Buyers (including private equity firms and their investors) that acquire the stock of a company wholly or partially owned by an employee stock ownership plan (ESOP) face a unique set of post-closing challenges. After closing, the target company (now under the buyer’s ownership) will continue to be responsible for the ESOP until it is fully wound-up and liquidated, which is a process that continues well beyond the transaction closing date and the ESOP’s formal plan termination date. To ensure a smooth transition and avoid unexpected liabilities, buyers should understand the key post-closing ESOP expenses that will arise when terminating an ESOP, and other legal and practical considerations when winding-down an ESOP and take deliberate steps during diligence and transaction structuring to prepare for these issues.
In our previous article, we discussed the practical considerations for a private equity buyer contemplating an acquisition of an ESOP-owned company. This article continues that discussion with a focus on post-closing considerations when acquiring an ESOP-owned company.
Winding-down an ESOP is not as simple as flipping a switch. Even if 100% of the stock is purchased in the transaction and the ESOP is terminated with the closing of the transaction, the ESOP remains active until it is formally liquidated and all assets in the ESOP trust are distributed to participants. Below is an overview of some typical ESOP wind-down action items and considerations that a buyer should be aware of when purchasing a previously ESOP-owned company. Each one of these action items requires the assistance of experienced ERISA legal counsel, TPAs (third-party administrators) and other compliance consultants who regularly work with ESOPs Buyers will be better positioned following the transaction if they engage with counsel on these items as early as possible during the transaction process.
- ESOP Termination Amendment. In most transactions involving an ESOP-owned company, the ESOP will terminate in connection with closing. The ESOP plan sponsor should adopt resolutions to amend and terminate the ESOP plan document. The ESOP is usually amended to freeze eligibility as of the termination date, eliminate the participants’ ability to invest in employer stock, and remove the option to receive distributions from the ESOP trust in the form of employer stock. In sum, the ESOP is converted from an ESOP structure to a general tax-qualified profit-sharing plan structure, without any continued investment in employer stock. In addition, if the ESOP has any outstanding exempt ESOP loans (i.e., a leveraged ESOP), the company should facilitate repayment of the ESOP loans in connection with closing and amend the ESOP to address the allocation of stock in the ESOP’s suspense account.
- Final Participant Distributions. After the deal closes, the ESOP trust will receive cash sale proceeds that must be allocated and timely distributed to ESOP participants. Buyers and their ESOP counsel and advisors will oversee the process of calculating ESOP account balances and allocating sale proceeds per the ESOP plan document (as amended in connection with closing). Plan distributions will require proper tax reporting and withholding. This process can stretch across months — or even years — depending on how the ESOP plan document is structured, whether the ESOP was subject to any escrows or earnouts under the sale transaction documents, and whether a determination letter application was filed with the Internal Revenue Service (IRS) in connection with the plan’s termination. It is common for an ESOP to distribute the majority of the cash proceeds it receives in the transaction shortly (though in some cases, months) after closing and additional distributions upon certain events, such as the end of the escrow period or after receiving a favorable IRS determination letter. The ESOP will need to provide legally required notices and communications to plan participants to allow participants to make proper distribution elections, and the ESOP will need to have appropriate systems in place to make these necessary distributions. Missteps in the distribution process can trigger participant complaints or even legal action.
- ESOP Trustee. In most transactions involving an ESOP-owned company, the seller will appoint an independent trustee whose engagement is limited to the transaction. Post-closing, seller and buyer often retain the independent trustee as a directed trustee who oversees the ESOP wind-down process. The trustee charges fees for its services and the services of its legal counsel and third-party financial advisors. If the trustee has fiduciary concerns — such as disputes over valuation or payout timing — those costs can escalate quickly. Some or all of these trustee expenses may be paid by the ESOP as expenses related to ongoing plan administration; however, each expense should be carefully reviewed prior to charging the ESOP to avoid a prohibited transaction under ERISA. In addition, the trustee and any other independent fiduciaries are usually indemnified by the ESOP-owned company and/or buyer for any liabilities stemming from their engagement.
- Final Form 5500. The ESOP must continue to file annual Forms 5500 for each year (or partial year) that it holds assets in the ESOP trust. Even if the ESOP trust is fully liquidated early in a calendar year, a Form 5500 is still required. In addition, ERISA requires annual plan audits for companies with 100 or more participants. Third-party administrator Form 5500 preparation fees and plan auditor fees are often overlooked in deal modeling, but some or all of these fees may also be paid by the ESOP trust as plan administration expenses.
- IRS Determination Letter. It is common for buyers and ESOP trustees to require sellers to obtain an IRS determination letter in connection with the ESOP’s termination. A favorable IRS determination letter provides the parties with greater assurance that the ESOP plan document meets the qualification requirements under the Internal Revenue Code. Trustees typically require that a portion of the purchase price proceeds remain in the ESOP until the IRS has issued a favorable determination letter holding that the termination of the ESOP does not adversely affect the ESOP’s status as a tax-qualified retirement plan. After filing an IRS determination letter, the IRS frequently inquires about certain ESOP plan provisions and may issue a favorable determination letter that is conditioned on the plan sponsor adopting certain amendments to the ESOP plan document. The IRS determination letter application and responses to IRS inquiries adds additional post-closing costs, and it may take the parties more than one year after the transaction closes to receive a favorable IRS determination letter.
To address the costs associated with the ESOP wind-down process, buyers should negotiate a dedicated escrow or reserve specifically for ESOP wind-down costs. This should be based on:
- Estimated distributions and participant counts;
- Projected legal, fiduciary and administrative costs (e.g., cost to administer participant distribution elections, obtain fiduciary tail policies, and seek an IRS determination letter); and
- Potential audit and compliance expenses, including any expenses related to operational or other compliance issues for the plan.
This reserve gives the buyer some financial protection to address costs or expenses that may come up following the closing of the transaction and a clear path to seek reimbursement for costs incurred by the buyer post-closing. Further, including generic indemnity language in the purchase agreement is not enough when allocating indemnity responsibilities between the buyer/company and the trust.. Buyers should negotiate clear provisions that cover ESOP administration and compliance costs, errors in distributions or allocations, fiduciary claims from participants or regulators, legal and consulting fees incurred, and, when possible, set longer survival periods for ESOP-related indemnities, as claims can take time to emerge.
Moreover, and in addition to any specific escrow or reserve, a buyer should push for the ESOP to include authorizing plan provisions and the trustee to contractually agree under the purchase agreement to pay for additional post-closing administrative wind-up expenses to the extent permitted by ERISA from the ESOP trust. These administrative expenses can include costs related to completing many of the administration issues described in this article, like the IRS determination letter application, Form 5500 preparation and third-party administration costs.
When targeting an acquisition of an ESOP-owned company, general M&A counsel may not spot all ESOP-specific issues. Buyers should involve specialized ESOP legal counsel and advisors during diligence to:
- Review the ESOP plan and related documents, and assess historical compliance risks;
- Assess potential liabilities or disputes;
- Estimate wind-down costs with greater accuracy; and
- Draft or review plan termination and escrow documentation.
Early involvement of specialists often pays dividends in smoother transitions and fewer surprises after closing.
Conclusion
Acquiring the stock of an ESOP-owned company often offers a buyer compelling value, but buyers must tread carefully when it comes to post-closing plan wind-down to ensure the process is handled efficiently and in compliance with various legal and plan requirements. By understanding the full scope of ESOP-related expenses and action items required to completely wind-down the plan and proactively managing termination and transition responsibilities, buyers can protect themselves from unexpected costs and legal exposure. As with any complex structure, diligence and deal structuring are everything — especially when the ESOP exits the stage, but its shadow remains.
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