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What Is "Adequate Security"?

December 1994

The focus of this first installment of the ESOP Forum is on one aspect of ESOP benefit distributions that has resulted in a substantial amount of discussion in the ESOP community and scrutiny by the Department of Labor (DOL) over the past year: How must promissory notes that are issued to participants in return for company stock sold to the company (that established the ESOP) under a put option after distribution be secured to comply with section 409(h)(5)(B) of the Internal Revenue Code of 1986, as amended (the Code)?

If company stock that is not readily tradable on an established market is distributed to a participant from an ESOP, section 409(h)(4) of the Code requires the company that established the ESOP to provide a "put option" to the participant. The put option must allow the participant to sell the company stock to the company at any time during two put option periods (for a period of at least 60 days following the date of distribution and for another period of at least 60 days in the following plan year) at the then fair market value.

If company stock is distributed as part of a total distribution of an ESOP participant's account that occurs within one taxable year of the participant, section 409(h)(5) of the Code requires the payment for any shares sold under the put option to begin within 30 days after the participant exercises the put option. Payment by the company may be made in a lump sum or in substantially equal periodic payments (not less frequently than annually) over a period not exceeding five years, with adequate security provided and reasonable interest paid on any unpaid installment balance.

The issue of what constitutes "adequate security" was responsible, in part, for the DOL issuing a 40-plus page letter on audit to an ESOP company in February 1994. Although there are no Internal Revenue Service (IRS) regulations that define this term in the put option context, the United States Court of Appeals for the Eighth Circuit addressed a similar issue in Roth v. Sawyer-Cleator Lumber Company Employee Stock Ownership Plan, 16 F.3d 915 (8th Cir. 1994). In Roth, the Eighth Circuit considered whether the trustees of an ESOP had breached their fiduciary duty by failing to provide "adequate security" (as required by the put option provisions of DOL Reg. section 2550.408b-3(l)(4)) for 10-year promissory notes participants received as payment for their stock. The Eighth Circuit held that the trustees had the fiduciary duty to evaluate not only the value of the security at the time the promissory notes were issued, but also whether it would retain its value throughout the repayment of the notes.

The IRS addressed this issue more directly, however, in a Technical Advice Memorandum (TAM) that it published in April 1994. In TAM 9438002 (dated April 29, 1994), the IRS concluded that promissory notes that are issued to participants in return for company stock sold to the sponsoring company under a put option after distribution, and backed only by the issuing sponsor's "full faith and credit," are not "adequately secured" under section 409(h)(5)(B) of the Code because they are not backed by tangible assets that may be sold or foreclosed upon in the event of default on the repayment of the promissory notes. In concluding that the unsecured corporate promissory notes did not provide "adequate security" for the unpaid amounts that the company owed on its company stock repurchases, the IRS indicated that the notes must be backed by tangible assets. The IRS reasoned that such tangible assets could be sold, foreclosed upon or otherwise disposed of in the event of default on the repayment of the promissory notes.

Many companies have simply issued unsecured promissory notes in connection with put options. This all-too-common practice does not meet the requirement for adequate security. Companies should adjust their practices accordingly. In addition, they should consider making installment distributions of company stock which must be paid for in full within 30 days after the put option is exercised rather than lump sum distributions of company stock that are normally paid for over time with promissory notes. Although the value of each installment distribution and the cost to the company of repurchasing the company stock distributed in each installment is determined at the time of distribution, and subsequent increases in value will increase the cost to the company of repurchasing the stock, this will avoid the "adequate security" issue that has caused some companies to spend a considerable amount of time dealing with the DOL and/or the IRS on audit. It also may help to avoid costly participant claims or lawsuits in the event the company is unable to make good on the promissory notes that it issues in connection with the put options.

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