All businesses go through cycles. This publication is a realistic look at how ESOP companies and ESOP trustees can deal with adverse business conditions. The authors not only describe alternatives when business conditions decline but also offer helpful proactive steps to avoid problems. They discuss how to modify or adapt an existing ESOP transaction structure to support or salvage the participant retirement benefits when cash flows can no longer support the initial ESOP design. They also address the role of the plan fiduciaries, both the board of directors and the ESOP trustee(s), and how this fiduciary role is coordinated with possible corporate and plan changes.
Table of Contents
Protecting Value in an Economic Downturn or When Debt Is Incurred
Protecting Value: Non-Economic Factors
Case Study 1: Economic Downturn
Case Study 2: Economic Downturn and Internal ESOP Debt
The Importance of Process Under Normal Circumstances and When Things Change: The Board's Role
The Importance of Process (Trustees)
Other Case Studies
Some Key Takeaways
Appendix A: ESOP Trustee Annual Valuation Review
Appendix B: Fiduciary Checklist for Plan Sponsors
Appendix C: Department of Labor Checklist of Data Request Items
About the Authors
About the NCEO
From "Protecting Value in an Economic Downturn or When Debt Is Incurred"
Let us now concentrate on the first issue raised above; an unexpected downturn affecting the profitability of the company. These circumstances may cause a number of issues to arise that may affect the value of ESOP stock. Management must be prepared to discuss with the appraiser the reasons for the downturn as well as best estimates for the duration of a negative earnings environment.
If there is insufficient cash flow to support the leveraged ESOP debt service, a decline in company stock value can occur. A strong balance sheet, of course, will help deter any temporary swings in value due to current circumstances.
To reduce the negative impact of an earnings downturn, we often suggest the adoption of the "seven fat cows and seven lean cows" strategy. In the years when the company is doing well, in addition to trying to grow and support shareholder value, it is understood capital may be needed to expand the enterprise. The intrinsic competition for capital between the ESOP and the company should be resolved on the basis of sound repurchase obligation analyses. These can define the meaningful levels of cash on the balance sheet required to fund future payouts to participants and to make ESOP loan payments in lean years. A repurchase obligation sinking fund is a pool of assets still under corporate control, but it is understood that this portfolio of cash and investments is earmarked for use to pay out ESOP distributions to participants in the future.
If a buildup of some cash in the ESOP occurs in the "fat years," it can be used to pay down ESOP debt in leaner years, depending on the source of the cash. If tax-deductible contributions have been made to the plan by the company in prior years and are still in cash in the ESOP a year or more later, they can be used by the plan to make ESOP loan payments if necessary to supplement company contributions that may otherwise be reduced due to poor corporate earnings.
The same is the case for C corporation dividends or distributions of S corporation earnings if the dividends or earnings are paid on shares that were acquired with the debt incurred by the ESOP. If the ESOP has bought shares with cash previously or has bought leveraged shares in several separate transactions, only dividends or earnings distributions on the current leveraged and unreleased (suspense) shares can be used to make the ESOP loan payments.
If, due to an earnings downturn, the appraiser indicates the stock value will go down, a possible change in valuation methodology may be warranted. A change in valuation methodology should not be undertaken lightly and should not be done to try and move toward a specific share value. However, from time to time a change in valuation methodology may be appropriate under certain circumstances. An example may be that a company has two consecutive years of declining earnings, and a capitalization of earnings method of valuation is being used, weighing the later years more heavily than the three years before that. If the company is capital-intensive and has a lot of assets on its balance sheet, the appraiser may choose to take a blended approach whereby some value is added for the strength of the balance sheet, thereby adding an asset-based component to the appraisal.
As noted above, it is important for management to regularly communicate with the appraiser in order to avoid sharp drops or unwarranted increases over a short period in light of the long-term sustainability needed for the ESOP as a retirement plan.
From "The Importance of Process Under Normal Circumstances and When Things Change: The Board's Role"
There is no "one size fits all" structure for governance that is correct for every ESOP company. There are various successful structures for ESOP companies that are small family businesses, large defense contractors, manufacturers, and other types of businesses in all sectors of the economy. Each ESOP enterprise must evaluate its available resources and determine how to best improve and evolve as a corporate organization, thinking at all times about shareholder value and seeing the ESOP as a different kind of shareholder, one established to provide retirement benefits to employees and regulated by the IRS and DOL.
The directors of an ESOP company do need to consider, in special circumstances, when to add other parties to the decision-making process to avoid conflicts and add a level of protection for the board and ESOP trustees as fiduciaries. Any time a stock transaction is to take place, careful consideration as to who the parties in interest are and whose interests are being served must be had. Hiring a special trustee or having those with conflicts abstain from decision-making should always be considered as options by the board of directors. Operating as if any transaction or adjustment to a transaction will be reviewed by the IRS and/or DOL may be a useful guide.
When determining a course of action, it is helpful to remember the role of the board of directors and that of the ESOP trustee.
From "The Importance of Process (Trustees)"
The trustee is also responsible for interacting with the board of directors relative to financial projections, anticipated capital expenditures, executive compensation, and developing a strategy for funding future ESOP repurchase obligations.
One of the most important tasks of the trustee is to review and accept the appraisal report provided to the trustee by the ESOP appraiser each year. In most instances, the trustee will receive a draft of the proposed appraisal of the ESOP stock and is tasked with reviewing the report for accuracy and methodological soundness. As a part of the review process, the trustee should document the questions posed to the appraisal, responses from the appraiser, any changes, and final acceptance of the report. These discussions should be memorialized in either trustee notes that are kept or in minutes of a trustee meeting if that meeting is the platform for the review process. Appendix A provides a possible checklist of areas to review in the draft appraisal report.
Once it is time for review of the annual appraisal update, the trustee should schedule a meeting with the appraiser to review the requested documents and draft valuation report. It is also important to take time to discuss the appraisal report to fully understand the assumptions and methodology used by the appraiser in arriving at a stock value. Formal acceptance of the appraisal report should be memorialized in writing through a trustee resolution or in the minutes of a trustee meeting. Appendix B provides a checklist for trustees to consider each year.