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The Employee Ownership Update

Corey Rosen

November 16, 2004

(Corey Rosen)

New Qualified Plan Limits Announced

The IRS has issued the new plan limits for 2005. The relevant limits for ESOPs and 401(k) plans are as follows:

FASB Allows Closely Held Companies Simpler Option Valuation Method

At its October 19 meeting, the Financial Accounting Standards Board (FASB) tentatively decided to change its stance on how closely held companies value options. The Exposure Draft on accounting reform allowed these companies to use either the fair value method public companies must use (that is, to apply a valuation model incorporating six required variables) or the intrinsic value method, with a strong preference for the former. The recent decision would now require these companies either to use the fair value method using an estimate of volatility for the individual company or, alternatively, a calculated value of volatility based on an appropriate stock market index. For most closely held companies, projecting volatility was by far the most difficult element in using one of the valuation models.

Court Dismisses Claim Against ESOP Fiduciaries

In Pennsylvania Federation, Brotherhood of Maintenance Way Employees v. Norfolk Southern Corp., No. 02-9049 (E.D. Pa., 10/12/04), a federal district court has issued one of the strongest decisions yet supporting the argument that fiduciaries following the requirements of a 401(k) plan to invest in employer stock are not violating their duties, even if this decision may not, in retrospect, seem prudent. The court dismissed plaintiff claims that fiduciaries of the company's 401(k) plan violated ERISA by investing in Norfolk stock because they wanted to bolster its stock price. The court ruled that even if the factual allegations were correct, the plan was operated according to its requirements, so fiduciary motives in investing were not at issue.

ESOP Companies on Acquisition Binge

We don't have any hard data, but all the indicators point to a remarkable increase in the number of ESOP companies doing acquisitions. At recent meetings, we have asked how many companies have done an acquisition recently or plan one soon, and over more than half the people from ESOP companies raise their hands. Plan advisors note the same trend. Two factors seem at work here. One is that many ESOP companies have now long since paid off their own acquisition debt and have more cash. The second is that many ESOP companies are now 100% S corporations and pay no federal, and often no state, income taxes. These savings can then be used to fuel new growth. Of course, ESOP companies also tend to be more successful as a result of employee ownership, so this also better positions them for acquisitions. An important challenge will be whether these companies can export their successful cultures to the acquired companies.

When Louis Kelso, the creator of ESOPs, first promoted the idea of employee ownership, he envisioned the main use of ESOPs would be to acquire productive capital, not to buy out existing owners. For most of their history, however, the majority of ESOPs have been used to buy out an owner. Now that they have matured, ESOPs seem to be returning to Kelso's original goal.

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