July 19, 2002

ESOP's Fables: Lessons in Selling an ESOP-Owned Company

The authors are partners in the law firm of Faegre & Benson, LLP. Faegre & Benson has represented sellers, buyers, and trustees in over a dozen transactions involving ESOPs with an aggregate value in excess of $7.5 billion.

Aesop told a fable of the fox that lost its tail in a trap. The fox sought to convince other foxes to dispense with their tails, claiming that the tail was a nuisance. Ultimately, the fox's efforts were thwarted by a wiser fox that questioned whether its motivation was borne from true belief or insecurity. The moral of this fable: distrust interested advice.

An employee stock ownership plan (or ESOP) is a tax-deferred mechanism to issue an interest in stock of a company to its employees. The purpose of the ESOP is to engender a sense of ownership in the employees and reward them commensurate with the company's performance. Typically, a company will issue stock to a trust owned by employees participating in the ESOP. The employee stock ownership plan sets forth who governs the trust, whether it is an independent trustee, a committee of the board, or, in certain circumstances, the participants. Upon termination of employment, the employee can usually sell its interest back to the trust, and either keep the proceeds (net of applicable taxes) or roll the proceeds over into another qualified, tax-deferred investment.

However, the presence of an ESOP adds additional levels of complexity when it comes to selling the company. The reference to Aesop's fable is not just a bad pun: the unifying theme of the complexities that arise is the need to treat the trust as an independent entity with its own fiduciary responsibilities and legal requirements (particularly under the Employee Retirement Income Security Act or ERISA). This article describes some of the unique issues that arise in the sale of an ESOP company.

When contemplating a sale of the company, the board of directors must become familiar with the terms of the plan, and in particular, the governance of the trust and the rights of its participants. For example, if the trust holds shares of voting stock, the plan will set forth whether the shares can be voted by the committee or trustee administering the ESOP or the participants. In addition, the trust may hold shares that have not been allocated to any particular participant, and the plan will set forth who, if anyone, is entitled to vote these unallocated shares. Typically, shareholders are entitled to vote on corporate actions such as the election of directors and amendments to the company's charter documents. In addition, shareholders are entitled to vote on—or in the case of a noncompulsory stock sale, determine whether to sell their shares in—a sale of the company. Consequently, the board must address the fundamental question "who votes the shares?"

First, ESOPs often have hundreds if not thousands of participants. If the participants have the right to vote the shares (known as "pass-through voting"), the company should view each participant as a shareholder. While it may be acceptable to manage the day-to-day affairs of a private company as a closely-held business, when considering a sale (or any significant transaction), the board should treat the company as a quasi-public entity.

Second, under federal and state securities laws, the amount and format of the information that the company is required to provide to its shareholders in connection with a sale of the company depends, in large part, on the number and financial sophistication of the shareholders. Literally, the trust is the owner of the shares, and it is likely that a trust with a sophisticated institutional trustee would be entitled to a lesser level of informational disclosure with respect to the sale than the average employee-shareholder. However, if the plan provides for pass-through voting, then the participants make an "investment decision"—the decision to sell or not to sell the company. In these circumstances, the company should not rely on the status of the trust in determining its disclosure requirements, and should instead look at the demographics of the participants. Often, this will lead to the conclusion that the company should provide the participants with the level of information typically seen in a proxy statement for a public or widely-held company.

Third, as with any company, the board of directors must attempt to maximize shareholder value. In considering a significant transaction such as a sale of the company, the board should consider all viable alternatives as well, including a public offering of securities or doing nothing at all. If a sale of the company is likely to create the best value for the shareholders, the board should evaluate proposals from a variety of suitors. Since value is in the eye of the beholder, the issue of maximizing value is a challenging one. One need look no further than the HP-Compaq merger to find an example of a board that believed that it was maximizing value, but only about fifty-one percent of the shareholders agreed. While HP and Compaq declared victory in obtaining shareholder approval of the merger, a board should not embark on such a Pyrrhic exercise blindly. In evaluating a transaction, a board needs to consider the likelihood that it will be approved by the shareholders and the possibility of dissent, and the determination of who is entitled to vote is fundamental to that evaluation.

On the topic of maximizing value, a board should also evaluate whether the taxability of the sale of the company is a material factor. Assuming that a seller and buyer have the flexibility to structure a sale as a tax-free reorganization, a lower offer on a tax-free basis may be more compelling to the seller than a significantly higher offer in a taxable transaction. However, if the proceeds of the sale are to be rolled over into another tax-deferred investment, the taxability of the transaction may not be relevant. This issue grows particularly complex where an ESOP trust owns less than all of the stock of the company—while the value to the trust may be maximized by accepting the highest offer regardless of the taxability of the transaction, the value to the other shareholders may be maximized by accepting the lower, tax-free offer. In this situation, the board must consider which deal will benefit the greatest number of shareholders the most.

Finally, under state law, the trustee or committee administering the trust, or in the case of pass-through voting, the participants, may have the right to exercise appraisal rights (also called dissenter's rights)—the right to sell shares to the company at a judicially determined fair value rather than receiving the price paid per share in the sale the company. Under many states' laws, the company is required to give notice to shareholders of their right to dissent prior to the shareholder vote on the sale of the company, and if notice is provided, the shareholders who wish to dissent must notify the company prior to the shareholder vote. If the company fails to give notice, the period of time during which the shareholders may exercise their appraisal rights is significantly extended.

As these examples illustrate, an ESOP creates a number of important issues to consider in significant transactions from the company's and the ESOP participants' perspectives. Further, the best interests of the ESOP participants may not coincide with the best interests of the other shareholders. Consequently, the board should not make decisions on behalf of the ESOP and the ESOP should not rely on the advice of the board. As a first step, if the ESOP is administered by a committee of the board, the board should appoint an independent trustee (such as a commercial trust department) to act on behalf of the trust. The independent trustee should select independent legal counsel and financial advisors to review the transaction. While the board should consider obtaining a fairness opinion from financial advisors that concludes that the purchase price is fair, the trustee or committee administering the trust should consider an independent valuation opinion to satisfy its obligations under ERISA, which is typically more precise than a fairness opinion.

In negotiating the sale of the company, the board should also consider a few other practical considerations. Often, significant shareholders are required to make representations and warranties to, and agree to indemnify, the buyer in connection with the sale of the company. ESOP trusts typically will not or cannot provide such assurances. Consequently, transaction structures typically include the escrow of a portion of the purchase price. Further, a typical sale negotiation involves the company, the buyer, and often one or more significant shareholders of the company. Because the ESOP's interests may not align with the interests of the company or the other shareholders, the presence of an ESOP adds another significant party to the negotiating mix, which can increase the time and expense of the transaction. Further, a heightened level of disclosure warranted by pass-through voting will also increase transaction time and expense.

Finally, the board should consider the impact, both psychological and financial, on the company's employees. The sense of ownership that the ESOP is designed to inspire continues through the sale of the company. While an employee with no equity interest in the company may be concerned with the prospects of continued employment after the sale, the employee that participates in an ESOP may also be concerned with the terms of the sale. Accordingly, it is important to develop a communication strategy with employees early on that addresses these concerns and is consistent with the company's confidentiality obligations to the buyer.


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