Since 1985, Krieg DeVault’s ESOP Practice Group (the “Practice Group”), which is part of the Firm’s Employee Benefits and Executive Compensation Practice Group (“ERISA Practice Group”), has structured over 125 ESOP transactions throughout the United States for public and private companies. The transactions range in size to approximately $175 Million.

What is an ESOP?

Why ESOPs?

The growth in employee stock ownership plans over the past few years has been explosive. ESOPs have always been popular in some areas because of their powerful tax advantages. For example, a sale to an ESOP may allow the seller of stock to defer all of the gain on the sale, provided that he or she reinvests the sale proceeds in “qualified replacement property” (basically, debt or equity securities of any U.S. operating company). The use of an ESOP may allow a corporation to deduct dividends paid to the ESOP. An ESOP can also be used as a tool of corporate finance, allowing the corporation to deduct debt service on corporate borrowings.

Recently, ESOPs received a major boost through the change in the Internal Revenue Code allowing ESOPs to be a shareholder of an S corporation. Basically, all of the income of the corporation that is allocated to the ESOP as an S corporation shareholder is not taxed, a powerful economic advantage. For example, if the ESOP owns 100% of the stock of an S corporation, none of the income of the corporation is subject to income tax.

These tax advantages, and the fact that more and more corporations are becoming aware of the possibilities of using an ESOP to achieve both shareholder and corporate objectives, have resulted in a larger number of employers implementing ESOPs.

Why Should Your Firm Be Interested In ESOPs?

ESOPs can be used in a number of situations to satisfy a client's needs. A typical fact pattern we see involves a small- to medium-sized business whose owner is ready to retire. One of the exit strategies that can be used is to sell stock to the ESOP. If the corporation is a C corporation (or revokes its S corporation election), as noted above, the sale of the stock can result in a deferral of gain for the selling shareholder. The debt incurred to pay the selling shareholder can be written off through tax deductible contributions to the ESOP. Finally, the corporation can elect S corporation status to shield the income allocated to the ESOP from current taxation.

Another use of an ESOPs is strictly as a corporate financing vehicle. The corporation borrows money, loans it to the ESOP, and the ESOP uses the proceeds to purchase additional shares of stock of the corporation. The loan is then written off over a period of time through contributions to the ESOP.

A final note is that your firm can continue to represent your client throughout the transaction. Krieg DeVault can act as special ESOP counsel representing the trustee and the ESOP fiduciaries, and work cooperatively with your firm to accomplish the transaction. After the transaction is closed, you continue to represent the client, and we as ESOP counsel only become involved if there is an issue that needs to be addressed.

Experience Dealing With Highly Regulated Industries

The Practice Group has extensive experience dealing with highly regulated industries, including financial institutions, insurance companies, accounting firms and healthcare firms. In fact, our group has structured the following three “firsts” in the area of ESOPs sponsored by regulated employers:

• The First ESOP to be Recognized as a Registered Bank Holding Company. In 1985, our ESOP Practice Group structured the Horizon Bancorp ESOP. In this transaction, the Board of Governors of the Federal Reserve approved, for the first time, an ESOP’s acquisition of more than 25 percent of the outstanding stock of a registered bank holding company. This required, in turn, the approval of the ESOP’s application for approval to become a “registered bank holding company.” The transaction involved 17 shareholders selling 31 percent, in the aggregate, of Horizon Bancorp’s outstanding stock to the ESOP in a leveraged transaction which qualified for tax deferral under Section 1042 of the Internal Revenue Code (“Code”).
• The First Accounting Firm to be Owned by an ESOP. In 2001, we structured the repurchase, from H&R Block, using solely the employer’s qualified plan assets (based on participants’ elections), of 100 percent of the stock of a large accounting firm. The structure involved the organization, due to state licensure laws, of a new accounting partnership and a management/consulting company; the latter corporation is the ESOP sponsor. At a recent meeting with the Treasury to discuss the transaction, the Treasury representative described the structure as “ . . . a poster child for how to structure an S corporation ESOP management company.”
• The First Optometry Firm to be Owned by an ESOP. In 2002, we structured the first ESOP to be sponsored by an optometry firm, the largest optometry practice in the Rocky Mountain Area. The transaction was structured in a manner which was similar to the structure developed for the accounting firm, as described above.

In addition to the transactions described above, the Practice Group has structured numerous leveraged and non-leveraged transactions for financial institutions subject to regulation by federal and state agencies, including tender offers, a “floor-offset” arrangement where the ESOP is the “offset” plan, acquisitions requiring prior approval of the Federal Reserve under the Bank Holding Company Act or prior notice under the Change in Bank Control Act, ESOP “spin-offs,” and “dividend switchback” arrangements coupled with dividend pass-through or reinvestment features.

Middle Market Private Company Experience

The majority of our ESOP transactions involve middle market companies. Industries represented include manufacturing, insurance, retail, commodities brokerage, wholesale, transportation, privately owned utilities, custom machinery design and manufacturing, biotechnical, equipment leasing, forestry products, commercial and residential construction and consulting services. Substantially all transactions have been leveraged. In many instances, the selling shareholders qualified for gain deferral under Section 1042 of the Code.

Our S Corporation ESOP Practice and Liberty Enterprises

In 1996, we were selected, through a process in which we competed with nationally-recognized ESOP practitioners, to structure an ESOP for Liberty Enterprises – which was (and still is) an S corporation. At that time we were retained, we advised Liberty that the Code did not allow S corporations to sponsor ESOPs. Liberty engaged us to change the applicable law to enable the company to implement an ESOP. Our ESOP Practice Group, together with a Washington, D.C.-based lobbying firm, literally re-wrote the provisions of the Code and ERISA necessary to enable S corporations to sponsor ESOPs. In the wake of the enabling legislation, we were also directly involved in the formation of Employee-Owned S Corporations of America (“ESCA”) – a lobbying group consisting of S corporation ESOP sponsors and their service providers. As a member of ESCA’s Advisory Board, Steve Smith, with the assistance of Paul Lindemann, was directly involved in drafting the 2001 “anti-abuse” legislation that became new Section 409(p) of the Code. Mr. Smith continues to serve on ESCA’s Advisory Board and is actively involved with Treasury in drafting new S corporation ESOP regulations. The regulations will be designed to shut down the abusive management company S corporation ESOP structures that have recently appeared.

Deal Experience

As noted above, the ESOP Practice Group has participated in over 100 ESOP transactions throughout the United States. In all but a few (less than ten), we have been responsible for structuring the transaction.

• Our Approach to Deals. As noted below, in most transactions, we are not the “regular” counsel to the ESOP sponsor. Rather, we are retained as special ESOP counsel to the plan sponsor, counsel to the ESOP committee or counsel to the ESOP trustee. In all cases, we are sensitive to the historical role of corporate counsel and make every effort to approach transactions on a “team-oriented” basis with the objective of all service providers working as a team to achieve a common objective.
  
  In most transactions, we act as “quarterback.” In this role, we hold weekly “all hands” telephone conferences based on an “actions and timelines” document with a view towards insuring that all service providers are on task and complete their work on a timely basis. However, we are pleased to perform services as a team member in cases where another service provider acts as quarterback.
• Nature of Transactions. In the early years of the practice, the ESOP Practice Group usually represented the Firm’s client as the plan sponsor. As the ESOP practice grew and expanded geographically, we have come to primarily represent the ESOP fiduciaries.
  
  The size of our ESOP transactions range from $500,000 to $175 Million.

In addition to the first-of-their-kind transactions described above, the Practice Group has structured the following types of transactions:

• Leveraged acquisitions, by ESOPs, sponsored by public and private companies, of blocks of stock owned by venture capital firms, including Citigroup and Norwest Equity Partners.
• Use of existing qualified plan assets to purchase employer securities, based on employee investment directions to ESOP trustees, with “floor price protection.” These transactions also involved the preparation of offering-type disclosure documents for employees.
• Use of dividend-payable convertible preferred and “super common” stock.
• Use of subordinated debt.
• Spin-offs and split-ups of corporations followed by leveraged ESOP acquisitions of the “new” or “old” corporations.
• Mergers of multiple plans, followed by leveraged ESOP transactions.
• “ESOP II” transactions with “price protection” for “ESOP I” shares.
• “Rebalancing” of “lopsided” ESOPs.
• “Unitization” of company stock and “liquidity” funds.
• Use of ESOPs to acquire target corporations. See “Use of an ESOP as an Acquisition Vehicle” included with the Firm Materials Package referred to below.
• Multi-investor leveraged ESOP transactions, including management and/or equity partner transactions involving financial fairness issues associated with the allocation of equity.
• Numerous purchases by, and sales of, companies which sponsor leveraged and non-leveraged ESOPs to public and private companies, including the disposition of target companies’ ESOPs.
• Multi-seller Section 1042 transactions.
• Use of ESOP “prefunds.”

The principal reason our ESOP practice has grown and prospered is the level of the Practice Group’s initial and ongoing client support. We visit our ESOP clients at least once per year and, for many of them, host an annual “ESOP Summit.” Our ESOP Summits are attended by all service providers (trustee, financial advisor, corporate counsel, accountants, and lender) on an off-the-clock basis. All relevant ESOP matters and the company’s business are addressed.

We currently continue to represent every ESOP client which has not been sold or terminated its ESOP. Moreover, many of our ESOP clients came to us from other ESOP counsel as mature ESOPs.