In Walsh v. Bowers,5 a federal district court ruled that the DOL failed to prove that the sale of shares of a restricted company to an ESOP violated the fiduciary duty of ERISA and prohibited transaction rules. The DOL sued ESOP`s trustees, alleging that they had violated these ERISA rules by requiring ESOP to pay more than fair market value for the shares purchased by the plan`s promoter`s founders. However, the court sided with the trustees and, in her published opinion, Justice Mollway discussed and analyzed several important issues related to the valuation of interests in ESOP transactions. Specifically, the court considered whether management`s financial projections had been adequately reviewed by ESOP`s independent trustees, analyzed the impact of a previous third-party tender offer on the estimated value of the share, and considered whether the speed at which the sale transaction was completed indicated an inadequate escrow process. Section 401(k) plans allow employees to transfer a portion of their pre-tax salary to a mutual fund set up by the company. The company typically offers at least four alternative investment vehicles. Since the law requires that plan participation not be overly targeted at higher-paid individuals, companies typically offer partial compensation to encourage broad participation in these voluntary plans. This match can be in any investment vehicle the company chooses, including the company`s shares. There is a limit of 25% of eligible salary that the business can contribute to the plan in a tax-deductible manner. This limit is reduced by other employer contributions to defined contribution plans. Several factors favor the use of a 401(k) plan as an employee ownership vehicle in public enterprises. From a business perspective, owning stock can be one of the most cost-effective ways to double employee contributions.
If there are existing own shares or if the Company prints new shares, the contribution to the 401(k) plan cannot impose immediate cash costs on the Company; In fact, it would offer a tax deduction. Other shareholders, of course, would be diluted. If the company needs to buy shares to fund the game, at least the dollars used are used to invest in itself rather than other investments. From an employee perspective, company shares are the investment the employee knows best and can therefore be attractive to people who don`t want to spend time looking for alternatives or who strongly believe in their own business. Of course, these benefits are offset by an awareness on the part of both the employee and the company that a lack of diversification of a retirement portfolio is very risky. For narrowly managed businesses, 401(k) plans are less appealing, although in some cases they are very appropriate. When employees have the opportunity to buy shares in a company, it can often lead to securities law issues that most private companies want to avoid. Employer counterparties make more sense, but require the company to dilute ownership or buy back shares from selling shareholders. In many tightly managed businesses, the former may not be desirable for control reasons, and the latter because there may be no vendors. In addition, the 401(k) approach does not offer the “rollover” tax benefit that selling to an ESOP provides, and the maximum amount that can be paid out depends on how much employees invest in savings. This limits the amount an employer can actually buy from a seller through a 401(k) plan to a fraction of what ESOP can buy.
401(k) contributions also can`t be leveraged, so a sale of company stock would have to happen slowly in annual increments. For example, if a company can involve 60% of its workforce in a 401(k) plan and increases 5% of salary (a reasonable amount but quite high in practice), the company could offset this on a dollar-for-dollar basis, but it might only be 4% of payroll (assuming 401(k) participants tend to be paid more than non-participants). 401(k) plans and ESOPs can also be combined, using the ESOP contribution as a 401(k) counterpart. It can work on a non-leverage or leveraged basis. In the case without leverage, the company simply characterizes its match as ESOP. This adds some installation and management costs, allowing the company to take advantage of the additional tax benefits of an ESOP, such as the 1042 rollover. In a leveraged case, the company estimates how much it needs to top up employees` contributions each year, and then borrows a sum of money so that the loan repayment is close to that amount. If it is not as high as the promised counterpart amount, the company can simply define it as its match, make up the difference with additional shares or money (if the loan payment is less), or pay the loan faster.
If the amount is higher, employees get a stroke of luck. Combination plans must follow complex testing rules to determine if they are too discriminatory in favor of higher-paid people. Despite the advantages of 401(k) plans as an owner`s vehicle, there are also significant drawbacks. These plans are intended to be diversified pension plans and therefore do not provide the same fiduciary protection for trustees and boards of directors as ESOPs. A high concentration of employer actions in a 401(k) plan is harder to defend in court, and more than 100 class action lawsuits have been filed over the past decade for company actions in the plans. The result has been that companies and employees are moving away from employer actions as a primary asset in 401(k) plans. In addition, the law now requires that employees of public companies can withdraw their 401(k) holdings of company stock at any time if they have used their own money to purchase shares, or at any time after three years for shares contributed by the employer. Voting rights are more complicated than they seem.
First, voting is not the same as offering shares. Thus, while employees may have to vote on all matters, they may not have a say in the filing of shares. This is a big problem in state-owned enterprises. Almost all SOEs are currently drafting their plans to give workers the right to direct the tender and the right to vote on their shares, for the reasons explained below. Second, employees do not need to be able to vote on unallocated shares. In a leveraged ESOP, this means that in the early years of the loan, the trustee can vote on the majority of the shares if the company so wishes. The Corporation may provide that the unallocated shares, as well as all the shares allotted for which the trustee has not received instructions, will be reconciled or tendered proportionately to the shares allotted for which instructions have been received. All of this means that for almost all ESOP companies, governance isn`t really an issue unless they want to. If companies want employees to play any role in corporate governance, they can; If they want to go beyond that, they can.
In practice, companies that assign a critical governance role to their employees find that this does not lead to radical changes in the way the company is run. An employee who receives an ISO does not earn any income by receiving or exercising it. Instead, the employee is taxed on the sale of shares acquired under ISO. A sale of ISO shares generally refers to any sale, exchange, gift or transfer of legal title to shares. The tax treatment of the sale of option shares depends on whether the share was sold in a qualifying sale during the legal holding period for ISO shares. The legal holding period of the ISO is two years from the date of granting the ISO to the employee or one year from the date on which the shares were transferred to the employee during the financial year. However, if the ISO is exercised more than three months after the departure of the employee from the company granting the option, there is no favourable tax treatment.