(a) Definitions. When used in this section, the terms listed below
have the following meanings:
(1) ESOP. The term ESOP refers to an employee stock ownership plan
that meets the requirements of section 407(d)(6) of the Employee
Retirement Income Security Act of 1974 (the Act) and 29 CFR 2550.407d-6.
It is not synonymous with ``stock bonus plan.'' A stock bonus plan must,
however, be an ESOP to engage in an exempt loan. The qualification of an
ESOP under section 401 (a) of the Internal Revenue Code (the Code) and
26 CFR 54.4975-11 will not be adversely affected merely because it
engages in a non-exempt loan.
(2) Loan. The term loan refers to a loan made to an ESOP by a party
in interest or a loan to an ESOP which is guaranteed by a party in
interest. It includes a direct loan of cash, a purchase-money
transaction, and an assumption of the obligation of an ESOP.
``Guarantee'' includes an unsecured guarantee and the use of assets of a
party in interest as collateral for a loan, even though the use of
assets may not be a guarantee under applicable state law. An amendment
of a loan in order to qualify as an exempt loan is not a refinancing of
the loan or the making of another loan.
(3) Exempt loan. The term exempt loan refers to a loan that
satisfies the provisions of this section. A ``non-exempt loan'' is one
that fails to satisfy such provisions.
(4) Publicly traded. The term publicly traded refers to a security
that is listed
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on a national securities exchange registered under section 6 of the
Securities Exchange Act of 1934 (15 U.S.C. 78f) or that is quoted on a
system sponsored by a national securities association registered under
section 15A(b) of the Securities Exchange Act (15 U.S.C. 78o).
(5) Qualifying employer security. The term qualifying employer
security reters to a security described in 29 CFR 2550.407d-5.
(b) Statutory exemption--(1) Scope. Section 408(b)(3) of the Act
provides an exemption from the prohibited transaction provisions of
sections 406(a) and 406(b)(1) of the Act (relating to fiduciaries
dealing with the assets of plans in their own interest or for their own
account) and 406(b)(2) of the Act (relating to fiduciaries in their
individual or in any other capacity acting in any transaction involving
the plan on behalf of a party (or representing a party) whose interests
are adverse to the interests of the plan or the interests of its
participants or beneficiaries). Section 408(b)(3) does not provide an
exemption from the prohibitions of section 406(b)(3) of the Act
(relating to fiduciaries receiving consideration for their own personal
account from any party dealing with a plan in connection with a
transaction involving the income or assets of the plan).
(2) Special scrutiny of transaction. The exemption under section
408(b)(3) includes within its scope certain transaction in which the
potential for self-dealing by fiduciaries exists and in which the
interests of fiduciaries may conflict with the interests of
participants. To guard against these potential abuses, the Department of
Labor will subject these transactions to special scrutiny to ensure that
they are primarily for the benefit of participants and their
beneficiaries. Although the transactions need not be arranged and
approved by an independent fiduciary,fiduciaries are cautioned to
scrupulously exercise their discretion in approving them. For example,
fiduciaries should be prepared to demonstrate compliance with the net
effect test and the arm's-length standard under paragraphs (c)(2) and
(3) of this section. Also, fiduciaries should determine that the
transaction is truly arranged primarily in the interest of participants
and their beneficiaries rather than, for example, in the interest of
certain selling shareholders.
(c) Primary benefit requirements--(1) In general. An exempt loan
must be primarily for the benefit of the ESOP participants and their
beneficiaries. All the surrounding facts and circumstances, including
those described in paragraphs (c)(2) and (3) of this section, will be
considered in determining whether such loan satisfies this requirement.
However, no loan will satisfy such requirement unless it satisfies the
requirements of paragraphs (d), (e) and (f) of this section.
(2) Net effect on plan assets. At the time that a loan is made, the
interest rate for the loan and the price of securities to be acquired
with the loan proceeds should not be such that plan assets might be
drained off.
(3) Arm's-length standard. The terms of a loan, whether or not
between independent parties, must, at the time the loan is made, be at
least as favorable to the ESOP as the terms of a comparable loan
resulting from arm`s-length negotiations between independent parties.
(d) Use of loan proceeds. The proceeds of an exempt loan must be
used, within a reasonable time after their receipt, by the borrowing
ESOP only for any or all of the following purposes:
(1) To acquire qualifying employer securities.
(2) To repay such loan.
(3) To repay a prior exempt loan. A new loan, the proceeds of which
are so used, must satisfy the provisions of this section.
Except as provided in paragraphs (i) and (j) of this section or as
otherwise required by applicable law, no security acquired with the
proceeds of an exempt loan may be subject to a put, call, or other
option, or buy-sell or similar arrangement while held by and when
distributed from a plan, whether or not the plan is then ESOP.
(e) Liability and collateral of ESOP for loan. An exempt loan must
be without recourse against the ESOP. Furthermore, the only assets of
the ESOP that may be given as collateral on an exempt loan are
qualifying employer securities of two classes: Those acquired with the
proceeds of the exempt loan
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and those that were used as collateral on a prior exempt loan repaid
with the proceeds of the current exempt loan. No person entitled to
payment under the exempt loan shall have any right to assets of the ESOP
other than:
(1) Collateral given for the loan,
(2) Contributions (other than contributions of employer securities)
that are made under an ESOP to meet its obligations under the loan, and
(3) Earnings attributable to such collateral and the investment of
such contributions.
The payments made with respect to an exempt loan by the ESOP during a
plan year must not exceed an amount equal to the sum of such
contributions and earnings received during or prior to the year less
such payments in prior years. Such contributions and earnings must be
accounted for separately in the books of account of the ESOP until the
loan is repaid.
(f) Default. In the event of default upon an exempt loan, the value
of plan assets transferred in satisfaction of the loan must not exceed
the amount of default. If the lender is a party in interest, a loan must
provide for a transfer of plan assets upon default only upon and to the
extent of the failure of the plan to meet the payment schedule of the
loan. For purposes of this paragraph, the making of a guarantee does not
make a person a lender.
(g) Reasonable rate of interest. The interest rate of a loan must
not be in excess of a reasonable rate of interest. All relevant factors
will be considered in determining a reasonable rate of interest,
including the amount and duration of the loan, the security and
guarantee (if any) involved, the credit standing of the ESOP and the
guarantor (if any), and the interest rate prevailing for comparable
loans. When these factors are considered, a variable interest rate may
be reasonable.
(h) Release from encumbrance--(1) General rule. In general, an
exempt loan must provide for the release from encumbrance of plan assets
used as collateral for the loan under this paragraph. For each plan year
during the duration of the loan, the number of securities released must
equal the number of encumbered securities held immediately before
release for the current plan year multiplied by a fraction. The
numerator of the fraction is the amount of principal and interest paid
for the year. The denominator of the fraction is the sum of the
numerator plus the principal and interest to be paid for all future
years. See Sec. 2550.408b-3(h)(4). The number of future years under the
loan must be definitely ascertainable and must be determined without
taking into account any possible extensions or renewal periods. If the
interest rate under the loan is variable, the interest to be paid in
future years must be computed by using the interest rate applicable as
of the end of the plan year. If collateral includes more than one class
of securities, the number of securities of each class to be released for
a plan year must be determined by applying the same fraction to each
class.
(2) Special rule. A loan will not fail to be exempt merely because
the number of securities to be released from encumbrance is determined
solely with reference to principal payments. However, if release is
determined with reference to principal payments only, the following
three additional rules apply. The first rule is that 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. The second rule is that 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
third rule is that subdivision (2) is not applicable from the time that,
by reason of a renewal, extension, or refinancing, the sum of the
expired duration of the exempt loan, the renewal period, the extension
period, and the duration of a new exempt loan exceeds 10 years.
(3) Caution against plan disqualification. Under an exempt loan, the
number of securities released from encumbrance may vary from year to
year. The release of securities depends upon certain employer
contributions and earnings under the ESOP. Under 26 CFR 54.4975-11(d)(2)
actual allocations to participants' accounts are based
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upon assets withdrawn from the suspense account. Nevertheless, for
purposes of applying the limitations under section 415 of the Code to
these allocations, under 26 CFR 54.4975-11(a)(8)(ii) contributions used
by the ESOP to pay the loan are treated as annual additions to
participants' accounts. Therefore, particular caution must be exercised
to avoid exceeding the maximum annual additions under section 415 of the
Code. At the same time, release from encumbrance in annually varying
numbers may reflect a failure on the part of the employer to make
substantial and recurring contributions to the ESOP which will lead to
loss of qualification under section 401(a) of the Code. The Internal
Revenue Service will observe closely the operation of ESOPs that release
encumbered securities in varying annual amounts, particularly those that
provide for the deferral of loan payments or for balloon payments. See
26 CFR 54.4975-7(b)(8)(iii).
(4) Illustration. The general rule under paragraph (h)(1) of this
section operates as illustrated in the following examples:
Example. Corporation X establishes an ESOP that borrows $750,000
from a bank. X guarantees the loan which is for 15 years at 5% interest
and is payable in level annual amounts of $72,256.72. Total payments on
the loan are $1,083,850.80. The ESOP uses the entire proceeds of the
loan to acquire 15,000 shares of X stock which is used as collateral for
the loan. The number of securities to be released for the first year is
1,000 shares, i.e., 15,000 shares x $72,256.72/$1,083,850.80 = 15,000
shares x \1/15\. The number of securities to be released for the second
year is 1,000 shares, i.e., 14,000 shares x $72,256.72/$1,011,594.08 =
14,000 shares x \1/14\. If all loan payments are made as originally
scheduled, the number of securities released in each succeeding year of
the loan will also be 1,000.
(i) Right of first refusal. Qualifying employer securities acquired
with proceeds of an exempt loan may, but need not, be subject to a right
of first refusal. However, any such right must meet the requirements of
this paragraph. Securities subject to such right must be stock or an
equity security, or a debt security convertible into stock or an equity
security. Also, they must not be publicly traded at the time the right
may be exercised. The right of first refusal must be in favor of the
employer, the ESOP, or both in any order of priority. The selling price
and other terms under the right must not be less favorable to the seller
than the greater of the value of the security determined under 26 CFR
54.4975-11(d)(5), or the purchase price and other terms offered by a
buyer, other than the employer or the ESOP, making a good faith offer to
purchase the security. The right of first refusal must lapse no later
than 14 days after the security holder gives written notice to the
holder of the right that an offer by a third party to purchase the
security has been received.
(j) Put option. A qualifying employer security acquired with the
proceeds of an exempt loan by an ESOP after September 30, 1976, must be
subject to a put option if it is not publicly traded when distributed or
if it is subject to a trading limitation when distributed. For purposes
of this paragraph, a ``trading limitation'' or a security is a
restriction under any Federal or State securities law or any regulation
thereunder, or an agreement (not prohibited by this section) affecting
the security which would make the security not as freely tradeable as
one not subject to such restriction. The put option must be exercisable
only by a participant, by the participant's donees, or by a person
(including an estate or its distributee) to whom the security passes by
reason of a participant's death. (Under this paragraph ``participant''
means a participant and the beneficiaries of the participant under the
ESOP.) The put option must permit a participant to put the security to
the employer. Under no circumstances may the put option bind the ESOP.
However, it may grant the ESOP an option to assume the rights and
obligations of the employer at the time that the put option is
exercised. If it is known at the time a loan is made that Federal or
state law will be violated by the employer's honoring such put option,
the put option must permit the security to be put, in a manner
consistent with such law, to a third party (e.g., an affiliate of the
employer or a shareholder other than the ESOP) that has substantial net
worth at the time the loan is made
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and whose net worth is reasonably expected to remain substantial.
(k) Duration of put option--(1) General rule. A put option must be
exercisable at least during a 15-month period which begins the date the
security subject to the put option is distributed by the ESOP.
(2) Special rule. In the case of a security that is publicly traded
without restriction when distributed but ceases to be so traded within
15 months after distribution, the employer must notify each security
holder in writing on or before the tenth day after the date the security
ceases to be so traded that for the remainder of the 15-month period the
security is subject to a put option. The number of days between the
tenth day and the date on which notice is actually given, if later than
the tenth day, must be added to the duration of the put option. The
notice must inform distributees of the terms of the put options that
they are to hold. The terms must satisfy the requirements of paragraphs
(j) through (l) of this section.
(l) Other put option provisions--(1) Manner of exercise. A put
option is exercised by the holder notifying the employer in writing that
the put option is being exercised.
(2) Time excluded from duration of put option. The period during
which a put option is exercisable does not include any time when a
distributee is unable to exercise it because the party bound by the put
option is prohibited from honoring it by applicable Federal or State
law.
(3) Price. The price at which a put option must be exercisable is
the value of the security, determined in accordance with paragraph
(d)(5) of 26 CFR 54.4975-11.
(4) Payment terms. The provisions for payment under a put option
must be reasonable. The deferral of payment is reasonable if adequate
security and a reasonable interest rate are provided for any credit
extended and if the cumulative payments at any time are no less than the
aggregate of reasonable periodic payments as of such time. Periodic
payments are reasonable if annual installments, beginning with 30 days
after the date the put option is exercised, are substantially equal.
Generally, the payment period may not end more than 5 years after the
date the put option is exercised. However, it may be extended to a date
no later than the earlier of 10 years from the date the put option is
exercised or the date the proceeds of the loan used by the ESOP to
acquire the security subject to such put option are entirely repaid.
(5) Payment restrictions. Payment under a put option may be
restricted by the terms of a loan, including one used to acquire a
security subject to a put option, made before November 1, 1977.
Otherwise, payment under a put option must not be restricted by the
provisions of a loan or any other arrangement, including the terms of
the employer's articles of incorporation, unless so required by
applicable state law.
(m) Other terms of loan. An exempt loan must be for a specific term.
Such loan may not be payable at the demand of any person, except in the
case of default.
(n) Status of plan as ESOP. To be exempt, a loan must be made to a
plan that is an ESOP at the time of such loan. However, a loan to a plan
formally designated as an ESOP at the time of the loan that fails to be
an ESOP because it does not comply with section 401(a) of the Code or 26
CFR 54.4975-11 will be exempt as of the time of such loan if the plan is
amended retroactively under section 401(b) of the Code or 26 CFR
54.4975-11(a)(4).
(o) Special rules for certain loans--(1) Loans made before January
1, 1976. A loan made before January 1, 1976, or made afterwards under a
binding agreement in effect on January 1, 1976 (or under renewals
permitted by the terms of such an agreement on that date) is exempt for
the entire period of such loan if it otherwise satisfies the provisions
of this section for such period, even though it does not satisfy the
following provisions of this section:
(i) The last sentence of paragraph (d);
(ii) Paragraphs (e), (f), and (h)(1) and (2); and
(iii) Paragraphs (i) through (m), inclusive.
(2) Loans made after December 31, 1975, but before November 1, 1977.
A loan made after December 31, 1975, but before November 1, 1977, or
made afterwards
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under a binding agreement in effect on November 1, 1977 (or under
renewals permitted by the terms of such an agreement on that date) is
exempt for the entire period of such loan if it otherwise satisfies the
provisions of this section for such period even though it does not
satisfy the following provisions of this section:
(i) Paragraph (f);
(ii) The three provisions of paragraph (h)(2); and
(iii) Paragraph (i).
(3) Release rule. Notwithstanding paragraphs (o)(1) and (2) of this
section, if the proceeds of a loan are used to acquire securities after
November 1, 1977, the loan must comply by such date with the provisions
of paragraph (h) of this section.
(4) Default rule. Notwithstanding paragraphs (o)(1) and (2) of this
section, a loan by a party in interest other than a guarantor must
satisfy the requirements of paragraph (f) of this section. A loan will
satisfy these requirements if it is retroactively amended before
November 1, 1977, to satisfy these requirements.
(5) Put option rule. With respect to a security distributed before
November 1, 1977, the put option provisions of paragraphs (j), (k), and
(l) of this section will be deemed satisfied as of the date the security
is distributed if by December 31, 1977, the security is subject to a put
option satisfying such provisions. For purposes of satisfying such
provisions, the security will be deemed distributed on the date the put
option is issued. However, the put option provisions need not be
satisfied with respect to a security that is not owned on November 1,
1977, by a person in whose hands a put option must be exercisable.
(Approved by the Office of Management and Budget under control number
1210-0046)
[42 FR 44385, Sept. 2, 1977; 42 FR 45907, Sept. 13, 1977, as amended at
49 FR 18295, Apr. 30, 1984]
