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ESOP LEGAL AND
FIDUCIARY
RESPONSIBILITIESPresented by
James Steiker
Chairman & CEO
SES ESOP STRATEGIES
555 City Avenue, Suite 910
Bala Cynwyd, PA 19004
Tel: (215) 508 – 5643
Email: [email protected]
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Good ESOP Candidates
• Non-cyclical slow to medium growth
• Stable cash flow
• Ownership group interested in remaining
involved/participating in the business
• Patient long-time horizon—not seeking
immediate cash payment in full
• Ownership group concerned about employees
and/or long term future of company/motivated
by "legacy" or mission goals in addition to
cash
• Lack of cash strategic buyers willing to pay
significant premium for the company
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Some Core ESOP Advantages and
Disadvantages
Advantages
• Tax efficient
• Shareholder directed process
• Control over timing
• Legacy
Disadvantages
• Complex
• Regulated
• Often involve Seller notes
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What is an ESOP?
• ESOP = “Employee Stock Ownership
Plan”
• Qualified deferred compensation plan
under ERISA and Internal Revenue
Code
• Similar to Profit Sharing and 401(k)
Plans
• Must invest primarily in company stock
• Can be leveraged
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Typical Goals of ESOP Transactions
• Shareholder Liquidity
• Long-term succession plan
• Corporate and personal tax planning
• Ownership/Partnership incentive for key
employees
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Significant ESOP Tax Preferences
• Effective deduction of principal on
ESOP loan repayment
• Section 1042 Capital Gains Deferral
• Deduction of dividends paid on ESOP
shares
• S Corporation ESOP non-recognition of
corporate income
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Section 1042 Capital Gains Deferral
• Permits shareholders selling to an ESOP
to defer indefinitely capital gains tax on
sale of shares
• ESOP must own 30% of value of all
company stock after sale
• Selling shareholders must purchase
qualified replacement property (“QRP”)—
stocks or bonds of any domestic
operating corporation
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“S” Corporation ESOPs
• “S” Corporation income attributed to
shareholders
• ESOP as S Corp shareholder pays no
taxes on its share of corporate income
• No section 1042 Capital Gains Deferral
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How Does an ESOP Work?
• Company establishes an ESOP Trust
• ESOP Trust purchases company stock
from shareholders or company
• Bank or seller provides financing to
Company
• Company pays contributions or
dividends to ESOP that ESOP uses to
repay debt
• Company or ESOP repurchases shares
from employees after termination
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Company
ESOP
Note &
Pledge
of Stock
Cash
Company Stock
Cash
Shareholders
Pledge of
QRP??
Cash
Note & Collateral
Initial “C” Corporation
ESOP Transaction
Bank
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Company
Bank and/or
Shareholder
ESOP
Release of Shares Pledged as
Collateral and Share Allocations
to Individual ESOP Accounts
Contributions or
Dividends ($$$)
Loan Payments ($$$)
Loan
Payments
($$$)
ESOP Loan Repayment
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Company
ESOP
Note &
Pledge
of Stock
Company
StockCompany
Stock
Cash &
Sub. Note
w/WarrantsShareholders
Cash
Note & Collateral
Initial “S” Corporation
ESOP Transaction
Bank
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ESOP Transaction
Concerns
• Valuation
• Financing
• Effect of ESOP on overall benefits
structure
• Legal/fiduciary risk
• Cost and complexity
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Steps in an ESOP Transaction
• Feasibility study
• Financing
• Appraisal
• Plan Design
• Legal Documents
• Closing
• IRS Determination Letter
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Ongoing ESOP Items
• Annual appraisal update
• Annual recordkeeping and
administration
• Repurchase obligations
• Communications training and education
• Legal compliance
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Key Legal Issues in an ESOP
Transaction
• Compliance with ERISA requirements
• Plan design
• Prohibited Transaction exemption
• Independent appraisal
• Prohibited allocations (Section 409(n))
• Section 409(p) S corporation rules
• Fiduciary considerations
• Trustee selection
• Trustee advisors
• Fiduciary process
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Key Legal Issues in an ESOP
Transaction (cont.)
• Tax and Related Considerations
• Section 1042 election
• Documenting contributions and loan
repayments
• Documenting plan adoption
• ESOP Transaction Documents
• ESOP purchase documents
• ESOP loan documents
• Related documents
• Financing
• Executive compensation
• Related party leases, etc.
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Key ESOP Legal Operational Issues
• Contributions/Dividends/Distributions paid to
the trust
• Operation of the ESOP in accordance with its
terms
• Annual appraisal
• Board monitoring of trustee
• Corporate governance
• Pass-through voting issues
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ESOP Fiduciary Obligation--Definition
• An ERISA fiduciary must act:
• Solely in the interest of plan participants
• With the care, skill and prudence that a
prudent person familiar with such matters
would use under the same circumstances
(the prudent expert rule)
• In accordance with the terms of the plan
documents insofar as they are consistent
with ERISA
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Typical Trustee Decisions
• Deciding whether to buy (or sell) Company
Stock
• Decide on how to vote company stock
• Establishing the annual Company Stock
valuation
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Trustee Role In ESOP Transactions
• Due diligence and transaction negotiation on
behalf of the ESOP
• Hire legal and financial advisors
• Review independent appraisal and embedded
assumptions and obtain transaction fairness
opinion
• Act on behalf of ESOP to enter into transaction
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Typical Transaction Terms Negotiated By
Trustee
• Price and terms of purchase
• Financing terms, including warrants and inside
ESOP loan terms
• Anticipated governance and board
composition
• Management compensation, including any
deferred compensation or synthetic equity
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Typical Ongoing Fiduciary Issues
• Corporate governance
• Offers to purchase the ESOP-owned
company and/or the ESOP shares
• Acquisitions
• Valuation
• Benefit levels/repurchase obligations
• Synthetic Equity
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ESOP As Shareholder
• Shares owned by an ESOP are held in trust of
behalf of ESOP participants and beneficiaries
• The trustee(s) of the ESOP have legal
possession of ESOP shares and the ability to
exercise all of the rights and privileges of a
shareholder
• ESOP participants and beneficiaries have no
direct shareholder rights—a participant has no
legal right to attend a shareholder meeting or
to demand information to which shareholders
are entitled
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ESOP as Shareholder (Cont.)
• ERISA requires that participants be permitted
to instruct the trustee as to voting of individual
allocated shares with respect to
recapitalization, reclassification, merger,
consolidation, dissolution, liquidation, or sale
of substantially all corporate assets
• ESOP plan may permit but does not require
“pass-through” voting on other corporate
matters or instruction as to tender or exchange
of shares held by the ESOP
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Role And Election
Of Board Of Directors
• The Board of Directors is the locus of
corporate authority and power
• Directors must be elected by
shareholders
• Corporation does not have authority to
agree to elect specific directors
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ROLE AND ELECTION OF
BOARD OF DIRECTORS (Cont.)
• Corporate organization documents may
provide:
• Staggered terms
• Restrictive nominating provisions
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Role And Election Of Directors (Cont.)
• Trustee in 100% ESOP-owned company often
has theoretical power to elect and/or remove
entire board
• Trustee will (as most institutional shareholders
in public companies) defer to management
nominees unless there are apparent issues
with business or director performance
• Some ESOPs have pass-through vote for or
against management slate
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Questions ?
James Steiker
Chairman & CEO
SES ESOP STRATEGIES
555 City Avenue, Suite 910
Bala Cynwyd, PA 19004
Tel: (215) 508 – 5643
Email: [email protected]