In late June, the U.S. Supreme Court handed down a ruling that limits certain legal protections affecting Employee Stock Ownership Plans (ESOPs). This action, combined with a crackdown by the Department of Labor, makes it clear the management of many ESOPs will need to be tightened. Here's a quick review of the current legal landscape, which may help you assess how your own company's ESOP is being handled.

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Supreme Court Weighs in on ESOPs

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Employee stock option plans (ESOPs) were conceived to be a "win-win" for
businesses, under the right circumstances. The premise is, when employees
have an equity stake in the company they work for, their interests will be
aligned with owners because they actually become owners themselves.
Congress established tax benefits for ESOPS to help business owners
overcome possible concerns about the administrative complexity involved in
establishing and maintaining an ESOP. Approximately 7,000 companies now
sponsor ESOPs. Small employers often use these plans as an exit strategy,
and happily sell their company over to the ESOP and, by extension, their
employees.
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About 13.4 million workers are covered by
employee stock option plans, whose combined
assets total approximately $940 billion, according
to the Employee Benefit Research Institute. For
roughly one-third of the companies which sponsor
them, ESOPs are the only retirement plan.

3. Tax-Favored Buy-Out
ESOPs exist as a trust whose sole purpose is to hold employer stock on behalf
of employees. As employees retire, employee shares are purchased back
from them by the ESOP. The company makes tax-deductible cash
contributions to the ESOP, enabling the trust to purchase company stock
from owners.
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In other words, owners are financing their own buy-out from company profits
with pre-tax dollars. In addition, ESOPs can borrow funds to purchase
employer stock, but the company will still need to make cash contributions to
the trust sufficient for the ESOP to service the debt it incurred.

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For business owners, the proceeds from the sale of their stock to the ESOP
are generally fully taxable (depending on their tax basis) -- unless the
proceeds are reinvested into publicly traded stock or bonds. In that case,
taxes are deferred until those investments are sold. The calculations can be
complex, requiring the assistance of a tax professional.
Problems arise when owners use overly optimistic valuations to set the price
of company stock they sell to the ESOP. Since the beginning of the Obama
administration, the Department of Labor (DOL) has aggressively sought out
cases it considers to include abusive valuations. The DOL has pursued 28
cases and recovered $241 million through out-of-court settlements. Trust
companies serving in a custodial capacity for ESOPs have also been in the
cross-hairs when they fail to monitor stock valuations.

5. DOL on the Prowl
In early June, for example, the DOL reached a $5.25 million settlement with
GreatBanc, which served as trustee for an ESOP of Sierra Aluminum Co., a
metal products company in Riverside, California. The ESOP had 385
participants. The DOL asserted that GreatBanc had failed to review the
methodology employed by a valuation firm, resulting in what the DOL
maintains were "unrealistic and aggressively optimistic assumptions" of the
company's earnings. The DOL also charged GreatBanc with asking the
valuation company to adjust its valuation upward to match the
target share price.
In another case earlier this year, the DOL reached a $10 million settlement
with two owners of a New York-based care-giving service called People Care.
The owners and the company itself were charged with "failing to correct
unrealistically optimistic projections of [the company's] future earnings." The
projection (and thus the company's valuation) failed to reflect the impact of
the recent loss of a large customer.
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Also, the DOL argued that the stock purchase agreement was invalid because
it contained a provision indemnifying the owners against the cost of any
litigation or investigations, such as this case. The result was the DOL was
required to cover such expenses instead.
In yet another stock over-valuation case (Chesemore et al v. Alliance Holdings
Inc.) the owners didn't settle, and the U.S. District Court for the Western
District of Wisconsin resolved the dispute. A key factor in this case was that
the company's valuation failed to take into account the financial impact of
the debt the ESOP (that is, the new owner of the company) incurred to buy
out its owners. The impact of the debt was to cut the value of the stock by
about 75 percent.

7. Supreme Court Verdict
Finally, the U.S. Supreme Court issued a unanimous ruling on June 25
in Bancorp et al v. Dudenhoeffer et al in which it shot down a prevailing legal
standard called the "Moench Presumption." That doctrine in effect gave ESOP
fiduciaries the benefit of the doubt in litigation arising from a drop in the
value of the employer stock.
Lower courts sympathized with ESOP trustees who were trapped between
two requirements: To carry out the ESOP's basic purpose through purchasing
and holding employer stock, and looking out for the best interests of ESOP
plan participants.
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"ESOP fiduciaries are not entitled to any special presumption of prudence.
Rather, they are subject to the same duty of prudence that applies to ERISA
fiduciaries in general," the court held. The ruling is most pertinent to publicly
held companies, however, whose ESOP fiduciaries can view market-based
stock valuation any time securities markets are open.
The bottom line for small employers: ESOPs can still be a successful employee
compensation, motivation and owner transition strategy all rolled into one.
But ESOPs are not an easy means to get an above-market price for your
company.

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10. 14550 Torrey Chase Blvd., Ste. 360 Houston, TX 77014 USA
www.hrp.net
E-mail : info@hrp.net
Toll Free
Phone
Fax
:
:
:
877.880.4477
281.880.6525
281.866.9426