OK to provide for reversion of voting rights to employer (lender) upon

[smm]

I am reviewing a stock pledge agreement for a leveraged ESOP transaction. The employer is the lender. The agreement states that on default, the Pledgor's (ESOP) voting rights to the stock that is held as collateral for the loan will cease and the Company will then be able to vote the shares. Obviously, the ESOP does not say this. Other than simply smelling bad, does this violate 54.4975-7(B)(6) (or any other section that you can think of?) The stock pledge agreement also provides that the loan is secured by "cash and non-cash proceeds and products of the stock"...I know that this is bad. Thanks.

[RLL]

State corporate law might address the issue as to whether a company is permitted to vote shares of its own stock. The ESOP loan reg doesn't prohibit the voting provision, but the use of "cash and non-cash proceeds" as security for the loan may be a problem.

[Kirk Maldonado]

RLL:

Would clarify why you think that the use of cash and non-cash proceeds as security for the loan may be a problem"?

Treasury Regulation Section 54.4975-7(B)(5) permits the "earnings attributable to such collateral" to be used as recourse for the loan.

Couldn't you argue that the "cash and non-cash proceeds" from the sale of the stock acquired by the ESOP would be "earnings atrtributable to such collateral?" My question presumes, of course, that the stock held by the ESOP is sold to a third party, so that (logically) the lender's security interest carries over (from the stock) to the proceeds from the sale of the stock.

[RLL]

Kirk ---

Reg. Section 54.4975-7(B)(5) limits collateral to the shares of stock. Nothing in the reg addresses issues relating to a sale of stock by the ESOP. Sales proceeds certainly may include "earnings" on the stock, but also include return of the amount invested (the cost)....which clearly is not "earnings."

What is also clear is that the 1977 ESOP loan regs are out of date, incomplete, and in need of clarification and updating.

[smm]

I guess one could argue that "earnings attributable to collateral" includes proceeds derived from the sale of the collateral, but based on my reading of everything, that is not what was intended by the terms. First, the purpose of the exempt loan is to be primarily for the benefit of the ESOP participants. If the document permits the trustee to sell the pledged shares to a third party or the employer in order to pay off the loan, the employer is essentialy manipulating the loan and the loan is not primarily for the benefit of the ESOP participants. This opinion is in the ESOP audit guidelines in Announcement 95-53.

[smm]

I cut myself off. Second, I don't have a problem if the Trustee sells the shares to 3rd party in a tender offer after the Employer has made several years worth of contributions to pay off the loan (there is a recent PLR regarding this), but I am uncomfortable about having this language in my stock pledge agreement. The plan that I am reviewing also gives the Trustee right to require the Employer to buy back collateralized shares on demand.

[RLL]

smm ---

The ability of the trustee to sell the ESOP's shares does not in and of itself allow the employer to "manipulate" the loan....unless the trustee is willing to be manipulated by the employer and, thus, to violate ERISA. This should not be a problem if the trustee is acting independently (as ERISA requires).

And why should a sale to a third party be limited to a "tender offer?" Any bona fide (and not pre-arranged) sale to an independent third party should be OK, even if it occurs soon after the ESOP's acquisition of the shares, so long as the sale is on favorable terms which result in substantial benefits to the ESOP participants. An independent fiduciary should assure this, and the stock pledge agreement shouldn't restrict the ESOP's ability to do this.

What's wrong with the ESOP's having the right to require the employer to buy back collateralized shares....so long as the fiduciary is acting independently on behalf of the ESOP participants?

[smm]

I agree with you and in an attempt to keep my message short, didn't say everything that I would want to say (one of the problems with message boards). The only time there is a potential for manipulation is if the employer does not make a loan payment, therby triggering other provisions in the plan that might require the sale of stock. . Also, the second scenario is not limited to a tender offer, a sale to a third party might also be permissible. However, getting back to my original question, I am still uncomfortable to having a provision in the stock pledge agreement that includes "cash and non-cash proceeds and products of the stock" as collateral because unlike Kirk, I'm not sure that earnings was intended to include such proceeds. I represent one of the trustees. Perhaps I can get an opinion of counsel for the ESOP and the Company that it is ok. Perhaps I'll reconsider the provision in the ESOP that requirs the Employer to buy back collateralized shares in the event the Employer fails to make a plan conrtibution sufficient to make the loan payment.

[RLL]

smm ---

Unless the documents require the employer to make contributions to the ESOP, why is it "manipulation" if the employer doesn't contribute and the ESOP loan goes into default? If the trustee was concerned, why did it agree to such an arrangement?

If you represent a new trustee, why did it agree to serve before getting comfortable with the ESOP loan documentation?

When the employer is the lender and the ESOP loan is in default, Section 54.4975-7(B)(6) of the ESOP loan regs provides for a special limitation on the transfer of plan assets to satisfy the default.

Maybe the trustee should demand a modification of the documents as a condition of its continuing to serve.

[Kirk Maldonado]

RLL:

You raised some very valid points.