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The Employee Ownership Report

NewsletterConcisely written for leaders in employee ownership companies and for service providers in the field, the NCEO's bimonthly newsletter, the Employee Ownership Report, is the most efficient way to stay informed about legal issues, current events, best practices, breaking research, management approaches, and communications ideas for employee ownership companies.

Available exclusively to NCEO members, the Employee Ownership Report is delivered in hard copy and all issues back to 1997 are available in the members-only area of the Web site.

Nonmembers are invited to read the sample article below from the current issue of the newsletter. Every time a new issue appears, the sample article on this page will be replaced by one from the new issue. Join online for only $90 to receive the Employee Ownership Report and all our other membership benefits.

Read a sample issue of the entire newsletter (September-October 2015).

Sample Article from the September-October 2018 Issue:

Control Premiums in ESOP Transactions

In recent years, the Department of Labor has been more concerned about ESOPs paying for control when, in the DOL's view, it doesn't really need to do so or is acquiring control more in form than substance. This article looks at several scenarios in which the ESOP may not be able to pay a control price.

Of course, the most obvious case is when the ESOP buys a minority interest. But it might also be inappropriate for an ESOP to pay for control in a transaction that is one part of a series of transactions designed to acquire control, such as when the ESOP acquires majority ownership but there are significant control constraints. Another example might be when the ESOP buys additional shares after it already owns a majority of the stock.

Multistage Transactions

Many ESOPs are designed to buy a minority of the stock in the initial transaction with the intention of buying additional shares sufficient to acquire control or even 100% ownership over time. Properly structured, an ESOP can pay a control price throughout this process, but several conditions must be met at the time of the initial transaction:

From the seller's perspective, it may not be a disadvantage for the ESOP not to acquire control in the first transaction. If the ESOP pays a non-control price, the remaining shares are worth more because there is less debt needed, so when these shares are sold, possibly at a control price, they will be worth more than otherwise. That is even more the case if the ESOP is buying out a minority owner, leaving the majority owner with more valuable shares. The minority owner may not view that as fair, however, if there had been an expectation that when an owner wanted to sell, the price would be the same as other owners could get. The kind of multistage transactional guarantees described above could allow that minority owner to get a control price.

Control in Form, But Not in Fact

In recent years, the courts have sided with plaintiffs when the control of the ESOP trustee is limited by covenants and practices at the company level. Most prominently these include:

In Brundle v. Wilmington Trust, for instance, the court objected to the ESOP's paying for control even though warrant holders who helped finance the ESOP were able to appoint a majority of the board. The court asked the defendant's expert how the ESOP could stop an action by the board, and was unsatisfied with the answer that it would have to file a lawsuit. The expert then noted that as a practical matter, "I guess the board could do anything."

Buying a Minority Interest When the ESOP Already Has Control

If the ESOP already has a majority interest and now buys additional shares, it may be able to pay a control price if this was part of the kind of phased transaction described above. If not, however, there seems to be little compelling interest for the trustee to pay for control any more than it would for a theoretical outside investor buying such an interest.

Levels of Control

Many ESOP valuations take a nuanced view of control. At the highest level, the ESOP owns a sufficient interest to control decisions even if the by-laws require a super-majority vote on some issues. If the ESOP does not have that level of control, then the control price may be reduced, but not eliminated. That same logic would apply to other limitations on control, such as loan or governance covenants or minority shareholder rights.

Losing Control

While not common, occasionally ESOPs go from a controlling to a noncontrolling position. In these cases, it is prudent for the trustee to continue to buy shares from departing employees at a control price. In addition, because the loss of control represents a loss of value to the ESOP trust as a whole, the trustee may want to negotiate something in return for the trust as well, such as a commitment to additional cash contributions to the plan for a period of years.

This article draws in part on the article "ESOP Trustee Considerations in Multistage ESOP Stock Purchase Transactions" by Scott Miller of Willamette Management Associates in the Spring 2018 issue of their publication Insights. Any conclusions, however, are ours.