DATE POSTED 08. 06. 2011, By

Employer Creating a Plan for Employees to Own the Company? Take a Close Look Before Investing in that ESOP

Employees of privately held companies in Chicago and the Midwest have tremendous opportunities and risks ahead, as the baby-boomers who own those companies get set to retire. Generally, an owners of a privately held business has two choices when it comes time to retire: pass the business on to a family member, or sell it. Passing the business on to a family members is often not feasible. Many of these baby-boomers built the sort of business that required a lot of elbow grease. Meanwhile, they sent their children to the best schools and encouraged them to pursue other sorts of careers: accounting, finance, medicine, law, etc. Therefore, the boomers will look to sell those businesses. But as there likely will be more boomers retiring in the next decade than entrepreneurs looking to buy the businesses, selling the business to the employees via an Employee Share Ownership Plan (ESOP) will likely become more commonplace. If you are an employee in such a company, that sounds great so far, right?

The answer depends. ESOPs usually get billed as tokens of generosity: a means for a benevolent owner to pass the legacy on to employees. But often the true purpose is one of corporate finance: a means for the owner to liquidate a holding in the company. Danger lurks in ESOPs where the outgoing owner sets up the ESOP and also serves as a trustee of the plan at the time the ESOP will decide what price to pay for the stock to that very same owner. Not surprisingly, many such business owners have been caught doing just that before.

The Department of Labor just obtained several consent judgments against ESOP trustees in a case where the DOL alleged the trustees paid over $60 million for company stock only worth about $18 million. See Solis v. Mattingly, No. 2:09-cv-00207-WOB (E.D. Ky).

This particular ESOP affected over 5,000 employee participants, causing them losses, but similar transactions will become more likely on a smaller scale, and they have been alleged in larger scales as well (e.g., the lawsuit against the famed real estate mogul turned Chicago Tribune owner, Sam Zell). For instance, the business with 20 employees, 50 employees, maybe even 100 employees could easily become the next plan sponsor of an ESOP that pays inflated prices for company stock. If you are on of the participants in a company that recently set up an ESOP, you should ask several questions. Are the individuals who are selling the stock also running the ESOP? Who performed the valuation of the company stock? How did the valuator arrive at that number? Privately held companies are more difficult to value than publicly held companies, because there are no shares traded on securities exchanges.

Because of the potential for such abuse, the IRS has even issued guidance recently with respect to S Corporations sponsoring ESOPs. If you are a participant in an ESOP, and you think the plan may have paid too much for employer stock, speak to an ERISA lawyer today.

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