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    ESOP Refinancing: Fiduciary Duties

    ESOP transactions using loans to purchase stock are complex, typically well thought out at the outset, based on the negotiated terms of the deal, the company's finances, the demographics of the ESOP participant census and the projections of repurchase liability. However, because any of these variables can change over time, ESOP loans can be refinanced. But a refinancing, no matter what the reason, must be agreed to between the ESOP trustee and the lenders and guarantors (if any) of the ESOP debt, which may include the selling shareholder, the company or a bank. This article identifies the seldom discussed yet appropriate factors under ERISA and trust law for fiduciaries to consider when refinancing an ESOP.

    ESOP Loans

    ESOP loans exist when the plan borrows money to purchase some or all of the company's stock. The stock is then held in a suspense account and allocated to participants as the loan is repaid. The loan can be structured in various ways. The ESOP may borrow money directly from a bank with the company or the seller guaranteeing the loan. The ESOP may give a promissory note directly to the party selling the shares. The company may borrow money from a bank and then enter into a separate loan agreement with the ESOP, in a two-step process, where the ESOP effectively borrows money from the bank through the company.

    The terms of the ESOP loan will dictate how much the company must contribute to the ESOP over time for repayment of the loan. This in turn will determine how quickly shares are released from the suspense account and allocated to participants.

    Reasons To Refinance

    Companies may desire to refinance their ESOP loans to: 

    • Accelerate the company's payment of bank debt or seller financing without accelerating share allocations to participants' accounts; or
    • Extend the period when shares are available for allocation to participants when the number of shares in the suspense account has dwindled and the ESOP owns all of the shares.

    In a down economy, companies with diminished cash flow or smaller workforces may desire to refinance their ESOP loans to:

    • Reduce the company's current cash flow contributed to the ESOP for loan repayment; or
    • Reduce the amount allocated each year to the smaller post-layoff participant pool.

    When the ESOP loan is extended, or if the bank debt is repaid more rapidly than the ESOP's loan to the company, it may appear that the company is benefiting at the expense of the ESOP. The company's near-term employee benefit costs (or levels) or third party debt may be reduced. At the same time, the rate of allocations to participant may slow or simply not keep up with the company's ability to pay off ESOP debt. However, in many situations, both the company and the ESOP can benefit from the extension of an ESOP loan or from accelerating the payment of bank debt. These benefits and the mechanics for properly accomplishing the refinancing are discussed below. 

    The ESOP Trustee's Duty

    Department of Labor (DOL) Field Assistance Bulletin (FAB) 2002-1 raises questions regarding a fiduciary's obligations under ERISA and the procedure for avoiding a prohibited transaction. The FAB provides that an ESOP loan refinancing must comply with the requirements of ERISA section 408(b)(3) and DOL regulation section 2550.408b-3. The regulation emphasizes a fiduciary's duty to act primarily in the plan participants' interests. To satisfy the primary benefit requirement, a fiduciary must consider all surrounding facts and circumstances.

    Unfortunately, in a refinancing context, a fiduciary's duties are often ambiguous and complicated. How does a trustee demonstrate that it considered all of the facts and circumstances in determining that the refinancing was primarily in the participants' interest? How does a trustee show undivided loyalty to participants when different classes of participants have different interests?

    Each ESOP refinancing is unique. Because of this, the FAB speaks in vague and general terms. This murkiness has unfortunately contributed to the widespread misconception that there is necessarily a tension between the company's interest and the ESOP's interest. The FAB may have caused particular confusion about when a trustee must obtain additional consideration for the plan before agreeing to an ESOP loan refinancing.

    Is There A Conflict Between The ESOP's Interest And Company's Interest?

    In order to refinance a loan, an ESOP trustee must negotiate with the creditors who may be the company, the bank or the seller. A trustee represents the plan in the negotiation and must satisfy its fiduciary duty to participants. The FAB lays out these duties and the general factors that need to be considered in an ESOP refinancing. The FAB's emphasis on participant protection begs the question of whether special protection is needed in an ESOP loan refinancing context.

    An ESOP can be the controlling shareholder or a minority shareholder of the company. In many situations, there is a unity of interest between the company and the ESOP. The unity of interest is most pronounced where the ESOP owns 100% of the shares. What is good for the company is good for the ESOP and the participants who are the company's sole owners. Even when the ESOP is a minority shareholder, the interests of the company and the ESOP are often aligned. This is true particularly in distress situations. The ESOP and the participants are equity investors who will be last in line, along with the other shareholders, if the company files for bankruptcy. This may be caused, in whole or in part, by the failure to refinance the ESOP loan.

    Gray areas emerge when the ESOP and the participants are not the sole owners and the company is not facing a distress situation. A trustee should always carefully consider how refinancing influences the value of the ESOP's holdings. Refinancing may improve the company's liquidity and the value of the ESOP's shares. However, if a proposed refinancing primarily benefits other shareholders or parties in interest, the trustee should consider obtaining extra consideration for the plan, such as additional contributions, as contemplated by the FAB.

    Conflict Between Current And Future Participants

    If an ESOP loan is extended, the rate at which the ESOP loan is repaid slows. Fewer shares are allocated to participants in early years and more are allocated in later years. Employees with short time horizons at the company will receive fewer shares under the refinancing than under the original loan's terms. Future participants will stand to gain when they receive shares that would not have been allocated to them under the terms of the original loan. This certainly suggests that there are circumstances when the interests of current and future participants conflict.

    It is possible to refinance an outside loan between the company and the bank and leave the terms of the inside loan between the ESOP and the company intact. The result is the company could accelerate or decelerate its debt payments while the ESOP continues to release shares to participants at the rate contemplated when the inside loan was established. 

    What if there is no inside loan? Can the trustee agree that the company will assume the ESOP's note to the seller and create a long-term inside loan between the company and the ESOP? This may allow the company to pay off the original note directly and more rapidly while creating a longer share allocation period. Must the trustee insist that the ESOP receive the same rapid repayment and share allocation?

    Trustees have a duty of impartiality to all plan participants. How is a trustee to balance the interests of current and future participants when their interests diverge? The answer lies in the law of trusts cited in the FAB. Trust law provides a trustee with considerable discretion in balancing the interests of current income, future income and remainder beneficiaries. In the context of an ESOP loan refinancing, current participants are analogous to current income beneficiaries. Future participants are analogous to future income and remainder beneficiaries. Because trust law is applicable to ESOP trustees, they possess considerable discretion to refinance an ESOP loan in order to balance the interests of current and future participants.

    This power has been confirmed in the scant ERISA case law concerning a trustee's power to resolve conflicts between the interests of different classes of participants. The courts have held that a deferential standard of review is appropriate when a trustee exercises its discretionary power. Courts will interfere only when a trustee abuses its discretion when balancing the participants' interests. This suggests considerable discretion, when a trustee considers securing a supply of stock for future participants.

    Trust law also addresses trustee powers when confronted with an over-productive trust portfolio. Such situations provide current income beneficiaries with excessive benefits in relation to future income and remainder beneficiaries. Trust law grants a trustee the discretion to realign the benefits to balance the needs of all beneficiaries. Following layoffs that result in a smaller pool of current ESOP participants, the current participants may reap substantially more individual benefits than was contemplated when the ESOP was established. This may be to the detriment of future participants. This is analogous to an over-productive trust portfolio. Consequently, an ESOP trustee may realign the individual benefit levels with what was intended when the ESOP was established. The refinancing may require exchanges of promissory notes and guarantees and other agreements to realign the parties.

    As noted, trust law provides a trustee with a considerable discretion in balancing the interests of current and future participants. It is important to recognize that discretion does not equal procedural prudence. A trustee should be careful to document its decision-making process. A trustee should be able to demonstrate that it acted diligently and in good faith to identify, respect and balance the various beneficial interests. 

    Is Additional Consideration Necessary?

    A company may offer additional consideration to entice a trustee to agree to a refinancing. For example, the company could reduce the interest rate, offer additional contributions over the long-term, or offer participants greater diversification rights. It is a misconception that refinancing requires such inducements in all contexts or that the FAB contemplated this. The FAB may appear to suggest that extra consideration for ESOP participants is needed for a trustee to agree to a refinancing. However, this is not stated as a requirement in the FAB. The FAB only provides that additional consideration is a factor that may help demonstrate that a trustee acted in the participants' interests.

    Suppose a company is having difficulty obtaining corporate financing on favorable terms because of mandatory loan payments under the existing ESOP loan. Is it meaningful to decrease the interest rate on an inside loan between the company and the ESOP if the company is 100% owned by the plan? How would this benefit the ESOP and the participants? There would be no economic benefit or detriment in extending the loan and changing the interest rate because the ESOP effectively owes money to itself. In this situation, it is relatively easy to demonstrate that a refinancing is in the participants' interest. A trustee may properly approve a refinancing without extra consideration from the company. The unity of interest between the company and the ESOP exists in this and in many other situations. 

    In cases where the ESOP is negotiating a refinancing with a note holder other than the company, the issue of consideration is arguably more acute. In such cases, where the note holder is a party in interest, it may be necessary to obtain consideration to avoid a prohibited transaction. In any situation, proper documentation is necessary to protect a trustee if it is called upon to demonstrate that it acted in the participants' interests.

    What To Do

    ERISA requires fiduciaries to act prudently and to fulfill the primary benefit requirement. The context of ESOP loan refinancing is no different. A trustee should be prepared to withstand scrutiny of its consent to a loan refinancing. A thorough decision-making process that is well documented is essential for the trustee. This should include an analysis of the beneficial interests of different classes of participants and an evaluation of the need for additional consideration before agreeing to the refinancing. Companies also have an interest in ensuring the refinancing meets the primary benefit requirement in order to avoid a prohibited transaction, which can result in penalties assessed against an interested party such as the company.

    If you are a corporate officer or a trustee who is considering an ESOP loan refinancing, you should consult with your benefits counsel to assess and evaluate the factors unique to your situation.