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Voting Unallocated ESOP Shares

David Johanson

September 1995

In a typical employee stock ownership plan and trust ("ESOP"), the corporation that sponsors the ESOP borrows money from a commercial lender and then loans that money to the ESOP on substantially similar repayment terms. The ESOP then uses the money to buy company stock either from the corporation or from a shareholder of the corporation. The company stock is placed in a loan suspense account after it is purchased and is released and allocated to ESOP participants' accounts as loan payments are made. As a result, immediately after the loan and purchase transactions occur, all of the company stock is held unallocated in the loan suspense account. It is not until the loan is repaid in full that all of the company stock is allocated to participants' accounts. During the interim, the number of allocated shares of company stock increases as the number of unallocated shares decreases.

In the past year, the U.S. Department of Labor (the "DOL") has taken what appears to be conflicting positions regarding the voting/tendering of unallocated shares of company stock in an ESOP. This has left the ESOP community in a difficult position in that it is now impossible to determine how fiduciaries should handle the voting/tendering of unallocated shares of company stock. This brief article attempts to state the conflicting positions, explain why the DOL's position in the Polaroid case should not be adopted by the courts and provide a workable alternative.

Reich v. NationsBank (the Polaroid case)

The Polaroid ESOP gives plan participants the right to direct the fiduciary with respect to the voting/tendering of allocated shares of company stock. It also provides that the unallocated shares are to be voted/tendered in the same proportion as the participants have instructed the fiduciary to vote/tender the allocated shares. In a U.S. District Court decision rendered by the Northern District Court of Georgia in March of 1995, the District Court agreed with the DOL's position that it is proper for the fiduciary to follow participant instructions with respect to allocated shares of company stock but not with respect to unallocated shares. The District Court reasoned that "allowing present participants, who have an inherent conflict of interest, to act as 'named fiduciaries' of unallocated shares is contrary to [the Employee Retirement Income Security Act of 1974, as amended ('ERISA')]." The District Court's decision has been appealed to the U.S. Court of Appeals for the Eleventh Circuit.

The DOL's Information Letter

In September of 1995, just six months after the District Court's decision in the Polaroid case, the DOL issued an information letter that appears to directly conflict with the position taken by the DOL and adopted by the District Court in that case. In a letter to a representative of the AFL-CIO, the DOL stated that a directed trustee may follow participant instructions with respect to unallocated shares of company stock. It also stated that it must follow such instructions unless there are "well-founded reasons why doing so would give rise to a violation of titles I or IV [of ERISA]." If a directed trustee does not do so, the DOL indicated that the directed trustee would be liable for a breach of fiduciary duty under Section 404(a)(1)(D) of ERISA for failing to discharge its duties "in accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with the provisions of [Titles I or IV of ERISA]."

Why Should the DOL's Position and the District Court's Decision in the Polaroid Case Not Be Followed?

The arguments for "mirror" voting/tendering as it existed in the Polaroid case and as many ESOPs apply the concept throughout this country are too numerous to address at length in this brief article. The DOL's argument that persuaded the District Court to invalidate mirror voting was that present participants have an inherent conflict of interest with future participants to whom the unallocated shares will ultimately be allocated. Although the District Court should not have accepted this argument for a number of reasons (i.e., there is substantial identity between "present" and "future" participants and the present participants in the Polaroid case appeared to act more in the interest of future participants by not accepting the above-market price of one of the tender offers), the primary reason it should have rejected the DOL's argument and affirmed mirror voting is employee empowerment.

Many ESOPs in this country have been created primarily for corporate finance purposes and for the benefit of the shareholders who sell stock to the ESOP and defer recognition of the capital gains on such sale. In those ESOPs, participant voting/tendering is usually only allowed with respect to allocated shares of company stock and only on major corporate issues. The pass-through of voting/tendering decisions and the mirror voting/tendering rules in the Polaroid ESOP should be encouraged not discouraged. The objectives of shareholders, management and employees will become far more aligned if the courts render decisions and the DOL adopts positions that provide encouragement to such ESOPs.

A Simpler Way

As indicated above, ERISA holds directed trustees accountable if they follow instructions from fiduciaries that violate ERISA. Allowing ESOP participants to direct fiduciaries to vote/tender both allocated shares of company stock and unallocated shares in the same proportion that allocated shares are voted/tendered, provided ERISA is not violated in doing so, should not only be the law but it should be strongly encouraged in all types of ESOPs.

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