ESOP distributions can be the most complex and challenging area of ESOP design and administration. As discussed in detail in our articles Designing And Drafting ESOPs, and Avoiding ERISA Liability Issues In ESOP Repurchase Liability Planning, ESOP sponsors and fiduciaries must be extremely careful to avoid fiduciary exposure, corporate liquidity (i.e., repurchase liability) problems and disgruntled participant claims.
Most ESOP distribution issues arise in the context of:
- Designing and drafting distribution provisions;
- Amendments and using distribution policies; and
- Distribution forms and administration.
Designing and Drafting Distribution Provisions
The impact of ESOP distribution provisions on company profits must be balanced with the company's desire to provide meaningful benefits to plan participants. In most cases, ESOP plan design starts with the assumption that distributions should resemble the form and timing for distributions from profit sharing plans or other plans sponsored by the employer. For example, it is not unusual to find ESOPs drafted to provide distributions commencing in the year after separation from service and including single sum distributions. Often, single sum distributions are called for in the document to allow distributees to take advantage of capital gain treatment for the appreciation in the stock's value - a sound, but often impractical planning point because of the financial pressure a single sum distribution can place on the company. As another example, we sometimes find ESOP plan documents drafted to allow the plan administrator to decide to distribute any time up to the sixth year after termination of employment in the administrator's discretion, in an effort to provide flexibility to the company.
The problem with both of these approaches is that by starting with generous distribution provisions, future amendments to modify and extend distribution terms can and will be viewed as a "take away" by ESOP participants. Unfortunately, when the plan administrator exercises discretion to delay distributions or eliminate a single sum payment, it is usually because the company's profitability has declined. Sometimes, these changes are made in anticipation of such a decline and plan participants view them as arbitrary. The worst case scenario involves some plan participant special circumstances that may result in an allegation of discriminatory treatment.
We also caution plan sponsors to ensure that the summary plan description does not conflict with the plan document or create an ambiguity between the plan document and the summary. If a plan participant wishes to assert a more generous summary plan description provision (perhaps in the face of an attempt to exercise discretion by a plan administrator), the company should consult with counsel. The law on this point has historically varied among the federal Circuit courts. For example, in the Ninth Circuit, a plan participant formerly had the right to the benefits, rights and features provided in the more participant-favorable document, whether that was the plan document or the summary plan description. Much of the variation among federal Circuit courts was resolved by the United States Supreme Court's decision in Cigna Corp. v. Amara when the court held that the summary plan description is not part of the plan document. Unfortunately, the Amara decision left the door open for participants to pursue alternate theories that could result in their recovering the more generous benefits promised in the summary plan description. Again, the best course of action is to ensure that the summary plan description clearly and accurately summarizes the plan's terms.
When drafting, keep in mind that there are numerous exceptions to an employee's statutory right to request a distribution in shares from an ESOP. There are also multiple mechanisms for converting ESOP participant stock accounts into cash for distribution or direct rollover, as most employees desire. For example, many corporations rely on restrictions in corporate articles or bylaws to prohibit plan participants from taking a stock distribution. The Internal Revenue Code (Code) permits a corporation's articles or bylaws to restrict share ownership to employees of the corporation or an employee ownership trust. However, we often see companies with non-employee shareholders rely on such a provision, seemingly negating the effectiveness of the restriction. We also find that these provisions are often not in place or not properly drafted in the corporation's documents, even though the administrator or document drafters incorrectly believe that they are. Note also that corporate articles calling for "statutory close corporation" status are both insufficient for this purpose and create a whole host of corporate governance problems when there is an ESOP shareholder.
When clients ask us to review their plan documents, we usually find plan documents drafted to include every possible alternative provision and clause found in the Code. All of the ESOP-specific provisions and the Code provisions governing all retirement plan distributions are included, without much clarity as to how to apply the interrelating provisions. As a result, it is not clear exactly how the ESOP in question will distribute benefits. The best practice is to spare no effort in explicitly coordinating these alternatives.
Amendments ad Using Distribution Policies
For years we have been encountering plan provisions, as described above, which appear to confer, or explicitly confer, discretionary authority on the plan administrator or trustee to change the form or manner in which distributions will be offered. We also find ESOPs relying on a separate document, often referred to as the "distribution policy," which either confers discretion on an administrative committee or specifies that modifications may be made to the distribution policy and not to the ESOP plan and trust document.
ESOPs such as these sometimes are relying on language in the Code which states that a plan sponsor may "modify" the ESOP's distribution options as long as it is done in a nondiscriminatory fashion and the modifications comply with the Code's ESOP distribution requirements generally. Some advisors have interpreted "modify" as meaning some action other than a plan amendment. Also, some advisors have taken the position that this Code provision trumps the more specific provisions found in Treasury regulations (enforced by the IRS) under this Code section. Statutorily and enforcement-wise, these are problematic positions to take.
This article cannot cover all of the issues raised by this approach, but the issues include:
- The definition of what is the "plan";
- What "modify" means in the Code;
- Who has the power to amend or modify; and
- Applying the general nondiscrimination requirements in the Code.
The ERISA definition of a "plan" includes the combination of documents, policies, utterances, etc. that together constitute the terms or benefits available to plan participants. This means that while any distribution "policy" is only part of the ERISA plan, it is nevertheless a plan document that is subject to ERISA and the Code's requirements, including the rules and limits on the ability to amend, or exercise discretion over, the availability of benefits.
ERISA also requires that every employee benefit plan provide a procedure for amending the plan and for identifying the persons who have authority to amend the plan. As a result, the plan's distribution terms may be amended only by the plan sponsor or a party that has been given plan sponsor or "settlor" authority for plan amendments. This authority must be clear and consistent among all the plan documents. This typically means the board of directors must amend the plan, and not a human resources representative or administrative committee. Attempts to amend or modify without proper plan terms or authority will fail. Further, delegating authority to amend to a committee of the board of directors, or having the sponsor also serve as the plan administrator when amending the plan, both raise subtle issues. There are also timing issues related to amendments that modify distribution terms. These issues go beyond the scope of this article but need to be considered very carefully.
"Modifications" to the plan's distribution provisions that are really exercises of discretion are particularly dangerous because the Treasury regulations specifically state that exercises of discretion over the availability of benefits or alternate forms of distributions are prohibited. The regulations limit the circumstances under which an ESOP plan may be amended to change distribution forms. These regulations should be carefully reviewed before making any changes. It might be best to list all of the permitted amendment alternatives in the section of the plan document dealing with powers to amend, along with the stated amendment procedure. The specific operative distribution provisions should then be included in the distribution section of the plan. This way, the employer and plan administrator will understand which alternatives are available under the Code and ERISA, from which they may properly amend or choose, subject to the other issues mentioned above.
In the current economic climate and in any situation where a company's liquidity or business circumstances change, plan consultants and attorneys need to be on top of these restrictions and opportunities. Finally, steps should be taken to keep distribution changes out of the hands of fiduciaries and in the hands of the employer to avoid the application of ERISA's standards to the decision or act of modifying or amending.
Distribution Forms and Administration
We seldom see ESOP distribution forms that completely and correctly match a plan document and summary plan description as far as types of benefit, rights to alternate forms of benefits and procedures for payment because the stock account rights in each ESOP are almost always unique. Because ESOP distributions are so complex, boiler plate distribution forms that are useful for 401(k) plans and profit sharing plans seldom address subtleties and complexities related to the ESOP rules and exceptions. Plan administrators should have their forms carefully reviewed and edited, (if not drafted) by plan counsel to ensure that the plan is not being operated contrary to the terms of the plan and the summary plan description. For example, there are three different mechanisms in the Code under which distributions may be made in stock with those shares then repurchased by the corporation to keep them out of the hands of former employees. One of these mechanisms applies to subchapter S corporations and the other two are available to C corporations. Depending upon which avenue is taken, the paperwork will be significantly different. Cover letters, explanations and disclosures need to be included in addition to otherwise standard distribution forms. We have seen IRS and DOL auditors asking for these documents and requiring plan administrators to go back to plan participants to offer them the alternate forms of benefits if they have not been properly notified.
ESOP distributions are confusing. Beyond the forms and required disclosures, we recommend communication pieces that are tailored to the client's workforce. Regardless of the education level or sophistication of the particular company's employees, ESOP distributions typically require a "road map" to make the participant's rights understandable. In our experience, participant rights are widely misunderstood in part due to the general publications that participants will read covering the wide array of ESOP rights and provisions. Unless the plan administrator (at the company) has carefully read the plan document (which is sometimes unintelligible for reasons discussed above) and studied the summary plan description (which is often not tailored enough), they will not be fully aware of their specific obligations and the mechanics of the distribution process.
To stay in compliance, no effort should be spared in an ESOP's first administration cycle after it has been installed, or after the plan has been amended, to ensure that the plan administrator understands the plan's distribution provisions, or how the plan's attorneys have amended those provisions.
What to do?
Be sure your ESOP documents are specific as to the form and mechanics of participant distributions. Safeguard against changes in distribution rights being construed as fiduciary acts of discretion. Examine your forms closely to ensure they accurately address the customization of your ESOP. Before you change the rules, plan ahead as much as possible, consult your counsel regarding the circumstances of your changes, and communicate the changes carefully.
 NCEO "Journal of Employee Ownership of Law and Finance," Vol. 20, No. 3, Summer 2008. Published by the National Center For Employee Ownership. For a reprint of this article please contact us at firstname.lastname@example.org.
 "Journal Of Pension Benefits," Spring 2006, Vol. 13, Number 3, © 2006, Aspen Publishers, Inc. Reprinted with permission (available at http://www.seethebenefits.com/showarticle.aspx?Show=4247.)
 No. 09-804, 2011 U.S. LEXIS 3540 (U.S., May 16, 2011).