ESOP Fiduciary Concerns in Change-of-Control Transactions

Several years ago, transactions involving employee stock ownership plans (ESOPs) grew tremendously. Fiduciaries of many ESOPs are now considering new transactions. These situations present new questions about the nature of the ESOP’s financial interest and ways it can or should be viewed under the Employee Retirement Income Security Act of 1974 (ERISA). Here are five key points about ESOPs for you to consider:

1. Transaction participation. The ESOP may be holding the same class of stock as the other shareholders (common stock) or another stock class that is convertible into common stock (convertible preferred stock). In either case, the ESOP may be offered a financial opportunity different from that offered to other shareholders. If the ESOP wants different treatment than other shareholders, the fiduciary should determine whether such treatment serves the participants’ best interests.

2. Evaluating a transaction’s total consideration. Consideration paid in a tender offer may be in cash, notes, other securities or retention of certain assets. Consideration may also include value attributed to employment contracts, non-compete agreements or other compensation arrangements. These usually are provided only to management shareholders but, in essence, represent a portion of the purchase price the acquirer is willing to pay.

The ESOP may be holding the same class of stock as the other shareholders (common stock) or another stock class that is convertible into common stock (convertible preferred stock). In either case, the ESOP may be offered a financial opportunity different from that offered to other shareholders. If the ESOP wants different treatment than other shareholders, the fiduciary should determine whether such treatment serves the participants’ best interests. Consideration paid in a tender offer may be in cash, notes, other securities or retention of certain assets. Consideration may also include value attributed to employment contracts, non-compete agreements or other compensation arrangements. These usually are provided only to management shareholders but, in essence, represent a portion of the purchase price the acquirer is willing to pay.

Standard valuation principles should apply when assessing the fairness of the total consideration to be received. Evaluating what the ESOP will receive as consideration addresses the transaction’s fairness.

3. Allocating total consideration among all equity holders. To ensure the ESOP is being treated fairly, it’s important to examine the terms of the securities each type of equity holder owns. For example, if an ESOP holds convertible preferred stock and the acquirer intends to terminate the ESOP when the transaction is completed, then the ESOP may be entitled to the greater of its redemption or fair market value. The value to the ESOP should never be less than what it would have received had it held only common stock; the fiduciary can always convert the preferred stock and receive the same value provided to all common shareholders.

4. Treatment of remaining ESOP debt. In a leveraged ESOP, the company commits to repaying the ESOP indebtedness through contributions or dividends. Effectively, the commitment becomes a corporate liability and, as such, affects all shareholders alike. This issue can cause controversy during subsequent transactions.

To ensure the ESOP is being treated fairly, it’s important to examine the terms of the securities each type of equity holder owns. For example, if an ESOP holds convertible preferred stock and the acquirer intends to terminate the ESOP when the transaction is completed, then the ESOP may be entitled to the greater of its redemption or fair market value. The value to the ESOP should never be less than what it would have received had it held only common stock; the fiduciary can always convert the preferred stock and receive the same value provided to all common shareholders. In a leveraged ESOP, the company commits to repaying the ESOP indebtedness through contributions or dividends. Effectively, the commitment becomes a corporate liability and, as such, affects all shareholders alike. This issue can cause controversy during subsequent transactions.

Because projected contributions or dividends used to repay the ESOP’s debt represent future benefits to the participants, some have argued that any sharing of the ESOP’s debt in a subsequent transaction would result in a benefits windfall to participants—effectively, participants would receive all future benefits at once. This windfall occurs because all unallocated shares would be released from the suspense account when the corporation repays the debt.

5. Continuing ESOP or other employee benefit plans. 

Whether the ESOP remains in place after a merger or tender offer may have value implications for ESOP shareholders. If a large amount of ESOP debt is outstanding with corresponding unallocated shares to be released as the debt is repaid, the fiduciary and its advisors should consider these questions:

• Has the merger partner or acquirer made a legal commitment to make future contributions or dividends sufficient to repay the ESOP indebtedness?

• Are current ESOP participant interests likely to be diluted through a substantial addition of new employees to the plan?

• If the ESOP is to be terminated, are replacement benefits contemplated, and how do they compare with the existing benefits?

The ESOP’s involvement in a change-of-control transaction raises a host of issues. While each situation is unique, the fiduciary’s knowledge of the original structure of the ESOP’s equity purchase, security holders’ rights and preferences, and the surviving company’s post-transaction intentions toward benefit plans and remaining ESOP debt repayment will help the fiduciary ensure fair treatment of the ESOP.

matt@bluewaterpartners.com

— BlueWater Partners LLC