers are concerned that this disclosure could end up in the hands of their competitors, should a disgruntled employee leave and go to a competitor.

[Kirk Maldonado]

By the way, to engage is a bit of shameless self-promotion, you might want to review my Tax Management Portfolio, #362, Securities Laws Aspects of Employee Benefit Plans. It addresses many of your concerns. By way of mitigation, I want to add that I do not receive any royalties from the sales of the portfolios.

You will find that it is written from the perspective of an ERISA attorney, not from the perspective of a securities lawyer, so that it may be more useful to an ERISA attorney than it would be for a securities lawyer.

[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!

[Kirk Maldonado]

RLL:

The way that I analyze the Rule 701 issue is that it is treated as if the shareholder sold the stock to the employer, and then the employer sold it to the plan. That is the SEC's analysis as to why the stock sold under a section 401(k) plan must be registered, even though the shares (1) are publicly traded and (2) are purchased on the open market.

The intrastate exemption is very difficult to satisfy and very easy to blow. I only tend to rely on it when absolutely necessary. Also, remember that is only a federal exemption, it is not a state exemption.

I thought that there was an exemption from BenefitsLink's prohibition on "shameless self-promotion" in the case of (i) a guide (ii) who discloses it and (iii) does not receive any remuneration as a result of it. Maybe I need to get a ruling from Dave Baker on it.

Anyway, if I was the type of person that needlessly engaged in "shameless self-promotion" then I probably would have mentioned in my prior message that the current edition of the Compensation Planning Journal has an article that I wrote on Rule 701.

[RLL]

Kirk ----

Who is Dave Baker? Does he work for the IRS or the DOL? Does he receive compensation from BNA? And what, if any, is the user fee for such a ruling request? And who will pay the user fee? And what is the Compensation Planning Journal?

[Kirk Maldonado]

RLL:

I thought that because you brought up the issue (about the prohibition on shameless self-promotion), I thought you were going to fund the user fee. I wasn't going to bill you for my fees, though. Isn't that offer per se reasonable?

[RLL]

Yes.