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September 26,
2002
Memorandum for: Virginia C. Smith
Director of Enforcement, Regional Directors
From: Robert J. Doyle
Director of Regulations and Interpretations
Subject: ESOP Refinancing Transactions
What are the
obligations of a fiduciary under sections 404(a) and 408(b)(3) of ERISA in
connection with the refinancing of an exempt ESOP loan?
An ESOP is a defined contribution pension plan
designed to invest primarily in stock of the sponsoring employer or an
affiliate. A leveraged ESOP is an ESOP that finances its purchase of such
stock through securities acquisition debt obtained from, or guaranteed by, the
sponsoring employer. A leveraged ESOP, operated in accordance with
applicable regulations, holds the shares purchased with the proceeds of such a
loan in a “suspense account,” and releases them from the suspense account as
the loan is repaid according to a set formula that is expressed in terms of
number of shares.(1)
This release formula requires that in a given year, the number of shares
released from the suspense account will be determined by multiplying the number
of shares in the suspense account by a fraction. The numerator of that
fraction is the amount of principal and interest paid for the year, and the
denominator is the sum of the numerator plus the amount of principal and
interest to be paid for all future years on the loan.(2) After the shares of
stock are released from the suspense account, they are allocated to
participants’ accounts.
Loan repayment schedules typically are designed to provide
for the release of stock from the ESOP suspense account consistent with a
specific projected level of benefits or participant contributions. Loan
repayment schedules, therefore, are often formulated based on projections as to
the future value of shares, the number of participants and, if relevant, levels
of participant contributions over the term of the loan. Accordingly, where
there are significant deviations from the projections – such as significant
increases in the value of the stock held in the ESOP suspense account or
significant decreases in the number of participating employees – the release
of stock in accordance with original loan terms will result in a level of
benefits greater than originally intended by the plan sponsor. Refinancing
of the underlying loans is a means by which some plan sponsors have sought to
bring future allocations closer to the amounts they originally intended.
In general, an ESOP refinancing involves entering into a new loan that extends
the repayment schedule and, therefore, the period over which stock will be
allocated from the suspense account to individual participants. Typically,
the ESOP uses the loan proceeds to retire the original loan and release suspense
account shares to the accounts of the participants only as the new, extended,
loan is repaid. While all of the shares acquired in the original stock
purchase are ultimately released under the extended terms of the new loan, fewer
shares are released from the suspense account during the period of the original
underlying loan and fewer shares are allocated to participants’ accounts
during that same period.
Section 404(a)(1)(A) of ERISA
requires, among other things, that a fiduciary of a plan discharge its duties
with respect to the plan solely in the interest of the plan’s participants and
beneficiaries and for the exclusive purpose of providing benefits to
participants and their beneficiaries and defraying reasonable expenses of
administering the plan. Section 404(a)(1)(B) requires that a fiduciary of
a plan discharge its duties with respect to the plan solely in the interest of
the participants and beneficiaries and with the care, skill, prudence, and
diligence under the circumstances then prevailing that a prudent person acting
in a like capacity and familiar with such matters would use in the conduct of an
enterprise of a like character and with like aims. Section 403(c)(1)
requires, in part, and subject to certain exceptions, that the assets of a plan
shall never inure to the benefit of any employer and shall be held for the
exclusive purpose of providing benefits to participants and beneficiaries and
defraying reasonable expenses of administering the plan.
Section 406(a)(1)(B) provides,
in pertinent part, that a fiduciary with respect to a plan shall not cause the
plan to engage in a transaction, if he or she knows or should know that such
transaction constitutes a direct or indirect “lending of money or other
extension of credit between the plan and a party in interest.” ERISA
section 3(14) defines a “party in interest” to include an employer.
Section 408(b)(3) provides that a loan to an ESOP is exempt from section 406
(except section 406(b)(3)(3))
if such loan is “primarily for the benefit of participants and beneficiaries
of the plan, and . . . such loan is at an interest rate which is not in excess
of a reasonable rate.” It is the view of the Department that the
requirements of section 408(b)(3) apply to the refinancing of an ESOP loan, as
well as to the original loan. Accordingly, an ESOP fiduciary, in order to
avoid engaging in a prohibited transaction, must take steps to ensure that a
refinancing transaction comports with the requirements of section 408(b)(3) and
29 C.F.R. § 2550.408b-3.
§ 2550.408b-3(c) addresses the
application of the “primary benefit” requirement of section 408(b)(3).
In applying the “primary benefit” requirement, paragraph (c)(1) of §
2550.408b-3 provides, among other things, that a fiduciary must consider
“[a]ll the surrounding circumstances, including those described in paragraphs
(c)(2) and (3) of this section.”(4) Paragraph (c)(2) of that
section provides that “[a]t 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.” Paragraph
(c)(3) of that section provides that “[t]he 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.” The preamble
to the final regulation explains that the tests encompassed in paragraphs (c)(2)
and (3) of § 2550.408b-3 were added to the regulation to illustrate how a
determination can be made with respect to whether a transaction meets the
primary benefit requirement.(5)
The regulation additionally states that the Department will give “special
scrutiny” to ESOP loans and that fiduciaries have an obligation to ensure that
such loans are “truly arranged primarily in the interest of participants and
beneficiaries.” 29 C.F.R. § 2550.408b-3(b)(2).
Whether a fiduciary acts in
accordance with its responsibilities under sections 404(a)(1)(A) and (B) and
403(c) of ERISA, and whether a particular loan satisfies the requirements of
section 408(b)(3) of ERISA, are inherently factual determinations that must be
made by the appropriate plan fiduciary based on all relevant facts and
circumstances. In determining whether a refinancing is consistent with the
fiduciary provisions of Title I of ERISA, the burden is on the fiduciary to
establish compliance. However, we note that certain procedures and factors
considered by a fiduciary may be appropriate in determining whether to cause an
ESOP to engage in a refinancing.
At a minimum, in determining
whether to cause an ESOP to engage in a refinancing, a fiduciary must make a
careful assessment of the costs and benefits conferred upon the ESOP and the
likely consequences of a failure to refinance, and ensure that the transaction
is “arranged primarily in the interest of participants and beneficiaries.”
29 C.F.R. § 2550.408b-3(b)(2). It is the view of the Department that,
consistent with the obligation to consider “all the surrounding
circumstances” pursuant to § 2550.408b-3(c)(1), an ESOP fiduciary must, in
considering any refinancing of an ESOP loan that results in an extension of the
period over which stock will be allocated to participant accounts, assess the
extent to which the refinancing is consistent with the documents and instruments
governing the plan, including loan and related agreements.(6) An ESOP fiduciary, in
our view, also should assess the extent to which such an extension is consistent
with the reasonable expectations of the plan’s participants and beneficiaries,
as might be determined by reference to the plan’s summary plan description or
other disclosures describing the funding and benefits of the plan.
Although a refinancing may also
benefit the employer (for example, by reducing the employer’s cost of
providing future pension benefits), the fiduciary must act with undivided
loyalty to the participants and beneficiaries of the plan if it is to satisfy
the requirements of sections 404(a)(1)(A) and 408(b)(3) of ERISA. The
“primary benefit” test set forth in section 408(b)(3) of ERISA and the
regulations thereunder require the fiduciary to focus on the benefits of the
refinancing transaction to the plan’s participants and beneficiaries.
Accordingly, a refinancing would satisfy the primary benefit test if the
fiduciary reasonably concludes that the transaction is advantageous to the
plan’s participants and beneficiaries after a careful assessment of the costs
and benefits of the transaction, and if the terms related to the refinancing are
at least as favorable as the terms that would have resulted from an
arm’s-length negotiation between independent parties.
Often, employers offer a number
of inducements for the plan to engage in the refinancing which could support a
fiduciary’s conclusion that the transaction is primarily for the benefit of
participants and beneficiaries, such as a commitment that shares held in the
suspense account will not be applied to repayment of the outstanding portion of
the refinanced loan if the ESOP is terminated (often referred to as “event
protection”); additional diversification rights for participants; an increase
in the amount of the employer’s matching contribution; the payment of a
“dividend make-whole” to compensate participants and beneficiaries for the
increased use of dividends for loan repayment; and other such inducements.
Whether some or all of such inducements are sufficient to satisfy the primary
benefit test is highly dependent on the particular facts and circumstances
surrounding the transaction.
One circumstance of particular
importance is whether the sponsoring employer has made an enforceable commitment
to make all of the contributions necessary to retire the loan. In such a
case, the ESOP may have an unqualified right to receive contributions and to
release stock in accordance with the original amortization schedule. As a
result, the negative consequences to the ESOP of rejecting a proposed
refinancing could be minimal, and the economic value transferred to a sponsoring
employer may be substantial, unless the ESOP receives substantial additional
consideration for entering into the transaction.
Further, we note that the
fiduciary has a duty of impartiality to all of the plan’s participants, and
may appropriately balance the interests of different classes of participants in
evaluating a proposed refinancing, including the potentially varying interests
of present and future participants. See Varity Corp. v. Howe, 516 U.S.
489, 514 (1996); Restatement (Second) of Trusts § 183. In our view,
however, the fiduciary cannot satisfy the duty of impartiality solely by
considering the asserted benefits of the refinancing to future participants
(e.g., more generous benefits in later years than the employer would otherwise
provide), but must also consider the interests of current participants and
beneficiaries. Although a refinancing does not remove shares from the
ESOP, those current participants who terminate employment before the full
repayment of a refinanced loan may receive fewer shares of stock than they would
have received absent the refinancing, and current participants who remain
employed by the sponsor must work more years to receive the same number of
shares that they would have received absent the refinancing. Accordingly,
a fiduciary cannot reasonably assess the costs and benefits conferred upon an
ESOP without giving due consideration to the interests of current participants.
With respect to the obligations
of an ESOP fiduciary under section 404(a)(1), it is the view of the Department
that satisfaction of the “primary benefit” requirement of section 408(b)(3)
and the regulation with respect to the refinancing of an ESOP loan also
typically would serve to satisfy a fiduciary’s obligations to act prudently
and solely in the interest of plan participants and beneficiaries under section
404(a)(1). Conversely, a failure to satisfy the “primary benefit”
requirement of section 408(b)(3) would also result in a violation of section
404(a)(1).
Any questions concerning this matter may be directed to
Louis Campagna or Fred Wong, Division of Fiduciary Interpretations at
202.693.8510.
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29 C.F.R. § 2550.408b-3(h); 26 C.F.R. § 54.4975-11(c).
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29 C.F.R. § 2550.408b-3(h)(1). Also note that § 2550.408b-3(h)(2) permits a release formula that is determined solely with reference to
principal payments.
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In adopting § 2550.408b-3, the Department expressed its view that the only
prohibited transactions to which the exemption under section 408(b)(3) does
not apply are those arising under section 406(b)(3), relating to the receipt
by a fiduciary of any consideration for his own personal account from a party
dealing with the plan. 42 Fed. Reg. 44384 (September 2, 1977).
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Paragraph (c) of § 2550.408b-3 also provides that no loan will satisfy the
primary benefit requirement unless it also satisfies the requirements of
paragraphs (d) [relating to use of loan proceeds], (e) [relating to liability
and collateral for an ESOP loan] and (f) [relating to defaults].
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42 Fed. Reg. 44384 (September 2, 1977).
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For purposes of this discussion, it
is assumed that there are no provisions in documents or instruments
governing the plan, including loan and related agreements, that
specifically preclude the refinancing of an ESOP loan.
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