ESOPS FABLES: From Happily Ever After to Sour Grapes

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ESOPS FABLES From Happily Ever After to Sour
Grapes

• November 15, 2005
• Presented by
• Carrie Brodzinski Beazley
• Michael Cavallaro ARC
• Michael Jacobster Jackson Lewis
• John Schultz Morgan Lewis

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What is an ESOP?

• Tax-qualified defined contribution benefit plan
  required to invest primarily in the sponsoring
  companys stock

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How is an ESOP created?

• Company creates a trust for the benefit of
  employees
• Company or its shareholders sell stock to the
  trust
• Transaction often leveraged

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How is an ESOP created? (contd)

• Employees are allocated shares based on pro rata
  compensation and, for leveraged shares, as loan
  is paid and shares are released from suspense
  account
• Employees receive shares or cash equivalent upon
  leaving the company

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Why create an ESOP?

• Creates tax advantages contribution deductible
  interest payments on leveraging loan deductible
  certain dividends deductible tax deferral for
  participants tax deferral for certain selling
  shareholders
• Raises capital by selling newly issued shares

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Why create an ESOP? (contd)

• Allows owner of closely held business to sell
  interest
• Improves cash flow by contributing shares vs.
  cash
• Provides retirement benefits
• Creates incentive of ownership

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How does an ESOP operate?

• Directed trustee
• ESOP committee
• Independent trustee
• Repurchase obligation
• Trustees roles and duties under ERISA

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What are the basic risks inherent in an ESOP?

• Conflict of interest resulting from an ESOPs
  dual purposes retirement benefit plan and
  financing vehicle
• Lack of diversity resulting from investing solely
  in companys stock ESOPs do not guarantee
  benefits and they put plan assets at a greater
  risk than the typical diversified ERISA-
  regulated plan

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What risks are associated with acquiring the
stock?

• ESOP cannot pay more than adequate
  consideration-the fair market value of the stock
• Stock is purchased from either the company or the
  owner
• For private companies, stock is not readily
  traded and there are significant fiduciary issues
  in valuing shares
• Duty of prudence requires an independent
  valuation of the stock

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If the ESOP owns company stock how is that stock
voted, and what are the ESOPs fiduciaries
duties as a shareholder?

• How are unallocated shares voted?
• Support of management in tough economic times
• Maintenance of investment
• Tender offers
• Duty to act solely in the interest of
  participants conflicts with voting decisions that
  contemplate non financial factors
• Job security for participants
• Conditions of employment

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What is the potential liability of an ESOP
fiduciary?

• Breach of duty of prudence valuation issues
• Breach of exclusive benefit rule Verity issues
• Breach of duty to diversify maintaining
  investment in failing company duty to divest
• Fiduciary liability insurance coverage

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What is the potential liability of and ESOP
companys officers and directors?

• ESOP committee members
• Selling owner
• Public ESOPs potential duty to disclose non
  public material information
• Directors and officers liability insurance
  coverage

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What do underwriters look for when evaluating an
ESOP?

• What was the reason for creation of the ESOP?
• How incestuous is the ESOP committee?
• Have any ESOP committee members sold stock to the
  ESOP?
• Is there an independent trustee?
• If there is a directed trustee, is it an insider?

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What do underwriters look for when evaluating an
ESOP? (contd)

• Was there a stock valuation by a reputable
  independent firm supported by such Methodology?
• Has there been any fluctuation in stock value?
• Is the company/ESOP able to meet its repurchase
  obligation?

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What do underwriters look for when evaluating an
ESOP? (contd)

• Are unallocated shares voted by the ESOP
  committee a mirror of voting of allocated shares?
• Is the ESOP the only pension plan offered?

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ESOPS FABLES

• Q A