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What’s new with ESOPs?

From transactions to valuations to regulation, changes continue


The employee stock ownership plan (ESOP) community has many unique technical issues to discuss each time professionals get together and the ESOP Association’s Annual Conference was no exception. Following are some key developments of which ESOP companies and companies considering ESOPs should be aware:

What is new in ESOP transactions?

  1. Taking a page from non-ESOP acquisitions, trustees are using clawbacks more often in transactions to mitigate some of the risk that a valuation used an overly aggressive projection.  The clawback is typically tied to seller debt so that the seller receives less money if, for example, company performance doesn’t hit at least some percentage of projections.
  2. It seems to be more important to carefully consider potential future change in control transactions during an initial ESOP transaction so that the fiduciary can appropriately advocate for participants and their beneficiaries if a transaction ends up making the original long-term planning horizon of the ESOP irrelevant. In reality, ESOPs may terminate much sooner than originally planned. Depending on the terms of the original ESOP transaction, the economic reality of a transaction that occurs before the ESOP has repaid its acquisition debt can drastically affect what the ESOP gets as compared to what it seems the ESOP purchased. If the company and the trustee take no other action, trustees should give thought at the time of the initial ESOP transaction to the plan terms governing the allocation of any shares released from collateral from the sale of the stock and repayment of the debt.
  3. For clients considering doing a 1042 tax-deferred sale option, the market has changed. First, it is more difficult to leverage an investment portfolio than it has been in the past—sellers need to get a minimum of 25 percent of the sale price in cash. Second, there has been a substantial reduction in the availability of floating-rate, long-term bonds that sellers can use as qualified replacement securities. The good news is that another form of long-term bond, which includes a fixed interest rate for five years with quarterly adjustments thereafter, has become available. This may meet the needs of some sellers.

What is new with regulators?

  1. The Department of Labor (DOL) continues to struggle with ESOP transactions. In October, the DOL filed the first case in which it named an individual employee of an institutional trustee, rather than just the trust company itself. The DOL has named individual trust company employees in its initial findings letter issued with respect to an investigation, but this is the first time the DOL carried that through to an actual compliant. The ESOP community strongly opposes the DOL’s position in this case. Since this case involves an individual working for a trust company, the implications extend beyond the ESOP community and could attach individual liability in other retirement plan cases. 
  2. There is still no answer on what to do about the change in the IRS’ determination letter program. Firms that may provide preapproved ESOP plan documents are still working through issues related to designing potential pre-approved documents for ESOPs. We will have to see when those documents become available and whether such documents will be flexible enough to meet the needs of a leveraged ESOP. Nonetheless, ESOP plan sponsors must be diligent in timely adopting any required amendments. Under current guidance, 2016 required amendments must be incorporated by Dec. 31, 2018.

What is not new and still not answered?

  1. There are a number of open questions concerning valuations for ESOP companies. What control premium is appropriate? Public company transactions are likely not the best comparison. Are risk-adjusted discount rates appropriate? In the past, trustees used this approach to adjust for less than reliable projections from management but it is likely better to have management fix the projections. What is the impact of warrants on the valuation? When warrants are a part of the deal, what should the strike price be? There are many possibilities one could use: the ESOP purchase price, the anticipated post-transaction value, or some other value tied to the long-term expectations for the company. No matter what the warrant price, you can be certain that the DOL will carefully evaluate the impact of warrants when they investigate such transactions. 
  2. The overwhelming answer for many questions is “it depends.” The unique fiduciary issues related to ESOPs make it necessary to weigh each decision carefully in relation to the facts to determine what the appropriate action might be in certain situations. For example, should a mature ESOP company re-leverage shares? There are pros and cons on both sides of the issue. What is the right level of stock appreciation rights or warrants in a transaction? What is the correct provision for floor price protection in a transaction that moves a plan from partial to 100 percent ESOP-owned? Is it even permissible for the company to dilute the interest of current and future participants by redeeming shares of former employees at a value higher than the appraised value? Each of these questions is just one piece of an overall transaction with several pieces, so the answer really depends on all of the other pieces.

The ESOP environment is always evolving, and given the lack of specific guidance for many ESOP transaction and operational issues, staying up-to-date with the community is important. Reach out to qualified professionals with ESOP experience to help guide you through the many ESOP nuances.


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