ESOP Repurchase Obligations in Bankruptcy

An employee stock ownership plan (an “ESOP”) is a type of employee benefit plan regulated by the Internal Revenue Code (the “Code”) and the Employee Retirement Income Security Act of 1974 (“ERISA”). An ESOP has many features that make it very different from other ERISA plans, the biggest one being that ESOP trust funds must be primarily invested in one company, the employer-creator of the ESOP (the “Company”). Employees who are ESOP participants not only benefit from corporate law and the Company’s internal rules, as do other shareholders, but also are protected by ERISA. Often, the rules of ERISA are different. This tension between ERISA and other rules creates plenty of legal issues. One example of such tension arises in bankruptcy, where ERISA clashes with not only corporate and contract law rules, but also federal bankruptcy law.

Generally, the ESOP and ESOP participants are treated as “equity holders” in bankruptcy, which makes them effectively last in line for getting paid for their stock in the Company that is being liquidated in bankruptcy. For most active ESOP participants, this may be the end of the story. As much as ERISA seeks to protect employees’ rights, when the Company, the stock of which is the ESOP’s main asset, goes under, there is not much even ERISA can do. But what about ESOP’s repurchase obligations to former and diversifying participants?

ESOP participants who retire or terminate employment for other reasons, have the right to demand that their shares be repurchased by the ESOP, or to “put” their shares to the Company that sponsors the ESOP. Further, under ERISA, at some point participants may become entitled to “diversify” their investment in the ESOP by requiring the Company to repurchase a portion of the stock allocated to their ESOP account. The obligations of the Company to repurchase shares from employees due to death, disability, retirement, or other employment termination or due to exercise of employee’s diversification rights are known as “repurchase obligations,” and such employees are therefore “repurchase obligation creditors.”

When a former or diversifying employee exercises their put right, the Company usually prefers not to make a lump-sum payment for the repurchased shares, but rather would want to spread out the repurchase obligations for as long as the law allows. Generally, for repurchase obligations triggered by retirement, death, or disability, the law limits such distribution to a period of five years after the triggering event. For terminated employees this period can be longer, while for diversifying employees payments must be made in accordance with the schedule set forth in the Code with no further delay allowed. The Code permits stock to be purchased from a participant using a promissory note, instead of cash, as long as “adequate security” is granted and reasonable interest is paid on the principal balance of the repurchase obligations. Because the law does not specify what “adequate security” means, in practice ESOPs comply with this obligation very differently. Some Companies take a very bold (and likely contrary to the statutory language) position that an unsecured note given to a repurchase obligation creditor is sufficient, others pledge Company stock as a security, while yet others buy a surety bond or pledge specific assets. Depending on how the particular Company complies with the “adequate security” requirement, repurchase obligation creditors may have a bond or security interest to protect their repurchase obligations claim in bankruptcy.

Assuming they do not have a security interest or a bond to rely on, are repurchase obligations entitled to a higher priority than claims by active ESOP participants? Based on recent case law, the answer seems to be yes.

In In re Indian Jewelers Supply Co., a 2019 case, the bankruptcy court held that several former employees of an ESOP-owned company were debt holders, and not equity holders, for bankruptcy purposes.(1)

First employee, Carolyn Bowen, exercised her put right and received a promissory note in exchanged for the repurchased shares. The court held that she was a debt holder entitled to a claim against the assets of the bankruptcy estate. The court also pointed out that debtor could have petitioned to recharacterize or equitably subordinate such claim, but expressed opinion that such request would have likely been unsuccessful, citing In re Merrimac Paper Co., Inc.(2) There, the appellate court reasoned that repurchase of an ESOP participant’s stock should not be treated as a usual stock redemption transaction, because unlike usual redemption note claims, which are in substance based on equity, ESOP repurchase obligations are primarily retirement benefits. In other words, the court in Merrimac seemed to suggest that ESOP repurchase obligations deserve to be treated as debt claims, rather than equity, because of retirement and ERISA policy goals.

The court in Indian Jewelers Supply further expanded on this when analyzing the claims of two other employees, Pierce Notah and Riley Valentino. Mr. Notah technically never received a note from the ESOP, but the court held that this was due to a violation of the ESOP’s own distribution policy. Had the ESOP issued him a note in time per the distribution policy, Mr. Notah would have been in the same position as Ms. Bowen. Therefore, the court refused to allow injustice to frustrate the ERISA-backed repurchase obligation claim.

However, the case of Mr. Valentino is the most interesting of the three. Mr. Valentino also never received a note from the ESOP. Nor was he entitled to receive such a note per the ESOP’s distribution policy, unlike Mr. Notah. The distribution policy had been amended a few months before Mr. Valentino was terminated, but the court still sided with the employee. The court held the change of the distribution policy constituted a breach of implied covenant of good faith and fair dealing and that it was ambiguous. Finally, in the part of the holding that seems to reveal the true reasoning behind the court’s sympathy toward the claims of all three employees, the court explained that “even if was not a breach of contract for the ESOP to refuse to distribute Mr. Valentino’s shares, upon termination Mr. Valentino’s interest in the ESOP changed from a plan participant to a frustrated creditor, trying to collect his retirement benefits from the Debtor.” 

Although one of the employees held a promissory note, two of the other employees did not. The court found that all three employees were to be considered as creditors, not stockholders. The court’s opinion in Indian Jewelers Supply was very specific: “The Court finds and concludes that former employees of the Corporation, who were or should have been “cashed out” of their ESOP interest years before, are creditors rather than stockholders.”     

Merrimac and Indian Jewelers Supply seem to signify a willingness of courts to give significant weight to ERISA and retirement policy considerations when resolving ESOP bankruptcy disputes, at least when claims are made by former participants who are entitled to ESOP benefits. But how far would the courts be willing to go?

In most ESOP transactions, when acquiring Company stock from selling shareholders ESOP relies on a third-party lender, usually a bank, for providing a significant portion of the financing of the purchase price. Not surprisingly, to secure the financing, the lender usually requires a first priority lien on all assets of the Company. In the light of Merrimac and Indian Jewelers Supply, some may question whether courts’ sympathetic treatment of repurchase obligation creditors’ claims could threaten the lender’s priority rights in ESOP Company’s bankruptcy.

To date, however, there has not been any indication of courts willing to go this far. Although equity and policy consideration could lead courts to put repurchase obligation creditors in a position of priority over equity holders, there has not been any suggestion of priority over a bona fide secured third-party lender. Therefore, assuming the lender properly perfects its security interest, it would maintain priority over any unsecured repurchase obligation creditor.

Bankruptcy, ERISA, and ESOPs are complicated matters that can be difficult to navigate without the advice of an attorney. If you have questions about these issues, please contact one of the authors of this article, attorney David O’Leary, at 847-241-1793 or doleary@lavellelaw.com, or attorney Roman Perchyts, at 224-836-6192 or rperchyts@lavellelaw.com.

This article is provided for informational purposes only and does not constitute legal advice. You should not rely on the information contained in this article without first consulting a licensed attorney.

(1)In re Indian Jewelers Supply Co., Inc., 604 B.R. 408, 415 (Bankr. D.N.M. 2019).

(2)In re Merrimac Paper Co., Inc., 420 F.3d 53 (1st Cir. 2005).