Article by Judy Kornfeld

One of the interesting issues in repurchase obligation planning and funding is whether shares should be recirculated in the ESOP or redeemed by the corporation. Over the years, I have heard many ESOP companies express the view that recirculating stock is undesirable because the cost is higher, i.e., you keep repurchasing the same shares over and over again. But the analyses I have done for clients have led me to conclude that this is not necessarily true. Furthermore, there are a number of other issues besides cost that need to be considered. The first page of this article considers the mechanics of redeeming vs. recirculating ESOP stock and some of the non-cost issues. The second page explores the potential effect on the value of the company's stock and the implications for the comparative costs.

First, let's review the mechanics of handling repurchase obligations through redemptions.

• The ESOP distributes stock (unless the corporate bylaws restrict ownership to employees, participants can demand distribution in stock). The distribution can be a lump sum or installments.
  
• The company buys shares from the participant (or the ESOP trustee, if there are ownership restrictions).
  o If the distribution from the ESOP is a lump sum, the company may pay in a lump sum or installments.
  o If the distribution from the ESOP is in installments, the company must pay for each installment in a lump sum.
  
• The cash can come from operations, a corporate sinking fund, or debt.
  
• The payments for the stock are not deductible.

When stock is recirculated, the mechanics are as follows:

• The company contributes cash to the ESOP or the trustee uses investments other than company stock that have accumulated in the ESOP.
  
• The cash can come from operations, a corporate sinking fund, or debt.
  
• The ESOP trustee distributes cash. Distribution can be in lump sum or installments.
  
• The cash contributions to the ESOP are deductible (as long as they are within relevant limits).

Some of the implications of redeeming versus recirculating are obvious:

• Redeeming will cause the number of shares in the ESOP to decline, while recirculating will leave the number of shares in the ESOP unchanged.
  
• Unless the ESOP is a 100% shareholder, redeeming will cause the ESOP's percentage of ownership to decline.
  
• Repurchase obligations, measured in number of shares, will be lower over the long term if shares are redeemed instead of recirculated.
  
• Individual account balances will have a lower number of shares allocated to them if stock is redeemed rather than recirculated.

Recirculating stock in the ESOP may raise fiduciary issues, because the trustee who is using cash balances from the plan to repurchase shares is actually making a decision to purchase the stock. The trustee must act in the best interest of plan participants and cannot be obligated to repurchase shares, so if there are reasons that a purchase of company stock might be inappropriate, the trustee may decide not to use cash from the plan to provide liquidity for distributions. This issue is mostly of concern in situations where the company has made ongoing contributions to the ESOP in excess of current liquidity needs to accumulate cash for future repurchases. The fiduciary issues can be avoided if the trustee distributes stock and the company redeems it. In a situation where the company does not want to make contributions to the ESOP in excess of current liquidity needs to create a "sinking fund" in the ESOP for future repurchases, the company can redeem shares and then recontribute them to the ESOP.

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