There is a very high probability an ESOP will be leveraged during its lifecycle. When this leveraging occurs and the ESOP takes on debt to acquire company stock, a number of legal documents are drafted to record the terms of the transaction and the requirements of the involved parties. As the Plan Sponsor or Trustee of an ESOP, it is important to understand the reason these documents exist and the differences between ESOP internal loans versus external loans.
Internal vs. External
Many leveraged ESOP transactions involve both internal loan documents and external loan documents. The internal loan will be between the ESOP Trustee, on behalf of the ESOP Trust, and the company. The external loan is between the company and the selling shareholder in seller financed transactions and between the company and a financial lender, such as a bank, in externally financed transactions.
Having separate loan transaction documents allows the Plan Sponsor more repayment and refinancing flexibility. For example, a Plan Sponsor can change the term of the internal loan to assist in releasing a desired number of shares to the plan participants at the company’s desired benefit level. In addition, the company can have a much shorter loan term on the external loan in order to remove debt from the company’s books and, in a seller financed transaction, pay off a selling shareholder without impacting the share allocation in the ESOP. It is common, for example, to see internal ESOP loans with terms of 15 to 30 years while external loans have terms of 5 to 7 years.
For accounting purposes, external debt is recorded on the company’s balance sheet as a liability. As a result, many companies have a goal to get the external loan paid off as quickly as possible. The internal ESOP loan is recorded as a contra-equity account on the balance sheet, with adjustments being made to the account as the shares purchased with the ESOP loan are released and allocated to the plan participants in the ESOP.
Transaction Documents
Common documents that will be drafted as part of the ESOP leveraged transaction include the ESOP Loan Agreement, ESOP Stock Purchase Agreement, ESOP Stock Pledge Agreement, and an ESOP Promissory Note. There are various ways to structure these transactions. The following illustrates one common way of drafting these legal documents in a seller funded transaction.
The ESOP Loan Agreement is a contract between the selling shareholder, the Plan Sponsor, and the Trustee of the ESOP. The loan agreement will state that the selling shareholder has agreed to sell and the ESOP Trustee has agreed to purchase a certain number of shares of company stock at a specified purchase price. To facilitate the transaction in this example, the seller will lend funds to the ESOP Trust to facilitate the purchase of the company stock. The seller and Trustee agree to assign this loan to the company and the company will then have a loan to the ESOP. This two-step process creates the external loan between the seller and the Plan Sponsor and the internal loan between the company and the ESOP as described above.
The ESOP Stock Purchase Agreement is the legal contract between the seller and the Trustee of the ESOP on behalf of the ESOP Trust. The document is the agreement of the sale of the stock by the seller and the purchase of the stock by the ESOP Trust. It will include the number of shares being sold, the purchase price paid by the ESOP Trust, and the time and place of the closing. In addition, the document will contain detailed representation and warranties.
The ESOP Stock Pledge Agreement pledges the stock purchased by the ESOP Trust in the leveraged transaction as collateral for the debt it owes to the Plan Sponsor. As payments are made on the ESOP internal loan, shares are released from the collateral pledge and the administrative loan suspense account and allocated to ESOP participants. Loan payments by the ESOP Trust can be made using ongoing contributions made to the plan by the company, earnings attributable to the contributions, or dividends or distributions attributable to the shares acquired using the proceeds of the loan being repaid. The pledge agreement will indicate how the shares are released from the collateral suspense account.
The share release formula can be either of two formulas, as defined in Treasury Regulations Sec. 54.4975-7(b)(8):
- General rule (Principal and Interest Method)
- Special rule (Principal Only Method)
The General rule share release formula is based on principal and interest payments made on the ESOP loan and is calculated as follows:
(principal and interest paid for the year) / (principal and interest paid for the year + principal and interest to be paid for all future years) * shares in suspense
The Special rule share release formula is based solely on principal payments made on the ESOP loan and is calculated as follows:
(principal paid for the year) / (principal paid for the year + principal to be paid for all future years) * shares in suspense
As noted in the Treasury Regulations, if the Special rule is to be used to calculate the share release, three additional rules must be followed:
- The loan must provide for annual payments of principal and interest at a cumulative rate that is not less rapid at any time than level annual payments of such amounts for 10 years.
- Interest included in any payment is disregarded only to the extent that it would be determined to be interest under standard loan amortization tables.
- The term of the loan cannot exceed 10 years (including any renewal, extension, or refinancing)
The ESOP Promissory Note identifies the repayment schedule for the internal ESOP debt. Key sections in the document include the date of the loan transaction, the dollar amount of the loan, the interest rate, the frequency and number of loan payments to be made, and the application of prepayments on the note.
From a plan administration standpoint, a particularly important provision in the promissory note is the prepayment provision, as prepayments will impact the share release to plan participants. The note will state prepayments are first used to pay any interest due on the ESOP Note. The remaining prepayment will then be applied to the principal balance on the loan either in “order of maturity” or the “inverse order of maturity”. The order of maturity provision reduces the subsequent principal loan payments needed to maintain the term length of the original ESOP note. The inverse order of maturity provision will keep subsequent loan payments in line with the original ESOP Note. It is more common to see loan documents drafted with the inverse order of maturity for loan payments, which will shorten the term of the loan.
The release of shares from the ESOP internal loan will drive the benefit levels allocated to the ESOP plan participants. Careful consideration should be given when drafting these documents to align the terms of the loan documents with the company’s goals of the retirement benefits being provided to their ESOP plan participants.
