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    ESOP Repurchase Liability Planning: Fiduciary Issues

    A non-publicly traded ESOP company has to plan for its obligation to repurchase ESOP participant shares. After all, those participants can't just sell their shares on the stock exchange.  So the law gives them a way to turn their retirement investment into cash. Thus, repurchase liability. But, what is the ESOP fiduciary's role in this process? This article addresses the nuances of ERISA fiduciary involvement in the company's share repurchase obligation.  The objective is to provide fiduciaries and plan sponsors with an understanding of how to best protect ESOP fiduciaries and corporate directors and officers dealing with this fundamental aspect of ESOP planning.  We start with a closer look at what repurchase liability is.

    What Is Repurchase Liability?

    Unlike other retirement plans, which are required to diversify their holdings by investing in a variety of assets, an ESOP, by law, invests primarily in the stock of the company sponsoring the plan.  For public corporations, these shares of company stock can be sold, if necessary, to fund a cash distribution to a participant who retires, dies, or who becomes disabled or otherwise leaves the company and is entitled to a distribution of his or her retirement benefit.  Privately held corporations that are not traded on a stock exchange (which is the vast majority of all ESOP companies) are required by law to repurchase a participant's account shares when he or she is entitled to a distribution.  This is referred to as "repurchase liability."

    The legal requirement to repurchase the shares, which is found in Internal Revenue Code (Code) section 409(h) and the Employee Retirement Income Security Act (ERISA) (via Department of Labor regulations at 29 C.F.R. section 2550.408b-3 and 29 C.F.R. section 2550.407d-6), provides the participant in most ESOP situations with the right to "put" the shares to the company upon distribution. This is known as the participant's put option.  Some ESOP companies do not distribute stock from the plan to the participants.  Instead, the company contributes cash to the plan which is then exchanged for the stock in the participant's account.  That cash is then distributed from the plan to the participant.  There are other variations on this theme which may result in the participant's receiving a promissory note or having the shares repurchased by a related party to the company.  These variations do not, however, change the fundamental nature of the company's legal requirement to create liquidity for the stock.  The obligation is enforceable against the company except to the extent that it is prohibited by other federal law or applicable state law, such as bankruptcy or receivership.

    In a growing company with healthy increases in the value of its stock, significant financial benefits from the ESOP can accrue to employees.  Of course, that means significant financial liability from the ESOP can also accrue to the company.  That repurchase liability can be a complex obligation to plan for because of the timing of the distribution rules that are built into the ESOP plan document, the retirement ages of participants, turnover of employees who quit or who are fired, and the unpredictability of mortality and disability.  Fortunately, there are repurchase liability specialists who can help you project and plan for these contingencies and develop creative funding devices to meet the repurchase obligation. Funding mechanisms can include sinking funds or insurance relationships that help mitigate the risk to the company of unforeseen changes in circumstances, census, or economics.

    Note, however, that the repurchase liability is not strictly speaking a balance sheet liability of the company. It is not required to be recorded in the liability section of the company's financial statements according to Generally Accepted Accounting Principles (GAAP).  In essence, repurchase liability is no different than the liability a company may face under a buy-sell agreement among non-ESOP shareholders, which requires the company to purchase shares of a departing shareholder.  In both cases, it is a contingent, off-balance sheet liability of the company that will fluctuate with the value of the company.

    Fiduciary or Corporate Concerns?

    Repurchase liability is rooted in the Code that requires a non-publicly traded corporation to repurchase the shares of its ESOP upon distribution, either through the exercise of a "put option" on distributed shares, or by immediate cash redemption, or by funding cash distributions in lieu of the put option exercise (for example, in the case of an S corporation sponsored ESOP under Code section 409(h)). It should be a basic tenet of every ESOP and each employer sponsor that repurchase liability and distribution planning are not ERISA fiduciary responsibilities — they are corporate finance obligations.  Because the financial responsibility for repurchasing the ESOP shares is rooted in the Code as a corporate obligation, careful drafting and procedures should ensure that it remains solely a corporate function.

    This can be accomplished with careful drafting of the ESOP plan documents and careful allocation and delegation of the responsibilities for repurchase liability planning.  The ESOP fiduciaries and plan participants should be informed and educated on this point. The plan document should specify that repurchase obligations are not to be measured or projected by plan administrators, administrative committees, or trustees. The plan document should go so far as to specify that repurchase liability planning will be the province of the corporation, just as the discretion over when and whether to make contributions to the plan is a corporate choice.  If the plan is drafted properly and if the right persons are named as the administrative committee and trustees, then repurchase liability planning can simply be built into corporate budgeting and cash flow projections. This is recommended, even though (as stated) the repurchase liability is not required to be recorded as a liability on corporate balance sheets under GAAP. The chief financial officer of the company or the company's finance committee should assume financial responsibility for maintaining some form of repurchase liability model and the iterative process that goes with it, when looking at the overall employee benefit costs of the company.

    If the company does not take these steps to isolate repurchase liability issues at the corporate level, ERISA fiduciary issues may result.

    Potential Fiduciary Issues — The Amsted Lesson

    Unfortunately, it is common to see language in ESOP plan documents that refers to the ESOP administrative committee's obligation to make or approve distributions to participants, select the modes and timing of distributions to participants, and to plan for repurchase liability, including performing repurchase liability studies.  Those ESOP committee members typically also wear corporate hats (e.g., CFO or VP of Human Resources).  Because these are the persons who have the information within the company to perform repurchase liability planning and typically have the skill and sophistication to serve on an ESOP committee, the hats can be confused, lines can be blurred, and fiduciary liability may arise.

    Some plan documents include a delegation of authority to the ESOP committee to make decisions about distributions and may go so far as to allow the committee to make amendments to a plan's "distribution policy" and alter the available forms of distribution in an attempt to manage the repurchase liability. A 2004 court case, Armstrong v. Amsted Industries, Inc. (N.D. Ill. July 30, 2004), gives us reason to be cautious and deliberate in setting up ESOP fiduciary structures with respect to handling repurchase liability.

    In the Amsted case, the plaintiffs alleged various violations of ERISA, including breaches of fiduciary duty and violation of the prohibited transaction rules. The Amsted ESOP required annual share valuations. These valuations determined the amount paid to participants who sold back their shares during that year. In 1999, Amsted acquired another corporation. The valuation of ESOP shares that occurred after the acquisition resulted in a value that reflected a 32% increase over the previous year's valuation. Perhaps as a result of this favorable valuation, Amsted's buyback liability for the year exceeded expectations and Amsted was forced to take certain measures to protect its cash reserves.  Amsted amended the ESOP to allow for quarterly valuations (to revalue the buy-back costs), eliminated the availability of lump-sum payouts, and began buying back ESOP shares with promissory notes that paid out over four years.  Unhappy participants sued.

    In the Amsted decision, the federal court acknowledged that it is indeed a settlor (i.e., company plan sponsor) function to amend a plan document.  The court correctly recognized that this was not a fiduciary issue or function. The court disposed of the notion that the ESOP committee had some duty to amend the plan document to deal with the repurchase liability obligation; however, the court also addressed a fiduciary duty to monitor repurchase liability, which is curious given that it is a company liability imposed by the Internal Revenue Code and not a fiduciary issue. So, how did the Amsted fact pattern result in a discussion of the blurred lines of fiduciary and settlor responsibility?

    In Amsted, the plaintiffs argued that the ESOP administrative committee should have monitored the exploding growth of the repurchase liability.  The ESOP administrative committee had been formed as a "committee of the board." This means that the ESOP committee had the authority under state corporate law to "bind the corporation" and to act in lieu of the board of directors. Therefore, the ESOP committee actually was standing in the shoes of the company's board of directors.  As a result, it was the ESOP administrative committee that had the authority to amend the plan documents.  It was also the party with the obligation under the ESOP documents to manage distributions and, arguably, to monitor repurchase liability.  As the maxim goes, bad facts create bad law. In other articles we have argued against having the board of directors of the corporation be the plan administrator of the ESOP.  See K.G. Long, "Designing and Drafting ESOPs," The Journal Of Employee Ownership and Finance, NCEO 14(4) (Summer 2008).  This confusion in roles is part of the reason why.  

    Consider the language of the court's decision that focuses on this confusion.  By making the ESOP committee a committee of the board, the corporation had made members of the board fiduciaries of the plan.  In a footnote to this decision, the court stated:

    Even if the plan documents imposed fiduciary liability on the administrators when making plan amendments…, that does not mean amendments are no longer a settlor function, only that the settlor is now subject to fiduciary responsibilities.

    The court therefore was required to analyze the actions of the ESOP committee under ERISA to determine the prudence of its actions in planning for repurchase liability and in deciding when and whether to amend the plan to change the distribution terms. Fortunately, the way in which the Amsted fiduciaries comported themselves in planning for repurchase liability enabled them to prevail on their motion to dismiss.  As for the charge that the defendants in the Amsted case were imprudent in their analysis of the repurchase obligations and share valuations, the court found that the information given to independent experts and the process by which the obligation was estimated were sound, regardless of the ultimate inaccuracy of the estimate. The company had undertaken repurchase liability projections and, even though they were examined under an ERISA fiduciary standard and NOT under the less stringent business judgment rule standard of state corporate law, the process was upheld and the fiduciaries were dismissed from the action.

    In other situations, with a similar structure, certain fiduciaries might not be so thorough.   So, why subject ESOP repurchase liability to the ERISA legal standard of review? This is the heart of the problem that ESOP companies simply need to avoid.

    The Difficulties of Amending the Plan to Address Repurchase Liability

    Several sets of rules may constrain the ability to change how an ESOP plan document deals with repurchase liability.  The first is the anti-cutback rules in the Code and the Treasury regulations that specify when and how a plan's distribution provisions can be amended.  Code section 411(d)(1); Treas. reg. section 1.411(d)-4.  Protected benefits and "optional forms of benefit" can be amended only as permitted by the Code and these regulations.  Distribution options may always be amended prospectively, to apply to benefits accrued after the amendment is effective, but generally not for benefits already accrued and vested.

    The anti-cutback regulations contain special exceptions for ESOPs that allow the elimination or addition of a lump-sum distribution option and a change in distribution options if the trading status of the stock changes (i.e., a nonpublic company goes public, or vice versa) or a plan terminates.  Treas. reg. section 1.411(d)-4, Q&A 2(d).  These ESOP exceptions permit distribution options to be modified so long as it is done in a nondiscriminatory fashion.  Code section 411(d)(6)(c).  Some ESOP commentators have suggested that the Code's language is broader than the exceptions in the regulations and that ESOPs should not feel constrained by the terms of these regulations.  Representatives of the IRS and the Treasury Department with whom the author has discussed this issue over the years have not shared that view.

    One exception that appears conspicuously absent from the anti-cutback regulations is the ability to insert a waiting period to delay the start of a participant's distribution.  This was done in the Amsted case, in which an amendment removed the immediate lump-sum distribution option and allowed payments only after five years for those participants who terminated for reasons other than for death, retirement, or disability.  There is a technical basis on which the Treasury regulations might be interpreted to permit the insertion of such a delay, but it was not addressed specifically by the court's opinion in Amsted.  It was not raised in the briefs before the court and is beyond the scope of this article.  Some ESOP commentators support the interpretation of the anti-cutback regulations that permits this kind of change; others do not.

    The anti-cutback regulations also state that too-frequent amendments may cause an optional form of benefit to become a protected benefit that may not be eliminated.  The bottom line, therefore, is that the form and timing of amendments might trigger ERISA issues.  Although these rules are confirmed in Treasury regulations, they also apply for the identical ERISA provisions.  Therefore, the Department of Labor (which enforces ERISA's provisions) or a participant can sue a fiduciary for breach resulting from the improper amendment of a plan's distribution provisions under the Treasury regulations.

    Other Potential Amendment Issues

    Beyond the anti-cutback regulations and their authority under the Code and ERISA, there is an aspect of ERISA case law that may be problematic to the company's ability to amend its ESOP to deal with repurchase liability by changing distribution options.  It arises out of ERISA section 502(a)(1)(B), which allows a participant to bring a civil action to enforce the terms of a plan in "an ERISA breach of contract action."  This was one of the causes of action brought by the plaintiff in the Pratt case.  Pratt v. Petroleum Production Management, Inc. Employee Savings Plan & Trust et al., 920 F.2d 651, 658 (10th Cir. 1990).  ERISA section 502(a)(1) provides in pertinent part:

    1. Persons empowered to bring a civil action. A civil action may be brought—
      1. by a participant or beneficiary—
        1. to recover benefits due him under the terms of his plan, to enforce his rights under the terms of the plan, or to clarify his rights to future benefits under the terms of the plan;

    The Pratt case had some unique and specific facts, however, the court's focus was whether a benefit could be amended after a participant has terminated employment and is otherwise ready to receive benefits under the terms of the plan.  The basic argument is that participants are entitled to their benefits under the terms of the plan in place at the time when they satisfied all conditions for receiving a benefit.  In the case of a person who is entitled to a benefit upon termination of employment, assuming his or her account is vested, the completion of service and leaving the plan is seen by some courts as the final event fixing the right to a benefit under the terms of the plan as they existed at the time he or she left employment.  At that time, the "contract" between the employer and employee is fixed and cannot be changed.  Again, it is not clear whether the ESOP exceptions in the anti-cutback regulations should be applied to permit the plan "contract" to be amended retroactively such that changes in distribution options can be applied to participants who are already in pay status.

    Most interestingly, a related opinion to the Armstrong v. Amsted Industries, Inc., decision involved a group of plaintiffs who sought to remove themselves from the class action and distinguish their status as plaintiffs with different claims. See Bradley v. Amsted Industries, Inc., U.S. Dist. Lexis 14780 (N.D. Ill. 2004).  The plaintiffs' allegations included that they had perfected contractual claims to benefits by leaving the company and applying for benefits prior to the amendments to the Amsted ESOP. Although the group was not able to plead facts to the court's satisfaction to distinguish themselves from the plaintiff class in Armstrong v. Amsted, the opinion in this case implied that their claim could have stood as a separate claim if they had successfully pleaded those facts. The court stated:

    Had plaintiffs begun the process of redeeming their ESOP shares only to have defendants apply the amendments to their pending distribution requests, then they might well have had a distinct claim.

    The court also said that:

    To receive their ESOP retirement benefits plaintiffs were required to submit an ESOP distribution request form, which was typically distributed to employees two to three months before retirement.

    Neither plaintiff submitted forms before the ESOP amendments were effective.  Some of the surrounding facts, however, are a bit murky.  For instance, the plaintiffs alleged they had left the company and had put the administrator on notice of their intent to take a distribution.  Furthermore, other cases applying the contract doctrine to non-ESOP plans do not require this degree of performance by a participant to be entitled to a form of benefit under the terms of the plan (in existence at termination of employment).  See Auwarter v. Donohue Paper Sales Corp., 802 F. Supp. 830 (E.D.N.Y. 1992).  The Bradley v. Amsted case leaves to another day the possibility that an ESOP participant will bring an action to enforce the provisions of a plan document upon termination of employment if the distribution provisions are amended after the participant leaves the employer.

    Fiduciary Discretion

    A final comment is also warranted regarding distribution "policies" and changes in distribution mechanisms to mitigate repurchase liability.  Since 1989, the anti-cutback regulations have prohibited the exercise of fiduciary discretion in the availability of protected benefits or optional forms of benefit.  In particular, a transition rule was required to be followed in 1989 by which these more flexible provisions were removed from plan documents and plan distribution options were fixed in the plan documents.  If the ESOP is operating under a "distribution policy" that gives the ESOP committee discretion about how benefits will be paid, care must be taken not to appear to be exercising discretion that is prohibited by the anti-cutback regulations.  It also raises the argument that such ESOP fiduciaries are trying to rely on the Code exceptions to the anti-cutback rules for ESOPs to support their right to exercise discretion over the availability of a form of distribution, whereas the regulations do not permit this even for ESOPs.

    Conclusion

    As a cautionary point, the ability to change distribution options should be clearly reserved in the plan as the exercise of a settlor function, not a fiduciary one.  Furthermore, care should be taken to specify that, if there is a "distribution policy," it is adopted by the settlor and not by the plan administrator, and treat it as a portion of the plan document.  Any such policy should be submitted along with the plan document in determination letter applications made to the IRS.  The board and the ESOP fiduciaries need to take care that changing distribution options to manage repurchase liability is not a fiduciary action.  Otherwise, fiduciaries such as the plan administrator or committees may run headlong into the Amsted fact pattern — to their detriment.

    ESOP plan sponsors should review their plan documents (including any policies under which the plan operates) to ensure that:

    1. They are clearly written to specify that repurchase liability planning is a corporate finance function;
    2. ESOP fiduciaries and administrative committees have not been given the right, authority, responsibility, or discretion for repurchase liability planning; and
    3. Distribution provisions are subject to amendment only by the corporation and its board of directors or its compensation committee acting as a committee of the board and not as an ESOP plan administrator or ESOP committee.

    In addition, ESOP plan sponsors should make certain that any amendments to distribution provisions dealing with repurchase liability are made by the plan sponsor with due regard for the ambiguities of the anti-cutback rules and the potential complications of participant breach of contract claims under ERISA section 502(a)(1)(B).

    This article was republished with permission from the Journal Of Pension Benefits, Spring 2006, Vol. 13, Number 3, © 2006, Aspen Publishers. All rights reserved. For more information on this or any other Aspen publication, please call 800-868-8437 or visit www.aspenpublishers.com.


    Editor's Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government's rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or contact us here.