Employee stock ownership plan participants have won big as a result of two recent rulings.
The first, an IRS ruling not yet made public, clears the way for workers covered by ESOPs to take home immediately profits from the sale of their companies instead of having to wait several years to collect the money.
The second, a federal appeals court decision earlier this month, could result in Polaroid Corp.'s ESOP participants collecting millions of dollars in damages from NationsBank of Georgia.
It is not immediately clear if the IRS ruling has come too late to help some former employees of Conrail Inc., acquired by CSX Corp. earlier this year. They will have to wait until the end of 1998 to collect their entire share of $533 million in ESOP profits on their company's acquisition.
But lawyers for Conrail employees are expected to argue that the IRS would have relented had the company tried hard enough.
The IRS ruling means that several hundred former employees of CBR Inc., a Houston-based credit bureau company liquidated after its assets were acquired in late 1995, can pocket as much as $100,000 each in profits from their company's sale because of the difference between the takeover price and the price the ESOP originally paid for the company's shares.
Traditional position reversed
The ruling reverses the Internal Revenue Service's traditional position that any profits collected by an ESOP in a corporate takeover -- after paying off any outstanding loans used to buy the company's shares -- must be treated as employer contributions.
Because Section 415(c) (1) of the Internal Revenue Code caps annual employer contributions at the lower of $30,000 or 25% of an employee's annual pay, ESOP participants must often wait years to collect all the windfall from their company's sale.
In its recent technical advice memorandum, the IRS said company sale proceeds used to pay off ESOP loans are neither employer nor employee contributions but should instead be treated as earnings or investment gains on employer stock.
Alan Sandals, a partner at the Philadelphia law firm of Sandals, Langer & Taylor, represents former Conrail employees in a class action lawsuit. He plans to use the IRS ruling in the CBR case in his appeal of a Philadelphia federal district court's recent decision to throw out the lawsuit, which alleges the company breached its fiduciary duty.
"This (IRS ruling) should help the employees' lawsuit against Conrail," said Ronald L. Ludwig, a partner at the San Francisco law firm of Ludwig, Goldberg and Krenzel, and an ESOP expert. "It shows that had Conrail basically challenged the IRS they might have prevailed."
Suit prompts favorable ruling
Luis Granados, a partner in the Washington office of McDermott, Will & Emery, who represented CBR, said the IRS relented from its original position only after he filed a lawsuit against the tax-collecting agency last summer.
Mr. Granados withdrew his lawsuit after IRS officials agreed to give a favorable ruling.
"It was the lawsuit that made the difference. Right up to the end they said they would rule against me," he said.
But, Mr. Granados said, while Conrail had other options available (paying out the gains to employees over a period of several years), his client had none. CBR had ceased to operate after its assets were acquired. It had no employees and no employee payroll to which profits from the sale could be linked.
"One difference is that companies like Conrail had a way out of the box so they could ultimately allocate the money to people over two or three years. Conrail as an entity still survives and still has employees, and 25% of their payroll is higher than zero while 25% of our payroll is zero," Mr. Granados said.
The IRS ruling is expected to have a huge effect on companies with new ESOPs that still have a lot of debt and in which most of the shares have not been allocated to employees' accounts at the time of a takeover, said J. Michael Keeling, president of The ESOP Association, a Washington-based trade association.
Before the IRS ruling, it was "almost impossible to pay employees in a short time" if a company had a large outstanding loan and the company's takeover price was considerably higher than the price at which the ESOP acquired the shares, Mr. Keeling said.
The Polaroid case
In the Polaroid case, the 11th Circuit Court of Appeals in Atlanta ruled NationsBank of Georgia failed to tender all the unallocated shares back to the company in a 1989 stock repurchase program aimed at thwarting a hostile takeover offer.
NationsBank is the successor to Citizens & Southern Trust Co., the plan's original trustee.
The Labor Department had sued NationsBank in 1992, alleging the trustee violated its fiduciary duties by failing to exercise independent judgment in responding to competing tender offers for the ESOP's shares.
The appeals court in a Nov. 5 decision said ESOP trustees cannot blindly rely on the plan's voting provisions, but must independently figure out what is in the best interests of the participants and tender shares accordingly, even if doing so contradicts the plan.
In Alexis M. Herman vs. NationsBank Trust Co. (Georgia), NationsBank argued it was carrying out the wishes of plan participants, who it said were "named fiduciaries" and ultimately responsible for deciding what to do with their ESOP shares, just as 401(k) plan participants are responsible for investing their retirement dollars.
The bank argued it could not be held liable for making imprudent decisions because it was "merely a directed trustee" and not subject to the Employee Retirement Income Security Act's fiduciary standards.
DOL's position upheld
However, the appeals court upheld the Labor Department's position that ESOP participants can be named fiduciaries only for allocated shares for which they are given explicit directions.
What's more, the court noted, Polaroid ESOP participants could not be considered ultimately responsible for the unallocated shares because the trustee's notice on the tender offer did not tell them that how they voted their allocated shares would also affect the unallocated shares.
Ultimately, while the appeals court said that such "mirror voting" provisions do not violate ERISA, the bank was responsible for independently determining the best course of action.
In Polaroid's January 1989 self-tender offer for 16 million of its 71.5 million outstanding shares, the ESOP trustee did not tender 4.2 million (unallocated) of the ESOP's 9.7 million shares because it mechanically followed the plan's "mirror voting" provision to tender unallocated shares in the same proportion as allocated shares voted by participants.
Had NationsBank tendered all of the ESOP's unallocated shares as well as allocated shares for which the participants gave no direction at Polaroid's $50 a share purchase price, the ESOP would have been able to use the proceeds to go back into the market and purchase more Polaroid shares, trading after the stock repurchase program at between $37.41 and $37.67 a share. Consequently, the ESOP would have owned an additional 332,917 shares.
"Had Citizens & Southern done what we had suggested they should have done, they would have owned more Polaroid shares," said Marc Machiz, assistant solicitor at the Labor Department.
Back to lower court
The case now goes back to the lower district court for a trial to determine if NationsBank failed to act in the best interests of plan participants in not tendering all the unallocated shares.
"We will have to show that it was imprudent to fail to tender all of the shares in the Polaroid, and they presumably will attempt to show it was not imprudent," Mr. Machiz said.
Philip C. Cook, a partner in the Atlanta law firm of Alston & Bird, who represents NationsBank, said it is the bank's policy not to comment on pending litigation.
At the same time, the appeals court upheld NationsBank's contention that the bank did the right thing by not tendering allocated ESOP shares if participants failed to tell NationsBank what to do.
"Contrary to what the (Labor Department) contends, a participant's informed failure to respond to a tender request is an exercise of control or discretion," the court wrote in its opinion.