The ESOP Association shared a Message from Senator Mitch McConnell at The ESOP Association’s 35th Annual Conference last week and on their blog. In his remarks, Sen. Mitch McConnell [R-KY] reiterated his support of ESOPs and employee ownership, noted the 100+ ESOP companies in Kentucky, cited the Findings of 2010 General Social Survey (GSS), shared his concerns with the DOL ESOP Fiduciary Regulation, and expressed his support of S.1232 A bill to modify the ERISA definition of fiduciary to exclude appraisers of ESOPs.
What is the ESOP repurchase liability?
The ESOP repurchase obligation or liability is the company’s obligation to buy back shares from ESOP participants according to the company’s ESOP document and ESOP Distribution Policy.
The obligation is created by the ESOP put option – right to demand employer securities as provided under IRC Section 409(h) – Right to demand employer securities; put option:
IRC 409(h) Right to demand employer securities; put option
(1) In general
A plan meets the requirements of this subsection if a participant who is entitled to a distribution from the plan—
(A) has a right to demand that his benefits be distributed in the form of employer securities, and
(B) if the employer securities are not readily tradable on an established market, has a right to require that the employer repurchase employer securities under a fair valuation formula.
The specific ESOP liquidity events are identified in our discussion on the timing of ESOP distributions.
How is the repurchase liability reported on the company’s financial statements?
The repurchase obligation is NOT a balance sheet liability required to be reported on the financial statements. [While there have been some discussions by the Financial Accounting Standards Board (FASB) to require the reporting in recent years, they have currently been shelved.]
The company should disclose the repurchase obligation per Statement of Position 93-6 Employers’ Accounting for Employee Stock Ownership Plans (SOP 93-6):
The existence and nature of any repurchase obligation, including disclosure of the fair value of the shares allocated as of the balance sheet date, which are subject to a repurchase obligation.
What is an ESOP repurchase obligation study?
The ESOP put option creates a call on the company’s cash flow. An ESOP repurchase obligation forecast or study is a long-term projection of the call on company cash needed to satisfy the plan’s ESOP distribution requirements. The results of the forecast are dependent on the participant data/demographics of the employee population, the ESOP Repurchase Obligation Forecast Assumptions, and the ESOP Distribution Policy. In addition to corporate and ESOP planning, the repurchase obligation forecast will help quantify the projected ESOP repurchase obligation for financial statement reporting and stock appraisal purposes.
The May 1, 2012 Employee Ownership Update is online and discusses the following:
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Defined Contribution Plans in Congress
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Annual Conference Breaks Records
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Innovations in Employee Ownership
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We the Owners: Trailer
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Other Employee Ownership Conferences
In our discussion on the History of ESOP Tax Law we reviewed the House Ways and Means Committee hearing on the Tax Reform and Tax-Favored Retirement Accounts. The Update provides more details on how all of the witnesses stated that eliminating current retirement plan tax incentives would hurt retirement savings:
The House Ways and Means Committee heard testimony on April 17 about the current system of retirement tax incentives. The five witnesses all suggested that eliminating the current tax incentives would weaken the state of retirement security. Chairman Dave Camp (R-Mich.) described three criteria the committee would consider: simplification; increasing participation, especially by those with lower incomes; and effectively targeting benefits. Judy Miller of the American Society of Pension Professionals and Actuaries, argued that the actual cost of the tax incentives is 54% less than projected by the Joint Committee on Taxation and the Treasury's Department's Office of Tax Analysis: "Every dollar that is excluded from income this year will be included in income in a future year. Unfortunately, that is not reflected in the cash basis measurement of the retirement savings tax expenditure."
It also discussed how Sen. Rob Portman [R-OH] and Sen. Benjamin Cardin [D-MD] are working on legislation that would mention their opposition to the DOL ESOP Fiduciary Regulation.
Separately, Senators Rob Portman (R-Ohio) and Ben Cardin (D-Md.) announced that they would continue working together on legislation to promote retirement security, specifically mentioning their opposition to the Department of Labor's proposed changes to the definition of a plan fiduciary. Many members of ESOP companies worry that the regulation would result in appraisers being fiduciaries and increase the cost and complexity of establishing plans.
As mentioned in my previous post, ESOP plan documents will typically indicate the share release formula can be either of the two acceptable formulas, as defined in the Treasury Regulations Sec. 54.4975-7(b)(8):
The Special rule share release formula is based solely on principal payments made on the ESOP loan:
(principal paid for the year) / (principal paid for the year + principal to be paid for all future years) * shares in suspense
As noted in the Treasury Regulations mentioned above, if the release is determined with reference to principal payments only, three additional rules must be followed:
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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 for 10 years.
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Interest included in any payment is disregarded only to the extent that it would be determined to be interest under standard loan amortization tables.
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The term of the loan cannot exceed 10 years (including any renewal, extension, or refinancing)
Summary
It is critical to know what share release formula is cited in the ESOP loan documents (normally noted in the Pledge Agreement) to ensure your plan is being administered correctly in conjunction with the formula(s) allowed in the ESOP plan document. Failure to properly release shares will result in allocation errors and administration rework as required under Employee Plans Compliance Resolution System (EPCRS).
We have recently discussed the importance of Identifying your Long-Term ESOP Objectives and Developing Accurate ESOP Repurchase Obligation Forecast Assumptions as part of the ESOP Repurchase Obligation process. Today we will look at the significance of the ESOP Distribution Policy. Here is a quick summary of the various Timing of ESOP Distribution rules:
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Participants that terminate due to Death, Disability, or Retirement are eligible to being taking distributions within one year after the plan year of termination.
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Participants that terminate due to Other Separations of Service will begin within six years after the plan year of termination. However, there is a ESOP Loan Exception that allows distributions to this group to be delayed until the ESOP loan is repaid in full.
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Participants age 55 with 10 years of participation are eligible to Diversify 25% of their account for five years. The diversification percentage goes up to 50% in the sixth and final year.
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Distributions generally cannot be forced by the company. However, a company can make Mandatory Distributions to terminated participants with an account balance of $5,000 or less. If the balance is greater than $1,000, then any forced distribution must be rolled into a safe harbor automatic rollover IRA. Distributions can also be forced to take a distribution if the participant attains their Latest Commencement Date (the later of age 65, termination from the plan, and attaining 10 years of participation) or is required to begin receiving Required Minimum Distributions (most participants must begin receiving taxable distributions after they reach age 70½ and terminate).
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Depending on the plan rules, a plan may pay the alternate payee of a Qualified Domestic Relations Order (QDRO) before the plan participant is eligible for a distribution.
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In addition to commencing distributions, a plan may effectively speed up the repurchase obligation if they employ an ESOP cash conversion strategy (aka ESOP Reshuffling) for terminated participants.
You will also have to determine whether the Form of ESOP Distribution will be paid in cash or shares and whether the Method of ESOP Distribution will be paid in a lump sum payment or installment payments.
Ensuring the distribution policy being used for your forecast is consistent with your actual distribution policy is an ESOP Repurchase Obligation (RO) best practice:
Ensure the distribution policy used in your RO forecast is properly reflected in your written distribution policy.
While adoping a written distribution policy is a best practice, all plans that have paid a distribution have adopted some form of a distribution policy. Every distribution policy starts with the plan document and the statutory minimum requirements discussed above and is then modified as needed to meet the objectives of the company, to manage cash flow, and to control the employee benefit level.
After reviewing the results of your repurchase obligation forecast you may decide to run different scenario(s) using alternate distribution policy(s). A change in distribution policy could significantly change your cash flow and company projections (and potentially the ESOP valuation) now and in the future which could have an impact on your other ESOP Repurchase Obligation Forecast Assumptions.
An employee stock ownership plan (ESOP) is a type of qualified retirement plan that buys, holds, and sells company stock for the benefit of the employees, providing them with an ownership stake in the company. The ability of the ESOP to purchase company stock Creates an Internal Market and Built-In Buyer.
ESOPs are unique in that they are allowed to incur debt to purchase stock from other shareholders or from corporate treasury. When company stock is purchased by the ESOP with the proceeds of an exempt loan, the shares are put into an ESOP suspense account as collateral on the loan. Shares are released from the ESOP suspense account as loan payments are made on the ESOP debt.
One benefit of using ESOP loans to purchase stock is the share release provides a predetermined share allocation to the ESOP participants over the term of the ESOP loan. A best practice is to structure the ESOP loan to assist a company in facilitating their desired benefit levels to the eligible ESOP participants.
ESOP plan documents will typically indicate the share release formula can be either of the two acceptable formulas, as defined in the Treasury Regulations Sec. 54.4975-7(b)(8):
The General rule share release formula is based on principal and interest payments made on the ESOP loan:
(principal and interest paid for the year) / (principal and interest paid for the year + principal and interest to be paid for all future years) * shares in suspense
Stay tuned for my next blog post on the Special rule option for releasing ESOP shares.
As part of the AICPA Employee Benefits Conference the DOL reiterated their desire to impose a potential legal liability on financial advisors (i.e. ESOP appraisers) and specifically mentioned ESOPs as an audit priority. They also provided an update on the timing of the DOL Re-Proposal of the DOL ESOP Fiduciary Regulation that would be consistent with the July 2012 timeframe we have been discussing.
Employee stock ownership plans, one of EBSA's audit priorities, require special vigilance on the part of auditors, Borzi said. EBSA has seen many cases in which auditors accepted improper ESOP valuation methodologies and assumptions, creating serious and expensive problems for ESOP participants.
Fiduciary Rule.
EBSA expects to repropose a redrafted fiduciary regulation when it completes work on clarifying aspects of the rule, which could be a couple of months from now, Borzi said.
In updating the regulation that defines a fiduciary, the department seeks to impose a legal liability on individuals who represent themselves as financial advisers when giving individualized investment advice, Borzi said.
Any financial service providers who represent themselves as trusted advisers to a client must put the client's financial interest first, she said.
They also denounced limited scope audits and stated that the ERISA expectation of auditors is to take a skeptical look at valuations.
We recently took a look at the importance of Identifying your Long-Term ESOP Objectives as part of the ESOP Repurchase Obligation process. Another important part of the process is developing your forecast assumptions. While any first attempt at preparing assumptions is better than not making an attempt at all, it is essential to continuously revisit the assumptions to ensure that they are accurate. If you don't use accurate assumptions in your forecast, then you won't have an accurate repurchase obligation forecast. In other words, garbage in, garbage out.
Comparing your results to your financial and strategic planning is an ESOP Repurchase Obligation (RO) best practice:
Review your financial forecast and strategic planning to ensure the assumptions are consistent with your RO forecast.
Here is a discussion of the important assumptions that go into a repurchase obligation forecast:
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Employee Groups – One of the first steps in the repurchase study process is to organize the participant data into groups. Groups of employees tend to have similar characteristics, such as compensation, account activity, vesting, turnover rates, and employee growth rates. While some companies prefer to group their employees by a method such as job classification or hourly vs. salaried, using a statistical approach to create groups based on the previously mentioned characteristics generally tends to be more accurate.
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Stock Growth Rates – This is the most important factor in the study, yet the most difficult to predict. The values used in this study should agree with the enterprise values used by your appraiser and in your corporate and strategic planning. A best practice is to include the appraiser in the repurchase study process, especially given the interrelationship between the stock appraisal and the repurchase obligation.
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Employee and Eligible Compensation Growth Rates – How many net new participants will be added to the plan each year as a result of hiring new employees? At what rate will your eligible compensation increase? These questions will need to be answered and the results will be combined to project eligible compensation in the future. While you could combine the numbers into one projection, projecting the numbers separately is another planning best practice and the projections should agree to your corporate and HR projections. These rates can be projected at a company level or by employee group.
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Termination Rates – One of the most accurate ways to project future termination rates is to use your own employment history. You will want to adjust your terminations to remove any terminations due to retirement, death, and disability as needed to avoid any double counting. You will also want to account for any unusual circumstances that would inflate or deflate the projected termination rates going forward. You may want to look at multiple years and use a weighted average. These rates should be projected by employee group as their termination rates will vary significantly.
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Retirement Rates – In addition to termination rates, you will need to project when active employees will retire from the company. Many plans will use the retirement age of the plan, but it is important that this age somewhat represent the age that most people retire from the company. The retirement age for key individuals with large balances may need to be adjusted accordinly.
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Diversification Rates – If your plan is less than 10 years old, diversification may be the first major repurchase obligation for the company. You will need to determine if your plan has the statutory minimum requirements or if provides for more liberal rules. One of the most challenging items to project for a company is the diversification rate, generally communicated as a percentage rate. The natural instinct of many companies is to assume 100% diversifications, but this method will likely overstate the projected diversification distributions in the short-term and, assuming a continuing growth in stock price, understate the long-term repurchase liability. A best practice is to monitor the diversification rate from year to year and make adjustments accordingly. I often see companies prepare multiple scenarios using various diversification rates.
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Death and Disability Rates – Generally speaking, the rates of death and disability are statistically insignificant to a repurchase obligation study. As an alternative you could apply a fixed percentage or other actuarially assumptions.
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Contribution Rates – This is another area that sparks a lot of discussion. While a loan is outstanding contributions will be made to the plan for loan payments. When the plan is paying distributions, a decision will have to made as to whether shares are recycled or redeemed and this will impact the plan contributions projection. This discussion becomes even more important when the loan is paid. This discussion will generally lead to a very important strategic question of what is the target employee benefit level (EBL) that the company will provide their employees in the long-term.
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Special Events – Major corporate events such as acquisitions, dispositions, and layoffs will affect the assumptions. If you are aware of any such events, we should include them in our calculations.
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Future Share Activity, ESOP Transactions, Synthetic Equity - If the plan is not 100% ESOP owned, a study would be incomplete if it didn't account for future share activity inside and outside the ESOP as well as any other significant draws on equity such as synthetic equity and deferred compensation.
Because there is a lot of overlap between your repurchase obligation assumptions and the information involved in the financial and strategic planning process, some companies will integrate the repurchase obligation forecasting process into their strategic planning.
In Schmalz v. Sovereign Bancorp Inc., No. 2:08-cv-0085 (E.D. Pa. 4/17/12), a U.S. District Court applied the Moench Presumption of Prudence For Investment in Company Stock in ESOPs and dismissed the related claims.
For the reasons set forth above, the defendants’ motion to dismiss plaintiffs’ claims that the defendants breached their fiduciary duties to prudently manage the Plan, to disclose complete and accurate information, to monitor fiduciaries, to be loyal, and committed breaches as co-fiduciaries, shall be granted and these claims are dismissed.
The ESOP participants had alleged a breach of ERISA Fiduciary Duties by continuing to offer company stock when the value dropped by 91%:
Over the same time period the value of Sovereign’s stock declined. “The price of Sovereign stock fell from $26.42 on February 20, 2007 to $2.33 on September 29, 2008 (a 91.2% drop)” Opp. to MTD at 5-6. In addition to this decline in stock value, on April 23, 2008, Moody’s Investors Service lowered Sovereign’s credit rating two levels from an A3 to a Baa2.
The president of The ESOP Association J. Michael Keeling provided some commentary on the DOL Re-Proposal of the DOL Regulation to Change the Definition of ESOP Fiduciary:
The April 2, 2012 Employee Ownership Update provided an update on the likelihood that the DOL Re-Proposal of the DOL Regulation to Change the Definition of ESOP Fiduciary will still be issued in May:
At a hearing of the House Committee on Education and the Workforce, Secretary of Labor Hilda Solis responded to questions from many members of Congress about the agency's proposal to change the definition of a plan fiduciary. One impact of the originally proposed regulations would have been to deem appraisers of ESOP shares to be plan fiduciaries, but the DOL withdrew that proposal in September 2011, promising to modify and re-propose the rules later. Rep. Rush Holt (D-NJ) inquired whether the Employee Benefits Security Administration is "asking the right questions" about the fiduciary rule, and whether the agency has finished collecting data. Solis responded that the agency is still willing to collect information relevant to the rule and described DOL as "not in a hurry" to re-propose the rule. The secretary did not provide a direct answer when asked if the re-proposal would still be issued in May.
We had previously shared an update that discussed how the DOL ESOP Fiduciary Regulation would be updated July 2012 (or later).
The rest of the April 2, 2012 Employee Ownership Update is online and discusses the following:
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UK Budget Proposals on Stock Options and Employee Ownership
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Secretary of Labor on Re-proposal of Fiduciary Rule
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Mondragon Announces Initiatives in the U.S. and India
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Deloitte Announces Global Share Plan Survey
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U.S. Workers Not Aware of Basic Facts About Their Employers
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New University Resource from Scotland
The April 16, 2012 Employee Ownership Update is also online and discusses the following:
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New Employee Ownership Fellowships at Rutgers
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Two Films on Employee Ownership
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Register for the CEP Exam
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New CEO at SAIC
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Ohio Employee Ownership Conference
The update discusses the Louis O. Kelso Fellows Chosen by Rutgers University.