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Using Promissory Notes to Repurchase ESOP Stock Becomes More Difficult

Laurence A. Goldberg and Marc R. Baluda

May 2002

(Laurence A. Goldberg and Marc R. Baluda)Many ESOP-owned companies pay for the repurchase of company stock from departing employees by issuing promissory notes in payment for the shares of stock. These companies have often purchased surety bonds to serve as collateral for the promissory notes. Recently (as of 2002), the principal issuer of surety bonds in this market has indicated it will no longer issue the surety bonds, leaving many ESOP companies in a precarious situation.

Collateral Is Required

The Internal Revenue Code of 1986, as amended (the "Code"), generally requires that an employee stock ownership plan (an "ESOP") give participants the option of receiving their distributions in company stock. See Code Section 409(h). Section 409(h)(1) requires that the participant have a put option to the company if the company's stock is not readily tradable on an established market. The amount to be paid to the participant for the company stock under the put option may be satisfied with a promissory note if: (1) the note provides for substantially equal periodic payments that begin within 30 days and end no longer than 5 years from the exercise of the put option; (2) there is "adequate security" for the note; and (3) the note bears a reasonable interest rate. See Section 409(h)(5); see also Department of Labor Regulations Section 2550.408b-3(l). In essence, these put option conversion notes must be collateralized to protect participants' distributions from the ESOP, which would be jeopardized by a default on the note by the company.

IRS Position

It is unclear what is meant by the term "adequate security," but presumably anything that would be deemed sufficient collateral for any given note in the commercial market should satisfy the standard. However, the Internal Revenue Service takes a more restrictive position with regard to the definition of "adequate security." 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 "tangible," "the value and liquidity of which security is such that it may be reasonably anticipated that loss of principal or interest will not result from the loan." See TAM at 4.

The Internal Revenue Manual, Section 4.72.4.2.8.1 (8/13/2001) (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. For example, 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 IRM'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.

Alternatives for ESOP Companies

In an effort to provide "adequate security" for put option conversion notes, some companies have looked to surety bonds. With the withdrawal from the market of the principal issuer of ESOP surety bonds, ESOP companies may need to focus on using irrevocable letters of credit or a pledge of the company's hard assets to secure these notes. Both solutions have drawbacks. For an ESOP company that cannot acquire an alternative financial security instrument, the only alternative may be to change the ESOP's benefit distribution rules. These companies may need to switch to annual installment distributions with immediate repurchases of the stock in each annual installment. This method is less attractive for many ESOP companies, as it allows terminated employees to remain invested in the company's stock. Of course, it improves the accounting impact, as the installment obligations do not appear on the company's financial statements, as do the promissory notes.
About the Author

Laurence A. Goldberg is a partner in the Tax, Employee Benefits, and Trusts and Estates Practice Group in the San Francisco office of Sheppard Mullin Richter & Hampton LLP, a law firm. Marc R. Baluda is a shareholder in the San Francisco office of Greenberg Traurig LLP, a law firm.

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