ESOPs What They Are and How They Work

ESOPs: What They Are and How They Work
Author(s): Henry C. Blackiston III, Linda E. Rappaport and Lawrence A. Pasini

Source: The Business Lawyer, Vol. 45, No. 1 (November 1989), pp. 85-143
Published by: American Bar Association
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ESOPs: What They Are and How They Work*

By Henry C. Blackiston III, Linda E. Rappaport, and Lawrence A. Pasini**
INTRODUCTION
OVERVIEW
As a tax-favored, congressionally approved "technique of corporate finance,"1
employee stock ownership plans ("ESOPs")2 are currently experiencing a

period of phenomenal growth in corporate America. In 1974, there were
roughly 300 ESOPs in corporate America. This year, there are approximately
10,000 ESOPs in which about 10 million U.S. workers participate, which

represents approximately one-fourth of all corporate employees in America.3
The reasons behind such growth are apparent. First (prior to the most recent
proposals), Congress has consistently enacted legislation that broadens the tax
advantages of ESOPs since the formal approval of such plans in 1974, with the
passage of the Employee Retirement Income Security Act of 1974 ("ERISA").4
Second, ESOPs can provide retirement benefits, and can develop employees'
participation in the ownership of the corporation, which, in turn, should
improve worker morale and productivity by shifting blocks of company equity
from outsiders to the employees. Third, the financial community has become
aware of the varied possibilities of an ESOP as a tool of corporate finance.

ESOPs can provide a market for the company's stock in order to raise capital
through tax deductions, provide an efficient method of selling a division to
employees, enable a company to reduce indebtedness with pre-tax dollars, prove
an effective way to finance an acquisition or leveraged buyout, and aid in the
development of a defensive strategy in change of control situations.
Because ESOPs are tax-qualified employee benefit plans, there is a myriad of
legal requirements which must be satisfied under ERISA and the Internal
Revenue Code of 1986, as amended (the "Code"), in order to retain the tax*Note that at the time of this article's submission for publication, Congress is considering proposals
that would eliminate certain of the tax incentives available to ESOPs. For a discussion of these
proposals, see infra notes 63, 80, and 91.
**Mr. Blackiston, Ms. Rappaport, and Mr. Pasini are members of the New York bar and practice
law with Shearman & Sterling in New York.
Editor's note: William E. Mattingly of the Illinois bar served as reviewer of this article.
1. 129 Cong. Rec. S16,629, S16,636 (daily ed. Nov. 17, 1983) (statement of Sen. Lone).
2. ESOPs are defined in 4975(eX7) of the Internal Revenue Code. I.R.C. 4975(e)(7) (1986).
3. See Ungeheuer, They Own The Place, Time, Feb. 6, 1989, at 50.
4. 29 U.S.C.A. 1001-1461 (West 1985 & Supp. 1989).

85
86 The Business Lawyer; Vol. 45, November 1989
qualified status of ESOPs. One overriding requirement is that the primary

purpose of the ESOP must be to benefit plan participants by distributing to such
participants "the corpus and income of the fund accumulated"5 under the
ESOP. This must be considered when implementing and administering any
ESOP. Thus, if the establishment of an ESOP cannot be justified as a valuable
employee benefit (rather than solely as a corporate financial device), a prospective plan sponsor should not adopt such a plan.
THE CONCEPT EXPLAINED

The term "ESOP" refers to a trusteed tax-qualified employee benefit plan,
which may take the form of a tax-qualified stock bonus plan or a combination
stock bonus and money purchase pension plan. The plan must be designed to
invest primarily in securities of the sponsoring employer. It is exempt from
certain prohibited transaction rules under ERISA that would otherwise prohibit
loans between a plan and a sponsoring corporation and loans to a plan

guaranteed by a sponsoring corporation. Because an ESOP is considered an
"eligible individual account plan" under section 407(d)(3) of ERISA, it is
exempt from the general qualified plan requirements that the assets of such
plans be diversified and that no more than ten percent of the assets of the plan
be held in employer securities.
Unlike other eligible individual account plans, however, an ESOP may invest
in the stock of the sponsoring employer by purchasing the stock with borrowed
funds (leveraging), which may be supplied either by the sponsoring employer or
a lending institution. Congress has adopted numerous tax benefits and incentives for the establishment of ESOPs, which are discussed below. On the other
hand, ESOPs are subject to more stringent regulation and scrutiny than are
standard stock bonus and other eligible individual account plans because Congress felt that the power to borrow may lead to the potential for abuse. Thus, in
order to enjoy favorable tax treatment, the assets of an ESOP must be invested
in so-called "qualifying employer securities," meeting certain specific criteria,
while a stock bonus plan other than an ESOP may invest in any class of
employer stock. In more recent years, however, Congress has extended many of
the requirements originally imposed on ESOPs to stock bonus plans, including
those involving distribution, put options, and voting provisions.
The type of companies that will be likely to find ESOP transactions most
attractive are companies that are labor-intensive and that have stable earnings.
The more labor-intensive the company, the more it will be able to fully utilize
the tax deduction allowances for employer contributions (which are limited by a
certain percentage of the total employee salary base).
What follows is a discussion of (i) the legal requirements for qualification of
ESOPs, (ii) the allocation rules applicable to ESOPs, (iii) the tax benefits and
incentives available to ESOPs, (iv) fiduciary considerations, (v) accounting and
securities law considerations, and (vi) the current use of ESOPs in financial
5. I.R.C. 401(a)(l)(1986).
transactions, including issues involving leveraged buyouts and securitized ESOP

loans.
LEGAL REQUIREMENTS FOR QUALIFICATION OF
ESOPs
QUALIFIED EMPLOYEE BENEFIT PLAN UNDER
CODE SECTION 401 (a)
Section 4975(e)(7) of the Code defines an "employee stock ownership plan"

as a stock bonus plan (or a stock bonus plan and a money purchase pension
plan) that is qualified under section 401 (a) of the Code. Code section 401 (a)
imposes the basic requirements for qualification purposes, among them, that: (i)
contributions must be made to the ESOP by the employer/sponsor, the employees, or both; (ii) the ESOP must be established and maintained for the exclusive
benefit of employees and their beneficiaries; (iii) the ESOP must permit
employee participation on a non-discriminatory basis; (iv) a proper vesting
schedule must be included by the terms of the ESOP; and (v) the ESOP may not
provide benefits in excess of certain limits.
Required Contributions
Under the Code, an ESOP, like other qualified employee benefit plans, is
required to be "supported" by contributions from the employer (or the employees) for the purpose of "distributing to such employees or their beneficiaries the
corpus and income of the fund."6 Further, qualified plans must be intended to
be permanent, and the failure of an employer to make substantial and recurring
contributions to a profit sharing plan, for example, will generally result in the
loss of its qualification.7 Thus, if an ESOP is formed, but neither the employer
nor the employees contribute any funds to the ESOP trust, either to pay down
an ESOP loan or to purchase additional stock, the ESOP will not constitute a
"qualified" plan under section 401 (a) of the Code. Additionally, the ESOP
regulations warn (in the course of discussing the timing of the repayment of
exempt loans and the resulting release of employer securities from the suspense
account) that not only must contributions be made to support the ESOP, but
any "failure on the part of the employer to make substantial and recurring
contributions to the ESOP" may lead to a loss of qualification under section
401 (a).8 It seems, therefore, that de minimis employer contributions would
violate the sponsoring employer's obligation to make "substantial and recurring
contributions," as required in the regulations. It is not clear whether an ESOP
supported solely by employee contributions would satisfy qualification require-
ments under the Code.
6. Id.
7. Treas. Reg. 1.401-l(b)(2) (as amended in 1976).

8. See Treas. Reg. 54.4975-7(b)(8)(iii) (1977) (emphasis added).
Although the regulations governing ESOPs and leveraged transactions make

no distinction between employer and employee contributions (referring instead
generically to "contributions"), practitioners are generally cautious with respect
to using employee contributions to repay an ESOP loan. Not only does the use
of employee contributions raise securities laws issues regarding registration and
disclosure, but, in addition, the Internal Revenue Service (the "1RS") has
informally indicated that it believes that the use of employee contributions to
repay an ESOP loan is inappropriate and inconsistent with the "exclusive

benefit" rule and that it is currently considering taking formal action on this
question.
Exclusive Benefit of Participants

All tax-qualified plans must be "created or organized ... for the exclusive
benefit of ... employees or their beneficiaries."9 However, despite the clear
language embodied in the statute, the degree to which this requirement has
meaning varies in different contexts. It seems obvious that what may be the rule
of "exclusive benefit" in a defined benefit pension plan would differ from the
rule in the context of a leveraged ESOP since, in the latter case, every
structuring of an ESOP transaction benefits others in some way: the sponsoring
corporation enjoys tax deductions, the lenders have tax incentives, and management may obtain increased control. Therefore, the fact that "incidental" benefits
are provided to third parties through ESOPs would not result in a violation of
this rule; however, what constitutes more than an incidental benefit remains
undefined. Similarly, the ESOP regulations require only that loans to ESOPs
be for the primary, but not necessarily the exclusive, benefit of the plan. ESOP
fiduciaries are "cautioned," in the ESOP regulations, to "exercise scrupulously
their discretion" in approving these loans, since the 1RS will subject ESOP
loans to "special scrutiny to ensure that they are primarily for the benefit of
participants."10
Non-discrimination
As a qualified employee benefit plan under the Code, an ESOP cannot

discriminate in favor of employees who are "highly compensated."11 One of the
following minimum coverage tests must be met in fact by the ESOP for it to be
considered non-discriminatory in plan years beginning after 1988:
9. I.R.C. 401 (a) (as amended in 1988). Under section 404(a)(l) of ERISA, fiduciaries of a
qualified plan must act solely in the interests of participants and beneficiaries for the exclusive
purpose of providing benefits to such persons and defraying reasonable expenses. See infra text
following note 100 for a discussion of ERISA's fiduciary responsibility rules.
10. Treas. Reg. 54.4975-7(b)(2)(iii) (1977) (emphasis added).

11. I.R.C. 401(a)(4) (1986). See also I.R.C. 414(g) (as amended in 1988) which defines a
"highly compensated employee" under the Code as an employee who, over the year or the preceding
year, (i) was a 5% (or more) owner of the company at any time, (ii) earned over $75,000 from the
company, (iii) earned over $50,000 and was in the top 20% of company compensation, or (iv) earned
over $45,000 and was an officer of the company.
(i) Seventy percent of all non-highly compensated employees are partici-
pants in the ESOP; or

(ii) The percentage of non-highly compensated employees covered under
the plan (in relation to the total number of participants) is at least seventy
percent of the percentage of highly compensated employees covered; or
(iii) The ESOP must cover a fair cross section of employees, and the
"average benefit percentage" for non-highly compensated employees is at
least seventy percent of such percentage for highly compensated employees.12
In applying these tests, generally employees under age twenty-one (if the
ESOP prescribes this minimum age requirement), employees completing less
than the minimum service requirement prescribed by the ESOP, employees in a
unit covered by a collective bargaining agreement (provided there is evidence
that retirement benefits were the subject of good faith negotiation) and nonresi-
dent aliens with no U.S. source income may be excluded from the calculation.13
In general, under the controlled group requirements of the Code, all affiliated
companies under common control (within the meaning of section 1563(a) of the
Code) are aggregated when calculating the above percentages. However, an

ESOP may not be considered with another qualified plan for purposes of
applying these tests, unless the other plan is also an ESOP whose assets are
invested in employer securities in the same proportion as the first ESOP.14
Vesting
The minimum vesting standards which an ESOP must generally provide
after December 31, 1988 are either:15
(i) 100% vesting after five years of service; or
(ii) a vesting schedule no less favorable than:
Years of Service Percentage Vested

3 20%
4 40%
5 60%
6 80%
7 or more 100%
Once a participant's benefit promised under the ESOP "vests," the benefit
becomes nonforfeitable. If a participant's service with the employer subse-
12. I.R.C. 410(b) (as amended in 1988). Under the Code, the "average benefit percentage"
means the average of the employer-provided benefits to an employee under all qualified plans
maintained by the employer, expressed as a percentage of such employee's compensation. See I.R.C.
410(b)(2)(C)(1986).
13. See I.R.C. 410(b)(3), (4) (as amended in 1988).

14. Treas. Reg. 54.4975-1 l(e) (as amended in 1979).
15. I.R.C. 41 l(a)(2) (1986).
quently terminates, the percentage which is vested will remain nonforfeitable,

and any non-fully vested percentage will be forfeited.
Benefit Limitations
An ESOP may not provide benefits to participants that exceed certain
statutory limits, and it must provide a formula in the plan document that
allocates employer contributions, and which in practice falls within such statu-
tory boundaries. Generally, annual allocations to an employee's account may

not exceed the lesser of: (i) twenty-five percent of the employee's compensation,
or (ii) $30,000 (or, if greater, one-quarter of the defined benefit plan limit
($90,000, subject to cost of living increases)).16 If no more than one-third of all
employer contributions are allocated to "highly compensated" employees, then

this annual allocation limit may be increased to the limit permitted under Code
section 41 5(c)(6).17
DEFINED CONTRIBUTION PLAN REQUIREMENT

An ESOP is a defined contribution plan under the Code and may be
structured as either:
(i) a stock bonus plan, with employer contributions tied to a formula

which may (but need not necessarily) be based upon profits; or
(ii) a combination stock bonus plan and money purchase pension plan,
with employer contributions that are fixed and not dependent upon profits.18
Distinctions Between Stock Bonus And Money Purchase
Plans
One distinction between the two types of plans is that benefits under a stock
bonus plan must be payable in stock, whereas money purchase pension plan
benefits may be payable in either cash or stock. The money purchase pension
plan is also different in that it is funded with fixed contributions not based upon
profits, whereas the stock bonus plan is often designed as an incentive plan, with
contributions and earnings directly based upon profits. Another distinction

between money purchase pension plans and stock bonus plans stems from the
former's status as a "pension" plan: withdrawals are not permitted until normal
retirement or termination of service. A stock bonus plan, in contrast, may

provide for in-service distributions.19
The most important reason for adding a money purchase pension plan to an
ESOP (other than a leveraged ESOP) is to increase the deductible limit for
employer contributions from fifteen percent to twenty-five percent of compensa-
16. I.R.C. 415(c)(l),(d)(l)(1986).

17. I.R.C. 415(c)(6) (as amended in 1988).
18. I.R.C. | 4975(eX7) (1986).

19. See Treas. Reg. 1.401-l(b)(l)(i), (ii) (as amended in 1976).
tion. A similar increase in deductible limits is also available to any ESOP with
respect to the repayment of a so-called "exempt loan."
Participants9 Individual Accounts

All assets of an ESOP must be held in an ESOP trust, established under a
written trust agreement, and administered by a trustee who is responsible for
protecting the interests of the employees and their beneficiaries. Each participating employee is given an individual account, and over the term of employment, each employee's account is credited with an appropriate number of shares
of employer stock. The proceeds of an ESOP account are generally not distributed until an employee dies, retires, suffers a disability, or otherwise terminates
his service with the employer. Upon the closing of a participant's account, an
employee's benefits are calculated by applying the value of the employer stock to
the number of shares held in the account. The account balance must initially be
distributed in shares of stock, unless a participant elects otherwise.
These requirements will affect both the participants and the employer. With
regard to the ESOP participants, as in other defined contribution plans, their
benefits under the ESOP are ultimately contingent upon the underlying value of
the employer stock. With regard to the employer, stock distributions to employees will increase the total number of shareholders. This may ultimately trans-
form a privately held company into a public company for securities law
purposes if as a result the employer has more than 500 shareholders. The
ESOP trust is considered to be one shareholder for this purpose.
"QUALIFYING EMPLOYER SECURITIES"

INVESTMENT REQUIREMENT
Investment in Other Assets
"A plan constitutes an ESOP only if the plan specifically states that it is
designed to invest primarily in qualifying employer securities."20 Thus, an
ESOP that is designed as a stock bonus plan or money purchase plan may also
invest part of its assets in non-qualifying employer securities (as long as the
ESOP invests "primarily" in qualifying employer stock), and the plan will be
treated as any other stock bonus or money purchase plan with respect to those
investments.21 Although it is not defined in the statute, the "primarily" element
of this phrase had been interpreted to permit a plan provision that required at
least fifty percent of the ESOP assets to be invested in qualifying employer
securities.22 Under the regulations, the proceeds of an ESOP loan must be used
20. Treas. Reg. 54.4975-1 l(b) (as amended in 1979); see also, Employment Retirement
Income Security Act (hereinafter ERISA) 407(d)(6), 29 U.S.C.A. 1107(d)(6) (West 1985).
21. Treas. Reg. 54.4975-1 l(b).
22. Dep't Labor Op. 83-6A (Jan. 24, 1983). The Department of Labor ("DOL") declined to
establish a fixed, quantitative standard for the "primarily invested" requirement, instead emphasizing that the applicable requirements were flexible and varied in different factual contexts.
"within a reasonable time" to acquire qualifying employer securities, or used to

repay such loan or a prior ESOP loan.23
Definition of Employer Securities

Publicly Traded Companies
Common Stock
Section 4975(e)(8) of the Code provides that a "qualifying employer security"

means an employer security within the meaning of section 409(1) of the Code.
Section 409(1) of the Code defines employer securities as, among other things,
common stock issued by an employer (or by a corporation which is a member of
the same controlled group) which is "readily tradable" on an established U.S.
securities market. If the employer has no readily tradable common stock, but
another member of the controlled group does, that "readily tradable" stock (or a
preferred stock meeting the requirements discussed below) must be the "em-
ployer securities" purchased by the ESOP. The 1RS has ruled that American
Depository Receipts ("ADRs") may be deemed to be "common stock," provided
they have the necessary voting and dividend rights, and that they are traded on
an established U.S. securities market.24
Section 409(l)(4)(A) of the Code further provides that for purposes of this
section, a "controlled group of corporations" has the meaning given to such term
by section 1563(a) of the Code (determined without regard to subsections (a)(4)
and (e)(3)(c) of section 1563), which generally requires an eighty percent of

vote or value test to determine controlled group status. Under Code sections
409(1 )(4)(B) and (C), the controlled group definition is expanded to include
situations in which (i) a common parent owns stock possessing at least fifty
percent of the total voting power, and fifty percent of each non-voting class of
stock in a first tier subsidiary, or (ii) the common parent owns the entire voting
power of a first tier subsidiary, and such first tier subsidiary owns at least fifty
percent of the total voting power, and fifty percent of each non-voting class of
stock in the second tier subsidiary.
The 1RS has ruled that common stock of a. foreign parent corporation traded
on a United States securities exchange, where the parent corporation is a

member of the same controlled group of corporations as the employer and where
members of the group have no readily tradable stock, must be regarded as

"readily tradable" common stock and, thus, "qualifying employer securities."25
However, if the foreign parent only has stock trading on a foreign exchange,
such stock will not be deemed "readily tradable" common stock for purposes of
section 409(1) of the Code.26
23. See Treas. Reg. ft 54.4975-7(bX4) (1977).
24. See Priv. Ltr. Rul. 85-46-125 (Aug. 23, 1985).

25. Id.
26. See Priv. Ltr. Rul. 87-27-025 (Apr. 2, 1987).
ESOPs 93
Preferred Stock
Under section 409(1 )(3) of the Code, preferred stock of the employer can be
qualified as "employer securities" if (i) it is noncallable, (ii) it is convertible at
any time into common stock that is readily tradable (or common stock having
the greatest dividend and voting rights where no readily tradable common
exists), and (iii) the conversion price is "reasonable."
There are no regulations at the present time under section 409 of the Code;
consequently, the available authoritative guidance as to what is a "reasonable"
conversion price is sparse. Former Treasury regulations regarding TRASOPs

(a form of ESOP no longer permitted under the Code) that addressed the issue
of a "reasonable" conversion price in the context of defining "employer securities" (for purposes of obtaining an investment tax credit for contribution to a
TRASOP), have been applied to an ESOP in a recent private letter ruling. The
TRASOP regulation states that a convertible employer security must be con-
vertible at all times into common stock "at a conversion price which is no
greater than the fair market value of that common stock at the time the plan
acquires the security," and the 1RS relied on this TRASOP regulation in
finding that a conversion price that was no greater than the fair market value of
the common stock at the time the plan acquired the security was a "reasonable"
conversion price under section 409.27 However, the private letter ruling did not
state that this was the only method of determining a "reasonable" conversion
price. Practitioners generally take the position that the former TRASOP
regulation is inapplicable to the qualification of a class of preferred stock as an
"employer security" in the context of an ESOP because the TRASOP regulation now is obsolete and is generally inconsistent with the standard market
terms for convertible preferred shares. Presently, the authors are aware of
transactions that have been undertaken using a conversion premium above
market, with some as large as thirty percent over market.
Non-Publicly Traded Companies

Under section 409(1 )(2) of the Code, if neither the employer nor any other
member of the controlled group has readily tradable common stock, stock which
is part of a class of common stock having the greatest dividend and voting rights
will be considered qualifying employer securities. In the context of leveraged
buyout companies, which typically have complex capital structures, it may often
be difficult to determine which class of common stock would satisfy the section
409(1 )(2) definition.
DISTRIBUTION REQUIREMENTS
Distributions attributable to employer stock acquired by an ESOP after
December 31, 1986 are subject to special distribution requirements. Unless a
participant elects otherwise, distribution of ESOP benefits must commence no
27. See Priv. Ltr. Rul. 87-52-079 (Sept. 30, 1987) (citing Treas. Reg. 1.46-8(gXi) (1982)).
later than one year after the last day of the plan year in which retirement,
disability, or death occurs, or the fifth year following the plan year in which
employment terminates for other reasons.28 However, this rule does not apply in
two instances. First, if the participant resumes employment before the distribution date, distribution is not required. Second, with exceptions relating to death,
disability, and normal retirement, distributions attributable to employer stock
acquired with the proceeds of an ESOP loan generally may be postponed until
the close of the plan year in which the loan is repaid in full.29
Unless a participant elects otherwise, distribution of ESOP benefits ordinarily must be made at least as rapidly as if they had been made in substantially
equal, annual installments over a period not exceeding five years.30 However,
for participants whose benefits exceed $500,000 in value, the distribution period
may be extended by one year for each $100,000 (or fraction thereof) by which
the value of benefits exceeds $500,000, up to an additional five years.31
INVESTMENT DIVERSIFICATION REQUIREMENT

The Code requires an ESOP to provide an investment diversification election
to certain participants. When an ESOP participant reaches age fifty-five or

completes ten years of participation, if later, he may elect to diversify a portion
of his ESOP balance the next plan year and each plan year thereafter for up to
a period of five years.32 For the first four years, a participant's election may
cover up to twenty-five percent of his account balance. In the final year, an
election may cover up to fifty percent of the participant's account balance. The
diversification requirement can be satisfied by offering three investment options
to each electing participant. Alternatively, the diversification requirement may
be satisfied by distributing the portion of the participant's account balance

subject to diversification.33
For purposes of valuations necessitated by the diversification rules and for all
other valuations under an ESOP of employer securities which are not readily
tradable in an established securities market, the Code requires that the plan
employ an independent appraiser meeting requirements similar to those of the
regulations promulgated under section 170(a)(l) of the Code with respect to

valuation of charitable contributions of property.34 The appraiser's name must
be reported to the 1RS.
28. I.R.C. 409(o)(l)(A) (as amended in 1988).

29. I.R.C. 409(o)(l)(B) (1986).
30. I.R.C. 409(o)(l)(C) (1986).
31. Id.
32. See I.R.C. 401(aX28)(A) (as amended in 1988).

33. I.R.C. 401(a)(28)(B)(ii) (as amended in 1988).
34. I.R.C. 401(a)(28)(C) (1986).
The diversification requirements are effective with respect to ESOPs adopted
after December 31, 1986 and contributions made to an existing ESOP after
December 31, 1986.35
VOTING RIGHTS REQUIREMENT

If an employer has a "registration-type class of securities," that is, a class of
securities registered under the Securities and Exchange Act of 1934, as amended
(the "1934 Act"),36 or is exempt from registration under section 12(g)(2)(H) of
the 1934 Act,37 each participant or beneficiary in the ESOP holding such
securities is entitled to direct the voting of securities allocated to his account.38
If the employer does not have a "registration-type class of securities," each
participant or beneficiary in the ESOP holding such securities is entitled to

direct the voting of allocated shares on corporate matters which involve the
voting of such shares for the approval or disapproval of any corporate merger or
consolidation, recapitalization, re-classification, liquidation, dissolution, sale of

substantially all assets of a trade or business, or such similar transactions as the
Secretary of the Treasury in future regulations may prescribe.39 The employer
may, however, allow greater pass-through voting rights. Section 409(e)(5)

permits the voting requirement described above to be satisfied by granting one
vote to each participant and voting all of the ESOP's shares in proportion to the
participants' vote. Neither the Code nor the ESOP regulations address the issue
of the voting of unallocated shares or shares that are allocated but with respect
to which no directions have been received. Under the former Treasury regula-
tions addressing TRASOPs, the former would be voted by the trustee in its
discretion, while the latter could not be voted at all.40
MISCELLANEOUS RULES
Written Plan Document
To constitute a qualified plan, an ESOP must be embodied in a written

instrument. This instrument must provide for at least one "fiduciary" who has
authority to manage and control the assets of the ESOP.41 All assets of the
35. A recent notice issued by the 1RS clarified these diversification provisions in several respects.
Among other things, the notice provided that the portion of a participant's account that is subject to
the diversification requirement is only that portion representing the securities purchased or contrib-
uted after December 31, 1986 and allocated to his account. I.R.S. Notice 88-56, A-9, 1988-1 C.B.
540, 541. Further, the notice indicated that the diversification requirement may be satisfied by the
ESOP permitting a participant to direct the transfer of the amounts subject to diversification to
another qualified defined contribution plan of the employer that offers at least three investment
options. Id., A- 13, at 541.
36. 15 U.S.C.A. 78a-78kk (West 1981 & Supp. 1989).

37. Id. 781(g)(2)(H).
38.
39.
40.
41.
See I.R.C. 409(e)(2) (1986).

See I.R.C. 409(e)(3) (1986).
Treas. Reg. 1.46-8(d)(8)(i), (iv) (1979).
ERISA 402, 29 U.S.C.A. 1102 (West 1985).
ESOP must be held in a trust held by the named trustees, or appointed by such
named trustee. An ESOP must be formally designated as an employee stock

ownership plan in the written instrument.42
Put Options
Participants must have a right to demand a distribution of benefits in the
form of employer securities. If a plan distributes employer securities that are not
readily tradable on an established market, a participant must be given the right
to require the employer to repurchase the employer securities under a fair

valuation formula (a "put option").43 With respect to stock acquired after
December 31, 1986, if an employer is required to repurchase employer securi-
ties that are distributed to employees as part of a total distribution, the

requirements of the put option will be deemed to be met provided (i) the amount
paid to the employee for the securities is paid in substantially equal periodic
payments, not less frequently than annually, over a period commencing not later
than thirty days after the exercise of the put option and not exceeding five years,
and (ii) reasonable interest is paid on the unpaid amounts.44 The ESOP
document must specifically provide that the put is nonterminable (the put will
survive the repayment of the loan made to the ESOP to acquire the securities),
even if the plan ceases to be an ESOP.45 These put requirements are an

important consideration, particularly in an LBO context, where they represent
a potential cash drain on a highly leveraged employer.
Valuation
All assets held by an ESOP must be valued at least once a year on a date
specified in the plan document, typically the last day of the plan year.46 If
employer securities that are not publicly traded make up any portion of the
ESOP's assets, this annual valuation must be made by an independent appraiser.
Social Security Integration

The ESOP's benefits may not be integrated with Social Security.47
Certain Amendments
Section 411(d)(6)(C) of the Code exempts ESOPs from the general requirement under section 411(d)(6) that a qualified plan may not be amended to
reduce the accrued benefit of any participant, including eliminating an early
42. Treas. Reg. 54.4975-1 l(a)(2) (as amended in 1979).
43. See l.K.U. $ 4Uy(h) (as amended m IWb).
44. I.R.C. 409(h)(5)(A), (B) (1986).

45. Treas. Reg. 54.4975-1 l(a)(3)(ii) (as amended in 1979).
46. See Rev. Rul. 80-155, 1980-1 C.B. 84.
47. Treas. Reg. 54.4975-1 l(a)(7)(ii) (as amended in 1979).
retirement subsidy or an optional form of benefit with respect to benefits

attributable to service prior to the amendment. Thus, an ESOP may eliminate a
lump sum option or an installment payment option as long as it does so in a
non-discriminatory manner.
EXEMPT LOAN AND ALLOCATION RULES FOR

LEVERAGED ESOPs
EXEMPT LOAN REQUIREMENTS

The following requirements must be met in order for an ESOP to borrow
funds from an employer, or borrow funds from a third party with a guarantee
from the employer, without violating ERISA's prohibited transaction rules

which would otherwise prohibit such a loan:
(i) The purpose of the loan must be "primarily" for the benefit of plan
participants and beneficiaries. The loan must be made to a plan that

qualifies as an ESOP at the time the loan is made.48
(ii) The rate of interest on the loan must be "reasonable," taking into
consideration all relevant factors.49 A variable interest rate may be considered reasonable.50
(iii) The term of the loan must be specified, the loan must not be payable
on demand, and the timing of payments may not be accelerated upon a

default. If the loan agreement provides that the qualifying employer
securities purchased with the loan will be released from the suspense
account using the "principal only" method of allocation, the term of the
loan may not exceed ten years.51
(iv) The loan proceeds must be used within a reasonable time after
receipt only to purchase qualifying employer securities, or to repay an
outstanding ESOP loan.52
(v) The only assets an ESOP may pledge as collateral for the exempt
loan are qualifying employer securities acquired with the proceeds of the
loan, or qualifying employer securities that were acquired with a previous
exempt loan that was repaid with the proceeds of the current loan.53
(iv) The terms of the loan, whether or not between independent parties,
must be at least as favorable to the ESOP as the terms of a comparable

loan resulting from arm's length negotiations between independent parties.54
(vii) The annual payments made by the ESOP to reduce the loan must
not exceed the sum of contributions and earnings on the securities for all
48.
49.
50.
51.
52.
53.
54.
Treas. Reg. 54.4975-7(b)(14) (1977).

I.R.C. 4975(d)(3)(B) (1986).
Treas. Reg. 54.4975-7(b)(7) (1977).
Treas. Reg. 54.4975-7(b)(8)(ii) (1977).
Treas. Reg. 54.4975-7(b)(4) (1977).
Treas. Reg. 54.4975-7(b)(5) (1977).
Treas. Reg. 54.4975-7(b)(3)(iii) (1977).
prior years, less the ESOP loan payments made in all prior years.55 Some
ESOP sponsors have read the concept of "earnings" broadly to include the
proceeds received by an ESOP on a sale of the employer securities pledged
as collateral for an exempt loan. Although earlier 1RS private letter rulings
approved of such an interpretation where the sale of collateral occurred in
connection with the termination of the ESOP,56 the 1RS more recently has
indicated that an ongoing ESOP could not provide for regular loan
repayments funded by the sale of pledged securities.57
RELEASE OF QUALIFIED SECURITIES FROM
SUSPENSE ACCOUNT
As indicated above, the only assets that may be pledged as collateral for an
exempt loan are qualifying employer securities.58 These securities must be held
in a suspense account and subsequently released from encumbrance and allocated to individual accounts as the debt is paid. This release from encumbrance
must be accomplished in one of two ways.
The "Proportional" Method

The proportional method, which the regulations call the "general rule" for
releasing encumbered securities, is used when the amount of shares to be

released from the suspense account is based upon the amount of loan principal
and interest paid.59 The number of shares released from encumbrance in each
plan year under this method must equal the number of shares encumbered
immediately prior to the release, multiplied by a fraction, the numerator of
which is the principal and interest paid in the particular year, and the denominator of which is the total of the loan payment due in such year (that is, the
numerator) plus all future loan payments to become due in subsequent plan
years. The denominator (the total amount) must be determined without the
possibility of extensions or renewals and, for a floating rate loan, must be based
on the rate in effect at the end of the plan year. For example, if an ESOP
suspense account initially holds 150,000 shares of qualifying employer securities, the amount of principal and interest on the loan paid in a given year equals
$40,000, and the total of all future years' payments plus payment for the
current year equals $400,000, the number of snares released in the current year
under the proportional method will equal:
150,000 $40,000 1 = 15,000 shares

shares [ $400,000 J = released this year.
55. Treas. Reg. 54.4975-7(b)(5) (1977).
56. See Priv. Ltr. Rul. 82-31-043 (May 4, 1982); Priv. Ltr. Rul. 80-44-074 (Aug. 11, 1980).
57. Priv. Ltr. Rul. 88-28-009 (Mar. 29, 1988).
58. See Treas. Reg. 54.4975-7(b)(5) (1977).
59. See Treas. Reg. 54.4975-7(b)(8)(i) (1977).
The number of shares released in year two will equal:
135,000 [ $40,000 1 = 15,000 shares

shares [ $350 000 J = released in year two.
The "Principal Only" Method

The regulations also contemplate a "special rule," which is used when the
number of shares released each year is determined solely with respect to
principal payments.60 Under this method, however, manipulation of the amorti-
zation schedule to release securities more slowly is discouraged, and, consequently, the "principal only" method is available only under limited circumstances. The three restrictions placed upon "principal only" releases are:
(i) the loan must provide for annual payments of principal and interest
at a "cumulative rate" that is "not less rapid at any time than level annual
payments of such amounts over ten years";
(ii) interest may be "disregarded" with respect to releasing shares only if
the amount of each loan payment considered to be interest does not exceed
the amount determined under a standard amortization table (i.e., interest
cannot be front-loaded in order to lower the amount of each payment

which is deemed to be "principal"); and
(iii) this method is not available if the duration of the loan period
exceeds ten years (including renewals or extensions).61
Substantial and Recurring Contributions Requirement

In addition, in an indirect reference to the "permanency" requirements of
section 401 (a) of the Code, the regulations state that "releases from encum-
brance in annual varying numbers may reflect a failure on the part of the
employer to make substantial and recurring contributions to the ESOP which
would lead to loss of qualification under section 401 (a)."62 Therefore, a proposal for an employer to contribute to an ESOP only enough each year to pay
interest in the first nine years of a ten-year loan, and contribute enough for one
balloon payment in the tenth year comprised of all principal, with release from
encumbrance dependent solely upon principal payments, would be unacceptable. Additionally, a contemplated arrangement that would utilize a three-year
loan, amortized using a ten-year schedule (that is, minimal principal and
maximum interest paid for two years, with a balloon at the end), although
technically falling within the requirements of the regulations, may very well run
afoul of the "substantial and recurring" contribution requirement of the regulations, as well as the annual benefit limitation under section 415 of the Code,
unless the loan is combined with a loan repayable over a longer term which,
60. See Treas. Reg. 54.4975-7(b)(8)(ii) (1977).
61. Id.
62. Treas. Reg. 54.4975-7(b)(8)(iii) (1977).
together with the three-year loan, results in relatively consistent contribution
requirements. Monthly releases of securities from a loan suspense account

should not violate such regulations, if the payments are relatively consistent.63
ALLOCATION TO INDIVIDUAL ACCOUNTS

Under section 54.4975-1 l(d)(2) of the Treasury regulations, the actual
allocations to participants' accounts are based upon assets withdrawn from the
suspense account.64 The size of the employer's contribution to the ESOP
determines the actual amount of securities released. At least as often as at the
end of each plan year, the ESOP must "consistently allocate" to the participants' accounts the non-monetary units which represent the participants' interests in the assets withdrawn from the suspense account.65 Income with respect to
securities acquired with the proceeds of an exempt loan must also be allocated to
individuals' accounts, unless the plan provides for the income to be used to repay
the loan.66 The proportion of assets allocated to each participant's account is

generally based upon the ratio of the participant's compensation to the total
compensation of all participating employees, except that, in years after 1988,
only the first $200,000 of any participant's salary may be included in the
qualifying annual payroll.
Code section 415 also places limitations on individual participants' accounts.
Allocations to each such account, combined with other defined contribution plan
benefits provided to the participant, generally may not exceed (i) the lesser of
twenty-five percent of the participant's compensation or $30,000 (unless the
special nondiscrimination test is met) or (ii) if greater, one quarter of the

defined benefit plan limit of $90,000, subject to cost of living increases. Additional limits apply if the employer is providing benefits to the same employees
under both defined benefit and defined contribution plans. The section 415
limits will further constrain the loan amortization schedule, since the value
(determined at the original purchase price) of shares released and allocated to a
participant's account in a given plan year cannot exceed the section 415 limit.
Accordingly, the design of an ESOP loan, among other things, must be based
upon the projected annual benefit limitation of participants over the term of the
loan.
ACCOUNTING CONSIDERATIONS
The American Institute of Certified Public Accountants ("AICPA") issued a
statement of position67 ("Statement of Position No. 76-3") in 1976 which has
provided a source of guidance for the accounting aspects of ESOPs. Although
63. See Priv. Ltr. Rul. 87-04-067 (Oct. 30, 1986).
64. See Treas. Reg. 54.4975-7(b)(8)(iii) (1977).
65. Treas. Reg. 54.4975-1 l(d)(2) (as amended in 1979).
66. Treas. Reg. 54.4975-1 l(d)(3) (as amended in 1979).
67. American Institute of Certified Public Accountants, Statement of Position on Accounting
Practices for Certain Employee Stock Ownership Plans No. 76-3 (Dec. 1976).
ESOPs 101
not binding on members of the AICPA, these recommendations present a

preferred accounting standard by which the financial statements of a company
would reflect the existence of a leveraged ESOP. Statement of Position 76-3,

however, was written at a time when ESOPs were used primarily as compensation vehicles for employees, and not financial vehicles; thus, in sophisticated
corporate transactions including ESOPs, the complexities of the situation will
necessarily involve accounting variances which better reflect the economic substance of the transaction.
The following are the three AICPA recommendations with respect to accounting for ESOPs.
FINANCIAL STATEMENTS EFFECT

The debt of the ESOP should be recorded as a liability on the balance sheet of
the sponsoring employer when the debt is either guaranteed by the employer, or
backed by a commitment by the employer to make future contributions to the

ESOP to pay down the debt. Since the assets held by the ESOP are assets of the
ESOP, not the employer, these assets should not be reflected on the financial
statements of the employer. The offsetting debit to the liability recorded by the
loan should be accounted for as a reduction to shareholders' equity. Both the
liability and the equity contra account should be adjusted as the debt is repaid;
the employer's liability decreases and shareholders' equity increases.
COMPENSATION AND INTEREST EXPENSE

When amounts contributed to the ESOP are applied to reduce the loan
balance in a given year, the amount contributed by the employer must be
apportioned to determine the amount of principal and interest deemed to
comprise each payment. The amount of the contribution representing principal
will be directly applied to reduce the loan balance, and the equity contra
account should be appropriately amortized and charged to compensation expense by the employer. The amount of the contribution representing interest
should be separately identified as interest expense. The terms of the loan,

including interest rate, should be disclosed in footnotes to the employer's
financial statements.
EARNINGS PER SHARE AND DIVIDENDS

All shares held by an ESOP should be treated as outstanding shares for
purposes of determining earnings per share. Thus, for example, if new shares or
treasury shares are issued to the ESOP by the employer, a dilution of earnings
per share will occur and, if debt is incurred to purchase outstanding shares,
earnings per share will be reduced. Dividends paid on all shares held by the
ESOP should be charged against retained earnings.
TAX BENEFITS AND INCENTIVES
As "qualified" plans under the Code, ESOPs generally enjoy all the tax
incentives available to other tax-qualified employee benefit plans, namely deductions for certain contributions to the plan by the employer, employee tax
deferral on earnings in the account, and exemption of the trust from taxation on
earnings. However, ESOPs also enjoy many other tax benefits and incentives
that are not available to other types of tax-qualified employee benefit plans.
FIFTY PERCENT INTEREST EXCLUSION

General Rule
Under section 133 of the Code, banks that are incorporated and doing
business under the laws of the United States, insurance companies to which
subchapter L applies, corporations "actively engaged in the business of lending
money" other than subchapter S corporations, or regulated investment companies as defined in Code section 851, which lend money to an ESOP to acquire
qualified employer securities or to refinance an earlier such loan, may exclude
from their gross income fifty percent of the interest received with respect to such
"securities acquisition loan."68 Lenders are generally willing to pass some of the
benefits of this interest exclusion through to borrowers thereby reducing borrowing costs.
68. I.R.C. 133(a), (b)(l), (b)(5) (1986). On June 7, 1989, House Ways and Means Committee Chairman Dan Rostenkowski (D. 111.) introduced a bill to repeal the 133 partial interest
exclusion. H.R. 2572 would repeal 133 effective as of June 7, 1989, thus barring the application
of the partial interest exclusion to loans (including refinancings) that were not subject to a binding
contractual commitment on or prior to June 6, 1989.
On June 14, 1989, Senator Robert Dole (R. Kan.) introduced a companion bill in the Senate that
would liberalize the effective date rules by continuing to permit the 133 exclusion for ESOP
transactions (i) that have been the subject of a public announcement made on or before June 6,
1989, setting forth the amount or value of the employer securities being acquired by the ESOP, or
(ii) in which the employer reached an agreement in principle with its lenders evidenced by written
confirmation on or before June 6, 1989, setting forth the principal amount, interest rate or spread
and maturity of the loan.
Under the July 11, 1989 Joint Committee Release, infra note 85, the effective date rules were
further modified. The 1 33 repeal would not apply to refinancings of loans that were made prior to
June 6, 1989, or are otherwise "grandfathered" under certain limited circumstances (e.g., where the
principal amount of the loan is not increased, the original lender was a "qualified lender" under
133, and the total commitment period - the original term and the term of the refinancing - does
not exceed the greater of the original term or seven years).
Finally, Congress had also discussed retaining the 133 exclusion for loans with a principal
amount below certain dollar thresholds, and loans to an ESOP used to buy more than a specified
percentage of a company's stock.
Whether the elimination of 1 33 would endanger the role of ESOPs in our economy is a matter
of some uncertainty. Many of the benefits and attractions of ESOPs remain notwithstanding any
elimination of tax-favored financing. ESOP lobbyists will continue to advocate the expansion of
employee ownership and participatory capitalism. Corporations will still have an incentive to follow
the example of Polaroid's successful ESOP-based defense against a hostile takeover attempt by
Shamrock Holdings. See infra note 181.
The interest exclusion provided under section 133 is also available to an

institutional lender who lends to the sponsoring employer who then re-lends the
borrowed funds to an ESOP to acquire employer securities.69 Such loan is

generally referred to as a "mirror loan." In order to qualify for the interest
exclusion, however, the loan to the ESOP must be qualified as an "exempt

loan" under sections 54.4975-7 and 54.4975-11 of the regulations and must also
meet all other requirements for such loans under section 133(b)(3).70
Notwithstanding the foregoing, a securities acquisition loan does not include
a loan between members of the same controlled group of corporations, or any
loan between an ESOP and the employer or a member of the controlled group
which includes the employer. Such a related party, although prohibited from
originating such a loan and from receiving the partial interest exclusion, may
nevertheless hold a securities acquisition loan without endangering the interest
exclusion for a subsequent holder that is a qualified lender.71 Thus, ESOP debt
securities may be held temporarily by the sponsor of the ESOP or one of its
affiliates as part of the structure of a securitized ESOP financing.
Immediate Allocation Loans

The partial interest exclusion is available for a loan to a sponsoring employer
who transfers qualifying employer securities equal to the proceeds of such loan
(an "immediate allocation loan") to its ESOP, provided that: (i) the employer
transfers these securities within thirty days of the loan, and (ii) the securities
transferred are allocable to accounts of plan participants within one year of the
date of the loan.72 Although section 133(b)(l)(B) speaks only of "transfers" of
employer securities within the prescribed period of the loan, the legislative
history suggests that the transfer must result from an employer contribution.
Thus, a loan to the sponsor of an ESOP, which is followed within thirty days by
a purchase by the ESOP of immediately allocable employer securities, which

purchase is funded through employee contributions, would not be an "immedi-
ate allocation loan" entitled to the partial interest exclusion. In addition,

although section 133 speaks of the securities being "allocable" within one year,
it seems clear from the Conference Report to the 1986 Tax Reform Act that this
should be read as "allocated" and that, accordingly, section 415 of the Code will
limit the size of any immediate allocation loan.
"Mirror" Loans
General Rule
If the initial loan is provided to the sponsoring employer, and the employer
wishes to on-lend the amount to a leveraged ESOP (commonly referred to as a
"mirror loan"), in order to retain the interest exclusion: (i) the loan to the
69. See I.R.C. 133(b)(3) (as amended in 1988).
70. See Temp. Treas. Reg. 1.33-1T (1986).
71. I.R.C. 133(b)(2) (1986).
72. I.R.C. 133(b)(l)(B) (as amended in 1988).

ESOP must include repayment terms "substantially similar" to the terms of the
loan between the corporation and the institutional lender, or (ii) the ESOP loan
may include repayment terms providing for a more rapid repayment of princi-
pal or interest, but only if allocations under the ESOP attributable to such
repayment do not discriminate in favor of highly compensated employees.73
"Substantially Similar'3 Requirement

Loans are treated as "substantially similar" under the temporary regulations
for Code section 133 only if the timing and rate at which securities would be
released from encumbrance if the initial loan had been the "exempt loan" is
substantially similar to the actual timing and rate of the loan between the
sponsor and the ESOP. The mirror loans may be considered substantially
similar even though one states a variable rate of interest and the other a fixed
rate. In such a case, the determination of whether the two loans are substantially similar will be made at the time the obligations are initially issued.74
Acceleration Upon Default

The credit agreement for the loan between a commercial lender and an
employer may provide for a complete acceleration of payment upon certain
broad events of default. An issue arises regarding the extent to which the
prepayment and acceleration upon default provisions of each of the mirror loans
may differ from one another. The regulations under the Code limit the amount
which can be accelerated with respect to an ESOP to the amount of the payment
deficiency.75 The regulations also severely narrow the permissible events of
default under an ESOP loan to a failure to meet scheduled payments. The

temporary regulations governing the partial interest exclusion also contemplate
a more rapid repayment of the loan between the employer and the ESOP than
the loan between the institutional lender and the employer. Thus, it would
appear that the ESOP regulations impose restrictions on the ability of institutional lenders to include fairly standard acceleration and prepayment terms in
loans to employers which then on-lend to ESOPs. A recent private letter ruling,
however, suggests that the 1RS will treat mirror loans as "substantially similar"
notwithstanding the inclusion of standard acceleration and prepayment provisions in the loan to the employer.76
73. I.R.C. 133(bX3) (as amended in 1988).

74. See Temp. Treas. Reg. 1.133-1T, at A-l (1986). As an example, the temporary regulations compare the initial interest rates on mirror loans, consisting of a variable interest rate loan
with a six-month adjustable rate, and fixed rate, ten-year maturity loans by measuring them against
the yields on six-month and ten-year Treasury obligations. Id.
75. See Treas. Reg. 54.4975-7(b)(6) (1977).

76. See Priv. Ltr. Rul. 88-21-021 (Feb. 24, 1988).
ESOPs 105
Refinancings
As noted above, the partial interest exclusion is also available for the refinancing of a loan to a corporation or an ESOP that met the requirements of a
"securities acquisition loan."77 In the amendment to section 133 of the Code

under the Technical and Miscellaneous Revenue Act of 1988 ("TAMRA"), the
interest exclusion for refinancings was clarified by adding a separate subsection
in Code section 133 delineating the basis of the exclusion. Under section
133(b)(5), the term "securities acquisition loan" includes any loan that is (or is
part of a series of loans) used to refinance an ESOP loan, immediate acquisition
loan, or "mirror" loan, and generally meets the requirements of sections

133(b)(2) and (3), which regulate loans between related parties, and the terms
applicable to mirror loans.
Refinancings should be distinguished from the syndication of securities acquisition loans, which is expressly permitted by the temporary regulations under
section 133 if the original lender was a "qualified holder."78 In contrast to a

refinancing, a syndication (including the offering and resale of ESOP debt
securities) does not alter the terms of the underlying debt, but instead changes
the identity of the creditors.
Period to Which Interest Exclusion Applies

TAMRA also amended the period to which the interest exclusion under
section 133 applies to securities acquisition loans. Prior to TAMRA, the
unamended Code limited this period by requiring that the commitment period
of immediate allocation loans and mirror loans extend not more than seven
years. There were no commitment period requirements under the prior Code
for loans made directly to ESOPs. Thus, the limitations on the commitment
period of certain loans determined the interest exclusion period. Accordingly,
there was an unlimited time period of exclusion for loans made directly to
ESOPs, but a maximum of seven years for immediate allocation and mirror
loans.
Under the current Code as amended by TAMRA, there are no loan commitment period limitations; in other words, any securities acquisition loan may be
made for any term. However, under section 133(e) as amended by TAMRA,
the interest exclusion will only apply to interest accruing during the "excludable
period," as explained below. With respect to immediate allocation loans, the

period to which the exclusion applies is the seven-year period beginning on the
date of such loan. With respect to ESOP loans made directly to ESOPs, which
use the proceeds to acquire employer securities, and mirror loans in which the
repayment terms of the ESOP loan are "substantially similar" to those between
the corporation and its lender, the interest exclusion period extends for the
greater of seven years or the term of the securities acquisition loan. With respect
to mirror loans that provide for a more rapid repayment of principal or interest
77. I.R.C. 133(b)(5)(1986).
78. Temp. Treas. Reg. 1.133-1T, at A-3 (1986).
on the ESOP loan than on the corporate loan, the interest exclusion period is
limited to seven years. With respect to any securities acquisition loan used to
refinance an original securities acquisition loan, the exclusion generally extends
for the greater of seven years or the term of the original securities acquisition
loan. However, if the original term of an immediate allocation loan or a non"substantially similar" mirror loan extends for a period longer than seven years
(that is, if a portion of the term of the original loan itself falls outside the
"excludable period"), any refinancing of such loan should have an interest

exclusion period limited to seven years.
The provisions regarding the period to which the interest exclusion applies
with respect to refinancings are particularly significant in the context of ESOP
financings undertaken during a contest for corporate control. In these instances,
time pressures are such that it is often necessary to put bridge financing in place
pending the negotiation of long-term credit arrangements. With respect to a
loan used to refinance the bridge loan, the rules described above make the
partial interest exclusion available for the greater of the first seven years of the
loan or, if the bridge financing was for a longer term, the term of such bridge
loan.
Effects of Interest Exclusion

An obvious effect of the partial exclusion of interest income is that it gives
lenders an incentive to encourage potential borrowers to establish ESOPs in

stock purchase scenarios. This, in turn, has the effect of encouraging lenders to
"share" their tax savings with ESOP borrowers, at rates that may be between
eighty and ninety percent of those available to borrowers who take loans on a
fully taxable basis. In addition, a growing number of ESOP sponsors are

financing their ESOPs with "securitized" loans. These loans are really floating
rate notes sold to institutional investors who qualify for the interest exclusion.
Since such "loans" are liquid and more attractive as an interest-reducing device,
securitized ESOP loans are currently priced at about seventy-five percent of
prime. Creative methods of syndicating a securities acquisition loan are clearly
permitted under the temporary regulations, which provide that such loans "may
be evidenced by any note, bond, debenture or certificate."79
EMPLOYER CONTRIBUTIONS DEDUCTION

Employer contributions to a leveraged ESOP are generally deductible in
accordance with Code section 404(a)(9). Under the Code, employer contributions applied by an ESOP toward the repayment of the principal of a loan
incurred by the ESOP to finance the purchase of qualifying employer securities
are deductible in an amount up to twenty-five percent of the compensation

otherwise paid or accrued by employees participating in the plan.80 Employer
79. Temp. Treas. Reg. 1.133-1T, at A-l (1986).
80. I.R.C. 404(a)(9)(A) (1986).
ESOPs 107
contributions applied by the ESOP toward the repayment of interest on such a

loan are fully deductible.81 Section 404(a)(9) does not apply to the repayment of
an immediate allocation loan by the ESOP sponsor. In the absence of an exempt
loan, section 404(a)(3)(A) of the Code permits deductible employer contributions of up to fifteen percent of covered compensation to an ESOP that consists
solely of a stock bonus plan. Under section 404(a)(7), this limit is increased to
an aggregate twenty-five percent in the case of a stock bonus plan ESOP and a
separate pension plan or an ESOP that consists of a money purchase pension

plan and a stock bonus plan.
Regardless of deduction limits, employer contributions to an ESOP are also
limited by the annual addition limitation to individual participants' accounts.
Under Code section 415(c)(l), the limitation is the lesser of $30,000 (or, if
greater, one quarter of the defined benefit plan limit of $90,000, subject to cost
of living increases) or twenty-five percent of compensation. However, as stated

above, if no more than one third of the employer contributions for a year are
allocated to highly-compensated employees, then this annual addition limitation
is increased in accordance with section 415(c)(6).82 Additionally, if the "onethird" requirement is met, the section 415 limitations will not apply to forfeitures of the stock, or to employer contributions representing interest payments
on the loan, and which are charged against the individual's account.83 If the
employer simultaneously maintains a defined benefit pension plan and an
ESOP, the limits applicable to each plan will still apply. However, the Code
will not permit the employer to maintain both plans at maximum benefit levels.
To determine whether the annual allocations are acceptable, the Code provides
a fractional test.84
DIVIDEND PAYMENT DEDUCTION

In addition to the deductions provided for employer contributions as noted
above, section 404(k) of the Code allows a deduction for: (i) dividends on ESOP
stock paid in cash by an employer directly to ESOP participants or their

beneficiaries, (ii) dividends on ESOP stock paid to the ESOP and distributed in
cash to ESOP participants or their beneficiaries within ninety days of the close
of the plan year, or (iii) dividends on ESOP stock (whether or not such stock has
been allocated to participants) used to make payments on an exempt loan as

81. I.R.C. 5 404(a)(9)(A) (1986).
82. See I.R.C. 415(c)(6)(A) (as amended in 1988). If no more than one-third of the employer
contributions for a year under an ESOP are allocated to highly compensated employees, the $30,000
figure is increased to the sum of (i) $30,000 plus (ii) the lesser of $30,000 or the amount of employer
securities contributed to the ESOP. This potential $60,000 maximum is limited to $50,000,
however, due to Code 415(c)(l)(B), which limits the maximum contribution for any participant
during a plan year to 25% of that participant's compensation for the year (which under TRA 1986
is limited to $200,000 per year).
83. I.R.C. 415(c)(6)(C) (1986).

84. I.R.C. 415(e)(i) (1986). Essentially, the sum of the fractions that the benefits and contribu-
tions actually provided under each type of plan, in relation to the unreduced limit which would
otherwise apply to that type of plan, may not exceed one (1.0).

described in section 404(a)(9), if the plan provides that employer securities with
a value equal to such dividends are allocated in the year when such dividends
would otherwise have been allocated.86 Since dividends paid to "ordinary"

shareholders are not tax deductible by the corporation, this dividend deduction
is an added congressional incentive for the formation of ESOPs.
Any dividend deductions for loan payments under mirror loans are not
included in calculating the tax deductible contribution limit of twenty-five
percent of compensation for the repayment of principal and are not considered
to be annual additions for section 415 purposes, since the statute clearly
indicates that such deductions are "in addition to" section 404(a) deductions.86
Additionally, since section 404(a)(9) contemplates the repayment of either the
principal or interest on the securities acquisition loan, dividend payments used
solely to pay the interest portion of the loan should be deductible as well,
assuming all applicable requirements of the ESOP are met.87
ESTATE TAX DEDUCTION AND ASSUMPTION OF

LIABILITY
ESTATE TAX DEDUCTION
Under the Code, an estate may sell employer securities of a privately-held
company to an ESOP, and may deduct fifty percent of the proceeds of the sale
generated thereby, if the sale occurs before 1992.88 The securities must not have
been acquired by the decedent through a compensation-type plan.89 In 1987,
Congress added numerous restrictions to the availability of the estate tax

deduction, including a requirement that the securities must be held by the
decedent since October 22, 1986, or, if longer, the five-year period ending on the
date of death.90
ESTATE TAX ASSUMPTION

Under the Code, an ESOP is permitted to assume all or a portion of the estate
tax liability of a decedent.91 To accomplish this, employer securities of a

privately-held corporation equal in value to the liability must be transferred to
the plan, and the sponsoring employer must guarantee payment of the tax
85. I.R.C. 404(k)(2) (1986). On July 11, 1989, JGX 28-89 was released from the Joint
Committee on Ways and Means, which embodied the description of the Revenue Reconciliation
proposal (the "Revenue Proposal"), from Rep. Dan Rostenkowski (D. 111.). Included in the
proposal is a provision that would repeal the 404(k) dividend deduction for securities held by an
ESOP. The repeal of the dividends paid deduction would apply to dividends paid or stock acquired
after July 10, 1989 (except to the extent dividends are paid on stock acquired with a loan that is
grandfathered from the repeal of 1 33).
86. See I.R.C. 404(k) (as amended in 1988).

87. See I.R.C. 404(kX2)(C) (as amended in 1988).
88. I.R.C. 2057(a)(l), (g) (as amended in 1987).
89. I.R.C. * 2057(cX2XB) (as amended in 1987).
90. I.R.C. 2057(d)(lXC) (as amended in 1987).

91. I.R.C. 2210(a), (b) (1986).
ESOPs 109
liability assumed by the ESOP.92 The estate tax, which is generally paid at four
percent interest, may, in effect, be paid entirely in employer stock.93
MISCELLANEOUS TAX IMPLICATIONS
Net Operating Loss Carryforward

The Tax Reform Act of 1986 ("TRA 1986") limited the use of net operating
loss carryforwards after an "ownership change," which is defined generally as a
greater than fifty percent change in the ownership of the entity.94 However,
ESOPs present an exception to this limitation. If an ESOP owns at least fifty
percent of the company after the ownership change, if the allocation requirements of Code section 409(n) are met, and if immediately after the acquisition,
the number of participants in the ESOP is generally not less than fifty percent
of the number of employees of the company (for acquisitions occurring after
December 31, 1988), then the acquisition of employer securities by the ESOP
"shall not be taken into account" for purposes of the ownership change test.
Thus, net operating losses may be applied against earnings without the restrictions of section 382 of the Code.96
Tax Deferred Rollover for Sale of Stock to ESOP

Individual (but not corporate) shareholders in privately-held companies may
defer the recognition of a gain on the sale of employer securities to an ESOP.96
After this sale, if the ESOP owns more than thirty percent of the company, the
shareholder can in effect "rollover" the capital gains by reinvesting the proceeds
within one year in non-passive instruments of a domestic corporation - stock or
bonds.97 The tax basis of the "new" stock or debt is reduced by the unrecognized
gain when the rollover occurred, so that tax is essentially deferred until the time
of the disposition of the new non-passive corporate instrument.98
Exception from Excise Tax on Reversion of Pension Plan

Surplus
If surplus is recovered by an employer from a terminating pension plan, such
amount will normally be taxed at ordinary income tax rates, plus an additional
fifteen percent excise tax imposed on such reversion.99 However, if any portion
92. I.R.C. 2210(d)(1986).
93. See I.R.C. 2210(c) (1986).
94. See I.R.C. 382(g) (as amended in 1988).
95. I.R.C. 382(1 )(3)(c) (1986).
96. See I.R.C. 1042(a) (1986). Under the Revenue Proposal, this provision would be modified
to provide that the deferral of recognition of gain on the sale of employer securities to an ESOP is
available only if the taxpayer held the securities for three years prior to the sale of the stock to the
ESOP. See supra note 85.
97. I.R.C. 1042(b) (1986).

98. I.R.C. 1042(d) (1986).
99. I.R.C. 4980(a), (b) (as amended in 1988).
of the reversion was transferred directly to an ESOP before 1989, or after

December 31, 1988 if the plan termination occurred prior to 1989, the excise
tax would not be imposed, to the extent of the transfer, if all the relevant
conditions enumerated in Code section 4980 are met.100 However, the 1RS is
currently not issuing determination letters approving the termination of pension
plans where surplus is to be transferred to an ESOP. This has discouraged the

use of this exemption from the reversion excise tax by employers.
FIDUCIARY CONSIDERATIONS
As employee benefit plans, ESOPs are subject to all of the provisions of
ERISA, and the use of ESOPs (or their assets) is consequently subject to the
fiduciary rules and restrictions contained in ERISA. These rules include provisions requiring that plan fiduciaries always discharge their duties regarding the
ESOP solely in the interest of the plan participants and their beneficiaries, with
prudence, and for the exclusive purpose of providing benefits to such partici-
pants and beneficiaries. Although these are the only interests appropriately
considered by plan fiduciaries under ERISA, these interests may sometimes
conflict with the interests of the plan sponsor in, for example, a hostile takeover
context. In such situations, the use of an ESOP as a defensive measure may

involve the risk that the fiduciaries will feel compelled to act contrary to the
defensive preferences of existing management. In circumstances involving a
possible conflict of interest, independent legal and financial advice will be
essential to the fiduciaries.
DEFINITION OF FIDUCIARY UNDER ERISA

General Rule
ERISA provides that a person is a fiduciary with respect to a plan if he
(i) exercises any discretionary authority or control respecting management of a plan or management or disposition of plan assets;
(ii) renders investment advice, or has authority or responsibility so to do,
concerning plan assets for which he receives direct or indirect compensation; or
(iii) has any discretionary authority or responsibility in the administration of a plan.101
This definition is functional since the status of an individual as a fiduciary

depends not so much upon job title as upon whether he has performed certain
acts specified in the statute.102 However, named trustees and administrators of
100. See generally I.R.C. 4980 (as amended in 1988).
101. ERISA 3(21)(A), 29 U.S.C.A. 1002(21)(A) (West Supp. 1989).

102. See Donovan v. Mercer, 747 F.2d 304, 308 (5th Cir. 1984) (in determining fiduciary
status, the court must consider both job title and actual authority vested in person); DOL
Interpretive Bulletin 75-8, 29 C.F.R. 2509.75-8, Question D-3 (1987) (job description more
important than job title in determining fiduciary status).
the ESOP will always be fiduciaries. To the extent that the sponsor's officers or
directors exercise control over the ESOP through their relationship with plan
administrators, they may also be deemed to be fiduciaries. Thus, because of

their selection on an investment committee or administrative committee, plan
officers and directors may in fact be fiduciaries of the plan. Because ERISA
provides that a person is a fiduciary to the extent of his fiduciary responsibilities
to the plan, liability of an officer of the sponsor may extend only to his decision
to select a plan administrator or a fiduciary with control over investments, and

not to the decisions of the plan administrator or other fiduciary.103
Plan Sponsors
The decision by a corporation to establish an ESOP is not in itself a fiduciary
decision under ERISA unless it involves the conversion of an existing ERISA

plan.104
Advisors
As a general rule, attorneys, accountants, actuaries, consultants, and other
advisors to employee benefit plans are not considered fiduciaries, since they have
no discretionary authority regarding the plan. However, if an advisor's advice is
regularly followed, he may be deemed to be exercising enough control to be

considered a fiduciary.105
FIDUCIARY LIABILITY UNDER ERISA

General Rule
ERISA provides that a fiduciary who breaches his duty to a plan will be
personally liable (i) to reimburse the plan for any losses resulting from his
breach and (ii) to restore any profits that he has made through the use of plan
assets. In this regard, a fiduciary who breaches his duties will be subject to
equitable and remedial penalties.106 In addition, a fiduciary may be held liable
for another fiduciary's breach of duty if he knowingly participates in, or

conceals, the breach, or if he discovers the breach but does not act reasonably to
103. See Sommers Drug Stores Co. Employee Profit Sharing Trust v. Corrigan Enterprises,
Inc., 793 F.2d 1456, 1459-60 (5th Cir. 1986), cert, denied, 107 S. Ct. 1298 (1987).
104. See Treas. Reg. 54.4975-1 l(a)(6) (as amended in 1979). It should be noted that the
conversion of another form of a qualified plan to an ESOP may require the consent of participants.
According to practitioners, many 1RS District Offices will not approve a plan merger involving an
ESOP unless such consents are received. Rizzo, Hardy & Griffith, Fiduciary and Corporate
Sponsor Concerns in Employee Stock Ownership Plan Transactions, in ALI- Course of Study:
Pension, Profit Sharing and Other Deferred Compensation Plans (1987).
105. See, e.g., Brock v. Self, 632 F. Supp. 1509, 1520 (W.D. La. 1986) (pension plan
consultants were fiduciaries because their advice, though not binding, was "relied heavily" upon by
plan trustees).
106. ERISA 409(a), 29 U.S.C.A. 1109(a) (West 1985).

remedy it.107 In determining the losses for which a fiduciary may be liable, the
Second Circuit Court of Appeals held that the appropriate measure of damages
is derived by comparing actual earnings on an investment with the earnings that
could have been received in' an alternative investment.108 Thus, management

trustees who caused a plan to purchase employer securities during a takeover
contest could not avoid liability merely by demonstrating that the shares were
subsequently sold at a gain to the plan.
Indemnification
Agreements exculpating a fiduciary from liability are, with few exceptions,
void as against public policy.109 Fiduciaries, however, may be indemnified by the
plan sponsor, but not by the plan itself, and only to the extent that such
indemnity does not relieve the fiduciary of statutory responsibility. If the plan
purchases insurance for its fiduciaries, or to cover its own losses due to breach,
the insurance carrier must be able to take recourse against the fiduciary if the
loss results from a breach of a fiduciary obligation.110 The sponsor, or the

fiduciary himself, may also purchase insurance to cover the potential liability of
one or more persons who serve in a fiduciary capacity.111
Exemptions
ERISA exempts fiduciaries from liability under certain circumstances. For
example, if the plan expressly authorizes a qualified "investment manager" to
invest plan assets, and certain other conditions are met, plan trustees will
generally be relieved from their fiduciary duties regarding the assets subject to
the manager's decisions.112 Section 404(c)(2) of ERISA also exempts fiduciaries
from liability for breach or loss due to a participant's exercise of control over
assets allocated to his account. However, the Department of Labor has taken the
position that such exercise must be part of a participant's general powers over
the account, rather than an isolated exercise of a limited power, such as control
over selling shares in a tender offer.113 Notwithstanding the foregoing examples
of the delegation of fiduciary authority, a fiduciary for a plan may be liable for
the actions of another fiduciary if the first fiduciary knowingly participates in,
conceals, facilitates or fails to take reasonable steps to prevent a violation by the
second fiduciary.114
107. See ERISA 405(a), 29 U.S.C.A. 1105(a) (West 1985).

108. Donovan v. Bierwirth, 754 F.2d 1049 (2d Cir. 1985).
109.
110.
111.
112.
ERISA 410(a), 29 U.S.C.A. 1110(a) (West 1985).

ERISA 410(b)(l), 29 U.S.C.A. 1110(b)(l) (West 1985).
ERISA 410(b)(2), (3), 29 U.S.C.A. 1110(b)(2), (3) (West 1985).
ERISA 402(c)(3), 403(a)(2), 29 U.S.C.A. 1102(c)(3), 1103(a)(2) (West 1985).
113. See infra note 138 and accompanying text.
114. See ERISA 405(a), 29 U.S.C.A. 1105(a) (West 1985).
ESOPs 113
FIDUCIARY RESPONSIBILITIES
General Rule
The ERISA provisions dealing with fiduciary duties and the applicable
fiduciary standards are generally based upon the common law principles involv-
ing trusts. As such, the principles by which a fiduciary's actions are judged
under ERISA are the "exclusive benefit" and the "prudent man" standards. A
fiduciary must "discharge his duties . . . solely in the interest of [plan] participants and beneficiaries and for the exclusive purpose of (i) providing benefits to
participants and their beneficiaries; and (ii) defraying reasonable [administrative] expenses. . . ."115 The fiduciary is expected to act "with the care, skill,
prudence, and diligence under the circumstances then prevailing that a prudent
man acting in a like capacity and familiar with such matters would use. . . ,"116
Prohibited Transactions
ERISA prohibits certain transactions between a "party in interest" and the
plan, regardless of the fairness of the particular transaction involved.117
Party in Interest Defined

A party in interest is generally defined as
(i) a fiduciary, including, without limitation, an administrator, officer,

trustee, or custodian of the plan;
(ii) a person providing services to the plan, including an employer of any
employees covered by the plan;
(iii) a person who owns, directly or indirectly, fifty percent or more of
the sponsor;
(iv) a relative - spouse, ancestor, lineal descendant, or spouse of a lineal

descendant - of any person described in (i), (ii), or (iii);
(v) an organization owned (fifty-percent control or greater) by any

person described in (i), (ii), or (iii); or
(vi) an employee, director, officer, or a ten-percent-or-greater shareholder of the plan or of persons or entities described in (ii), (iii), or (v).118
Prohibited Transactions Defined

ERISA generally prohibits any transaction between a plan and a party in
interest that constitutes a direct or indirect
(i) sale, exchange, or leasing of property between the plan and a party in
interest;
(ii) extension of credit between the plan and a party in interest;

115. ERISA 404(a)(l)(A), 29 U.S.C.A. 1104(a)(l)(A) (West 1985).
116. ERISA 404(aXlXB), 29 U.S.C.A. 1104(a)(l)(B) (West 1985).
117. See ERISA 406, 29 U.S.C.A. 1106 (West 1985).
118. See ERISA 3(14), 29 U.S.C.A. 1002(14) (West Supp. 1987).
(iii) furnishings of goods, services, or facilities between the plan and a

party in interest; or
(iv) a transfer or use of any assets of the plan for the benefit of a party in
interest.119
Self-Dealing
ERISA also prohibits self-dealing on the part of plan fiduciaries. A fiduciary
is not permitted to
(i) deal with the assets of the plan in his own interest or for his own
account;
(ii) act in any transaction involving the plan on behalf of a person whose
interests are adverse to the plan, its participants, or beneficiaries;
(iii) receive any consideration for his personal account from any person
dealing with the plan in a transaction involving plan assets.120
Violations
A plan fiduciary who knowingly engages in a prohibited transaction is liable
for a breach of fiduciary duty.121 A party in interest,122 other than a fiduciary
acting only as such, will ordinarily be subject to excise taxes for engaging in a
prohibited transaction, regardless of whether he did so knowingly.123 Such taxes
are assessed initially at the rate of five percent of the amount involved, and in
each subsequent taxable year may be taxed at 100% of the amount involved if
the violation is not corrected.
ESOP Exceptions to the Prohibited Transaction Rules

Investment in Employer Securities
Since an ESOP is designed to invest primarily in employer securities, and the
purpose of establishing an ESOP is to place employer securities in the hands of
employees, ESOPs are exempt from a number of requirements under ERISA

which normally would prohibit extensive investment by a plan in employer
securities. For example, although ERISA prohibits many types of plans from
investing more than ten percent of its assets in qualifying employer securities or
property, ESOPs are exempt from this prohibition.124 ESOPs are also exempt
120. ERISA 406(b), 29 U.S.C.A. 1106(b) (West 1985).
121. See ERISA 406(a), 409(a), 29 U.S.C.A. 1106(a), 1109(a) (West 1985); see, e.g.,
Cutaiar v. Marshall, 590 F.2d 523, 529-530 (3d Cir. 1979) (breach of fiduciary duty occurs when
plan fiduciaries engage in prohibited transaction regardless of good faith in transaction).
122. The Code's prohibited transaction provisions refer to "disqualified persons" rather than to
"parties in interest" as in ERISA. The terms are generally synonymous. Compare I.R.C.
4975(e)(2) (1986) with ERISA 3(14), 29 U.S.C.A. 1002(14) (West Supp. 1987).
123. I.R.C. 4975(a), (b) (1986).
124. ERISA 407(b)(l), 404(aX2), 29 U.S.C.A. 1107(b)(l), 1104(a)(2) (West 1985).
ESOPs 115
from the requirement that plan investments be diversified and from the prudence rule to the extent that it requires diversification.125
Frequently, ESOPs have been used in a "floor-offset" arrangement with a

pension plan maintained by an employer. In other words, the pension plan
could offset or reduce pension amounts payable from its assets by amounts
accumulated for the same employee under the ESOP. However, effective with
respect to arrangements established after December 17, 1987, provisions added
by the Omnibus Budget Reconciliation Act of 1987 state that an ESOP used for
such an "offset" arrangement will be subject to the ten-percent restriction on
holding employer securities, effectively prohibiting the arrangement.126
Purchase of Employer Securities from Parties in Interest

ERISA generally prohibits the sale or exchange of property between a plan
and a party in interest.127 An ESOP, however, may purchase employer stock
from the sponsor, a major stockholder, or any party in interest without violating
this rule. However, this exception is conditioned upon the following: (i) "adequate consideration" must be paid, and (ii) no commission may be charged.128
Adequate Consideration Defined

In the case of a security which is listed on a registered national securities
exchange, "adequate consideration" will be the prevailing price on that exchange.129 In the case of a security that is not listed on a national exchange but
has a market, "adequate consideration" will be the offering price established by

the current bid and asked price quoted by persons independent of the issuer and
of a party in interest. In the case of a security for which there is no generally
recognized market, "adequate consideration" will be the fair market value "as
determined in good faith by the trustee or named fiduciary pursuant to the
terms of the plan and in accordance with regulations promulgated by the

Secretary [of Labor]."130
The Department of Labor ("DOL") has recently published proposed regulations that provide guidance in determining what is "adequate consideration" for
125. ERISA 404(a)(2), 29 U.S.C.A. 1104(a)(2) (West 1985).
126. ERISA 407(d)(3)(C), (d)(9), 29 U.S.C.A. 1107(d)(3)(C), (d)(9) (West Supp. 1987).
128. ERISA 408(e), 29 U.S.C.A. 1108(e) (West 1985). If the ESOP buys the stock from a
party in interest, it can pay no more than adequate consideration. If it sells stock to a party in
interest, it can receive no less. Id.; see DOL Reg. 2550.408(e), 29 C.F.R. 2550.408(e) (1980);
I.R.C. 4975(d)(13)(1986).
129. Thus, if an ESOP is used, it may purchase or sell employer securities from or to a party in
interest so long as the price is the currently traded price in a generally recognized market and so
long as no premium is paid by the ESOP above market value. It appears that even if the price has
been inflated by a tender offer, such inflated price can be paid by the ESOP, so long as it is the
current traded price. The summary of the proposed DOL regulations indicates that isolated trading,
or trades between related parties, will not be sufficient to be deemed a "generally recognized
market." Proposed DOL Reg. 2510.3-18, 53 Fed. Reg. 17,632 (1988).

130. See ERISA 3(18), 29 U.S.C.A. 1002(18) (West Supp. 1987).

securities that do not have a generally recognized market.131 First, with respect
to the "good faith" requirement, the DOL proposal rejects a subjective approach ("pure heart - empty head"), and adopts an objective standard of
conduct by which the fiduciary must apply sound business principles and
conduct a prudent investigation of the circumstances surrounding the valuation.
The objective good faith test cannot be "passed" unless the independent fidu-
ciary possesses the skill, facilities, and experience needed to accomplish the
valuation. The valuation must be determined as of the date of the relevant
transaction and be set forth in written documentation. Second, with respect to

the independence of the valuation, the proposal states that either the fiduciary
himself must be "independent" of all parties to the transaction to make the
valuation, or the fiduciary must rely upon the reports of independent appraisers.132 A fiduciary will not be considered independent if he possesses the power
to influence management, or otherwise controls, any party to the transaction, or
if he is an officer, director, partner, employee, or employer of any of such
parties. An appraiser will be considered independent only if the fiduciary has
chosen the appraiser and has a right to terminate the appraiser's services at any
time, and the plan is established as a client of the appraiser at such time.
The DOL has frequently expressed concern that the structuring of multiinvestor corporate transactions involving ESOPs may result in the plan paying
more than adequate consideration for the securities it receives. Even if the
transaction is structured so that the ESOP does not purchase employer securi-
ties from a party in interest (thus avoiding a prohibited transaction), an

inequitable economic "deal" for the ESOP may result in a violation of the
prudence or exclusive purpose rules under ERISA's general fiduciary provisions, as well as of the primary benefit requirements of the ESOP regulations
promulgated under section 4975 of the Code.
Borrowing by the ESOP

ERISA generally prohibits the extension of credit between a plan and a party
in interest.133 ESOPs, however, may leverage stock purchases through loans

from a party in interest or a lending institution if certain conditions are met.
The loan must be for the "primary benefit" of the participants and their
beneficiaries; its terms must be "t least as favorable to the plan as the terms of
a comparable loan resulting from arm's-length negotiations between indepen-
dent parties"; and the interest rate for the loan and the price of the stock
purchased with the loan proceeds must be such that plan assets are not "drained
off."134
131. See Proposed DOL Reg. 2510.3-18, 53 Fed. Reg. 17,632 (1988).
132. See supra text accompanying note 34 regarding Code requirement under 401(a)(28)(C)
that an independent appraiser perform all valuation with respect to non-tradable employer securi-
ties acquired by the ESOP after December 31, 1986.
133. ERISA 406(a)(l)(B), 29 U.S.C.A. 1106(a)(lXB) (West 1985).

134. Treas. Reg. 54.4975-7(b)(3) (1977).
ESOPs 117
The leveraging exception for ESOPs may create a potential for abuse, since
an ESOP, despite its status as an employee benefit plan, can be employed as an
anti-takeover device for the sole benefit of certain management employees in the
context of a tender offer. A potential conflict between ERISA fiduciary obligations and the desires of the plan sponsor is even more likely if the fiduciaries are
officers or directors of the sponsor. Fiduciaries, therefore, are required to

"scrupulously exercise their discretion in approving [these transactions]," because the DOL "will subject these transactions to special scrutiny to ensure that
they are primarily for the benefit of participants and their beneficiaries."135
Fiduciary Concerns with Respect to Voting and Tendering

Allocated Shares
The voting or tendering of shares of stock held in trust under a plan subject to
ERISA is part of the fiduciary responsibilities of the plan's trustee or other

fiduciary managing such stock.136 Nevertheless, many ESOPs provide for the
"pass-through" of the decision to vote or tender shares to plan participants. A
pass-through of voting decisions on allocated shares is required by section

409(e) of the Code. This section mandates the pass-through on all matters if the
ESOP holds a "registration-type class of security," but only on matters involv-
ing mergers, recapitalizations, and other new corporate transactions if the

ESOP holds any other class of security. It should be noted that neither the Code
nor ERISA requires the pass-through of tendering decisions. Pass-throughs,

whether required by section 409(e) or not, will not relieve trustees of their
fiduciary obligations under ERISA with respect to such decisions.
When shares have been allocated to participants' individual accounts under
the ESOP, the DOL may be less likely to assert liability against the trustee with
respect to the voting of such shares if the trustee acts according to the wishes of
the participant on matters in which Code section 409(e) requires pass-through

voting. In contrast, the DOL may scrutinize more closely the pass-through of
tender decisions or of voting to an extent not required by Code section 409(e). In
structuring the terms of an ESOP to provide for a pass-through to participants
of these fiduciary decisions, sponsors have often relied upon the "named fiduciary" provisions of section 403(a)(l) of ERISA, which may insulate the trustee
from liability in complying with directions of a named fiduciary. The rationale
is that the participants can be viewed as a "named fiduciary" for purposes of the
provision. However, even under this provision, the DOL has made clear that in
order for a trustee to be protected, the directions must be "proper" and

consistent both with the terms of the plan and the relevant provisions of ERISA,
135. Treas. Reg. 54.4975-7(bX2Xii) (1977). See Leigh v. Engle, 727 F.2d 113, 125-26 (7th
Cir. 1984), vacated and remanded, 669 F. Supp. 1390 (N.D. 111. 1987), affd% 858 F.2d 361 (7th
Cir. 1988) (requiring an "intensive and scrupulous independent investigation" when dual loyalties
and potential conflicts of interest are present).
1 36. See Labor Department Letter on Proxy Voting by Plan Fiduciaries re: Avon Products, Inc.
Employees' Retirement Plan, 15 Pens. Rep. (BNA) 391 (Feb. 29, 1988).
including the fiduciary rules. In the context of a tender offer, for example, the
DOL may attack a fiduciary's reliance on the instructions of participants unless

the fiduciary determines that the participants gave tendering directions independently and free from the pressure of the employer.137
The DOL has provided a major statement of its views on the need to balance
the choices of plan participants and the responsibilities of ERISA fiduciaries.
Examining the matter in the context of the Texas Air takeover of Eastern
Airlines, the DOL stressed in an amicus curiae brief that fiduciary decisions
generally reside with plan trustees.138 Section 404(c) of ERISA protects a trustee
from liability with respect to control exercised by participants over plan assets
in an individual account plan. The DOL maintained that the provisions of

Section 404(c) apply only to plans which provide each participant with a
meaningful measure of control over assets in his individual account, a broad
range of investment alternatives, and an opportunity to invest assets in certain
liquid, United States insured, or guaranteed investments.139 In the DOL's view,
the plans at issue in the Eastern Airlines litigation clearly did not satisfy this
standard, so that the plan trustees were required to look to section 403(a)(l) of
ERISA to determine the scope of their duties and liabilities with respect to
participant directions. Thus, the trustees had an obligation to investigate the
propriety of the participants' directions and whether they reflected informed,
independent decisions. The Secretary's brief expressed the suspicion that certain
Eastern/Texas Air employee-participants may have been under employer pressure to tender their shares. Therefore, notwithstanding the profitability of
tendering, the plan trustees were obligated to use their objective judgment and
should not have been permitted simply to act on the apparent wishes of
individual participants.
In another recent statement,140 the DOL took the position that, merely
because a tender offer represents a premium over the prevailing market price
for shares of a target company's stock, the fiduciary provisions of ERISA do not
require that pension plan trustees automatically tender their shares. Rather, the
fiduciary should evaluate the tender offer on its merits, appropriately weighing
137. See Labor Department Advisory Opinion on Fiduciary Responsibility in Connection with
Attempted Corporate Takeovers re: Profit-Sharing Retirement Plan for the Employees of Carter
Hawley Hale Stores, Inc., 11 Pens. Rep. (BNA) 633 (May 7, 1984) [hereinafter Carter Hawley
Hale Letter].
138. Amicus Curiae Brief for the Secretary of Labor, Harris v. Texas Air Corp., 129 L.R.R.M.
(BNA) 2640 (D.D.C. 1987), vacated, 129 L.R.R.M. (BNA) 2641 (D.D.C. 1988) (No. 87-2057).
139. See Proposed DOL Reg. 2550.404c, 52 Fed. Reg. 33,508 (1987). The DOL has long
taken the position that the exercise of voting rights by participants in an ESOP does not amount to
the kind of investment control necessary for the application of 404(c). An ESOP is unlikely to be
able to satisfy the requirements set forth in the proposed regulations and, moreover, such regulations
do not provide for fiduciary liability in connection with the acquisition or sale of an employer
security. Proposed DOL Reg. 2550.404c-l(e)(2)(ii)(DX3), 52 Fed. Reg. 33,516 (1987).

140. Joint Department of Labor/Department of Treasury Statement of Pension Investments, 16
Pens. Rep. (BNA) 215 (Jan. 31, 1989).
ESOPs 119
the offer against the intrinsic value of the target company and the likelihood of
that value being realized by current management.
Thus, it seems clear that the use of ESOPs in change of control situations
places a high burden of fiduciary duty on trustees, even where decisions
regarding voting and tendering of shares have been passed through to plan
participants. Trustees must determine that participant decisions are free from
employer pressure: "[Instructions from participants cannot ... be put into

effect if the trustee is aware that the decision rendered by participants is not in
fact independent or has been made under pressure from the employer."141 As
stated by the DOL in the Eastern Airlines litigation:
[Responsibility for deciding whether or not to tender the shares in the
participants' account rests on the trustee. ... A trustee remains responsible
for ... assuring that the plan's provisions are fairly implemented . . . [and]
for determining whether following participant instructions would result in
a violation of Title I of ERISA.142
Unallocated Shares
A more ambiguous situation faces the fiduciary with respect to shares in a
suspense account that have not yet been allocated to participants' accounts
(either because an exempt loan has not been fully paid or because assets
transferred from a terminated deferred benefit plan have yet to be allocated) or
for allocated shares with respect to which no participant instruction has been
received. The terms of the ESOP will often direct a fiduciary to vote unallocated
shares in the same proportion as the allocated shares for which instructions have
been received.
The DOL's position on the matter is that this type of provision will not be
completely effective in relieving the fiduciary from making an independent
judgment as to the advisability of tendering or voting unallocated shares,

particularly when the ESOP is used as a defensive measure and unallocated
shares constitute a substantial majority of the shares held by the ESOP.143 In
February 1989, the DOL reaffirmed its position that tender decisions with
respect to unallocated (or non-voted allocated) shares are the exclusive responsi-
bilities of the plan trustee, and that the trustee may follow pass-through
instructions only to the extent consistent with the trustee's independent fiduciary
duties.144
141. Amicus Curiae Brief, supra note 138, at 28.

142. Id. at 29-30.
143. See Carter Hawley Hale Letter, supra, note 137; see also Danaher Corp. v. Chicago
Pneumatic Tool Co., 635 F. Supp. 246, 249-50 (S.D.N.Y. 1986) (fiduciary duty is not discharged
merely by following directions of current employees but, rather, "by evaluating the best interests of
beneficiaries in the abstract as beneficiaries").
144. Letter from Alan D. Lebwitz, Deputy Asst. Sec'y Labor to Polaroid ESOP trustee (Feb.
23, 1989).
STATE CORPORATE LAW CONCERNS

The establishment or use of an ESOP, particularly in the context of a contest
for corporate control, may raise corporate fiduciary issues as well as ERISA
concerns. Where a corporation is the subject of a potential hostile acquisition,
the establishment or expansion of an existing ESOP, or the use of an ESOP in a
leveraged "going private" transaction, may serve as a major weapon in the antitakeover arsenals used to deter corporate raiders. The corporate directors who
approve the utilization of an ESOP do so in the exercise of their state corporate
law fiduciary duties to the corporation and its shareholders. In the exercise of
these fiduciary duties, the directors are generally provided with the presumptive
protections of the "business judgment rule."146 Under this rule, the court will
not consider the substance or advisability of the directors' action unless the
plaintiff can overcome the presumption that the directors satisfied their fiduciary duties of loyalty and care by undertaking the challenged action pursuant to
a business decision made in good faith by the disinterested members of the board
with due care and without an abuse of discretion. Normally, the presumption
will not be rebuttable if the action was in fact taken in good faith by directors
who did not have a direct or indirect personal interest in the matter, based on a
thorough and careful investigation and informed consideration of all relevant

information, and in the honest and reasonable belief that such action taken was
in the best interests of the corporation and its stockholders.
In the context of actions taken in the face of a hostile offer, however, these
decisions are subject to a higher level of scrutiny. In such instances, courts

applying Delaware law have adopted a "modified business judgment rule" in
which the directors bear an initial burden of proving that (i) the directors have
made an informed business judgment based on all material information, (ii)

they had reasonable grounds to believe that a bid was a threat to corporate
policy and effectiveness, and (iii) the measures they took were reasonable in
relation to the threat posed.146 If these standards are not met, an ESOP
established after the commencement of a tender offer may be set aside as a
management entrenchment device.147 Additionally, under the Delaware takeover
statute, in order to "sanitize" the shares held by an ESOP in certain tender offer
contexts, and thus include the ESOP's shares in the calculation of the company's
145. See generally, Gilson & Kraakman, Delaware's Intermediate Standard for Defensive
Tactics: Proportionality Review, 44 Bus. Law. 247 (1989).
146. See Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).
147. See Buckhorn, Inc. v. Ropak Corp., 656 F. Supp. 209, 231-32 (S.D. Ohio 1987); Norlin
Corp. v. Rooney, Pace Inc., 744 F.2d 255, 256 (2d Cir. 1984); see also Danaher, 635 F. Supp. at
248 (requiring corporate president to step down as ESOP trustee during hostile offer); but see
Shamrock Holdings, Inc. v. Polaroid Corp., 709 F. Supp. 1311 (D. Del. 1989) (ESOP established
after a takeover threat had been received, but before a tender offer was commenced, was upheld as
"fundamentally fair"); Danaher Corp. v. Chicago Pneumatic Tool Co., 633 F. Supp. 1066
(S.D.N.Y. 1986) (refusing to enjoin target management's funding of established ESOP, even if it
served an anti-takeover function). It should be noted that when management directors act as
fiduciaries with respect to an ESOP, their state corporate law duties to shareholders may conflict
with their ERISA obligations to plan participants and beneficiaries.
total outstanding shares so as to effectively reduce hostile threats, plan participants must have the right to direct the tender of their shares "confidentially."148
SECURITIES LAW CONSIDERATIONS

SECURITIES ACT OF 1933
Registration
Generally, the Securities Act of 1933, as amended (the "1933 Act"),149
requires that a registration statement be in effect prior to "sale" of a "security,"
made through any form of interstate commerce, unless an exemption from
registration applies.150 Therefore, the necessity of registration will depend upon
the facts and circumstances surrounding each transaction.
Establishment of ESO
The applicability of the registration requirements of the 1933 Act depends
upon the status of the interests of participants in the plan as "securities," as well
as the status of the employer stock held by the plan. The Securities and
Exchange Commission ("SEC") has taken the position that interests in ESOPs
which do not accept employee contributions are not subject to the registration
requirements of the 1 933 Act, because interests in non-contributory ESOPs are
not "securities." In addition, the underlying stock of the ESOP does not have to
be registered because there is no "sale" of the stock to employees. However, if
the ESOP does accept employee contributions, its establishment will involve a
"solicitation of an offer to buy" a "security," triggering registration requirements for both the interests in the plan and the underlying stock deemed "sold"
to employees by virtue of their contributions to the plan.151
Resale of Stock by ESOP Participant

Rule 144- Unregistered Stock
If an ESOP acquires unregistered stock from the employer in an exempt
private placement under section 4(2) of the 1933 Act,152 and if it distributes the
unregistered stock to participants, which the SEC has stated is not a "registrable
event,"153 the participant of the ESOP would hold unregistered securities. The
148. See infra note 180 and accompanying text.
149. 15 U.S.C.A. 77a-77aa (West 1981 & Supp. 1989).

150. A/. 77e(a).
151. See Securities Act Release No. 4,790, 30 Fed. Reg. 9,059 (1965). In addition, a registrable
event could be deemed to occur if the conversion of an existing defined contribution plan into an
ESOP is effected through individual participant elections. In a series of no-action letters, the SEC
staff has agreed that registration will not be required as long as participants are not given the
opportunity to withdraw cash from the relevant plans as an alternative to the conversion. See, e.g.,
Heinhold Hog Markets Inc., SEC No-Action Letter (Apr. 28, 1987) (LEXIS Fedsec library, NoAct file).
152. 15 U.S.C.A. 77d(2) (West 1981).

153. See Securities Act Release No. 6,188, 45 Fed. Reg. 8,962 (1980).
extent to which a participant is free to resell his unregistered ESOP shares

ultimately hinges upon whether the shares will be deemed "restricted securities"
within the meaning of rule 144 of the 1933 Act.154
Generally, shares issued without registration are deemed to be restricted

securities for purposes of the resale restrictions under the 1933 Act. If such
shares are deemed "restricted," all participants will need to hold the shares for a
minimum of two years prior to resale, at which time such sale would also be
subject to the volume limitation and manner of sale requirements contained in
the rule. If, however, such shares are not deemed "restricted," persons who are
not affiliates would not be subject to the requirements of rule 144, while
affiliates could resell the shares without regard to the two-year holding requirement, although the volume and manner of sale restrictions of the rule would still
apply. An affiliate is generally defined as a person or entity who can exercise

"control" over the issuer, such as its officers, directors and principal stockholders.
Rule 144 defines "restricted securities" as all "securities acquired directly or

indirectly from the issuer thereof, or from an affiliate of such issuer, in a
transaction or chain of transactions not involving any public offering. ..." Such
restricted securities must either be registered, sold in reliance upon an applicable exemption, or sold through compliance with the restrictions of rule 144.
However, the SEC has carved out an exception to this general rule, and has
expressed the position that shares issued pursuant to employee stock plans, such
as an ESOP, would not constitute "restricted securities" for purposes of rule
144 if the following three conditions are satisfied: (i) the issuer of the shares is
subject to the periodic reporting requirements of section 13 or 15(d) of the 1934
Act; (ii) the stock being distributed is actively traded in the open market; and
(iii) the number of shares being distributed is small in relation to the number of
shares of that class issued and outstanding.166 Thus, non-affiliates generally may
resell their unregistered ESOP shares immediately upon distribution from the
ESOP without complying with rule 144; affiliates also need not comply with the
two-year holding requirement, although the volume and manner of sale requirements of the rule must be met.
Registered Stock
Participants who are not affiliates of the issuer may resell registered securities
without restriction. However, if the participant is an affiliate of the issuer, sales
must be made pursuant to an effective registration statement, rule 144, or in a
private transaction. In this latter event, restricted securities will retain that
status in the hands of a subsequent purchaser.
154. 17 C.F.R. 230.144 (1988).

155. Securities Act Release No. 6188, supra note 153. The SEC has indicated that if no more
than one percent of the relevant class outstanding is issued to participants in a fiscal year, the
amount distributed will always be a "relatively small amount" for these purposes.
ESOPs 123
SECURITIES EXCHANGE ACT OF 1934
Antifraud and Antimanipulation Rules

Rule Wb-5
Rule 10b-5, the antifraud rule promulgated under section 10(b) of the 1934
Act, generally prohibits the use of an instrumentality of interstate commerce,
the mails, or a stock exchange, to employ a scheme to defraud, to make an

untrue statement of material fact or omit to state a material fact, or to engage in
any fraud, in connection with the purchase or sale of a security.156 The

prohibitions with respect to rule 10b-5 generally come into play with ESOPs
when purchases and sales are made by a rcon-independent trustee, that is, an
ESOP trustee who is not independent of the issuer. Open market purchases of
shares by an ESOP made by such a non-independent trustee, while in possession of material non-public information, may be a violation of Rule 10b-5.
Rule 10b-6
Rule 10b-6 states that it is a manipulative and deceptive device for the issuer
or an affiliated person to make purchases of a security during the course of a
"distribution" of that class of stock.157 The purpose of this rule is to prevent the
artificial stabilization of stock prices through purchases by the issuer or an

affiliate. Here again, the rule can apply to purchases by the ESOP trustee
during a distribution if the trustee is not "independent" of the issuer. A
distribution is an offering of securities by the issuer or an affiliate which is
distinguished from ordinary trading typically by the magnitude of the transac-
tion or by special selling efforts. For this purpose, control over the trustee's
purchase is the key element.158
Thus, purchases of employer stock by an ESOP during a distribution could

be a violation of rule 10b-6 if the employer can control or influence the manner
if which the plan trustee effects the purchase. The existence of outstanding
publicly held options, warrants, and similar instruments such as convertible
preferred, which are immediately exchangeable for or convertible into another
security, is deemed to be a continuing "distribution" of that security. In order to
guard against potential rule 10b-6 liability, therefore, it would be advisable to
be certain that the ESOP trustee has control over the time, price, volume, and
manner of the purchases at all times when a distribution of that class of stock is
underway.
Section 16(b)
Section 16 Prohibition
Any officer, director, or holder of more than ten percent of a class of

registered securities of a publicly traded company is deemed to be an "insider"
156. 17 C.F.R. 240.10-5 (1988).
157. Id. 240. 10b-6 (1988).
158. See 17 C.F.R. 240.10b-6, Appendix 1-B9(b) (1988).

for purposes of section 16 of the 1934 Act.159 Section 16(b) imposes liability on
insiders for engaging in profitable short-term transactions. Section 16(b) specifi-
cally provides the company, or any shareholder acting on its behalf, may bring
suit to recover all profits realized by insiders from any purchase and sale, or sale
and purchase, of the company's equity securities within a period of less than six
months.
Section 16b-3 Exemption

The SEC has adopted rule 16b-3, which specifically exempts certain transactions made pursuant to ESOPs and other stock plans from the scope of section
16(b) liability.160 If all the requirements for rule 16b-3 qualification are satisfied
by a plan, the issuance, expiration, and cancellation of rights under such plan
will be exempt from section 16(b) liability. In the case of an ESOP, this assures
that the allocation of stock to an insider's account or the distribution of such
stock to him will not be a matchable transaction under section 16(b). In

addition, many intra-plan transactions are subject to the reporting exemption
contained in rule 16a-8161 and are therefore exempt from section 16(b) liability
by virtue of rule 16a-10,162 which provides for an exemption from short-swing
profit liability for transactions that are not subject to section 16(a) reporting
requirements.
Requirements
Generally, to qualify for exemptions under rule 16b-3:
(i) The plan must be approved by the company's shareholders;
(ii) The participation interests of insiders must be administered by

"disinterested" persons;
(iii) The terms of the plan must limit the amount or dollar value of
shares allocable to participants.
Reporting and Disclosure

Section 16(q)
Section 16(a) of the 1934 Act requires "insiders" to report (i) their beneficial
ownership of any equity securities of the company and (ii) any changes in such
beneficial ownership.163 The ESOP itself is required to file initial ownership
reports, and periodic reports reflecting any changes in ownership upon acquisition of more than ten percent of a non-exempt security.164 Pursuant to rule 16a8(a)(2), "beneficial ownership" includes ownership of a vested beneficial inter159. 15 U.S.C.A. 78p (West 1981).
160. 17 C.F.R. 240.16b-3 (1988).
161. Id. 240.16a-8(1988).
162. Id. 240.16a-10(1988).

163. 15 U.S.C.A. 78p(a) (West 1981).
164. See 17 C.F.R. 240.16a-8(c) (1988).
ESOPs 125
est in a trust; thus, officers and directors must report vesting of interests in
ESOPs if the shares are registered under the 1934 Act, unless otherwise exempt
under rule 16a-8(b).165 Under rule 16a-8(b), filing by the settlor or beneficiary
of an ESOP trust is not necessary where (i) less than twenty percent of the
market value of stock held by the ESOP consists of stock subject to section 16(a)
reporting requirements, or (ii) the acquisition or disposition of stock held by the
ESOP is made without prior approval by participants. However, this exemption
is not available where the employer has full control over the disposition of stock
held by the plan.166
Section 13(d)
An ESOP is required, by section 13(d) of the 1934 Act,167 to make public
disclosures when its "beneficial ownership" climbs to more than five percent of
any class of an employer's equity security registered under section 12 of the

1934 Act. "Beneficial ownership," as defined in rule 13d-3,168 includes indirect
ownership by virtue of an argreement to share voting or investment power. If
the ESOP holds unallocated securities or securities voted by the plan trustee
which amount to more than five percent of a class, the plan trustee must file a
report on schedule 13D. Where voting rights are exercised by participants after
shares are allocated to the participants' account, the participants are deemed to
have beneficial ownership of the allocated shares, and they must file schedule
13D within ten days after allocation, if the allocation to any participant, when
aggregated with other shares the participant beneficially owns, exceeds five
percent of a class. As a practical matter, unless a particular participant is

already a large stockholder, it is unlikely that the allocation of ESOP shares
would be large enough to trigger the above reporting requirement.
USE OF ESOPs IN FINANCIAL TRANSACTIONS

Since an ESOP is the only qualified employee benefit plan that is permitted
to borrow funds on employer credit in order to acquire employer stock, ESOPs
provide a significant degree of flexibility as a tool of corporate finance. Their
structure and tax advantages also enable ESOPs to accomplish a variety of

corporate and shareholder objectives not readily achievable through other
means. A description of some of the possible uses of ESOPs as financial vehicles
follows.
165. Id. 240.16a-8(b) (1988).

166. See Exchange Act Release No. 18,114, 46 Fed. Reg. 48,147 (1981).
167. 15 U.S.C.A. 78m(d) (West 1981 & Supp. 1989).
168. 17C.F.R. 240.1 3d-3 ( 1988).
RAISING CAPITAL THROUGH SALE OF EMPLOYER

SECURITIES
Leveraged ESOPs, because of their tax advantages, may be an effective way
to shelter principal payments on corporate debt. When coupled with lower rates
of interest generally charged for ESOP loans due to the Code section 133
exclusion, this leveraging may lead to significantly reducing the after-tax cost of
borrowing.
Leveraged ESOP Example (Diagram 1)

As an example, assume Company X wishes to raise $50 million of capital for
research and development into new areas with the hope of diversifying its
business. Company X could establish a qualified leveraged ESOP and the
Company X ESOP could then borrow the $50 million from a lending institution qualified under the Code to exclude from its taxable income half of the
interest received on the repayment of such loan.
DIAGRAM 1
Bank >^
/ >^ Lends $50,000,000

/'
S ^ Loan '^
<*mnte*
/ ^ ' d*X
> ^Contributions ^w
/'X
/''x
$50,000,000
Purchased Securities
Company X
_ MuribleContributions
Company X would generally be the guarantor on such a loan obligation. The
qualified lender would "share" some of its tax savings with the ESOP by
lending to the ESOP at a rate which might be eighty-five percent of prime. The
Company X ESOP would use the proceeds of the loan to purchase from
Company X qualified employer securities. Company X has essentially

"purchased" the proceeds of a reduced rate loan with its transfer of stock to the
ESOP, and may now invest the $50 million in research and development. This
effect may also be accomplished by Company X borrowing from the bank, and
on-lending the funds to the ESOP (Diagram 2), in accordance with the
requirements for a "mirror loan."
ESOPs 127
DIAGRAM 2
Bank
Loan t Lends SSO.000,000

lF3edbytt I
Contribution* | Ln
Contribution
*_ - - mm - - - . -
I Lend! $50,000,000 I
Company X ' ESOP
$50,000,000
Advantages
When Company X makes contributions to the Company X ESOP, the ESOP
will use the contributions to repay the principal and interest associated with the
debt, thereby releasing the "suspended" shares from encumbrances over the
term of the loan. Subject to certain limitations, Company X's contributions will
be fully deductible, including the portion used by the ESOP to make principal
payments on the debt. In addition, any dividends paid on the Company X stock
that are used to make payments on the loan, as well as dividends paid directly to
ESOP participants or to their ESOP accounts, will also be tax-deductible for

Company X. Therefore, the lower debt rate, deductible interest and principal
payments, deductible dividends, and, theoretically, increased employee loyalty
combine to make the use of a leveraged ESOP an attractive financing vehicle.
Disadvantages
There are certain negative effects of a leveraged ESOP transaction, however,
that Company X must also consider before entering into such transaction:
(i) As with any qualified plan subject to regulation under both ERISA
and the Code, the Company X ESOP must comply with complex requirements, and should secure approval from the 1RS of the tax-qualified status
of the ESOP under the Code.
(ii) The Company X ESOP transactions will be subject to DOL review

at any time. ESOP fiduciaries, therefore, will be required to act "solely in
the interest of participants and beneficiaries" in all ESOP transactions. As
a result, ESOP sponsors are well advised to establish procedural safe-

guards, such as the engagement of independent legal and financial advisers
on the ESOP's behalf.
(iii) With respect to the balance sheet of Company X, the loan to the
ESOP generally will be treated as the debt of Company X because of its
guarantee of the ESOP loan. Although Company X's cash will increase by
$50 million, its liabilities will also increase by the same amount. The
equity generated by this transaction will not be treated as such until and to
the extent that the loan is repaid.
(iv) As with any equity-based employee plan, there will be dilution of

the ownership interest of Company X's current stockholders.
(v) The ESOP will have a dilutive effect on Company X earnings per
share, since the unallocated shares held by the ESOP will be included in
the calculations for earnings per share. However, if the compensation
program for Company X included, for example, a profit sharing plan with
mandatory employer contributions, Company X's contributions to its

ESOP would represent an expense that otherwise would have been incurred and, to this extent, the negative effect on earnings per share would
be diminished.
(vi) Finally, a private company sponsoring an ESOP may face a major

cash drain in satisfying put options with respect to stock distributed to
employees.
Some practitioners believe that a corporation can enjoy financial advantages
similar to a leveraged ESOP transaction, particularly the deductibility of

principal repayments, by issuing stock to the public and using the proceeds to
make deductible contributions over time to employee benefit plans. Nevertheless, such a mimicking transaction cannot enjoy other ESOP advantages, such as
the partial interest exclusion, and has particular problems of its own, such as
the transaction costs of a public offering and the placement of equity in

presumably less friendly hands than those of the employees.
RAISING CAPITAL THROUGH IMMEDIATE

ALLOCATION LOANS
Unleveraged ESOP Transaction Example

Under certain conditions, an unleveraged ESOP transaction might be appropriate (Diagram 3). Such would be the case where, for example, Company X is
reluctant to leverage its ESOP because of the balance sheet treatment, or

because the unallocated shares will appear as a contra account to equity and
thereby distort earnings per share calculations. However, Company X itself,
and not the ESOP, could borrow the $50 million from a qualified lending
institution, and the Company would then transfer an equal amount of qualifying Company X securities to its ESOP within thirty days of the loan.
In order for the loan to enjoy the tax advantages under section 133 of the
Code, the securities transferred must be allocated to the participants' account
ESOPs 129
DIAGRAM 3
Bank
Lends $S0 000,000
Transfers
$50,000,000
Company X
within one year of the date of the loan. This is known as an "immediate
allocation loan." The period for which the interest exclusion would apply is the
seven-year period beginning on the date of the loan.
Tax Advantages
Since TRA 1986, the immediate allocation loans are qualified as loans in
which fifty percent of interest paid may be excluded by the lender under Code
section 133. Dividends, however, are not deductible to the same extent as they
are in leveraged ESOPs. Company X may only deduct the amount of dividends
paid in cash directly to ESOP participants or, if distributed to the plan, the
amount that is paid ninety days after the plan year. This stands in contrast to
full dividend deductions for contributions to ESOPs used to pay principal and
interest on ESOP loans. Additionally, employer contributions are not deductible
to the same extent as they are with a leveraged ESOP. Company X's deduction
is limited to its stock contribution initially made to the ESOP to the extent that
such amount does not exceed fifteen percent of covered employee payroll
(twenty-five percent if the ESOP is a combination stock bonus and money
purchase pension plan).169 Thus, the size of a loan is somewhat constrained to
the extent that employer contributions may become non-deductible. In addition,
Code section 415, which limits annual allocations to an employee's account, will
also place a cap on the size of the loan. Depending on the value of covered
employee payroll, the amount of the hypothetical $50 million loan may need to
be reduced if Company X wishes to keep its full deduction.
169. I.R.C. 404(a)(7) (as amended in 1988).
Distinctions Between Leveraged and Unleveraged ESOP

Financing
The immediate allocation format is different from leveraged ESOP transactions in other respects as well. In a leveraged ESOP transaction, employees will
receive a predetermined number of shares since the proceeds of the loan have
gone to purchase a specific number of shares at the inception of the transaction.
Because allocations are based on the original purchase price paid by the ESOP
for the shares, employees bear the burden of risk from any depreciation that
might occur between the stock purchase date and the allocation date, and
conversely they will gain from any stock appreciation. With the unleveraged
ESOP format, however, Company X is subject to the risks and rewards of stock
price changes prior to the time the shares are contributed. If, for instance,
Company X stock lost half its value between the date of the loan and the date of
stock contribution, Company X would need to contribute twice as many shares
as had been contemplated on the date of the loan. For their part, the employees,
because of the immediate allocation nature of the transaction, will own twice as
large a share in Company X within one year of the transaction.
One major advantage of an immediate allocation loan to a corporate sponsor
is that the loan does not need to comply with the requirements of sections 133
and 4975 of the Code that are applicable to mirror loans. Thus, the corporation
and the lender will have much more flexibility in structuring the debt and the
transaction will not be subject to the "special scrutiny" applied to leveraged

ESOP transactions under section 54.4975-7(b)(2)(ii) of the Treasury regulations.170 Further, the proceeds of the loan may be used for any purpose,
including the refinancing of general corporate debt.
SECURITIZED ESOP LOANS

In General
The ESOP's many tax advantages, in particular the fifty percent interest
exclusion, have encouraged the introduction of new financing instruments.
Recently, some sponsors have financed loans to ESOPs by "securitizing" these
loans, typically in the form of long-term floating rate notes. These notes are
issued by the ESOP sponsor or the ESOP (and guaranteed by the sponsoring
company) in a "primary issuance" to a qualified lender entitled to the interest
exclusion, who then makes an initial placement with investors that are also
qualified under section 133. The interest on the notes floats at short-term rates,
which are reset weekly or monthly by a "remarketing" agent. The notes may be
"put" to the sponsoring corporation or one of its affiliates, which then "puts"
the notes to the originating lender, at par value, on a weekly or monthly basis.171
The remarketing agent, often an affiliate of the originating lender, then takes
170. Treas. Reg. 54.4975-7(b)(2)(ii) (1977).
171. Because of the last sentence of Code 133(b)(2), the "put" to the sponsoring employer or
affiliate is not prohibited by the general exclusion from the definition of "securities acquisition loan"
of a loan between affiliated entities, or a loan between an employer and an ESOP.
ESOPs 131
the notes and "remarkets" them to investors, and the cycle continues. Thus, the
ESOP loan itself becomes a liquid investment; this, coupled with the fifty
percent interest exclusion available to qualified investors of ESOP debt, has
caused securitized ESOP loans to be currently priced at about seventy-five
percent of prime.
On June 2, 1989, the 1RS issued an advance copy of a Revenue Ruling that
permits the underwritten public offering of freely-transferable ESOP notes.172
Revenue Ruling 89-76 makes it clear that the partial interest exclusion under
section 133 for ESOP notes will be available to a qualified lender regardless of
whether the securities were issued in a firm commitment underwriting by an
investment bank or whether other prior holders of such notes were qualified
lenders. Accordingly, investment banks, which generally are not considered
qualified lenders, can now underwrite appropriately structured ESOP debt

securities without concern for the availability of the interest exclusion to
subsequent purchasers who are qualified lenders.
Investment banks have refrained from firm commitment underwritings, in
part, for two reasons. First, the temporary regulations under section 133 appear
to require that a securities acquisition loan must be originated by a qualified
lender. Second, the temporary regulations also create an ambiguity as to

whether an entity holding an ESOP note will be entitled to the partial interest
exclusion under section 133 if a prior holder of the ESOP note was not a
qualified lender.
Revenue Ruling 89-76 resolves both issues in the context of underwritten
public offerings, concluding that qualified lenders may receive the benefits of the
fifty percent interest exclusion whether or not the first holder of the ESOP notes
was an underwriter buying in a firm commitment underwriting or whether any
intermediate holder of the ESOP notes was not a qualified lender. In effect, this
means that underwriters may engage in firm commitment underwritings of
ESOP notes, as well as other activities in ESOP notes in which the firms act as
principal, without endangering the tax benefits otherwise available to subsequent qualified lenders.
One could argue that the logic underlying the Revenue Ruling should apply
to situations other than firm commitment underwritings, and that the Revenue
Ruling effectively eliminates the requirement of a qualified originating lender.
Types of Securitized Loans

Both exempt ESOP loans, either directly to the ESOP or to the sponsor in an
on-lending transaction, and immediate allocation loans may be securitized. As
noted earlier, the immediate allocation loan is subject to fewer constraints and
thus provides greater flexibility in structuring the ESOP security. In contrast,
ESOP notes representing a back-to-back loan or a direct loan to an ESOP may
be subject to substantial restrictions regarding the terms of the notes.
172. Rev. Rul. 89-76, 1989-25 I.R.B. 5.
In a recent financing, one major corporation issued a series of seven-year and

ten-year notes, the proceeds of which were used to on-lend to an ESOP and to
refinance prior mirror loans. The seven-year notes used to repay existing ESOP
financings, consistent with the rules on refinancing, had a maturity that was
measured from the date the refinanced loan was entered into. The interest rates
on the ESOP notes were redetermined with respect to periods of one week, one
month, or three months. The notes were subject to both permissive redemption
and mandatory redemption in the event that, as a result of a breach by the issuer
of a representation or covenant in the note facility agreement, an investor lost
the benefit of the partial interest exclusion under section 133 of the Code.
Another major corporation, in a recent transaction, has commenced a series of
private placements of ESOP notes which securitized annual immediate allocation loans with respect to an ESOP. The amount of the notes issued in each year
will be affected, in part, by the limitations contained in Code sections 404 and
415 regarding deductibility and contributions, respectively, which in turn are a
function of the size of the company's payroll and the nature of the ESOP, that
is, whether it is a stock bonus plan or a combination stock bonus and money
purchase pension plan. The seven-year maturity of the notes is mandated by the
immediate allocation loan rules of section 133. The other terms of the notes,
however, are not controlled by sections 133 and 4975 of the Code. Thus, for
example, there is no need to be concerned about whether early redemption

provisions of the notes will be similar to the repayment provisions of a second
loan, as in the case of a mirror loan format.
LEVERAGED BUYOUTS USING ESOPs

ESOPs have also been used to assist investor groups, including incumbent
management, in consummating leveraged buyouts. ESOPs have been useful in
this context because of their ability to secure lower borrowing rates and the tax
deductible nature of loan repayments, both of which result in increased cash
flow, a desirable goal in a highly leveraged transaction.
Structure of Leveraged Buyout Transactions

The following example (Diagram 4) illustrates one way in which multiple
investors participate with a leveraged ESOP to arrange a leveraged buyout. A
new company ("NewCo") is formed by an investor group including certain key
members of the current management for the purpose of purchasing management's existing company ("OldCo"). The investor group would then contribute
capital to NewCo, generally equal to approximately ten percent of the estimated
purchase price of OldCo. NewCo would also establish a leveraged ESOP at this
time. The ESOP would borrow funds from a qualifying lending institution, and
would use those funds to purchase NewCo securities from NewCo. The ESOP
loan would generally bankroll a much larger percentage of the purchase price of
OldCo than that pledged by the investor group. NewCo would also attempt to
borrow additional funds aside from the ESOP transaction. With the proceeds of
this debt, NewCo is able to purchase OldCo, and the management LBO is
accomplished.
DIAGRAM 4
OldCo
Purchased Secunues I I $
. Purchased Securities
SS
Investors NewCo ' Leveraged ESOP
Deductible
Contributions t
II/'
Lends S I Lends %^/^ S

^^ S Loan Repayments Funded
Bank '
S byConbribuiions
Department of Labor Concerns

The DOL has regulatory authority to enforce the rules of ERISA against all
qualified plans, and may sue to enjoin any transaction in violation of ERISA.
When the SEC receives a proxy indicating the use of an ESOP in a tender offer
or leveraged buyout situation, it may, and routinely does, forward copies of such
proxy materials to the DOL. The DOL closely scrutinizes these multi-investor
transactions to ensure that the terms offered to the ESOP are fair in relation to
those offered to other investors. In each of the three following transactions, the
DOL intervened and became an active negotiator in the deal; as a result, the
terms of the Blue Bell and Raymond International transactions were altered,
and the ESOP's participation in the Scott & Fetzer deal with eliminated.
Raymond International, Inc.

The intervention by the DOL in the leveraged buyout of Raymond International illustrates the importance of appointing independent fiduciaries, assisted
by counsel and investment advisers, to evaluate a proposed ESOP transaction on
behalf of the plan's participants and beneficiaries. Raymond International was
purchased in 1983 by a newly established ESOP, a management group, continuing holders of preferred stock and Kelso Investment Associates in a transaction
in most respects similar to that illustrated in Diagram 3. The DOL intervened
in this 1983 leveraged buyout to indicate its concerns over the independence of
plan fiduciaries, the care with which such fiduciaries exercised their duties, and
the substantive terms of the original transaction. According to the DOL, the
ESOP was paying more than "adequate consideration." In particular, the DOL
cited the potential conflict of interest presented by having directors act as plan
fiduciaries. Raymond responded to the DOL's objections by appointing independent fiduciaries for the plans, as well as investment bankers and special
counsel to advise the company's ESOP and pension committees. In addition, the
company amended the terms of the stock transfer to the ESOP. The transaction,
as amended, was successfully consummated.
The Scott ir Fetzer Company

In 1985, a proposed ESOP leveraged buyout of Scott & Fetzer collapsed
after the transaction was restructured in response to objections by the DOL.
The restructured version proved unsatisfactory to management and institutional
investors. The failure of the transaction has been cited by many observers as
evidence of the DOL's lack of sophistication regarding the financial structure of
multi-investor leveraged buyouts. In seeking to ensure that the transaction was
fair to the ESOP under ERISA, the DOL made the buyout economically
unfeasible and unattractive to investors. To some extent, this has had a chilling
effect on the use of ESOPs in multi-investor leveraged buyouts.
The initial version of the transaction contemplated a merger of an acquisition
company and acquisition subsidiary (the latter wholly-owned by the company's
existing ESOP) into Scott & Fetzer, with existing public shareholders bought
out. The ESOP would then purchase new common stock with the proceeds of a
loan from the company, and the other investors would receive the new stock,
together with options and warrants exercisable at a later date. The DOL
indicated to the ESOP trustee that it had preliminarily concluded that the
trustee would breach its fiduciary duties under ERISA if it caused the ESOP to
participate under the existing terms of the leveraged buyout.173 The DOL cited
what in its view was the excessive consideration paid by the ESOP for its
percentage share of the company's equity on a fully diluted basis (i.e., after the
exercise of options and warrants by the other investors).174
Blue Bell, Inc.

Like the Scott & Fetzer transaction, the leveraged buyout of Blue Bell, Inc.
illustrates the importance of structuring the relative interests of the investors so
that the ESOP is not placed at an economic disadvantage. Further, by question173. Letter from Charles Lerner, Ass't Adm'r for Enforcement, Dep't Labor, to Scott & Fetzer
ESOP trustee (July 30, 1985), 12 Pens. Rep. (BNA) 1182 (Aug. 26, 1985).
174. Id. The DOL's analysis treated the ESOP note as the equivalent of cash, rather than
assigning a discounted value to the note to reflect the time value of money. Moreover, the DOL did
not consider whether the securities that would be acquired by the investors following the buyout
pursuant to the exercise of the options and warrants would have a lesser value (given the acquisition
debt with which the company would then be burdened) than securities acquired at the time of the
leveraged buyout.
ing whether the ESOP's investment in the new leveraged entity ("NewCo")
was prudent, the DOL provided a warning that ESOP fiduciaries need to be
concerned not only with securing a fair valuation of the equity offered to the
ESOP, but also with the wisdom of engaging in the transaction at all.
The Blue Bell buyout was structured so that the ESOP provided cash which represented most of the proceeds the ESOP had received when NewCo
purchased Blue Bell common stock previously owned by the ESOP - in exchange for shares of NewCo's preferred stock and common stock. The other
parties to the transaction received combinations of debt, convertible equity, and
common stock on terms that were arguably more favorable than those offered to
the ESOP.
The structure of the equity participation in the buyout relative to the cash
consideration provided by the ESOP raised concerns for the DOL. First, the
DOL questioned whether the ESOP committee had satisfied the prudence
standard of ERISA's fiduciary requirements by electing to "forego other,
possibly sounder, investment opportunities [for the buyout proceeds] for an
illiquid investment in a highly leveraged firm with large opportunities for gain
but also large risk of loss."175
Second, the DOL questioned whether the transaction called for the ESOP to
pay more than adequate consideration for the equity interest it was to receive,
thus violating the prohibited transaction provisions of section 406(a)(l)(A) of

ERISA. Specifically, the DOL noted that the consideration received by the
ESOP must not only be adequate in terms of the portion of the underlying
assets represented by the ESOP equity stake, but that it must also satisfy critical
questions of fairness when viewed in light of consideration and rate of return of
other post-buyout investors.
In response to the DOL's concerns, the transaction was modified. The ESOP
purchased additional shares of NewCo common stock and the other investors
received somewhat less equity and fewer conversion privileges. On the basis of
these and other modifications, the DOL issued a "no-action" letter.176
Recommendations of the ERISA Advisory Council

In 1987, the DOL established a working group under the ERISA Advisory
Council to make recommendations to the DOL concerning the use of ESOPs in
multi-investor leveraged buyouts.177 One recommendation of the council is that
the DOL should neither encourage nor discourage ESOP participation in such
leveraged buyouts. Another suggestion is that an independent fiduciary act on
behalf of the ESOP, and that the fiduciary be retained at the earliest possible
time in the transaction. If the cost of retaining such independent fiduciary would
175. Letter from Norman P. Goldberg, Dep't Labor, to Charles R. Smith (Nov. 23, 1984), 12
Pens. Rep. (BNA) 52, 53 (Jan. 7, 1985).
176. Letter from Norman P. Goldberg, Dep't Labor, to Charles R. Smith (Nov. 26, 1984), 12
Pens. Rep. (BNA) 59 (Jan. 7, 1985).
177. ESOP Work Group Seeks Neutrality on Multi-Investor Leveraged Buyouts, 14 Pens. Rep.
(BNA) 1431 (Nov. 16, 1987).
preclude the ESOP from participation, then it is recommended that the ESOP
obtain independent legal and financial advisers for assistance. Certain other
recommendations include establishing a safeguard for participants' stock allocations in the event of a sale of the company before the loan is amortized and
allowing a pre-closing safe harbor to shield transactions from DOL review until
after completion.
Advantages and Disadvantages of ESOP s in Leveraged
Buyouts
Advantages
The tax benefits associated with a leveraged ESOP typically provide a
principal motivation for using an ESOP in financial transactions. The ability to
repay principal and interest on ESOP loans on a tax deductible basis, the ability
to secure lower financing rates because of the fifty percent exclusion, and the
ability to deduct certain dividend payments on the employer securities, all

contribute to a greatly enhanced after-tax cash flow for the borrower. Increased
cash flow is essential to a successful leveraged buyout since the additional debt
typically taken on in such transactions may be serviced with the cash. Addition-
ally, in many cases, the trustees for the ESOP in leveraged buyout situations
will be, at the very least, sympathetic to the desires of the management of the
new company. With respect to employee productivity and motivation, it is

widely thought that ESOPs have a significant positive impact on employee
productivity and thereby on corporate growth.
Disadvantages
From management's perspective, one main disadvantage to using an ESOP in
a leveraged buyout situation is that management and the outside investors will
need to relinquish a substantial portion of the new company to the employee
participants in the ESOP. There is always a risk that the interests of the
employees participating in the ESOP may, at some point, diverge from that of
management or the investor group. Second, ESOPs add a separate layer of

complexity to a highly leveraged transaction and generally necessitate the
additional expense of hiring independent counsel and financial advisers. Third,
as with any employee benefit plan, ESOPs must comply with the complex
requirements of the Code and ERISA, including the fiduciary duty considerations with respect to the adequate consideration paid for the securities, appropriate valuations and equity allocations between the ESOP and other investors,
and voting and tendering of the ESOP shares. Fourth, the tax advantages
associated with an ESOP are, in the final analysis, useful only if the new
company will generate taxable income after the transaction. Fifth, the ESOP
will require a significant level of cash flow to fund contributions and, if the
company is private, to fund purchases of stock from employees in later years
upon the exercise of put rights. Finally, the eventual distribution of shares to
employees may create a public company and trigger 1934 Act reporting requirements.
SALE OF A DIVISION TO EMPLOYEES

ESOPs may also serve as a tool for selling a division of a company to its
employees (Diagram 5). Selling the operational unit of a large company to the
employees of that unit involves direct employee ownership as the principal

purpose of such transaction, as opposed to the unavoidable by-product of the
transaction as in the case of the multi-investor leveraged buyout.
DIAGRAM 5
Bank ^^^v.
Loan Repayments'** %* ^V^
Funded by Contributions ** ^ >.
NewCo ' $
Purchased Securities S
Division
Structure of a Sale of a Division

As in the leveraged buyout scenario, an acquisition entity and an ESOP may
be established to purchase the target division. The ESOP will borrow enough
funds from a qualifying lending institution to purchase all of the securities of
the new company, the proceeds of which will be used by the new company to
purchase the assets of the division. If the division were, for instance, a U.S.
subsidiary of a foreign company that was already incorporated, then the
transaction may be structured as a sale of stock of the target division by the
foreign company to the ESOP. The ESOP loan is repaid through the contributions of the new company to the ESOP, in accordance with all the applicable
allocation and loan repayment regulations. One recent example of this sort was
Wesray Corporation's sale of Avis-Rent- -Car System, Inc. to the Avis ESOP.
Advantages and Disadvantages

An ESOP is one of the most advantageous methods of selling a division to
employees, because the object of the transaction, employee ownership, is contemplated in the very fabric of the transaction. In a very real sense, after the
transaction discussed immediately above is completed, the employees of the

target division now "own" the company, and the new company is able to use the
tax advantages of a leveraged ESOP discussed above. Employee morale should

also be at an all-time high after a 100% employee buyout. The spin-off of
Weirton Steel Corporation to an ESOP in 1983 serves as an example of a
troubled division of a major corporation being able to successfully reverse its
fortunes through employee ownership.
Generally, the same disadvantages attach to the leveraged buyout situation

apply here as well. An additional issue, not encountered with the multi-investor
buyout, is whether the total compensation package received by the employees
participating in the new ESOP is fair. If the employees retain their salary level
and participate in the ESOP as a part of their compensation, the division, which
is now a separate corporation, may be spending a greater amount or proportion
of its earnings on compensation expense. This, in turn, would make the business
less profitable.
DEFENSIVE STRATEGIES
The Concept Explained

One often-discussed and sometimes-used weapon in the arsenal of takeover
defenses is to place a large portion of the stock of a "vulnerable" company into
the hands of "friendly" shareholders. In the case of an ESOP, these friendly
shareholders are the employees who are expected to side with management in a
takeover fight. However, an ESOP sponsor should recognize that decisions

regarding voting and tendering ESOP shares may not always be passed to
participants; even if they are, the DOL may seek to enjoin the transaction based
on a claimed breach of fiduciary duty by the trustee.
As a method of defending against hostile suitors, companies have used ESOPs

to repurchase outstanding shares of stock of the company on the open market
prior to the takeover battle. A repurchase through an ESOP, rather than

through the company, has all the tax advantages previously mentioned; how-
ever, instead of the company retaining the repurchased shares, the ESOP
participants, whose interests may deviate from the company's at some point,
now control the shares. If the ESOP is established, or substantially modified,
after the making of a hostile bid, the ESOP fiduciaries may be enjoined from
causing the ESOP to purchase shares on the open market or from voting such
shares in a proxy fight on the theory that the purchase of the shares is not for
the "exclusive benefit of plan participants."178 If, however, an ESOP that was
178. See Norlin Corp. v. Rooney, Pace Inc., 744 F.2d 255 (2d Cir. 1984); Buckhorn, Inc. v.
Ropak Corp., 656 F. Supp. 209 (S.D. Ohio 1987).
ESOPs 139
established prior to a hostile bid is part of an ongoing compensation package,

the ESOP's stock purchase is more likely to be upheld.179
The Use of ESOPs under the Delaware Takeover Statute

In 1988, a remedial takeover statute became effective in Delaware.180 The
statute was aimed at discouraging the use of two-tiered, highly leveraged
takeovers which typically pressure stockholders into selling their stock for short-
term gain rather than holding for long-term value and which give management
little time to contemplate and respond to the offer. Under the statute, "material
transactions" between an acquiror and the target company are generally prohibited for a period of three years following the date the acquiror became an
"interested" (greater than fifteen percent ownership) shareholder. The statute
contains certain exceptions, one of which is for an interested shareholder who
acquires, in the transaction by which it became "interested," eighty-five percent
or more of the outstanding voting stock of the target. However, the stock held by
an ESOP will be excluded from the calculation of total outstanding shares

unless plan participants have the right to direct the tender of their shares
"confidentially." If the ESOP shares are excluded, the acquiror's task of
attaining eighty-five percent of the "outstanding" shares will be easier. The
right to tender confidentially is not defined in the Delaware statute and it is not
clear whether the express terms of the ESOP must provide for such a confiden-
tial right, or whether the ESOP may be silent on the point and the trustee
merely grant such confidential tender rights at the time of the bid. In view of the
DOL's position that the voting and tendering of unallocated shares is the
exclusive responsibility of the ESOP's trustee, there is some question as to
whether unallocated shares should be included in the number of the total
outstanding shares for purposes of the Delaware statute.

The Polaroid Decision
Recently, in Shamrock Holdings, Inc. v. Polaroid Corp.,181 an ESOP established by Polaroid was ruled "fundamentally fair," even though it was implemented after a takeover threat had been received, but before a tender offer was
commenced.
Commencing in 1985, and at various times over the next two years, the
concept of creating an ESOP for Polaroid employees was given concentrated
attention by the management of Polaroid. On March 28, 1988, the board of
directors of Polaroid met at a regularly scheduled meeting, and the establishment of an ESOP was approved. The board contemplated that the ESOP would
179. See British Printing & Communication Corp. v. Harcourt Brace Jovanovich, Inc., 664 F.
Supp. 1519 (S.D.N.Y. 1987); Danaher Corp. v. Chicago Pneumatic Tool Co., 633 F. Supp. 1066
(S.D.N.Y. 1986).
180. Del. Code Ann. tit. 8, 203 (Supp. 1988) (effective Feb. 2, 1988).
181. 709 F. Supp. 1311 (D. Del. 1989).
only own up to five percent of Polaroid's outstanding stock, and on June 14,
1988, the Polaroid board approved and adopted an ESOP plan document.
On June 16, 1988, Shamrock acquired slightly less than five percent of
Polaroid's outstanding stock, and approached management to discuss the establishment of a non-hostile, good relationship with Polaroid. Polaroid declined
and management decided during early July that an ESOP holding over fifteen
percent of Polaroid stock, valued at approximately $300 million, would be

appropriate as opposed to the earlier concept that the ESOP would hold only
five percent of Polaroid stock. On July 12, 1988, at a special meeting, the board
adopted an ESOP of this size. The ESOP was funded by (i) an immediate five
percent pay cut for all employees of Polaroid, (ii) a delayed pay scale increase,
(iii) section 401 (k) plan's employer matching contributions under a section
401(k) plan, and (iv) profit sharing retirement plan contributions. Shamrock
responded to the events of July 12 by instituting suit, on July 20, challenging
the validity of the ESOP. Shamrock commenced its tender offer on September 9,
1988.
The Delaware court held that the ESOP, although partially defensive in
nature, was not unfair to shareholders and should not be invalidated. The court
based its "fairness" opinion upon several factors:
(i) The ESOP did not impose significant additional costs to the Polaroid
shareholders. Although the ESOP's initial funding was provided by a bank
loan to Polaroid, the discounted present value of the reductions in pay scale
and other compensation more than offset the present value of the loan and
debt service. Thus, in effect, the employees "funded" their own participa-
tion in the ESOP, rather than the Polaroid shareholders. The court
suggested that the ESOP may, in fact, add value to the company.
(ii) The ESOP was not viewed as a management entrenchment device

because the tender decision was passed through to the ESOP participants,
whose tender decision was to be kept confidential by the independent

trustee. Also, the court concluded that the ESOP fit well within Polaroid's
participatory culture in the area of employee relations.
(iii) The ESOP was not viewed as resulting in significantly decreased

earnings per share or significant dilution of shareholder interests. Although
the ESOP acquired newly issued shares, and the price paid for those shares
was less than the market price after Shamrock's intentions became public
knowledge, the court concluded that the evidence was uncontradicted that
ESOPs promote productivity. According to the court, this increase in

productivity would offset any dilution in shareholder interest or earnings
per share.
(iv) The court seemed more sympathetic to Polaroid's argument that the
ESOP was beneficial to shareholders, since Polaroid had considered the

ESOP before Shamrock began to acquire significant amounts of Polaroid
stock, and since the ESOP was formed prior to the time when Shamrock
launched its tender offer.
The court was, however, critical of the board's decision to adopt the ESOP in
a number of respects. The court criticized the failure of the board to consider the
employee opposition to the funding of the ESOP, the ESOP's use as a defensive
mechanism, and the probability that an ESOP of this size would significantly
impact upon an acquirer's ability to effect a takeover due to the Delaware

takeover statute. Additionally, the board did not consider the reasonableness of
the ESOP in light of the impending takeover threat. Despite these shortcomings,
however, the court held that the test for validity was one of fundamental
fairness, which the Polaroid ESOP met.
Leveraged Cashouts
Several major corporations, including Colt Industries, FMC Corporation,
and Harcourt Brace Jovanovich, have engaged in a new form of recapitalization
program largely designed to deter takeover attempts - the so-called "leveraged
cashout" or "public leveraged buyout." Under a leveraged cashout, public

shareholders receive a package consisting of a new security and a large cash
payment for each share. The value of the package is well in excess of the recent
market value of the shares. Shares held in employee plans are exchanged for a
package of equal value, consisting of a number of new securities. Employee

ownership is thus increased dramatically, while public shareholders reap an
immediate economic benefit made even more attractive by favorable tax treatment of the cash distributions.182
As a result of their leveraged cashouts, FMC, Colt and Harcourt now carry a
significant amount of debt and are presumably much less attractive takeover
targets. An ESOP is not a necessary component of a leveraged cashout, but such
a recapitalization will often require the existence of either an ESOP or some

other plan permitted under ERISA to invest its assets primarily in employer
securities. While Colt did not have an ESOP, Harcourt did and FMC had a
payroll-based ESOP. Harcourt's use of an ESOP recapitalization plan to fend
off a hostile takeover attempt by Robert Maxwell has been widely cited as a
model of such transactions.
OTHER USES OF ESOPs
ESOP Tender Offers

An ESOP may participate as an offeror in a tender offer for an acquisition
target. Examples of buyouts involving an ESOP as a tender offeror include

Amsted, Parsons, and United States Sugar. In each of these transactions, the
target's ESOP joined with the potential acquiror to make an offer designed to
1 82. Under section 302 of the Code, a redemption will be treated as a dividend to shareholders,
and thus ordinary income, unless it qualifies, pursuant to certain tests contained in such section for
capital gains treatment as a sale or exchange. Under one of these tests, leveraged cashout
redemptions will be deemed a sale or exchange if shareholders equity is reduced by 20% or more by
virtue of the transaction.
gain control of the target more quickly than through a shareholder-approved

merger by purchasing enough shares to effect a short-form merger.
An ESOP's participation in a tender offer poses special problems under

ERISA. First and most importantly, the ESOP must beware of the requirement
that it pay no more than adequate consideration to parties in interest for their
shares. Thus, given the premium over market price that is usually necessary for
a tender offer to succeed, the ESOP tender offer must be structured so that the
other tender offeror, rather than the ESOP, purchases shares from parties in
interest. Second, as in any buyout transaction, the ESOP must participate in the
negotiation of the structure of the offer and merger, and plan fiduciaries must
satisfy themselves that the acquisition satisfies applicable prudence and other
fiduciary standards under ERISA and the Code.
Payment of Greenmail
An ESOP may also be used to pay so-called "greenmail," that is, to purchase
shares from a party that has acquired a significant, and unwelcome, stake in the
company sponsoring the ESOP. Of course, such an action would always have to
be analyzed under the applicable fiduciary standards. The results of such

inquiry will often hinge on whether the greenmailer has accumulated a ten
percent ownership interest in the ESOP's sponsor, it which case he would
become a party in interest and thus limit the ESOP's ability to pay a premium
above the currently traded price on a generally recognized market.
ESOPs and Labor Concessions

Whether as part of a sale of a division to employees or as an employee benefit
plan established outside of an acquisition context, ESOPs can serve as a means
for troubled companies to secure short-term labor concessions. Thus, companies
like Eastern Airlines seeking to stave off bankruptcy have ESOPs and similar
plans to offer stock to employees in exchange for reductions in current salary
and benefits. The track record of these efforts, however, has been spotty, in large
part because of the difficulties generated when multiple labor unions, with
oftentimes conflicting interests, participate in the negotiations.
CONCLUSION
ESOPs have become an attractive tool available for corporations because their
tax benefits create a cheap way of borrowing for corporate employers and a
method of increasing cash flow for highly leveraged companies. It should be
noted that these tax benefits may be cut back in the future, as the charmed life of
ESOPs to date in Congress may have ended with the retirement of Senator
Russell Long, their most zealous and powerful Congressional advocate. Even
without some of those tax benefits, however, ESOPs serve to place large blocks
of stock in the hands of a trust for employees, and thereby create a formidable
obstacle (although not an impenetrable one) to a zealous corporate raider. An
ESOPs 143
understanding of their advantages, limitations, and operation is vitally important to anyone rendering sophisticated financial advice to corporate America.

ESOPs What They Are and How They Work

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ESOPs: What They Are and How They Work

Author(s): Henry C. Blackiston III, Linda E. Rappaport and Lawrence A. Pasini

ESOPs: What They Are and How They Work*

employee stock ownership plans ("ESOPs")2 are currently experiencing a

10,000 ESOPs in which about 10 million U.S. workers participate, which

aware of the varied possibilities of an ESOP as a tool of corporate finance.

4. 29 U.S.C.A. 1001-1461 (West 1985 & Supp. 1989).

86 The Business Lawyer; Vol. 45, November 1989

qualified status of ESOPs. One overriding requirement is that the primary

THE CONCEPT EXPLAINED

loans between a plan and a sponsoring corporation and loans to a plan

transactions, including issues involving leveraged buyouts and securitized ESOP

LEGAL REQUIREMENTS FOR QUALIFICATION OF

QUALIFIED EMPLOYEE BENEFIT PLAN UNDER

CODE SECTION 401 (a)

Section 4975(e)(7) of the Code defines an "employee stock ownership plan"

ments under the Code.

7. Treas. Reg. 1.401-l(b)(2) (as amended in 1976).

88 The Business Lawyer; Vol. 45, November 1989

Although the regulations governing ESOPs and leveraged transactions make

repay an ESOP loan is inappropriate and inconsistent with the "exclusive

Exclusive Benefit of Participants

fiduciaries are "cautioned," in the ESOP regulations, to "exercise scrupulously

As a qualified employee benefit plan under the Code, an ESOP cannot

10. Treas. Reg. 54.4975-7(b)(2)(iii) (1977) (emphasis added).

(i) Seventy percent of all non-highly compensated employees are partici-

pants in the ESOP; or

Code) are aggregated when calculating the above percentages. However, an

Years of Service Percentage Vested

13. See I.R.C. 410(b)(3), (4) (as amended in 1988).

15. I.R.C. 41 l(a)(2) (1986).

90 The Business Lawyer; Vol. 45, November 1989

quently terminates, the percentage which is vested will remain nonforfeitable,

tory boundaries. Generally, annual allocations to an employee's account may

employer contributions are allocated to "highly compensated" employees, then

DEFINED CONTRIBUTION PLAN REQUIREMENT

(i) a stock bonus plan, with employer contributions tied to a formula

Distinctions Between Stock Bonus And Money Purchase

contributions and earnings directly based upon profits. Another distinction

retirement or termination of service. A stock bonus plan, in contrast, may

16. I.R.C. 415(c)(l),(d)(l)(1986).

18. I.R.C. | 4975(eX7) (1986).

Participants9 Individual Accounts

"QUALIFYING EMPLOYER SECURITIES"

92 The Business Lawyer; Vol. 45, November 1989

"within a reasonable time" to acquire qualifying employer securities, or used to

Definition of Employer Securities

Section 4975(e)(8) of the Code provides that a "qualifying employer security"

by section 1563(a) of the Code (determined without regard to subsections (a)(4)

and (e)(3)(c) of section 1563), which generally requires an eighty percent of

on a United States securities exchange, where the parent corporation is a

members of the group have no readily tradable stock, must be regarded as

23. See Treas. Reg. ft 54.4975-7(bX4) (1977).

24. See Priv. Ltr. Rul. 85-46-125 (Aug. 23, 1985).

26. See Priv. Ltr. Rul. 87-27-025 (Apr. 2, 1987).

conversion price is sparse. Former Treasury regulations regarding TRASOPs

Non-Publicly Traded Companies

94 The Business Lawyer; Vol. 45, November 1989

INVESTMENT DIVERSIFICATION REQUIREMENT

to certain participants. When an ESOP participant reaches age fifty-five or

be satisfied by distributing the portion of the participant's account balance

regulations promulgated under section 170(a)(l) of the Code with respect to

28. I.R.C. 409(o)(l)(A) (as amended in 1988).