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A Summary of ESOP Legal Developments During 2000

David Johanson

March 2001

This is a brief summary of legislative, case law and regulatory developments that affected employee stock ownership plans (ESOPs) and related plans during the calendar year 2000. A comprehensive article covering the items included in this brief summary will appear in the spring 2001 issue of the the Journal of Employee Ownership Law and Finance (the "Journal") that the National Center for Employee Ownership will publish in April or May 2001. This summary is intended to (1) provide professional advisors, consultants and employee owned companies with some background regarding these developments, (2) assist professional advisors and consultants in continuing to provide updated advice to their clients and (3) assist employee owned companies in identifying areas in which they may need continuing professional advice and/or consulting services.

In the area of case law, the courts focused once again on valuation and fiduciary issues under the Employee Retirement Income Security Act of 1974, as amended (ERISA), during 2000. For example, did the ESOP pay more than fair market value for the company stock that it purchased? Furthermore, did the ESOP’s fiduciaries act in the best interests of ESOP participants and beneficiaries in deciding to purchase company stock for the ESOP? The courts also issued two very significant decisions during 2000 regarding allocation limits under Section 415 of the Internal Revenue Code of 1986, as amended (the "Code"), and rendered a number of decisions regarding various matters of civil procedure applicable to litigation involving ESOP companies. Among the many significant issues that the Internal Revenue Service (IRS) handled during 2000, the IRS issued Private Letter Rulings (PLRs) regarding (1) Subchapter S corporations, (2) the primary benefit requirement of the ESOP loan prohibited transaction exemption under Section 4975(d)(3)(A) of the Code, (3) the repayment of an ESOP loan with proceeds from the sale of company stock, (4) the treatment of proceeds from the sale of company stock as "earnings" rather than "annual additions" under Section 415(c) of the Code, (5) the concept of "readily tradable on an established securities market" as it relates to Section 1042 of the Code and (6) a very tax efficient way of structuring acquisition transactions and mergers of two companies and their ESOPs. The IRS also revised Forms 5309 and 5500 during 2000. Form 5309 is used specifically for an ESOP when requesting a favorable determination letter from the IRS for an ESOP. Form 5500 is the annual return/report for qualified retirement plans, including ESOPs. The IRS substantially changed Form 5500. During 2000, the IRS also extended the deadline for making various changes that Congress has provided for in legislation over the past few years (since 1994) and applying for new favorable determination letters with respect to such changes for individually designed plans, including ESOPs. The new deadline is generally the end of the first plan year beginning in 2001. This will be something that all ESOP companies and companies that sponsor other qualified retirement plans will have to focus on during 2001 and/or 2002. The U.S. Department of Labor (the DOL) announced a program during 2000 that describes how companies may voluntarily correct fiduciary violations with respect to their retirement plans, including ESOPs. The DOL also released final regulations on the claims procedures proscribed under ERISA for all employee benefit plans, again including ESOPs.

Case Law

Among the many significant Federal court decisions during 2000, the U.S. District Court for the Southern District of Alabama (Northern Division), in Dairy Fresh Corporation v. Poole (August 9, 2000), held that Dairy Fresh Corporation (the "Company") could not reform the terms of an eight-year-old ESOP transaction in order to correct what it viewed (in hindsight) as a mistake made to the benefit of the Dairy Fresh Employee Stock Ownership Plan (the "ESOP") in the number of the shares the ESOP was to receive. In addition to the manner in which the district court handled this substantive issue, this decision is particularly instructive with respect to the district court’s removal of the Company and the ESOP’s individual trustee as fiduciaries for failing to act in the best interests of the ESOP. The U.S. Court of Appeals for the Fourth Circuit, in Smith v. Sydnor (July 9, 1999), originally reversed the dismissal of a claim for breach of fiduciary duty against a profit sharing plan trustee and sent the case back to the district court for further proceedings. In a major reversal of an opinion that this article highlighted in the 1999 Legal Update, the U.S. District Court, in Smith v. Sydnor (August 25, 2000), held that the trustee had not breached his fiduciary duty when he sold the ESOP's company stock back to the company at a price that was below the stated redemption price. The conclusion in the 1999 Legal Update (based upon a preliminary review of the Fourth Circuit decision) was that the trustee's actions were an example of what not to do as a plan fiduciary. The underlying facts have now become much clearer following the trial of the case. It now appears that the trustee acted in the interests of the plan participants and in accordance with their ERISA fiduciary duties. In Howard E. Clendenen, Inc. v. Commissioner (March 29, 2000), the U.S. Court of Appeals for the Eighth Circuit affirmed the U.S. Tax Court's determination that a corporation's contributions to an ESOP on behalf of its president exceeded the limitations under Section 415(c) of the Code, causing the ESOP to fail to qualify under Section 401(a) of the Code. In a very similar case, Van Roekel Farms, Inc. v. Commissioner (May 24, 2000), the U.S. Tax Court ruled that a company’s contributions to an ESOP on behalf of its sole participant exceeded the limitations applicable under Section 415(c)(1) of the Code, causing the ESOP to fail to qualify under Section 401(a) of the Code. This case addresses the same issue and reaches the same conclusion as two other cases, Roblene, Inc. v. Commissioner and Howard E. Clendenen, Inc. v. Commissioner. All three cases hold that an individual’s compensation as an independent contractor for a company that sponsors an ESOP (or any other qualified retirement plan) is not "participant's compensation" under Section 415(c) of the Code for purposes of that ESOP. In a case whose origin dates back to the early 1990s, it is noteworthy that on June 6, 2000, the U.S. Department of Labor (the "DOL") announced, in U.S.DOL/PWBA Press Release 00-29, that it had reached a settlement with Wachovia National Bank ("Wachovia") and William A. Fickling, Jr., the former president and CEO of Charter Medical Corporation ("Charter"), in the sum of $42 million. This settlement puts an end to a 10-year battle among the DOL and fiduciaries and parties-in-interest to the Charter Medical Corp. Employee Stock Ownership Plan, now known as the Magellan Health Services, Inc. Employee Stock Ownership Plan. This litigation also is noteworthy in two other respects as a result of holdings that occurred prior to the settlement. First, relying upon Section 502(a)(5) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), which authorizes the DOL to obtain "appropriate equitable relief" in order to redress violations of ERISA, including "prohibited transactions" under Section 406 of ERISA, the Eleventh Circuit originally held that ERISA authorizes the DOL to sue non-fiduciary "parties-in-interest" whose acts violate Section 406 of ERISA for equitable relief. Second, the Eleventh Circuit also had previously held that the private litigants’ settlement did not bar the DOL’s action against Mr. Fickling and Wachovia; the DOL had national public interests separate and distinct from those of private litigants. On February 22, 1999, the U.S. Supreme Court had denied review of the decision of the Eleventh Circuit. On August 10, 2000, in Bins v. Exxon Company U.S.A., the U.S. Court of Appeals for the Ninth Circuit determined, as a matter of first impression on a rehearing en banc, the point at which an employer who administers a plan under ERISA has a duty to inform plan participants that it is considering a proposal to offer more generous retirement incentive benefits. This decision is instructive generally with respect to an employer-fiduciary’s ERISA responsibilities for communicating with its ERISA plan participants. Furthermore, although this decision did not involve an ESOP, it also is instructive for a company that sponsors an ESOP and to their employees who participate in an ESOP (e.g., in the context of information that is communicated to such participants regarding the fair market value of their stock account balances, corporate changes that may impact such stock account balances and the timing, form and procedures for distribution of vested retirement benefits). In another significant fiduciary responsibility case, on December 15, 2000, the DOL announced that a Federal district court in Louisville, Kentucky entered a default judgment against a trustee and plan sponsor of an ESOP requiring them to restore $1,941,519 to the ESOP trust. In 1998, the DOL had filed a lawsuit against the individual and the bank, Stock Yards Bank, the co-trustees of the ESOP, and the plan sponsor, Building Services Unlimited, Inc., alleging that actions taken by the trustees violated provisions under ERISA that prohibit plan fiduciaries from self-dealing and dealing with plan assets in a manner adverse to plan participants. In a holding that has a bearing on communications between legal counsel and a company, on June 28, 2000, in the case In Re Occidental Petroleum Corporation, the U.S. Court of Appeals for the Fifth Circuit held that a company could not assert the attorney-client privilege as grounds for its refusal to provide documents to certain former employees who had brought suit against it on behalf of an ESOP that the company had established for one of its subsidiaries. A number of case law decisions during 2000 handled very important issues of civil procedure, including preemption of state law claims by ERISA, binding arbitration of ERISA claims and standing to bring a lawsuit, all of which are discussed in this year’s Spring issue of the Journal.

Internal Revenue Service

In the area of regulatory law, the IRS issued one more significant Private Letter Ruling (PLR) that will impact the many corporations that have elected S corporation status over the last two years. In PLR 200014043 (January 12, 2000), the IRS ruled that it is permissible to use earnings on unallocated shares in the ESOP's loan suspense account to make payments on an ESOP loan to the extent that such earnings are from either accumulated earnings and profits or from the S corporation's accumulated adjustments account. Although PLR 200014043 does not address the use of earnings on allocated shares of company stock or other S corporation/ESOP issues, it does break new ground in confirming that because S corporation distributions are earnings they do not constitute "annual additions" for purposes of Section 415(c)(2) of the Code. In PLR 200006054 (November 16, 1999), the IRS issued a rare ruling on the primary benefit requirement of the ESOP loan prohibited transaction exemption under Section 4975(d)(3)(A) of the Code. Although the ruling itself is not extraordinary, the decision to issue it is significant because the IRS does not generally issue rulings on the Code's primary benefit requirement due to the factual nature of the issues involved. In PLR 200018058 (February 9, 2000), the IRS ruled that the termination of an ESOP and the ESOP's sale of shares of company stock to the plan sponsor in connection with the merger of the plan sponsor with another, unrelated company did not violate: (1) the requirement of Section 4975(d)(3)(A) of the Code, that an ESOP loan be for the primary benefit of ESOP participants; (2) the release from encumbrance rules of Treasury Regulation ("Treas. Reg.") Section 54.4975-7(b)(8); or (3) the requirement of Treas. Reg. Section 54.4975-7(b)(13) that an ESOP loan be for a specific term and not be payable on demand. The IRS also ruled that the proceeds that the ESOP received from the sale of unallocated shares of company stock was a permissible source of repayment of the ESOP loan under Treas. Reg. Section 54.4975-7(b)(5). The IRS also reached similar conclusions in PLR 200034039 (June 2, 2000). The IRS also ruled in PLR 200034039 that to the extent that any proceeds of the sale of the unallocated stock were allocated to participant accounts after the acquisition loan was repaid, such amounts would be considered earnings, not annual additions subject to the limitations of Section 415 of the Code. The IRS also issued two significant rulings regarding Section 1042 of the Code during 2000. First, the IRS ruled in Revenue Ruling ("Rev. Rul.") 2000-18 that a transfer of qualified replacement property (QRP) to a partnership in exchange for an interest in that partnership is a disposition of the QRP that results in recapture of the gain deferred by the transferor in the sale of stock to an ESOP. Second, the IRS ruled in PLR 200052014 that a company's voting and nonvoting stock that was quoted on the Over the Counter Bulletin Board (OTCBB) would not be considered "readily tradable on a established securities market" under Sections 409(l) or 1042(c)(1)(A) of the Code. As a result of this ruling, the shareholders of the company's stock would be permitted to sell their stock to an ESOP and make the nonrecognition of gain election under Section 1042 of the Code. In PLR 200007038 (February 18, 2000), the IRS ruled that a restorative payment made by a company to its ESOP would not be considered an employer contribution for purposes of the qualified retirement plan provisions of the Code. The IRS also issued final regulations during 2000, which relax the rules that generally prohibit qualified plans from eliminating forms of benefit distribution. Of particular interest to ESOPs is a provision that may permit the elimination of distributions in the form of company stock when an ESOP terminates after having sold all of its shares of company stock. The IRS issued another significant ruling during 2000 that positively impacts the structuring of acquisition transactions involving ESOPs. In PLR 200052023, the IRS ruled that an acquisition of all of the outstanding stock of an unrelated target corporation (the "Target Company") in an exchange for stock of the acquiring corporation (the "Acquiring Company") was a valid tax-free reorganization. This ruling alone is unremarkable. The more interesting part of the ruling was that the Target Company shareholder sold stock to the Target Company ESOP in a Section 1042 transaction and the Target Company ESOP then merged into the Acquiring Company ESOP at the same time that the tax-free reorganization occurred. The IRS also issued a number of other PLRs that generally affect retirement plans (including ESOPs) and their sponsors, all of which are addressed in this year’s article in the Spring issue of the Journal.

U.S. Department of Labor

From the other major regulatory agency that periodically audits and investigates ESOP companies with respect to their ESOPs and other retirement plans, the DOL finally announced its long-awaited Voluntary Fiduciary Correction Program (VFCP) for the correction of fiduciary violations of ERISA. Analogous to the programs created by the IRS over the last ten years for the correction of qualification failures, a company may apply under VFCP to the DOL for the voluntary correction of certain fiduciary violations of ERISA. The 13 fiduciary violations covered by VFCP include, for example, "improper" sales of assets between plans and parties in interest, loans by plans to participants with inadequate security or interest rates, a plan's payment of excessive expenses and improper valuation of plan assets. The DOL also was active in other areas during 2000. On November 21, 2000, the DOL released final regulations on the claims procedures proscribed under ERISA for all employee benefit plans. The revisions to the existing ERISA claims procedure regulations focus mainly on medical benefit and disability benefit plans, but some changes were made which apply to all pension plans, including ESOPs, as well. The regulations became effective on January 20, 2001, but will only apply to claims filed on or after January 1, 2002. These and many other significant matters are addressed in this year’s Spring issue of the Journal.

Conclusion

Hopefully, this article will assist professional advisors, consultants and employee owned companies identify issues that they need to learn more about in order to keep update with the regulatory and legal environment involving ESOPs. As indicated throughout, please refer to the Spring issue of the Journal for detailed summaries of all of the major legislative, case law and regulatory developments that occurred during 2000.

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