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Don't Do That
Common Mistakes in Operating an ESOP and What to Do About Them
(Print Version)
by Corey Rosen (editor and coauthor), with contributors Merri Ash, Deborah Baker, Carmen Brickner, Gregory K. Brown, Jude Anne Carluccio, Barbara Clough, William Dietrich, Nancy Dittmer, Steven Etkind, Ron Gilbert, Tim Jochim, Judith L. Kornfeld, Steven R. Lifson, Michael Quarrey, Loren Rodgers, Randy Rowland, Paige A. Ryan, Peter J. Shuler, Stephen D. Smith, James Steiker, and Jack Veale
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For many years, we at the NCEO would hear stories about ESOPs that made us wince. People experienced problems, sometimes serious ones, that good and timely advice would have prevented. As these stories mounted, it seemed we could save people a lot of headaches if we could write about some of the common (and a few not-so-common) mistakes ESOP companies make and how to avoid them.
Rather than just another long checklist, however, we have written this as a series of stories. The company name is usually disguised, but the scenarios and solutions are real. We engaged leading ESOP experts from all fields to help us with this task and added quite a few stories of our own. There is a good chance you will recognize your own company in at least a few of these dilemmas. If not, the book will give you greater confidence that you really aren't missing something. Either way, you'll sleep better at night.
Rather than just another long checklist, however, we have written this as a series of stories. The company name is usually disguised, but the scenarios and solutions are real. We engaged leading ESOP experts from all fields to help us with this task and added quite a few stories of our own. There is a good chance you will recognize your own company in at least a few of these dilemmas. If not, the book will give you greater confidence that you really aren't missing something. Either way, you'll sleep better at night.
Publication Details
Format: Perfect-bound book, 130 pages
Publication date: April 2010
Status: In stock
Contents
Introduction: Not Knowing What You Don't Know
Chapter 1: Setting Up the ESOP
Chapter 2: Executive Compensation
Chapter 3: Corporate Governance Goofs
Chapter 4: Repurchase Obligations and Distribution Policy Issues
Chapter 5: Plan Administration
Chapter 6: S Corporation Issues
Chapter 7: Fiduciary Faux Pax
Chapter 8: Valuation Vexations
Chapter 9: Financial Foibles
Chapter 10: Cultural Conundrums
Chapter 1: Setting Up the ESOP
Chapter 2: Executive Compensation
Chapter 3: Corporate Governance Goofs
Chapter 4: Repurchase Obligations and Distribution Policy Issues
Chapter 5: Plan Administration
Chapter 6: S Corporation Issues
Chapter 7: Fiduciary Faux Pax
Chapter 8: Valuation Vexations
Chapter 9: Financial Foibles
Chapter 10: Cultural Conundrums
Excerpts
From Chapter 9, "Financial Foibles":
A company implemented an ESOP in 2000. The company first borrowed funds from a financial institution (the "bank loan"). The ESOP in turn borrowed those funds from the company (the "inside loan") and used the proceeds to buy stock. Both the bank loan and the inside loan had a term of three years.
The folks involved in the ESOP implementation at the company had a financial background (e.g., VP of Finance, CFO, etc.) and brought a bias against debt to the ESOP transaction design process. Their natural tendency was to want the ESOP debt off of their balance sheet as soon as possible. They did not have any advisors with sufficient ESOP experience to warn them of the consequences of their decisions.
In the distant past, there may have been a reason for the terms of these two loans to be identical (other than the occasional ESOP advisor who erroneously still tells clients they have to be). Specifically, Internal Revenue Code Section 133 provided an incentive to the lenders to provide the ESOP financing. One of the requirements of that provision was that the terms of the inside loan mirror the terms of the bank loan. However, Code Section 133 has long since been repealed, and so that is no longer a reason to tie the terms of these two loans to each other.
As with any leveraged ESOP transaction, the shares acquired with the inside loan were held in a suspense account and were released each year as that loan was repaid. So all of those shares were released and allocated at the end of those three years.
The problems encountered by the company included:
Lessons
To prevent these types of issues, many companies are structuring the inside loans to have longer terms of 15 years or even longer. The determination of the loan term is made by modeling what would be the desired level of annual benefit to the ESOP participants, assuming this is not some unreasonably low level. Note that your legal counsel and transactional trustee will likely also have some input on how long the term should be. Just resist the urge to settle on a short-loan term without doing some modeling and thinking ahead to what you want your ESOP to look like in the longer term.
Before making this change, however, please note that inside loans can be paid off more slowly, but if the length of the loan means that employees will not get distributions for far into the future (because the law allows distributions to be delayed until the loan is repaid), you potentially have a fiduciary issue, and you will make the plan largely irrelevant to most employees because they will see the distribution event as far off and uncertain.
We Repaid the Loan Too Soon
Nancy Dittmer, RSM McGladreyA company implemented an ESOP in 2000. The company first borrowed funds from a financial institution (the "bank loan"). The ESOP in turn borrowed those funds from the company (the "inside loan") and used the proceeds to buy stock. Both the bank loan and the inside loan had a term of three years.
The folks involved in the ESOP implementation at the company had a financial background (e.g., VP of Finance, CFO, etc.) and brought a bias against debt to the ESOP transaction design process. Their natural tendency was to want the ESOP debt off of their balance sheet as soon as possible. They did not have any advisors with sufficient ESOP experience to warn them of the consequences of their decisions.
In the distant past, there may have been a reason for the terms of these two loans to be identical (other than the occasional ESOP advisor who erroneously still tells clients they have to be). Specifically, Internal Revenue Code Section 133 provided an incentive to the lenders to provide the ESOP financing. One of the requirements of that provision was that the terms of the inside loan mirror the terms of the bank loan. However, Code Section 133 has long since been repealed, and so that is no longer a reason to tie the terms of these two loans to each other.
As with any leveraged ESOP transaction, the shares acquired with the inside loan were held in a suspense account and were released each year as that loan was repaid. So all of those shares were released and allocated at the end of those three years.
The problems encountered by the company included:
- The level of contributions required to repay an inside loan in three years resulted in an annual contribution for each participant of close to 25% of compensation. The participants who received this level of contribution developed a sense of entitlement to this benefit. However, this level of benefit was not sustainable after the debt was repaid. Those participants were upset with the reduction in their ESOP contributions that occurred in 2004 and the following years.
- Once the loan was repaid, that pool of shares was completely allocated. This particular ESOP never entered into a second transaction, and there were not any additional share contributions made to the ESOP. Thus, the participants who entered the ESOP after the inside loan was repaid have only received very small allocations of shares as the long-term participants terminate employment and their shares are recycled. This has created a situation of Haves vs. Have-Nots (i.e., some employees have a significant number of shares in their ESOP accounts, and others do not.) The company is finding it arduous to create that desired culture of employee ownership when some employees do not have meaningful ownership.
Lessons
To prevent these types of issues, many companies are structuring the inside loans to have longer terms of 15 years or even longer. The determination of the loan term is made by modeling what would be the desired level of annual benefit to the ESOP participants, assuming this is not some unreasonably low level. Note that your legal counsel and transactional trustee will likely also have some input on how long the term should be. Just resist the urge to settle on a short-loan term without doing some modeling and thinking ahead to what you want your ESOP to look like in the longer term.
Before making this change, however, please note that inside loans can be paid off more slowly, but if the length of the loan means that employees will not get distributions for far into the future (because the law allows distributions to be delayed until the loan is repaid), you potentially have a fiduciary issue, and you will make the plan largely irrelevant to most employees because they will see the distribution event as far off and uncertain.
