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The Employee Ownership Update

Corey Rosen

November 16, 2005

(Corey Rosen)

Director of President's Tax Panel Says ESOPs Were Not Specifically Discussed

The Presidential Advisory Panel on Federal Tax Reform (the "Advisory Panel") recently issued its final report, which proposed eliminating all present forms of defined contribution plans, which on its face would include ESOPs. However, the executive director of the Advisory Panel told the Employee-Owned S Corporations of America (ESCA), a lobbying group, that panel members simply did not get to the level of detail of the appropriate role of ESOPs, Subchapter S or otherwise. Stephanie Silverman, ESCA's director, said that "simply put, we have been told the Panel has made no decision to support or eliminate the continuation of current-law ESOPs. We have also been told that it would be inaccurate to infer that, simply because ESOPs are not mentioned in the report, the Panel intended that they be eliminated."

District Court Says ESOP Fiduciaries Have to Diversify Only If the Company Faces "Impending Doom"

In In re McKesson HBOC Inc. ERISA Litigation, No. C-00-20030 RMW, (U.S. Dist. Ct., 9/9/05), a U.S. district court rejected the arguments made in the Moench v. Robertson case in 1995 that found that ESOP fiduciaries have an affirmative obligation to divest company stock if they know, or should have known, that the stock was about to drop severely. Instead, the district court ruled that ERISA "unequivocally declares that ESOP fiduciaries may 'hold' company stock even when a prudent fiduciary would diversify the plan." The court held that the ruling in Moench, which has served as strong guidance for ESOP fiduciaries for 10 years, was "fundamentally flawed" because it puts ESOP fiduciaries in a bind. If they divest company stock in a downturn, they may be violating their obligations under the plan and ERISA to invest primarily in employer securities; if they fail to diversify, they may be liable under Moench." Instead, the court found that fiduciaries would have to know that the company was facing "impending doom" or "dire circumstances" to be required to act. Nonetheless, the court allowed the lawsuit to proceed on the narrower plan administrative grounds centered on when stock was converted to cash. The ruling is does not set a precedent (and the Third Circuit's ruling in Moench only has precedent in that circuit), but it does represent a very different conclusion than other courts have reached on this matter.

FASB Moves Towards Final Staff Guidance on Equity Plan Tax Effects

Perhaps the most complicated rules for expensing equity plan compensation are those concerning tax effects. Particularly troubling for many companies has been how to handle transitional issues moving from APB 25 to FAS123(R) for the "additional paid-in capital" attributable to tax effects. FASB had assumed that companies would have the requisite information to make these calculations. Comments indicated that this was often not the case, so the staff has come up with a simplified method, described in detail on FASB's site.

New Data on Broad-Based Ownership Plans in Global Companies

The "2005 Global Equity Incentives Survey Report" from PricewaterhouseCoopers shows that 24.4% of the 82 respondents with U.S. employees make all staff eligible for options, 4.8% make all staff eligible for restricted stock units, and 5.6% for restricted stock. The survey included 131 global companies, 126 of whom had U.S. employees. In the high-tech sector, 43.3% of the responding companies report that all staff are eligible for options, while none make options available only to senior management. The study also reports, however, that 16% of the companies say they will reduce or eliminate option grants to all staff, compared to 18% for middle to upper management and 10% for senior management. In some cases, these grants will be replaced with other forms of equity, although the survey does not make it possible to know how often this replacement will occur specifically in broad-based plans. Fifty-six percent of the companies, however, say they will maintain their plans as they are, and 22.8% have not yet decided.

In responding to changing accounting rules, 12.9% of the respondents plan to eliminate broad-based stock purchase plans, such as ESPPs, while 10.8% say they will change the plan, 24.7% will continue the plans as they are, and 51.6% don't know. Interestingly, these possible reductions come in the face of growing participation and satisfaction with the plans. According to the companies, 85% of their employees are happy with their stock purchase plans. More tellingly, employee participation reached an all-time high, with 32% of the companies reporting that over 50% and 75% of employees were involved, an impressive results for cross-national plans. The report urges companies to retain their stock purchase plans, noting that the accounting cost is minimal and the employee benefit high.

The report provides considerable detail on other aspects of global plans, including compliance, administration, and accounting procedures, often broken down by country. A copy of the report is available at PWC's site.

Federal Regulators Probe Option Backdating

The Securities and Exchange Commission (SEC) is investigating a broad pattern of felicitously timed stock option grants, looking into the possibility that they were improperly backdated. Academic studies have found that stock prices tended to go down sharply just before options were granted, rising quickly afterwards. The pattern stopped after enactment of Sarbanes-Oxley. The data raise concerns that this is more than coincidence, coming instead from a pattern of at least some companies backdating grants to take advantage of market fluctuations. Backdating is not per se illegal, although it can raise accounting and tax issues. If there is an intention to backdate to take advantage of stock fluctuations, however, it could constitute securities fraud.

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