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Adequate Security for ESOP Promissory Notes
Laurence Goldberg, ESOP Law GroupMany ESOP-owned companies view the termination of a participant's employment as a time to also terminate the participant's investment in the employer's stock. Employers have considered a few methods for accomplishing this investment conversion. This article considers the use of "conversion notes" as an alternative that may be worthy of consideration. An employer is permitted to direct that ESOP distributions be made in the form of shares of stock, followed by a repurchase of company stock from departing employees using a promissory note issued by the employer. We provide some insight here into the legal requirements for the issuance of such promissory notes (referred to as "conversion notes") and financial challenges in their use, including the "adequate security" requirement.
Rationale for the Conversion NotesThe conversion note converts the terminated participant from an equity holder to a creditor. Typically, a benefit distribution of the shares would be made to the terminated participant followed by a repurchase of the shares by the employer. The participant would receive a cash down payment with installments payable over a five-year period. From that point forward, the terminated employee would earn interest on the note at the stated rate but would not share in the ups and downs of the share price.
IRS Requires Adequate SecuritySection 409(h) does not define the term "adequate security," but the Internal Revenue Service takes a position that is more restrictive than might be inferred from the statute. IRS Technical Advice Memorandum 9438002 (1994) (the "TAM") defines "adequate security" under Section 409(h)(5) by borrowing the definition applied by Code Section 503 and Income Tax Regulations Section 1.503(b)-1(b)(1) and DOL Regulations Section 2550.408b-1. Section 503 requires a pledge of security that may be sold, foreclosed upon, or otherwise disposed of upon default. The IRS concludes that such security must be "tangible," and that "the value and liquidity of which security must be such that it may be reasonably anticipated that loss of principal or interest will not result from the loan."
The Internal Revenue Manual, Section 220.127.116.11.8.1 (5/23/2017) (the "IRM"), goes a step further. It states the following with regard to an IRS review:
"Examination Steps . . . . If the employee puts shares to the employer received in a total distribution, make sure the employer provides adequate security and pays reasonable interest on the unpaid portion. A put option is not adequately secured if it is not secured by any tangible assets. Adequate security may be an irrevocable letter of credit, a surety bond issued by a third party insurance company rated "A" or better by a recognized insurance rating agency, or by a first priority perfected security interest against company assets capable of being sold, foreclosed upon or otherwise disposed of in case of default. Promissory notes secured by a company's full faith and credit are not adequate security. Nor are employer securities adequate security."The IRM's conclusion that employer securities are per se not adequate security for a put option conversion note under Section 409(h)(5) may not be consistent with court precedent. Prior to both the TAM and the IRM, the Court of Appeals for the Eighth Circuit held that whether the "adequate security" requirement was satisfied by a pledge of the employer securities, which were put to the company under the option, was a factual question for trial. Roth v. Sawyer-Cleator Lumber Company, 16 F.3d 915 (8th Cir. 1994), 61 F.3d 599 (8th Cir. 1995).
Despite the Eighth Circuit's holding in Roth, the policy behind the IRS's position has merit. Code Section 503 is designed to protect a plan from a participant's default under a loan. Code Section 409(h)(5) is designed to protect the participant from the company's default, which would effectively lead to a reduction in benefits from the plan. Securing a Section 503 loan with company stock is inherently different than securing a Section 409 loan with company stock because in the Section 409 context the collateral (i.e. the company stock) is directly related to the company's ability to satisfy its obligations (i.e. the promissory notes). A default on the promissory notes is likely to arise only in the context where the collateral's value is reduced or eliminated (i.e. such as in bankruptcy), raising the question of whether a trustee can have exercised its standard of care in allowing the issuance of a put option conversion note collateralized by company stock.
Alternative Forms of CollateralIn an effort to provide "adequate security" for put option conversion notes, the Internal Revenue Manual suggests three possibilities: (i) an irrevocable letter of credit; (ii) a surety bond; or a first perfected security interest in company assets. A number of ESOP companies used the surety bond approach until that product was discontinued in 2001 by its underwriter. No surety product has come along to replace it. A number of ESOP companies have arranged letters of credit with their bankers as part of their credit facilities to security the conversion notes. Finally, a handful of companies have created asset pools, approved by their senior lenders, and then granted blanket security interests in these pools for the conversion notes.
Companies should consult with their advisors on the pros and cons of using conversion notes as opposed to other ways of making the stock liquid and have financial scenarios run on each.