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Some ESOP Issues In Tough Economic Times discusses how one of the main consequences of an ESOP Partial Plan Termination is to increase (due to the 100% vesting requirement) and accelerate (due to terminations) the repurchase liability obligation and how delaying distributions can help minimize the impact on cash flow. It also discusses the fiduciary issues associated with refinancing an ESOP loan:

Refinancing an ESOP loan is a fiduciary decision that the Trustee should not take lightly. The Department of Labor will give special scrutiny to the refinancing of an ESOP loan to determine whether the Trustee made a decision in the best interest of the plan participants. Job protection or improving the company's cash flow may not be enough justification for an ESOP Trustee to agree to the refinancing of an ESOP loan. The ESOP Trustee may need to consider additional terms that could justify extending the length of an ESOP loan, such as:

  • The employer's obligation to make larger contributions to the ESOP over time than the company is currently obligated to make, or to sell additional stock to the ESOP.
  • An agreement from the holder of the ESOP loan that if the ESOP is terminated, the ESOP loan will be forgiven and any shares remaining in the ESOP will be allocated to the participants.
  • "Price protection" providing a floor price for repurchases of ESOP stock from terminated participants.

It discusses how a reduction in the workforce may make it possible to refinance the ESOP loan and maintain the participants' benefit level and notes that the share value needs to be considered when evaluating the participants' benefit level.

We discussed some of the Department of Labor's (DOL) considerations in What a DOL Auditor is Looking For When Auditing an ESOP . The DOL provided guidance in Field Assistance Bulletin 2002-01 - ESOP Refinancing Transactions about the obligations of a fiduciary in connection with the refinancing of an exempt ESOP loan:

At a minimum, in determining whether to cause an ESOP to engage in a refinancing, a fiduciary must make a careful assessment of the costs and benefits conferred upon the ESOP and the likely consequences of a failure to refinance, and ensure that the transaction is "arranged primarily in the interest of participants and beneficiaries." 29 C.F.R. § 2550.408b-3(b)(2). It is the view of the Department that, consistent with the obligation to consider "all the surrounding circumstances" pursuant to § 2550.408b-3(c)(1), an ESOP fiduciary must, in considering any refinancing of an ESOP loan that results in an extension of the period over which stock will be allocated to participant accounts, assess the extent to which the refinancing is consistent with the documents and instruments governing the plan, including loan and related agreements.(6) An ESOP fiduciary, in our view, also should assess the extent to which such an extension is consistent with the reasonable expectations of the plan's participants and beneficiaries, as might be determined by reference to the plan's summary plan description or other disclosures describing the funding and benefits of the plan.

Although a refinancing may also benefit the employer (for example, by reducing the employer's cost of providing future pension benefits), the fiduciary must act with undivided loyalty to the participants and beneficiaries of the plan if it is to satisfy the requirements of sections 404(a)(1)(A) and 408(b)(3) of ERISA. The "primary benefit" test set forth in section 408(b)(3) of ERISA and the regulations thereunder require the fiduciary to focus on the benefits of the refinancing transaction to the plan's participants and beneficiaries. Accordingly, a refinancing would satisfy the primary benefit test if the fiduciary reasonably concludes that the transaction is advantageous to the plan's participants and beneficiaries after a careful assessment of the costs and benefits of the transaction, and if the terms related to the refinancing are at least as favorable as the terms that would have resulted from an arm's-length negotiation between independent parties.

Often, employers offer a number of inducements for the plan to engage in the refinancing which could support a fiduciary's conclusion that the transaction is primarily for the benefit of participants and beneficiaries, such as a commitment that shares held in the suspense account will not be applied to repayment of the outstanding portion of the refinanced loan if the ESOP is terminated (often referred to as "event protection"); additional diversification rights for participants; an increase in the amount of the employer's matching contribution; the payment of a "dividend make-whole" to compensate participants and beneficiaries for the increased use of dividends for loan repayment; and other such inducements. Whether some or all of such inducements are sufficient to satisfy the primary benefit test is highly dependent on the particular facts and circumstances surrounding the transaction.

One circumstance of particular importance is whether the sponsoring employer has made an enforceable commitment to make all of the contributions necessary to retire the loan. In such a case, the ESOP may have an unqualified right to receive contributions and to release stock in accordance with the original amortization schedule. As a result, the negative consequences to the ESOP of rejecting a proposed refinancing could be minimal, and the economic value transferred to a sponsoring employer may be substantial, unless the ESOP receives substantial additional consideration for entering into the transaction.

Further, we note that the fiduciary has a duty of impartiality to all of the plan's participants, and may appropriately balance the interests of different classes of participants in evaluating a proposed refinancing, including the potentially varying interests of present and future participants. See Varity Corp. v. Howe, 516 U.S. 489, 514 (1996); Restatement (Second) of Trusts § 183. In our view, however, the fiduciary cannot satisfy the duty of impartiality solely by considering the asserted benefits of the refinancing to future participants (e.g., more generous benefits in later years than the employer would otherwise provide), but must also consider the interests of current participants and beneficiaries. Although a refinancing does not remove shares from the ESOP, those current participants who terminate employment before the full repayment of a refinanced loan may receive fewer shares of stock than they would have received absent the refinancing, and current participants who remain employed by the sponsor must work more years to receive the same number of shares that they would have received absent the refinancing. Accordingly, a fiduciary cannot reasonably assess the costs and benefits conferred upon an ESOP without giving due consideration to the interests of current participants.

With respect to the obligations of an ESOP fiduciary under section 404(a)(1), it is the view of the Department that satisfaction of the "primary benefit" requirement of section 408(b)(3) and the regulation with respect to the refinancing of an ESOP loan also typically would serve to satisfy a fiduciary's obligations to act prudently and solely in the interest of plan participants and beneficiaries under section 404(a)(1). Conversely, a failure to satisfy the "primary benefit" requirement of section 408(b)(3) would also result in a violation of section 404(a)(1).

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