Employee stock ownership plans

Navigating the fiduciary maze: The role of independent oversight in ESOP M&A transactions

By: Jason Veit

Employee stock ownership plans (ESOPs) have gained traction in recent years, driven by increased adoption among professional service firms and their use in succession planning for retiring business owners.

M&A transactions involving ESOP-owned companies may present particular complexities. Often, retaining an independent transactional trustee to act solely on behalf of the plan participants and ensure compliance with the Employee Retirement Income Security Act’s (ERISA) stringent fiduciary standards is required. This trustee must secure a robust fairness opinion to validate that the purchase price and all terms of the sale are objectively fair and adequate for the plan participants – particularly when complex deal structures, such as contingent earn-outs, are involved.

The independent trustee's scrutiny extends to indemnification provisions and the accuracy of representations made by the selling company's management team, demanding a higher level of diligence than a typical shareholder sale to protect the ESOP from future liability and purchase price adjustments. Careful planning and expert guidance are key to navigating a successful ESOP transaction.

ERISA litigation

Mitigating risk of successor unfunded pension liability

By: Jonathan Rose

When exploring potential M&A deals, parties may request documentation during due diligence to identify whether any unfunded pension liabilities could be unintentionally assumed. Under ERISA, employers with defined benefit plans lacking sufficient assets to pay all vested benefits have unfunded liabilities, and the allocation of these liabilities warrants careful review in the purchase agreement.

For plan sponsors of single-employer underfunded defined benefit plans, transactions may result in the Pension Benefit Guaranty Corporation – a government agency that insures defined benefit plans up to a guaranteed maximum, similar to the Federal Deposit Insurance Corporation – becoming the statutory trustee of underfunded plans and asserting enforcement authority to recover assumed liabilities.

Employers that are signatories to collective bargaining agreements typically contribute to multiemployer (defined benefit) pension plans. If an employer’s contribution obligation ceases and the multiemployer pension plan is underfunded, withdrawal liability claims may be enforced against the employer and, if necessary, its affiliated control group members.

Accordingly, if due diligence reveals unfunded pension liability (whether in the single- or multiple-employer context), the stock purchase agreement must make clear that the liability remains with the seller, unless negotiated otherwise.

However, in asset sales, the buyer generally does not assume the seller’s unfunded or withdrawal liability under ERISA. Clear allocation of the parties’ responsibility for any unfunded pension liability after closing is addressed in the asset purchase agreements.

Executive compensation

Transaction bonuses and Section 409A compliance

By: Atul Jain

Transaction bonuses are a common tool for incentivizing employees to drive toward a successful closing, but their structures and payment terms can vary widely. Designing a transaction bonus arrangement requires careful attention to Section 409A of the Internal Revenue Code, which governs nonqualified deferred compensation and imposes significant penalties for noncompliance.

Arrangements that do not utilize a valid change-in-control definition for Section 409A purposes, provide for payment in connection with a pre-closing termination of employment, or utilize payment schedules extending more than five years beyond closing may inadvertently create deferred compensation issues under Section 409A. Early coordination between companies envisioning an M&A exit and their legal advisors helps to ensure that transaction bonuses are designed to achieve intended retention and incentive objectives without introducing Section 409A tax exposure.

Employment

Assessing and mitigating risks associated with employee misclassification

By: Sarah Tauman

Improper classification of employees as exempt rather than nonexempt) may materially affect purchase price, indemnity scope, and representations and warranties insurance coverage. Prospective buyers are encouraged to conduct focused wage and hour diligence, including confirming consistent exemption status for employees with shared job titles and reviewing job descriptions and pay arrangements to ensure each exempt role meets (or arguably could meet) the criteria for exemption under the Fair Labor Standards Act and applicable state laws.

Misclassification of employees may expose an employer to back wages, liquidated damages, and attorneys’ fees. Where diligence indicates misclassification, buyers may consider undertaking a granular exposure assessment to quantify risk and tailor purchase price adjustments and special indemnities for historic issues, as appropriate. Post-closing integration also presents informed buyers with an opportunity for thoughtful, relatively lower-risk reclassifications to mitigate prospective liability.

Tax

Limits on deductibility of transaction costs

By: Brian Hamano

Parties often incur significant transaction costs in connection with acquisitions and other capital transactions, and often are surprised to learn that many of those costs cannot be currently deducted. Generally, amounts paid to “facilitate” certain specified transactions – including the acquisition of a trade or business – are required to be capitalized, subject to key exceptions (e.g., employee compensation expenses).

For sellers, whether an expense is deductible or capitalized may impact only the character of the income that the seller recognizes in the transaction (i.e., there is no timing impact).

For buyers, on the other hand, capitalization generally results in meaningful timing differences (current deduction versus incremental basis that only provides a benefit in a subsequent transaction) and, in certain instances, may eliminate any tax benefit entirely. Given the complexity and the significant economic impact of these rules, parties are encouraged to consult tax advisors to get early visibility on the deductibility of transaction costs.