If company pledges ESOP shares as collateral upon put, are the shares

[Guest RBJ]

I have a closely held client that sponsors an ESOP. In the past, when a participant exercised his or her put option, the ESOP purchased the shares from the participant. The ESOP was "frozen" two years ago and the company began redeeming shares when the put option was exercised, with the repurchased shares pledged as collateral for the company's repurchase obligation. Prior counsel advised the company that shares pledged as collateral were considered outstanding under state law, and therefore should be considered outstanding for valuation purposes until the shares were no longer pledged. The state law in question simply states that shares pledged in a redemption are not considered redeemed, but are also given no voting or distribution rights, except in the case of the company's failure to pay the redemption amount. My interpretation of the state law is that it protects sellers from pledged shares being considered retired in the event of default. If shares were considered retired, the selling shareholder would not automatically receive shares upon default and board action would be required to "reissue" the shares. I conclude that shares pledged as collateral for the company's repurchase upon the put should not be considered outstanding for ESOP valuation purposes unless and until default. Any thoughts?

[RLL]

The repurchased shares do not constitute "adequate security" under IRC Section 409(h)(5)(B), so the company appears to be violating the ESOP put option requirement.

The shares should not be considered as outstanding for valuation purposes unless the company is in poor financial condition and there is a likelihood that it will be unable to meet its obligations under the repurchase notes.

[Guest RBJ]

Thanks for the response, RLL. I agree with your analysis and should have stated in my original question that the company provides security in addition to the repurchased shares (a bond) to satisfy the §409 requirement.

[RLL]

If there is a bond to provide "adequate security" for the repurchase notes, why bother with a pledge of the repurchased shares?

Such pledge unnecessarily complicates matters (such as raising the valuation issue) and requires additional paperwork, etc., for no real benefit to anyone (except, perhaps, the lawyers who designed the arrangement and, thus, created the need for additional documentation, etc.).

[Guest RBJ]

Good question. The only response that comes to mind is that the distributee could retain the shares in lieu of receiving the cash payment under the bond, but that doesn't make any sense to me, since most, if not all, former employees would opt for the cash rather than ownership of illiquid stock. For future distributions I anticipate providing only the bond as security. Thanks again for your thoughts.

[RLL]

Those distributees would have previously elected to sell the stock by exercising their put options. In addition, as the employer would be defaulting on the repurchase payment, the stock would be of questionable value at that time. Why would a company provide distributees with more options than are required under these circumstances?