Employee owners shouldn’t lose their retirement savings
by Bret Keisling
No one likes to talk about firms with Employee Stock Ownership Plans (ESOPs) going bankrupt, but the ongoing economic crisis brought on by COVID-19 has already led to bankruptcy filings by well-known non-ESOP brands such as J. Crew and Neiman Marcus, with other prominent companies, such as Hertz rental cars, teetering on the brink of insolvency. Despite evidence that ESOPs are more resilient in a downturn, there can be no doubt that some employee-owned firms won’t survive the current economic crisis and will file for Chapter 7 liquidation.
This could have a devastating impact on employees who have accumulated company shares in their retirement accounts and are now at risk of seeing those shares lose all their value, if the company is dissolved. I would argue this is unfair to employees—and that we can and should change the laws to ensure ESOP participants who lose their jobs don’t lose their retirement savings as well.
ESOP participants are not normal shareholders, and those differences matter, particularly in a bankruptcy.
To be sure, it is not uncommon when a firm goes bankrupt for shareholders to lose their entire investment. In an ESOP, where employees are treated as shareholders, the result is often the same. But ESOP participants are not normal shareholders, and those differences matter, particularly in a bankruptcy.
ESOP Participants: Shareholders of a Different Sort
Let’s take a moment to go back to ESOP 101 and define some terms. In ESOPs, the participants in the employee stock ownership plan are often called “employee owners” even though their situation is technically more complicated than direct stock ownership. If a company creates an ESOP, the shares of the company are owned by a trust called an Employee Stock Ownership Trust (ESOT). Even though we call ESOP participants “owners,” they don’t directly own any of the shares. Instead, the trust holds the shares on the behalf of “participants,” defined as anybody who participates in the plan–i.e., current and former employees.
Pursuant to the Plan, participants receive the value of a certain number of shares each year in their ESOP participant account. In order to track the annual value, participants receive annual account statements that reflect the total value of their ESOP account: the shares assigned to them multiplied by the value of each share as of the valuation date. The duty to pay participants is known as the “repurchase obligation.” Most ESOP plans include some vesting period, usually five years, although it might be a few years less or more.
This is one major difference between ESOP participants and typical shareholders. When an ESOP participant vests, they become a creditor of the company in the sense that the company owes them money and absent a bankruptcy, the company would run into severe problems with the Department of Labor and Internal Revenue Service, if they didn’t pay the repurchase obligation.
In the event of a bankruptcy by an ESOP company, outside shareholders (if the company is not a 100-percent ESOP) stand to lose everything, just as they would in the bankruptcy of a non-ESOP firm. The shareholders are not creditors. By contrast, the vested ESOP participants could have a claim as creditors. Even though the repurchase obligation does not get categorized as “debt” until the participant leaves the company through death, disability, termination, or retirement, it is certain that eventually all participants will leave the company and become subjects of the repurchase obligation.
Treat ESOP Participants as Secured Creditors
In a bankruptcy, there are two types of creditors: those with secured debt, which is paid off first, and those with unsecured debt, which is paid off if there is anything left over. Under current law the repurchase obligation is treated as unsecured debt.
We can and should change the laws to ensure ESOP participants who lose their jobs don’t lose their retirement savings as well.
This is problematic for several reasons. First, unlike most people who become shareholders after making an investment, ESOP participants usually have no say in the creation of the trust. At some point, they came to work and were informed that the company was now employee owned. Second, if you own shares of stock, you have the right and ability to sell them. It’s easy to sell shares in publicly traded companies, but even in privately held companies shares can usually be sold. ESOP participants generally don’t have the right to cash in any of their company shares before retirement.
The biggest and, in my view, the most important difference between shareholders and ESOP participants is that shareholders generally buy shares as an investment, knowing the value may increase or decrease. ESOP participants are not investors; they have been awarded shares specifically intended for their retirement. When ESOP participants vest they should be able to rely on the repurchase obligation being met, even if the company goes bankrupt, particularly if other secured creditors receive something in the bankruptcy.
For this change to occur, Congress will need to pass legislation requiring bankruptcy courts to treat ESOP participants as secured creditors. ESOP trade associations should add this change to their lobbying agendas. But in addition, we should martial the estimated 17 million ESOP participants to interact directly with their members of Congress and other elected officials. If one percent of ESOP participants wrote Congress, that would mean 17,000 people (and hopefully voters) communicating directly to our political leaders. This type of grassroots communication could serve us well, not only in protecting ESOP participants in a bankruptcy, but in enacting a broader employee agenda to support and scale employee ownership in all its forms.
Bret Keisling is the host of The ESOP Podcast. Prior to forming The Keisop Group in June 2019, he spent seven years as an ESOP trustee and two and a half years as the CEO of a 100-percent ESOP company.