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Don't Do That

Common Mistakes in Operating an ESOP and What to Do About Them

(Print Version)

2nd Edition

by Corey Rosen (editor and coauthor), with contributors Merri Ash, Deborah Baker, Ted Becker, Carmen Brickner, Greg Brown, Jude Anne Carluccio, Barbara Clough, Bill Dietrich, Nancy Dittmer, Steven Etkind, Ron Gilbert, Tim Jochim, Lou Joseph, Matt Keene, Judy Kornfeld, Steven Lifson, Michael Quarrey, Loren Rodgers, Randy Rowland, Paige Ryan, Pete Shuler, Stephen 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. In 2010, we engaged leading ESOP experts from all fields to do this and added quite a few stories of our own. The company name is usually disguised, but the scenarios and solutions are real.

For the second edition in 2015, NCEO members and staff contributed a number of new cases, and a few minor updates were made. 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, 147 pages
Dimensions: 6 x 9 inches
Edition: 2nd (April 2015)
Status: In stock


Introduction: Not Knowing What You Don't Know
Chapter 1: Setting Up the ESOP
Were Those ESOP Floating Rate Notes Really the Best Idea?
What Is an ESOP Loan?
But My Brother-in-Law Said He'd Done Lots of ESOPs!
The Case of the ESOP Where Everything Went Wrong
Gosh, It Costs That Much?
Honey, I Forgot to Mention the Options
The ESOP May Be Great for You, But It's Not for Me
Old Harold Turned Out to Be Irreplaceable After All
We Shouldn't Have Been So Optimistic About That Light at the End of the Tunnel
Chapter 2: Executive Compensation
We Should Have Converted Those Options Before We Became a 100% ESOP
Consider Your SAR Design
You Mean Managers Can't Get Whatever They Want?
But I Could Get More Equity Without an ESOP!
Chapter 3: Corporate Governance Goofs
Help—I'm Over My Head Here on This Board
The Information We Got for Voting Wasn't Exactly Objective
They Were My Buddies and Advisors. Why Not Have Them on the Board
But I Promised My Son He Could Be Boss
We Used to Get Along So Well: When Managers Are at Odds After an ESOP
Chapter 4: Repurchase Obligations and Distribution Policy Issues
We Paid Our Loan Off Too Fast, Vested Too Slowly, Had No Inside ESOP Loan. Oops.
The Tale of the Too-Liberal Distribution Policy (with What Will Probably Be a Happy Ending)
We Had the Extra Cash, So Why Not Pay People Out Now?
We Forgot to Tell the Employees, and They Didn't Just Get Mad, They Sued
Delayed Distributions and Internal Loans: The Rap
Be Careful What Your Lawyer Tells You
Oops—We Grew Too Fast
We Needed the Cash, So We Just Borrowed It from Participants
We Can't Just Get Print Shares Whenever We Like? (The Dilution Solution)
Diversification Follies
The Security Was, Well, Not So Secure
Chapter 5: Plan Administration
Funding ESOP Distributions: Can the End Justify the Means?
Our New Employees Aren't Owners
We Were Supposed to Allocate Shares Using That Formula?
We Paid the Loan at One Time and Allocated the Shares at Another
Our 401(k) and ESOP Didn't Get Along
What's This Primarily Invested Thing?
Chapter 6: S Corporation Issues
But We Didn't Mean to Be Abusive
Our S Distributions Were Great. Maybe Too Great.
Our Synthetic Equity Was Creating Real Problems
Distributions, Our 70% ESOP, and Those Unmanageable Distributions
Too Much Cash, or When Printing More Shares Is the Answer
Chapter 7: Fiduciary Faux Pax
It's Not Your Company Anymore
I'm the Trustee, and I Think the CEO (My Boss) Is Raiding the Company
I Sold My Company, But It's Still My Piggy Bank
The Trustees Aren't There to Do the Former Owner's Bidding
When Two Hats Aren't Better Than One
Why Can't I Be a Director, Officer, ESOP Committee Member, and Trustee?
We Had Indemnification. Why Pay for Insurance Too?
Indemnification Issues, Round Two: What the Courts Say
It's Not Your Job to Provide Investment Advice
When It Comes to the Future of Your Distributions, Be Careful What You Predict
Chapter 8: Valuation Vexations
The Appraisal Really Is Meant to Be by a Qualified, Independent, and Unbiased Expert
The Case of the Missing Forecast
Value Once and Value Twice and Value Once Again?
It's Not Really Worth That Much, Is It?
Sometimes It Isn't Good to Share
Paying for Control When You Don't Have It
An Untimely Valuation
Chapter 9: Financial Foibles
We Wanted to Pay Down the ESOP Loan as Fast as Possible, So We Used All the Dividends in the Plan to Make a Loan Payment
The Wrong Entity Held the ESOP Loan
You Mean Our ESOP Loan Isn't Like Any Other Bank Loan?
We Repaid the Loan Too Soon
Our Unreasonable Dividends
Our Extremely Unreasonable Dividends
Really, the Bank Loan and ESOP Loan Do Not Have to Have the Same Terms
Chapter 10: Cultural Conundrums
You Mean We Aren't Really Owners?
It's You, Irv: The Case of the Owners Who Don't Act That Way
The Web of Our Ownership Culture Was Not Fully Woven
I Gave Them the Business, and No One Even Thanked Me
Questions Anyone? OK, Thanks for Listening
We Shared the Numbers, But It Didn't Get Us Anywhere
We Forgot the Middle Managers


From Chapter 5, "Plan Administration"

Funding ESOP Distributions: Can the End Justify the Means?
Lou Joseph
Morgan, Lewis and Bockius, LLP

Like many S corporation ESOPs (and some C corporation ESOPs, as well), the plan document for the Good Intentions Corp. ESOP gives the company discretion whether to make distributions to participants in the form of cash or company stock. The company is well aware that virtually all retirees and former employees want and need cash. The company also understands, and has fully communicated to the employees, that the amount to be distributed is based upon the fair market value of the company's stock allocated to the participant's account on the most recent valuation date—for this plan, the immediately preceding December 31. The Good Intentions ESOP generally makes distributions in May or June, after the year-end plan administration, audit, and valuation are completed.

Years earlier, when the ESOP was first being adopted, Good Intentions management had the foresight to ask their advisors about how they would go about funding future ESOP distributions if the ESOP lacked liquid assets to pay the amounts due former employees. Their notes of that discussion recorded four approaches to generating the required funding:
  • Cash contributions to the plan
  • Cash dividends (S corporation distributions) to the plan
  • Stock distributions to participants followed by redemption by the company (using a "deemed put" to assure the redemption would occur)
  • Redemptions of stock by the company from the ESOP (with the cash consideration then distributed to the participants)

Their notes also indicated that the company could repurchase shares using the most recent valuation, which made perfect sense since this was exactly the amount owed to the former employees.

When it came time to start making distributions from the ESOP to the company's former employees, Good Intentions' management reviewed the advice they had previously received. They immediately dispensed with the cash contribution alternative, as the company was already making contributions at the legal limit to allow the ESOP to repay its securities acquisition loan. The idea of paying dividends to the ESOP initially seemed like a more viable alternative but, in the end, was found to be unattractive because such dividends would also flow to the company stock accounts of former employees, ultimately resulting in those former employees receiving additional shares of company stock.

On balance, redemption of the shares allocated to the accounts of participants due to receive distributions seemed like the best course for Good Intentions to follow. Although they knew that this course could be effectuated by distributing shares to the participants immediately followed by a "deemed put" and repurchase by the company, this seemed like an unnecessarily complex way in which to proceed. Participants who just wanted their cash would not understand why they were receiving stock, what the purpose and meaning of the "deemed put" might be, the special tax rules applicable to stock distributions, how they would be able to rollover the proceeds, etc.

At that point, the answer appeared clear. The easiest and most efficient way to fund distributions would be for the company to redeem the shares directly from the ESOP for cash based on the stock value determined as of the most recent valuation date. This would give the ESOP the exact amount of funds required to meet its distribution obligations, and the participants would receive exactly the amount of money they expected and were entitled to receive.

And so, for a number of years, Good Intentions funded ESOP distributions in exactly this manner. Unfortunately, when the DOL came to audit the ESOP, Good Intentions discovered that good intentions were not enough to avoid a determination that each of the stock redemptions constituted a prohibited transaction under ERISA and the Internal Revenue Code. Where did Good Intentions go wrong? They failed to understand (or, perhaps, were not clearly advised) that there is a critical difference in the price to be paid for company stock depending on whether the shares are being purchased from the participants versus being purchased from the ESOP.

[this case continues for several more paragraphs]

From Chapter 8, "Valuation Vexations"

The Appraisal Really Is Meant to Be by a Qualified, Independent, and Unbiased Expert
Ted Becker
Drinker Biddle & Reath LLP

Bruister and Associates Inc. was a company that installed and serviced satellite television equipment in homes for its sole client DirectTV. Herbert Bruister, the sole owner of the company, sold 100% of his shares in the company to ESOPs for $24 million. The company later went bankrupt. ESOP participants and the Department of Labor sued Mr. Bruister and others, claiming that Mr. Bruister entered into prohibited transactions and the fiduciaries breached their fiduciary duties under ERISA. Mr. Bruister and other ESOP fiduciaries were ordered by the court to restore nearly $6.5 million to the ESOPs.

There are several "don't do's" for ESOP fiduciaries pointed out in the court's opinion:

Don't wear conflicting hats. Although there were two named fiduciaries (an employee and the company's CPA), the court found that Mr. Bruister, the seller of stock to the ESOPs, was also an ESOP fiduciary because he exercised an influence on the named fiduciaries. He also had a fiduciary capacity as a director of the company. The court found that the ESOP fiduciaries' duty of loyalty "was breached from start to finish."

Don't rely on an unqualified appraiser. The appraiser who valued the stock for sale to the ESOPs did not have a college education and had been convicted of a felony for embezzlement from a trust. The court found that the ESOP fiduciaries failed to adequately investigate the appraiser's qualifications.

Don't improperly influence the appraiser to overvalue stock purchased by the ESOP. The court found that Mr. Bruister received draft valuation reports from the appraiser before they were provided to the ESOP, the appraiser accepted suggestions from the company's attorney regarding the appraisal amount, and the appraiser ultimately issued a valuation that was $9 million higher than his initial number.

Don't fail to provide the appraiser with complete and accurate company information. The court found that the fiduciaries unreasonably relied on the appraiser's conclusions when they knew he had not been given complete information, such as that DirectTV had been slashing rates and requiring the company to provide its own vehicles. The court found that the fiduciaries painted a "rosy picture" of the company's prospects to the appraiser while voicing serious concerns in private.

From Chapter 10, "Cultural Conundrums"

You Mean We Aren't Really Owners?
Corey Rosen
National Center for Employee Ownership

Few months go by without our getting at least one call like this at the NCEO:

Caller: I work for an employee ownership plan company and I just wanted to know what my rights are. They keep telling us we are employee-owners, but then we don't seem to have any say about what goes on.

Us: Can you tell me more about what kinds of issues that is creating?

Caller: Well, for instance, the board decided to replace the old CEO with a new one, and the new one is really making a mess of things. Some of the decisions he is making just don't make sense. He has decided to change the way we operate one of our lines of business, and it is really costing us money. (Or he has hired incompetent friends as executives, or he has fired some really good people, or he has spent money on new equipment we really can't use, or he won't listen to any employee ideas, and we think he is actually stealing money from the company, etc.) But when we raised the issue at a staff meeting, he said that our job was to be employees and his job was to make decisions, even if they were not popular. Don't we have a right to have a say about any of this?

Us: Well, actually the legal owner of the shares is the trust, and the trustee has the right to vote the shares to elect the board. The board then runs the company.

Caller: So we are not really owners. They told us we were owners.

Us: You are actually beneficiaries of the trust. You have the rights to the value of ownership in your company, but, in most ESOPs, you do not have any control rights.

Caller: That doesn't seem right. If you are an owner, you should have some control.

Us: I understand your concern, but put yourself in the shoes of the owner who set up the ESOP. If he knew in advance that employees could now control the company, he might worry about what they might decide to do with it, especially since he is probably still on the line for the money the ESOP trust borrows to buy the shares. So he might just decide to sell to someone else.

Caller: OK, I can understand that, but it really seems that if things are not going well, we should have some say to protect our company. But I guess there is just nothing we can do, right?

Us: You should try to present your concerns in a positive way to the CEO, but if he chooses not to listen, there really isn't.

The caller's frustration is understandable—but so is the point of view of the seller in setting up the plan rules. Ideally, the CEO should welcome employee input and take it seriously, but many don't. And even those who do will often find that some employees just disagree and can't be persuaded otherwise.

It would help greatly if when the plan was—and is—communicated, companies make very clear just what they mean by employee ownership. If input will be limited, let people know that this is beneficial ownership of the value of the company, not control. Explain why the company would be concerned about letting employees have more control and what kinds of input they can have. Stress that the ESOP is a free benefit—if they paid for the stock, they could legitimately expect more rights. There is a temptation to sell the ESOP by stressing ownership, but just explaining it will work much better in the long run.