Practical Considerations for a Private Equity Buyer Contemplating an Acquisition of an ESOP-Owned Company

Are you a private equity buyer presented with an opportunity to acquire a business owned by an Employee Stock Ownership Plan (ESOP)? Be prepared for a unique transaction process. Transactions involving an ESOP shareholder and, more importantly, an ESOP trustee serving as a fiduciary for the ESOP’s participants, can create additional complexity and will likely find the private equity buyer agreeing to terms and encountering issues unique to non-ESOP-related transactions. Notwithstanding the additional complexity involved, these are perfectly manageable scenarios with the right knowledge and expertise and should not dissuade a private equity buyer from an otherwise attractive opportunity. Below are 12 practical and important considerations for the private equity buyer looking to acquire an ESOP-owned company:

1. ESOP Trustee.  Although you may negotiate with the board of directors or executive officers of the target company, the transaction ultimately is subject to the review and approval of the ESOP trustee. An ESOP trustee (a “trustee”) is often an independent, professional trustee (though, in a minority of cases, the trustee may be an individual from inside the target organization). The trustee may receive input from the ESOP participants but will also have its own considerations and separate valuation advisors and counsel. Importantly, any decisions made by the trustee are subject to the fiduciary requirements of the Employee Retirement Income Security Act of 1974 (ERISA). ERISA imposes certain duties on the actions of the trustee, including the duty to act prudently and a duty to act solely in the interest of the ESOP participants (i.e., generally speaking, the employees of the target company). Accordingly, the trustee must conduct a thorough and meticulously documented process to ensure these fiduciary requirements are met and avoid any additional scrutiny from the Department of Labor (DOL) following the sale.
2. Structure Considerations.  Your transaction will likely be structured as a stock purchase. While an asset purchase of an ESOP-owned company is possible, most transactions are structured as stock purchases—many ESOP sponsors and trustees insist on a stock purchase structure, and a stock purchase structure is necessary to avoid a “pass-through” vote of the ESOP participants. In most cases, a “pass-through” vote of the ESOP participants is required under the Internal Revenue Code Section 409(e) and applicable state law in connection with the sale of the assets of a target company, the target company’s entry into a merger, and even an “f” reorganization of the target company—these fundamental transactions cannot unilaterally be approved by the trustee. A pass-through vote is akin to a non-binding shareholder vote but, instead of a vote of shareholders, it is a vote of the ESOP participants. A pass-through vote requires additional time, disclosure, and complexity. On the contrary, in most cases, the sale of the stock of the target company may be unilaterally approved by the trustee, so long as the transaction is fair to the ESOP participants. But be warned, notwithstanding the trustee’s ability to authorize the stock sale, an overly cautious trustee may still require a pass-through vote to bolster its perceived compliance with the ERISA fiduciary obligations. Accordingly, structure should be top of mind during initial negotiations with the trustee. If a pass-through vote is insisted upon by the trustee or target company in connection with a stock purchase transaction, the private equity buyer should consider leveraging the “ask” by requiring an asset sale for further liability protection and to avoid potentially burdensome post-closing ERISA compliance procedures as the ESOP is wound down and terminated post-closing (as these responsibilities would remain with the target company following the sale of its assets).
3. Post-Closing Tax Structure.  The target company will likely be taxed as a C-corporation immediately following the closing of a stock purchase. ESOP-owned companies are typically taxed as S-corporations because income attributable to an ESOP shareholder of an S-corporation is effectively tax-free and the S-corporation structure prevents an unnecessary layer of tax to the otherwise income tax-exempt ESOP. While the trust is an eligible shareholder of an S-corporation, odds are your acquisition vehicle is not. As a result, immediately upon closing of the sale of the equity of the target company, the S-corporation will automatically convert to a C-corporation. If a C-corporation in your ownership structure is an issue, we would suggest consulting tax counsel to determine the availability, if any, of tax-efficient conversion strategies.
4. “Adequate Consideration”.  The trustee must objectively show that the deal is fair and in the best interests of the ESOP participants. The trustee’s primary goal (and obligation) will be to deliver “adequate consideration” for the shares of the target company and ensure that the sale is in the financial best interests of the ESOP participants—the trustee must comply with the high fiduciary standards imposed under ERISA as that of a “prudent expert.” If it fails to do so, the trustee may face litigation or scrutiny by the DOL. The DOL frequently audits ESOP-related transactions, both on the DOL’s own initiative and in response to claims made by disgruntled ESOP participants. Accordingly, a private equity buyer should expect the trustee to require, as a condition to closing, that the trustee first obtain a favorable “fairness opinion” prepared by an independent financial advisor (or even a full, independent valuation) justifying the ultimate purchase price for the shares of the target company. The “fairness opinion” is an integral part of the transaction process because a sale of the ESOP’s stock for less than “adequate consideration” will be imprudent under ERISA’s general fiduciary standards and will constitute a prohibited transaction under both ERISA and the Internal Revenue Code.
5. Limited Recourse against Seller.  The ESOP’s liability is limited to amounts escrowed at closing. Following the closing, the ESOP will be wound down, with proceeds from the sale either distributed to the ESOP participants or transferred to another qualified retirement plan (such as a 401(k) plan). Accordingly, the trustee must be in a position to distribute sale proceeds without fear of a claim against the ESOP. In addition, any post-closing recovery by the buyer against the assets held in the ESOP likely raises ERISA and Internal Revenue Code prohibited transaction concerns which, if violated, would require both correction of the prohibited transaction and payment of prohibited transaction excise taxes. As such, recovery against the ESOP seller will be very limited as compared to a traditional seller; however, several tactics may be utilized to mitigate the associated risk. It is highly advisable for the private equity buyer to purchase a robust representation and warranty insurance policy and couple its protection with a negotiated special indemnity escrow covering matters excluded from such policy and other specified liabilities identified in diligence. Additionally, a sufficient escrow amount for any purchase price adjustments should be escrowed at closing. But be warned, because escrows or other amounts otherwise withheld from the purchase price at closing are not guaranteed to be paid to the ESOP, such amounts will be excluded by the ESOP’s valuation advisor from the consideration payable to the ESOP for purposes of the fairness opinion. As a result, the trustee may resist the proposed amount of an escrow on the basis that it may jeopardize its ability to obtain a favorable fairness opinion.  Similarly, the trustee may attempt to limit the duration of any escrow or other adjustment period because the potential of its receipt of additional consideration contingent upon events following closing will prevent the ESOP from fully winding up and liquidating until the obligation matures.
6. Careful Structuring of Employment Agreements / Retention Bonuses.  Avoid outsized transaction and retention bonuses payable to target company employees at or following closing. Transaction and retention bonuses are not inherently inappropriate, but the DOL highly scrutinizes transactions involving large transaction or retention bonuses with key members of management of the target company. High transaction bonuses paid at closing serve as a deduction to the purchase price otherwise payable to the ESOP (for the benefit of the ESOP participants) and high retention bonuses to key members of management may serve as evidence of “sweetheart” deals that create a potential conflict of interest for target company management employees who are involved in negotiating the sale transaction on behalf of the ESOP (although subject to trustee approval). As such, a private equity buyer should be cognizant of structuring bonuses such that none of the parties’ collective actions could be deemed to be allocating an inappropriate amount of funds to certain participants of the ESOP to the detriment of the ESOP plan (and its participants) as a whole, or that call into question the ability of management to objectively evaluate the merits of the transaction on behalf of the ESOP (and its participants). Remember, as the purchaser of the stock, the private equity buyer will own the plan sponsor (i.e. the target company) following the closing, leaving your portfolio company open to the risk of residual claims brought by the DOL or participants of the ESOP, so it is important to ensure a fair process that complies with all ESOP-related provisions of ERISA and the Internal Revenue Code.
7. Termination of the ESOP.  In the context of a stock sale, the ESOP might formally terminate at closing, but the process of winding up and liquidating the ESOP will continue for an extended period following closing, and as such, responsibility for continued ERISA compliance rests with the target company (now under the private equity buyer’s ownership) and the trustee. After the closing of a stock purchase of an ESOP-owned company, the ESOP will be wound down, and proceeds will either be distributed to ESOP participants or transferred to a 401(k) plan or another qualified retirement plan on behalf of the ESOP participants; however, the ESOP cannot be fully wound-up and liquidated until all rights to potential future payment have been finally determined. In other words, the ESOP will be frozen but will continue in effect until any escrows or other adjustments are finally determined and paid. During this period of post-closing existence, the buyer and target company must continue to comply with the terms of the plan (i.e., maintaining ESOP formalities, filing annual reports, securing a plan audit (if required), etc.). Importantly, trustees typically require that a portion of the purchase price proceeds remain in the ESOP until the Internal Revenue Service has issued a favorable determination letter holding that the termination of the ESOP does not adversely affect the ESOP’s status as a tax-qualified retirement plan. The combination of these factors means that the complete wind-up and liquidation of the ESOP will be a lengthy process that continues well beyond the transaction closing date. 
8. Retention Issues.  A large number of your (newly acquired) workforce may receive substantial cash benefits from the transaction, resulting in potential retention issues. Unlike a traditional transaction, where a small number of individuals receive closing consideration and do not likely continue as employees of the target company, in an ESOP transaction it is possible that a target company’s most seasoned and longest tenured employees will receive significant consideration resulting from the sale. Accordingly, a private equity buyer should consider entering into employment agreements or other reasonable post-closing bonus arrangements for key employees of the target company to ensure continued retention and preservation of the value of its investment.
9. ESOP Due Diligence.  Do your diligence. It is important to conduct a fulsome diligence exercise with respect to the formation of the ESOP, its past activities (to ensure current and historic compliance with applicable laws and regulations), and the existence and adequacy of fiduciary insurance policies. Fulsome diligence may result in added transaction costs but is highly advisable considering that the ESOP will be examined with the highest-level scrutiny upon wind-up, termination, and accompanying distribution of sale proceeds. It is possible for a DOL investigation to be triggered by one formal complaint by an ESOP participant arguing that the target company was sold at less than fair value. Furthermore, the target company has likely agreed to indemnify internal plan fiduciaries (i.e., the trustee and the board of directors) for any liability they may incur related to the operations of the ESOP; therefore, if operational/compliance issues are not identified and remedied early in the transaction process, special escrows will be required to mitigate this risk which, as discussed above, could affect the trustee’s ability to obtain a favorable fairness opinion.
10. Fiduciary Liability.  Purchase a fiduciary liability tail policy.  In addition to the potential indemnification of internal plan fiduciaries, the target company has likely contractually agreed to indemnify the trustee as a key term of the trustee’s engagement and likely has insurance policies to backstop this potential obligation. Do not forget to purchase a tail policy at closing, as this will likely be your sole recourse in the event that a claim is subsequently made against the trustee. These potential indemnity obligations serve as further justification for a highly detailed due diligence exercise prior to closing, as fiduciary errors by the ESOP trustee or internal plan fiduciaries likely will be the burden of the acquired company post-closing.
11. Significant Trustee Leverage.  The trustee does not have a financial interest in the transaction. Unlike a traditional acquisition, where sellers may be willing to assume outsized risk in the face of a considerable payday at closing, the trustee does not financially benefit from the closing of the acquisition. From a business perspective, it is more favorable to the trustee for an ESOP to remain in place (as ESOP administration fees are how the professional trustee earns its living). If the terms of the deal are too risky or otherwise could potentially call into question the trustee’s satisfaction of its fiduciary obligations to the ESOP, expect a firm “no” to the risk-shifting proposition. Accordingly, a private equity buyer must carefully pick its battles considering the dynamic—any unwavering, hardline positions run the risk of potentially jeopardizing the acquisition. A private equity buyer should be prepared for middle-of-the-road (or skewing seller-friendly) deal terms in any acquisition of an ESOP-owned company.
12. Transaction Timeline.  Prepare for an extended transaction and closing timeline. There are a number of factors that will likely cause the closing of the acquisition to occur at least 90 to 120 days after the execution of a letter of intent. Professional trustees are notoriously busy, servicing dozens (if not hundreds) of ESOPs on a regular basis, and the speed at which the transaction moves is in part dictated by the trustee’s (and trustee’s counsel’s) cooperation. Many institutional trustees have detailed (and generally inflexible) processes for considering and approving transactions. Additionally, the unique aspects of the deal, such as heavy ERISA and tax due diligence, negotiations regarding the post-closing wind-down and termination of the ESOP, the involvement of the trustee and its independent valuation consultant (needed for the fairness opinion), and trustee legal counsel, among many other factors, tend to extend transaction negotiation and closing past timelines that would otherwise be considered “market” in a traditional private equity acquisition. As such, a private equity buyer should reserve a sufficiently long exclusivity or “no shop” period when negotiating a letter of intent for the acquisition. Trustees are generally reluctant to grant exclusivity on the grounds that doing so might be inconsistent with their fiduciary obligations under ERISA but typically will agree not to affirmatively “shop” the business during the prescribed period.

In sum, there are a number of complexities and unique considerations associated with the acquisition of an ESOP-owned company; however, these complexities and unique considerations can be mitigated by sufficient due diligence and fulsome discussions with the trustee early in the process. This, coupled with the engagement of counsel well-versed in these unique types of transactions, will save time and money and will help secure a favorable outcome for all parties involved.