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Trust Examination Manual
of Labor - Employee Benefits Security Administration
September 26, 2002
Memorandum for: Virginia C. Smith
From: Robert J. Doyle
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.