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The Employee Ownership Update

Corey Rosen

January 18, 2005

(Corey Rosen)

New DOL ESOP Enforcement Efforts

The Assistant Labor Secretary for the Employee Benefits Security Administration, Ann Combs, has told the BNA Pension & Benefits Reporter (January 4, 2005) that the Labor Department will begin a special enforcement project on employer stock in defined contribution plans. Combs said a key issue will be valuation, noting that "one of the most common problems we've found with ESOPs is the incorrect valuation of employer stock. . . . We're looking at a sample of stock plans throughout the country to see how widespread the valuation problem is." She said other issues will be examined as well, including "voting rights, exercise of put options, the ability to diversify account balances at certain times, and compliance with the Department guidance on ESOP refinancing."

Just how serious a threat is this to well-intentioned ESOPs? For companies using experienced, qualified professionals, chances are this will not represent a serious problem, although it may be a nuisance for those companies the DOL chooses to investigate. Outside of S corporation ESOP scams, Combs is correct that valuation issues are the dominant cause of significant ESOP problems. Most ESOP lawsuits that go to trial concern valuation problems. Companies run into trouble in two ways. Some simply fail to use qualified, independent appraisers. More common are overly aggressive appraisals relying on generally unaccepted assumptions, unrealistic data, or, in some cases, fraud. Well-intentioned ESOPs that carefully follow the rules should not have a problem with these issues. A more uncertain issue is how aggressive the DOL will be concerning valuation theory. For instance, will it reject any control premiums in phased transactions in which the ESOP acquires a minority interest now and the right to acquire control later? If history (all history is past) is a guide, agency enforcement efforts typically do not themselves result in breaking new ground on legal theory, so this result seems less likely. It is certainly possible, however, that the DOL, based on what it learns, will consider issuing new guidance on ESOP valuation issues.

The other matters are more procedural. If a company uses experienced ESOP counsel and administrators, these areas should not result in problems.

New 401(k) Rules Allow ESOPs and 401(k) plans to Be Treated as Single Plan for Anti-Discrimination Testing in Spin-offs and Mergers

Effective December 29, 2004, final regulations under Section 401(k) (T.D. 9169) allow the ESOP and non-ESOP portions of a "Section 414(l) plan" (a cash or deferred arrangement defined contribution plan that results from a merger or spin-off) to be aggregated for purposes of assessing whether the plans meet the average deferral percentage (ADP) and average compensation percentage (ACP) tests applicable to 401(k) plans. In other words, if an ESOP is, for instance, combined with a 401(k) plan, the contributions made to the ESOP by the employer and, if applicable, employees are added to the 401(k) contributions and deferrals to determine if these anti-discrimination rules for contributions and deferrals are satisfied.

Companies Will Have to Disclose Stock Buybacks for Option Programs

Under the new accounting rules to come into affect this year, public companies will have to disclose how much money they intend to spend in the following year buying back shares to satisfy stock option exercises. The purpose is to give investors an idea of to what extent the company is paying for options through cash versus dilution. The number can only be an estimate, of course, because future stock prices and intentions are necessarily speculative.

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