For every negative story that those management team members had heard about ESOPs, there are a dozen success stories that they hadn't heard.  That being said, any company purchasing an entity with an ESOP should proceed with caution and consider the following:

1. The nature of an ESOP

First, it is important to remember what makes an ESOP unique.  An ESOP, unlike all other types of defined contribution plans, is designed to invest primarily in securities of the sponsoring company.  Instead of participants having retirement accounts invested in a variety of marketable securities and mutual funds, ESOP participants have accounts invested primarily in their employers' stock.

For a company that is owned, in part, by an ESOP, the trustee of the ESOP is essentially a shareholder of the company, entitled to participate in the sale or transaction just as other shareholders would. The trustee represents ESOP participants as the beneficial owners of the company stock.

Second, while there are many legal requirements unique to ESOPs, perhaps the most important rule is that anytime the ESOP is involved in the purchase or sale of company stock, the purchase or sale must be for "adequate consideration," and the trustee's decision to buy or sell must in the best interest of the ESOP participants from a financial point of view.

As discussed below, this point is critical when discussing the involvement of an independent trustee or during any review by the U.S. Department of Labor (DOL).

2. Stock or asset purchase

The form of the transaction, whether a stock or asset purchase, is the first issue to consider in determining the ESOP's involvement in the impending transaction, as well as what type of liability the buyer may be assuming relative to the ESOP.

If the transaction is structured as an asset purchase and such purchase involves substantially all of the company's assets, then the selling company's ESOP is required by applicable provisions of the Internal Revenue Code to pass-through the voting rights on the transaction to the individual participants in the ESOP.

If voting rights are passed through, then the fate of the transaction may lie with how participants decide to vote (depending upon the number of shares owned by the ESOP). Therefore, communication to ESOP participants is key, including delivery of objective proxy material.

Regarding liability, although the buyer in an asset deal typically does not have successor liability related to the seller's ESOP, it is in the best interest of buyer to ensure that all applicable rules related to the ESOP's involvement in the deal are followed.  The reasons are that the buyer may be taking on some or all of seller's employees and therefore has an interest in ensuring these employees were treated fairly in the deal; and, if the transaction is ever scrutinized by the DOL, the buyer will likely be involved in any investigation.

If the transaction is structured as a stock sale and seller is a private company, then (unless the ESOP document provides otherwise) the ESOP trustee (not the participants) retains the right to decide whether the ESOP will agree to participate in the sale.  In terms of liability, buyer will likely have some exposure related to the ESOP in the case of a stock sale, irrespective of whether the ESOP is terminated concurrently with the closing or whether it continues to exist post-close for a period of time.  Often times, the selling company has agreed to indemnify ESOP fiduciaries for any liability they may incur related to the ESOP, and that indemnification obligation flows to the buyer in a stock deal.

3. Independent trustee and appraiser involvement

After deciding on the form of the transaction, perhaps the most important next step is determining whether an independent trustee will be appointed to represent the ESOP's interest in the transaction.

This applies to situations where the current ESOP trustee is an insider (i.e., employee, officer or owner) of the selling company.  For an insider trustee, particularly one who is also an owner of the selling company, it is often difficult to prove that he or she acted solely in the interest of ESOP participants when deciding to enter into the transaction, which is required as part of the trustee's fiduciary duties.

Being able to prove trustee independence is critical if the transaction is ever scrutinized by the DOL, which has certainly increased its review of transactions involving ESOPs in recent years.  In general, it is recommended that an independent trustee be involved and be brought in early in the process.  Fortunately, there are a number of qualified independent trustees and trust companies that will agree to be hired specifically and solely as transactional trustees.  In order to prove independent trustee involvement if ever questioned by the DOL, the record should show significant involvement by the trustee in negotiating the terms of the deal relative to the ESOP.

After an independent trustee is retained, the next step is for the independent trustee to hire a qualified independent appraiser.  As stated above, the trustee not only has a duty to prove independence in the transaction, but the trustee also has to be able to show that the consideration being paid to the ESOP in the transaction is "adequate consideration" and fair to the ESOP participants from a financial point of view.  The concept of adequate consideration is rooted in the prohibited transaction rules, one of which prohibits the sale of stock between a qualified plan and the sponsoring employer, unless the sale is for "adequate consideration."  In order to prove independence and adequate consideration, a qualified independent appraiser should be appointed to issue a valuation and fairness opinion.

4. Redemption or participation

The next important decision is deciding whether the shares of company stock held by the ESOP will be sold back to or "redeemed" by the selling company prior to the transaction or whether the ESOP will participate in the actual sale.

In most cases, the ESOP will participate in the sale and be a party to the purchase agreement; but, there may be situations where a redemption makes sense, for example where the ESOP owns a small minority of the selling company's stock or where the stock is subject to a "redemption" right per its terms.

In the case of a redemption, the selling company and the ESOP trustee negotiate separately for the ESOP to sell back to the company all the company shares held by the ESOP.  This type of sale would occur immediately prior to closing of the main transaction.

In the case of a redemption, participants are not entitled by law to a pass-through vote, and the ESOP trustee will not be directly involved with negotiating the terms of the main transaction.  However, even though a redemption is separate from the main transaction, the same rules regarding trustee independence and adequate consideration discussed above apply. The ESOP trustee will consider the financial details of the main transaction (e.g., transaction bonuses, deal expenses and the ultimate per-share price to shareholders) in determining whether the redemption terms proposed by the company are fair to the ESOP participants from a financial point of view, and a fairness opinion will be required.

If, on the other hand, the ESOP will participate in the main transaction, then the ESOP trustee will be directly involved with negotiating and approving the terms of the purchase agreement. This presents its own challenges as the ESOP trustee may request that certain provisions of the purchase agreement apply differently to the ESOP than to other selling shareholders. For example, the ESOP trustee will likely not agree to joint and several indemnification liability and may push back against a prolonged escrow.  While the ESOP should not be jointly liable with other shareholders for breach of the representations and warranties, many have gotten comfortable with the ESOP participating in an escrow that lasts up to two years, even in cases where the ESOP is being officially terminated in connection with or shortly after the transaction close.

5. Exposure for prior ESOP transactions

As a result of the prohibited transaction rules and DOL scrutiny mentioned above, careful due diligence should be undertaken in order to assess any liability for prior transactions involving the ESOP, particularly transactions in which the ESOP purchased stock from the selling company or a company shareholder.

If any aspects of the prior transactions reveal a lack of procedural prudence or adherence to the rules regarding trustee independence and adequate consideration, then buyer should consider asking the selling company for specific indemnity to cover any risk to buyer.

While the thought of purchase an entity with an ESOP may cause initial concern, proper planning, disclosure and due diligence should allow the transaction to proceed successfully.

Douglas W. Dahl II is a member at Bass, Berry & Sims PLC.  He regularly advises both public and private companies on employee benefit issues that arise during and following various corporate transactions and events, such as mergers, acquisitions, dispositions and bankruptcies. He can be reached at [email protected].