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ESOP Repurchase Obligation Insights

The Cash-Out Dilemma

Judith Kornfeld

November 1999

(Judith Kornfeld)Many ESOP companies like to take advantage of the rules that allow distributions to terminated participants (i.e., those who leave for reasons other than death, disability or retirement) to be delayed until the end of the fifth year following the year in which the participant incurred a break in service. At the same time, however, they don't want former employees to participate in changes in the value of the stock after they leave. The question is how to reconcile these two potentially conflicting goals.

There are two reasons that companies want to do delay distributions. First, they want to discourage employees from leaving to gain access to their account balances. While there do not seem to be any statistics or formal studies on this issue, there is some anecdotal evidence that, particularly in periods of low unemployment (i.e., when it's easy to get another job) and high stock prices, employees may quit in order to cash out their ESOP balances. By making terminated participants wait for a significant period of time, the theory is that people will not have an incentive to leave just to get their hands on their ESOP account balance. (Another alternative to accomplish this goal is to allow participants to take distributions while still employed. The subject of in-service distributions will be covered in a future column.)

The second reason for delaying distributions is to take advantage of the increased planning horizon that it provides. In most ESOP companies, turnover accounts for the largest portion of repurchase obligations. In smaller companies (those with less than a few hundred employees), even if a repurchase obligation study has been done, it can be difficult to accurately predict turnover, because actuarial calculations provide less reliable projections than in large populations. The number of shares that have to be repurchased due to turnover can vary significantly from year to year. Taking advantage of the ability to delay distributions for five years gives companies time to plan for the liquidity required for distributions. The cash requirements can be managed further by making distributions in installments, or having the company pay for shares with an installment note, which tends to smooth out year to year variations in the liquidity requirements. This provides a high degree of predictability for budgeting purposes.

The problem with delaying distributions is that, in most ESOPs, the terminated participants remain invested in company stock until they receive a distribution and, as a result, participate in changes in the value of the stock after they are no longer employed by the company. Many ESOP companies express a desire not to have former employees share in increases in the value of the stock after they leave. (There seems to be less concern about former employees sharing in decreases in the value of the stock. This may be the result of an extended period of generally rising stock prices. In a period of rising stock prices, there is also the concern that leaving terminated accounts invested in company stock increases the ultimate cost of repurchasing the shares.)

The ideal solution would be to fix the value of the participant's company stock account at the time employment terminates, but not have to fund the liability until the (delayed) distributions are to be made. Unfortunately, there does not seem to be a way to "have your cake and eat it too" on this issue. There are basically two ways to handle terminated participants' accounts. The first is to leave them invested in company stock until it is time to make a distribution. This, of course, defeats the goal of fixing the value of the account. The second way is to cash terminated participants out of company stock by actually putting the cash into the ESOP and creating a segregated investment account which is invested appropriately and credited with investment earnings until the account is actually distributed. This accomplishes the goal of fixing the value of the participant's account at the time of termination, but it requires that the value of the shares be fully funded at the time the segregated account is created. In terms of cash requirements, it is as though the trust were making immediate lump sum distributions This defeats the goal of having extended time to plan for liquidity requirements. A hybrid approach is also possible, where the trust applies any available cash to cash terminated accounts out of company stock without requiring a complete cash out of the stock at the time of termination.

In the past, some companies used a technique that seemed to allow them to "have their cake and eat it too" but is no longer considered acceptable. This was to set up an "phantom" cash account at the time a participant terminated. This account was based on the value of the stock in the year the participant left and was credited with interest at some specified market rate, such as treasury bills or bank money market accounts, until the account was distributed. The shares from the terminated participants' accounts were reallocated among the active participants' accounts, offset by the "debt" associated with the phantom cash account. However, the cash to fund the liability was not actually put in the trust until the time that distributions were required. The Department of Labor apparently considered this unacceptable, because of the issues that would arise if the company's stock price were to decline, and this technique is not generally used any longer.

How participant accounts are handled is governed by the ESOP document, so you want to be sure that your plan document permits you to handle repurchases in the manner that best meets your goals. Ideally, the document should also provide flexibility so that you are not locked into provisions that are more restrictive than necessary. There is no authority in either the Internal Revenue Code, the Employee Retirement Income Security Act (ERISA), or the regulations thereunder that provides guidance concerning how ESOP account balances that are being held pending distribution should be handled. This leaves room for some flexibility in drafting. As with all other ESOP administration issues, you should make sure that your plan is actually being administered in accordance with the plan document.

Author biography and other columns in this series

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