Fiduciary Concerns in Change-of-Control Transactions
Several years ago, corporate transactions involving employee stock ownership plans (ESOPs) grew tremendously. Yet, just as ESOPs became an integral part of the leveraging of corporate America, they got slammed by the same forces as domestic companies. Some ESOP companies prospered while others faded away, starved for more capital.
Fiduciaries of many ESOPs that have some acquisition debt outstanding now need to consider new transactions. Each of these situations presents a host of questions about the nature of the ESOP’s financial interest and ways it can or should be viewed under the Employee Retirement Income Security Act of 1974 (ERISA).
5 Issues To Be Seen and Heard Fiduciaries should address several matters when an existing ESOP is involved in a corporate change-of-control, whether to ensure survival or just capitalize on good fortune. These include:
- Transaction participation.The ESOP may be holding the same class of stock as the other shareholders (common stock) or another stock class that is convertible into common stock (convertible preferred stock). In either case, the ESOP may be offered a financial opportunity different from that offered to other shareholders. If the ESOP wants different treatment than other shareholders, the fiduciary should determine whether such treatment serves the participants’ best interests. Although no established guidelines exist for resolving this, a prudent ESOP fiduciary course of action would be to treat transaction participation the same as any other investment decision, as the following example suggests.In the case of a tender offer to other shareholders, the fiduciary may be requested to exchange its shares for those of the acquirer’s similar stock class rather than to tender them. When this option is compared with that offered to other shareholders who are receiving cash consideration for their stock, the fiduciary should evaluate it from the standpoint of two investment decisions: first, selling the stock; and second, reinvesting the proceeds in the acquirer’s stock. If both investments meet the “adequate consideration” requirement under ERISA, the decision to exchange the shares may be a justifiable course of action. In other words, the investment makes sense if reinvesting the proceeds allows the ESOP to continue providing a potentially greater return than would otherwise be earned.
- Evaluating a transaction’s total consideration. Consideration paid in a tender offer may be in cash, notes, other securities or retention of certain assets. Merger consideration typically takes the form of the acquirer’s stock. Consideration may also include value attributed to employment contracts, non-compete agreements or other compensation arrangements. These usually are provided only to management shareholders but, in essence, represent a portion of the purchase price the acquirer is willing to pay.
Standard valuation principles should apply when one assesses the fairness of the total consideration to be received. Important factors would include, but not be limited to, the:
- Company’s and industry’s outlook,
- Company’s cash-generating ability
- Securities market pricing for comparable public companies’ stock, and
- Actual prices paid in comparable change-of-control transactions.
- Evaluating what the ESOP will receive as consideration addresses the transaction’s absolute fairness. This analysis enables the fiduciary to ensure the ESOP is receiving adequate stock consideration.
- Allocating total consideration among all equity holders.To ensure the ESOP is being treated fairly, it’s important to examine the terms of the securities each type of equity holder owns. Different classes of stock may be assessed differently depending on their rights and preferences. For example, if an ESOP holds convertible preferred stock and the acquirer intends to terminate the ESOP when the transaction is completed, then the ESOP may be entitled to the greater of its redemption or fair market value. The value to the ESOP should never be less than what it would have received had it held only common stock; the fiduciary can always convert the preferred stock and receive the same value provided to all common shareholders.It’s also important to determine whether a disproportionate amount of the total consideration is being paid to shareholders other than the ESOP. Some practitioners believe that if the ESOP holds a minority interest in the company, the plan is entitled to less than its pro rata share of the total enterprise value realized in a change-of-control transaction. But all common shareholders, including the ESOP, ordinarily have a right to receive their share of the total value proportionate to their percentage of stock ownership, regardless of whether they hold a minority or controlling interest.Even if the value to be received by the ESOP is fair on an absolute basis, allocating any excess value may be unfair. For example, no guidelines exist about how much value one should attribute to management shareholder agreements. The fiduciary’s financial advisor could consider whether employment and non-compete agreements were in place before negotiations, whether they conform to industry market standards and whether the proportion of the total purchase price these agreements represent is reasonable.Evaluating allocation of total consideration addresses the transaction’s relative fairness. The fiduciary’s objective? Ensure the ESOP is treated fairly financially – in terms of absolute and relative fairness.
- Treatment of remaining ESOP debt.In a leveraged ESOP, the company commits to repaying the ESOP indebtedness through contributions or dividends. Effectively, the commitment becomes a corporate liability and, as such, affects all shareholders alike. This issue can cause controversy during subsequent transactions.If the ESOP debt is treated as a corporate liability when the sale takes place, shares held by non-ESOP shareholders and shares allocated to ESOP participants will be valued (all else being equal) similarly to the annual valuations; that is, all shares will reflect a value after payment of the ESOP debt. Alternatively, if the ESOP’s unallocated shares are used to satisfy the ESOP’s indebtedness, the percentage of the total value flowing to the ESOP (after the debt repayment) is reduced; the shares held by the non-ESOP shareholders and the ESOP’s allocated shares (that is, all shares unencumbered by debt) increase in value.Because projected contributions or dividends used to repay the ESOP’s debt represent future benefits to the participants, some have argued that any sharing of the ESOP’s debt in a subsequent transaction would result in a benefits windfall to participants – effectively, participants would receive all future benefits at once. This windfall occurs because all unallocated shares would be released from the suspense account when the corporation repays the debt. Others have argued that the commitment to repay the ESOP debt always has been a corporate liability, and any transaction that alters this design merely transfers value away from the ESOP.
- Continuing ESOP or other employee benefit plans.Whether the ESOP remains in place after a merger or tender offer may have value implications for ESOP shareholders. If the ESOP benefit is considered favorable relative to standard industry benefits, continuing future contributions or dividends to the ESOP may represent real value.If a substantial amount of ESOP debt is outstanding with corresponding unallocated shares to be released as the debt is repaid, the fiduciary and its advisors should consider these questions:
- Has the merger partner or acquirer made a legal commitment to make future contributions or dividends sufficient to repay the ESOP indebtedness?
- Are current ESOP participant interests likely to be diluted through a substantial addition of new employees to the plan?
- If the ESOP is to be terminated, are replacement benefits contemplated, and how do they compare with the existing benefits?
- The answers to these questions will help the fiduciary and its advisors more accurately assess valuation considerations of retaining the ESOP.
The Moral of the Story
The ESOP’s involvement in a change-of-control transaction raises a host of new issues that must be appropriately addressed by ESOP fiduciaries, legal and financial advisors, and company management. While each situation is unique, the fiduciary’s knowledge of the original structure of the ESOP’s equity purchase, securityholders’ rights and preferences, and the surviving company’s post-transaction intentions toward benefit plans and remaining ESOP debt repayment will help the fiduciary ensure fair treatment of the ESOP. As a great Greek philosopher once said, “Prepare today for the wants of tomorrow.” Please call us.