EMPLOYEE STOCK OWNERSHIP PLANS (“ESOPs”)

1. EMPLOYEE STOCK OWNERSHIP PLANS (“ESOPs”) Why Private Companies Offer Them And The Issues They Create

2. ESOPs • Created in 1974 with the passage of ERISA. • Purpose is to encourage employee stock ownership. • More than 10,000 ESOPs have been established covering some 10 million employees • ESOPs used in smallest private companies as well as America's largest corporations.

3. ESOPs – What are they? • An ESOP is a qualified, defined contribution employee benefit plan required to invest primarily in the company’s securities.

4. ESOPs – Dual and Conflicting Purposes • ESOPs function as both an employee retirement benefit plan and a technique of corporate finance intended to encourage employee ownership of a company. • ESOPs are not intended to guarantee retirement funds, and they place employee retirement assets at a greater risk than the typical diversified, ERISA-regulated plan.

5. ESOPs – Who are ESOPs to benefit? • ESOPs are supposed to be primarily for the benefit of the ESOP participants (rather than the selling shareholder). • Conflict exists because the ESOP is typically created by the company for reasons that would benefit the company.

6. ESOPs – How are they created? • Company creates a trust for benefit of company’s employees. • Corporation or corporation's shareholders sell stock to the trust. • Employees are allocated stock each year based on plan's vesting schedule. • Employee receives shares (or cash equivalent) after leaving the company.

7. ESOPs - Non-Tax Advantages • Allow owner of closely held business to sell interest. • Raise capital by selling newly issued shares. • Improve company’s cash flow because sponsor contributes company shares, rather than cash. • Provides employees with both retirement benefits and added incentives from having an ownership interest. • Trade stock for wage or other benefit concessions from employees.

8. ESOPs - Tax Advantages • Sellers of stock to ESOP can defer any capital gains tax, under certain circumstances. • Interest and principal is potentially tax deductible. • Dividends paid on ESOP shares are tax deductible when passed through directly to employees. • Participants are not subject to tax until the benefit is actually distributed, when participants often are in lower tax brackets.

9. ESOPs – Disadvantages • If newly issued shares are sold to the ESOP, the issuance of new stock dilutes the value of the existing stock. • It costs time and money to comply with complicated ESOP rules and regulations. • Legal liability for sponsor, fiduciary and trustees

10. ESOPs – Use by Private Companies • Provide a mechanism for owner of private company to sell interest. • Sell interest in company with little or no market. • Sell minority interest in company while retaining control of business. • Estate Planning Tool. • Raise Capital.

11. ESOPs – Sale of Ownership Interest • Wealth of owners of closely held business often tied up in closely held, illiquid business. • ESOPs are attractive way for owners of closely held businesses to achieve a cash flow equivalent to past salary and other perquisites. • ESOP allows a business owner to receive maximum value on the sale of a business through "tax-free" sale. • Sale may be of total interest or a minority interest only.

12. ESOPs – Estate Planning Tool • Leaving a closely held business to an untrained family is unattractive. • ESOP allows family to move into business of managing a portfolio of liquid investments rather than a business. • ESOP can be used in transitioning ownership of the business to the next generation with minimum tax cost.

13. ESOPs – Raising Capital • Company can take advantage of tax benefits of ESOP to raise capital at reduced cost. • Company can use stock to raise capital even though stock not readily traded. • Capital can be used for any business purpose.

14. ESOPs – Underwriting Issues • Determine the reason for the creation of the ESOP and any subsequent purchase transactions by ESOP. • Sale of business in its entirety may present less risk than sale of minority interest by owner seeking to retain control or capital raising transaction.

15. ESOPs – ESOP Structure • Typically, the decisions of the ESOP will be made by the ESOP committee, which is created by the company and populated by the company’s officers, directors or family members. • Trustee will typically be a directed trustee required to discharge the instructions of the ESOP committee. • Occasionally, trustee may be an independent trustee or an uninformed trustee.

16. ESOPs – ESOP Committee • Trend in the public company environment to remove executives with inside financial information of the company from the ESOP committee. • Private companies may seek to avoid the expense and loss of control associated with an independent, outside fiduciary.

17. ESOPs – Underwriting Issues • Identify the members of the ESOP committee and determine how they relate to the company or the owner. • The more incestuous the ESOP committee, the greater the risk of liability. • Determine whether any of the members of the ESOP committee have sold stock to the ESOP.

18. ESOPs – Underwriting Issues • Determine whether the trustee is a directed trustee or an independent trustee. • An independent trustee entails less risk than a directed trustee. • If a directed trustee is involved, is it a reputable, independent company or a company insider or hand-picked service provider.

19. ESOPs – Leveraged ESOP • Bank lends money to company, which in turns loans money to ESOP. • ESOP used cash to purchase company’s stock. • ESOP repays the loan by virtue of tax free contributions from company and stock dividends. • Stock used as security for the loan; As loan repaid, stock is released from suspense account and allocated to individual employee accounts.

20. ESOPs – Leveraged ESOPs • At the time the loan is made, the interest rate for the loan and the price of securities should not be such that plan assets might be drained off; and • The terms of the loan must be at least as favorable to the ESOP as the terms of a comparable loan resulting from arms-length negotiations between independent parties

21. ESOPs – Underwriting Issues • Determine whether loan between ESOP and Company is consistent with the loan rate between the Company and the commercial lender. • Determine whether the loan between the ESOP and the Company has been refinanced or whether there has been a change in terms.

22. ESOPs – Purchase of Sponsor’s Stock • The key transaction in establishing an ESOP is the purchase of stock from the company or the owner. • The ESOP can never pay more than the fair market value for the stock. • In private companies with stock that is not readily traded, there is no existing market valuation. • ESOP should obtain an independent appraisal of stock’s value.

23. ESOPs – Purchase of Sponsor’s Stock • Many ESOPs involve the sale of a minority interest by the owner of the company. • Typically owner seek to retain control of the company, but wishes to convert illiquid stock into cash. • Value of minority stock interest in a private company is very difficult to ascertain. • Owner’s interest will be to maximize stock price.

24. ESOPs – Purchase of Sponsor’s Stock • Except for company securities that are readily tradable on an established securities market, all valuations of company securities contributed to or purchased by an ESOP must be made by an independent appraiser.

25. ESOPs –Purchase of Sponsor’s Stock • Duty of prudence requires that the fiduciary conduct an independent investigation that a purchase of the company stock is fair. • Fiduciary’s reliance on experts' advice must be reasonably justified. • A fiduciary should therefore: • Retain independent expert; • Investigate expert‘s qualifications; • Provide expert with complete and accurate information; • Scrutinize expert’s conclusions.

26. ESOPs – Breach of Fiduciary Duty • Trustee breached fiduciary duty by failing to prudently investigate value of company stock purchased by the ESOP. • Trustee motivated primarily in retaining control of the ESOP sponsor. • Acquisition was based upon a selling price determined without negotiation and upon a deadline set by the selling shareholder. • Trustee violated prohibited transaction provisions of ERISA § 406 by causing ESOP to make the purchase for more than adequate consideration. Horn v. McQueen, 215 F. Supp. 2d 867 (W.D.Ky. 2002)

27. ESOPs – Breach of Fiduciary Duty • The members of an ESOP committee not fiduciaries before their appointment. • Accordingly, committee members not liable for ESOP's acquisition of company securities before the date of their appointment. • Committee members could be liable for breach of fiduciary duty by allowing ESOP assets to decline in value without undertaking investigation into the cause of the decline or possible recourse. Keach v. U.S. Trust Co., 240 F. Supp. 2d 840 (C.D. Ill. 2002)

28. ESOPs – Underwriting Issues • Determine who sold stock to the ESOP. • Obtain copy of appraisal for all stock purchases by ESOP. • Determine whether appraisal done by reputable, independent appraisal firm. • Obtain due diligence file of ESOP committee or trustee with regard to appraisal firm. • Review appraisal to evaluate whether it was thorough and supported by comparables. • Determine whether ESOP has sold stock and if so, what the sales price was.

29. ESOPs – Liability Concerns • Because an ESOP invests in the stock of the sponsoring company, if the company suffers a decline, the wisdom of the investment will be brought into question.

30. ESOPs – Underwriting Issues • Evaluating the financial health of the company could be critical. • Evaluating the company’s financial health pertains to both avoiding suits over the stock price and control issues as well as the potential inability of the Company to repurchase shares. • Obtain copies of recent annual independent valuations. • Evaluate history of ESOPs purchase of stock and Company’s history of repurchase of stock.

31. ESOPs – Issues of Economic Decline • Difficult decisions faced by fiduciaries in times of economic troubles: • Whether to support management when the company is in economic difficulty. • whether to remain invested in company securities when the company is in distress.

32. ESOPs – Issues of Economic Decline • Falling stock price may trigger suits alleging: • ESOP paid more than fair market value for the stock initially purchased. • ESOP should not have continued to buy company’s stock as price fell. • ESOP should have divested itself of company’s stock. • Fiduciaries should have voted unallocated and uninstructed shares to change management.

33. ESOPs – Issues of Economic Decline • Trustee or ESOP committee may include members of Company’s management with information they have an obligation to use to avoid ESOP’s loss in the Company stock. • Management has conflict of interest between supporting stock price and avoiding loss for ESOP.

34. ESOPs – Duty of Prudence • General presumption that an ESOP fiduciary who invested in company’s stock acted consistently with ERISA. • Plaintiff can overcome presumption by establishing that the fiduciary abused its discretion by investing in company securities.

35. ESOPs – Duty of Prudence • Investment in company securities may violate fiduciary duty requirements even where plan documents require all investments to be in company securities. • Courts have held that fiduciaries investing in stock of a failing company or fail to diversify out of company securities may violate ERISA's fiduciary duties.

36. ESOPs – Fiduciary Duty to Divest • Presumption that an investment in company securities is appropriate overcome by establishing that fiduciary abused discretion. • ESOP committee had knowledge of the company's financial decline and situation through its members who were on the company's board • Committee continued investment until stock almost worthless. • ESOP committee breached its fiduciary obligations by failing to disclose and misrepresenting pertinent information regarding the company's condition. • ESOP did not absolutely require the committee to invest exclusively in company stock without regard to the financial condition of the company. Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995)

37. ESOPs – Fiduciary Duty to Divest • ERISA could require a fiduciary to diversify ESOP assets if: • Most of the plan participants are near retirement age; • ESOP is the principal retirement vehicle for the participants; • ESOP is entirely invested in company stock; • ESOP is assumed by a company that demonstrates a bankruptcy risk. Steinman v. Hicks, 352 F.3d 1101 (7th Cir. 2003)

38. ESOPs – Fiduciary Duty to Divest • ESOP fiduciary not breach duty by failing to reduce company stock holdings during an 18-month period in which the value declined by 80%. • ESOP fiduciary presumed to have acted reasonably in following the terms of the ESOP. • Fiduciary’s awareness of company's financial problems, and failure to investigate diversification, insufficient to overcome this presumption. Kuper v. Iovenko, 66 F.3d 1447 (6th Cir. 1995)

39. ESOPs – Fiduciary Duty to Divest • No breach of fiduciary duty where trustee had no knowledge of any malfeasance within company, but, at most, learned only as events were unfolding that company's stock price and profits were declining and that company was undergoing restructuring. Lalonde v. Textron, Inc. 369 F.3d 1 C.A.1 (R.I.), May 7, 2004

40. ESOPs – Repurchase Obligation • If the securities are not readily tradable on an established market, ESOP participants must be given the right to put the securities to the company at the price determined under a fair valuation formula.

41. ESOPs – Repurchase Obligation • With private company stock, only the company or ESOP will be available to purchase participant stock. • Purchase must be for fair market value and will be based upon annual independent appraisal.

42. ESOPs – Repurchase Obligation • Fiduciary likely has duty to ensure that repurchase is for fair market value. • Fiduciary likely has duty to ensure that company can meet its repurchase obligations. • Fiduciary likely has duty to ensure that company provides adequate security for repurchase of stock over time.

43. ESOPs – Repurchase Obligation • Private companies have independent appraisals performed on an annual basis. • Private companies may also have repurchase obligation studies performed. • Private companies may also fund ESOP with cash to repurchase participant shares.

44. ESOPs – Underwriting Issues • Evaluate repurchases valuation mechanism and recently conducted repurchases. • Look for drop in repurchase price. • Determine whether repurchase obligation study conducted and if so, evaluate the same. • If no repurchase obligation study, examine repurchase liability and company’s ability to meet liability. • Evaluate source of funds for repurchases. • Examine ESOP’s cash position.

45. ESOPs – Change of Control Issues • Voting decisions taking into account non-financial factors may violate exclusive benefit rule: • continuing job security of participants; • conditions of employment; • employment opportunities; and • prospect of participants for future benefits under the plan.

46. ESOPs – Voting Allocated Shares • IRS rules require that participants and beneficiaries be entitled to direct the voting rights with respect to: • any corporate merger or consolidation, • Recapitalization or reclassification, • Liquidation or dissolution, • asset sale, • or any similar transaction but only as to securities that are allocated to the participant.

47. ESOPs – Voting Allocated Shares • DOL’s position is that trustee has responsibility to ensure that the participants are fully informed with correct information when they vote their shares. • Trustee protected if it assures that ESOP is fairly implemented, that participants have not been coerced, participants received all necessary information, and not receive any false or misleading information.

48. ESOPs – Voting Unallocated Shares • Trustee is entitled to vote all unallocated shares and uninstructed shares. • Directed trustee will vote as directed by ESOP committee, which will likely reflect the interests of management or the owners. • As an alternative, plan may provide that unallocated and undirected shares are to be voted in the same proportion as directed shares.

49. ESOPs – Voting Unallocated Shares • Voting unallocated shares strictly in accordance with allocated shares breached fiduciary duty, • Votes of current participants not reflect interests of future participants. Danaher Corp. v. Chicago Pneumatic Tool Co., 635 F. Supp. 246, 250 (S.D.N.Y. 1986)

50. ESOPs – Voting Unallocated Shares • ESOP committee, composed of a majority of management, breached fiduciary duty by abstaining from voting unallocated shares where participants voted against management. • Committee failed to conduct an independent investigation. • Committee also not obligated to implement mirrored voting and to do so would itself constitute a breach of fiduciary duty. Newton v. Van Otterloo, 756 F. Supp. 1121 (N.D. Ind. 1991)