Article by Judy Kornfeld

An ESOP is a type of qualified retirement plan under ERISA, and one of its main purposes is to provide benefits to participants. Since an ESOP holds assets that consist primarily of stock of the sponsoring company, there must be a mechanism for participants to realize the value of the stock that is held on their behalf. This mechanism exists in the public securities markets if the stock is publicly traded. If the stock is not publicly traded, then the Internal Revenue Code (the "Code") requires that the company sponsoring the ESOP must buy the stock back from participants who receive distributions from the plan. This is accomplished by a "put" option,[1] which entitles participants to require that the corporation buy back the stock at fair market value. An additional requirement for ESOPs, designed to protect participants from the investment risks of lack of diversification, is that participants have the right to diversify a portion of the company stock allocated to their accounts beginning at age 55, with 10 years of participation in the ESOP.[2] The obligation to honor the "put" option and the obligation to provide cash to the ESOP when participants exercise diversification rights are usually referred to together as the ESOP "repurchase obligations."

The timing and magnitude of a company's repurchase obligations depends upon the provisions of its ESOP plan document, the demographics of its employee population, and the value of its stock.

The plan provisions which have the greatest impact on repurchase obligations are those relating to the timing and form of distributions from the plan, and the vesting schedule. The impact that plan provisions will have on repurchase obligations should be considered at the time the plan document is being drafted, because there are certain limitations on the changes that can be made after the plan has become effective.

The Code requires that distributions made because of retirement, death, or disability begin no later than the end of the plan year after the year in which the event occurs. Distributions due to termination of employment can be delayed for an additional five years or until an ESOP loan used to acquire the stock has been repaid, if later.[3] Distributions can be made in installments over a five year period (or longer, for certain large accounts). An ESOP plan document can provide for distributions to occur sooner than required by the Code. For example, the plan can provide for immediate distributions and for lump sum payouts instead of installments, but this will accelerate the repurchase obligations.

The vesting schedule determines the time at which the amounts allocated to a participant's account become non-forfeitable. The Code requires that an ESOP use one of two vesting schedules. Under seven year graded vesting, a participant must be at least 20% vested after three years of service, and an additional 20% must vest per year so that a participant is 100% vested in seven years. With five year "cliff" vesting, a participant is 100% vested after five years of service, but has no vesting prior to that time. However, an ESOP sponsor can choose to have more rapid vesting. As with the distribution provisions, this will tend to accelerate the repurchase obligations, particularly if the company has high turnover.

The primary demographic characteristics of the employee population that affect repurchase obligations are the age distribution and turnover. High turnover will tend to accelerate the repurchases. The age distribution of the employee population will affect when employees will have diversification rights and will reach retirement. Age clusters in the employee population tend to create "spikes" in the repurchase obligations which the company should anticipate and for which it should plan.

The first step in planning for repurchase obligations is usually the preparation of a study that projects the timing and magnitude of the liquidity needs that the company will face in connection with the repurchase obligations. Such studies are usually prepared by consulting firms that can assist the company in developing appropriate assumptions. These studies can be used to compare the impact of different distribution and vesting provisions, varying rates of turnover and other demographics, and variations in the price of the company's stock. It is not unusual for the lender in an ESOP transaction to require that a repurchase obligation study be prepared, so that the cash requirements associated with repurchases can be anticipated.

There are a number of techniques that companies can use to fund repurchase obligations. In many instances, particularly in companies whose ESOPs hold less than a majority of the stock, repurchase obligations can easily be handled out of current cash flow. Where cash requirements for repurchases are expected to vary significantly from year to year because of the demographics of the employee population, it may be desirable to set aside funds to help meet the cash needs in years when repurchases are larger than average. Corporate owned life insurance can also be used to accumulate funds for repurchases as well as to provide funding in the event of a participant's death. In companies whose ESOPs own a large portion of the stock, or whose stock is appreciating rapidly, there can be substantial cash requirements associated with the repurchase obligations. Advance planning is extremely important to make sure that the company anticipates and can meet its repurchase obligations.

Notes

1. Code Section 409(h) gives participants the right to demand that benefits be distributed in the form of employer securities and gives the employee a "put" option pursuant to which he can require the employer repurchase such shares at fair market value, as determined by an independent appraiser. The put option can be exercised during a 60 day period that begins on the date of distribution, or during a similar 60 day period one year later. [return to text]
2. Code Section 401(a)(28)(B). A participant can diversify up to 25% of his company stock account during the five that begins when he reaches age 55 and has ten years of participation in the plan. At age 60 (with ten years of participation) he can diversify up to 50% of his company stock account. [return to text]
3. See Code Sections 401(o)(1)(A) through (C). [return to text]
4. Code Sections 411(a)(2)(A) and (B).

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