4000 - Advisory Opinions
Employee Stock Ownership Plan (ESOP)
June 3, 1981
Joseph A. DiNuzzo, Attorney
In March 1978 *** established an Employee Stock Ownership Plan ("ESOP") as a means of improving its capital condition. In order to effectuate the capitalization, the ESOP borrowed funds from a certain lender. At that time the management of *** Bank was advised by the FDIC that the bank could not guarantee the ESOP's debt without violating section 332.1 of the FDIC's rules and regulations. Consequently, the directors of the bank guaranteed repayment of the ESOP's obligation in their individual capacities. Sometime thereafter, however, the guaranties executed by the directors were released and their responsibilities were assumed by *** Bank under a "continuing guaranty agreement." Hence, *** an apparent violation of section 332.1 was scheduled.
Attempting to correct the violation, the management of *** Bank has presented to the FDIC a proposed agreement which, it contends, modifies the ESOP financing plan so as to comply with section 332.1. The pertinent part of the proposed agreement imposes a direct obligation upon *** Bank to make periodic payments to the ESOP (or to the lender) equal to the total amount owed by the ESOP to the lender. It also provides that *** Bank's failure to make the designated payments will entitle the lender to a legal cause of action against *** Bank for breach of contract.
The issue is whether *** Bank's contractual obligation to pay the ESOP (or the lender) an amount equal to that owed by the ESOP to the lender constitutes a prohibited guarantee under section 332.1 of the FDIC rules and regulations.
The proposed agreement imposes a direct obligation upon *** Bank to pay to the ESOP (or to the lender) an amount equal to the sum owed by the ESOP to the lender. This contractual obligation constitutes a bona fide debt agreement and is legally enforceable. Inasmuch as the agreement does not include a guaranty by *** Bank of the ESOP's debt, there is no violation of section 332.1.
Even if the proposed agreement did include a guaranty by the bank to pay the ESOP's debt, there would be no violation of section 332.1. This is because the bank's existing obligation to pay the designated sum to the ESOP would constitute a "substantial interest" in the overall transaction so as to qualify as an exception to the general prohibition against bank guaranties.
An ESOP is an employee benefit plan which is accorded special treatment under the Internal Revenue Code.1 It is designed to enable an employer to make tax-deductible contributions to an employee benefit plan and to have those funds invested by the trustee of the plan in the employer's stock. The stock purchased by the ESOP is held in trust for the employees and distributed to them upon retirement.
The concomitant purpose of most ESOPs is corporate financing. An ESOP may utilize the credit of an employer corporation for the purpose of debt-financing its acquisition of employer stock. This allows the employer to finance its capital growth with pre-tax corporate dollars, while building ownership interests in its employees. The typical plan operates as follows:
1) The ESOP borrows funds from a lender;
2) The employer guarantees the lender that the ESOP will repay the loan and that each year the employer will pay to the ESOP an amount sufficient to enable the ESOP to remit its annual payment;
3) The ESOP uses the borrowed funds to purchase employer stock; and
4) Each year the employer makes a tax-deductible payment to the ESOP equal to the amount due from the ESOP to the lender.
This financing plan enables corporate credit to be extended to acquire employer stock for the benefit of employees, while enabling the corporation to finance its capital requirements with pretax dollars.
A problem arises in using an ESOP as a capital-financing technique when the employer is a bank. This is because banks, generally, cannot serve as guarantors. With regard to state nonmember banks insured by the FDIC, the operative regulation is 12 C.F.R. § 332.1. Section 332.1 provides that a state nonmember bank "shall not . . . exercise, take, or assume the power . . . to guarantee . . . the obligations of others. . . ." A recognized exception to this prohibition applies, however, when the bank has a "substantial interest" in the transaction in issue. In that case the bank may extend itself as guarantor on an obligation.2
In accordance with this exception, the Legal Division has maintained in past situations that a bank may guarantee the debt incurred by an ESOP when the employer-bank has committed itself to pay to the ESOP an amount equal to the sum owed by the ESOP to the lender. This legal obligation by the bank is deemed to be a "substantial" enough "interest" in the transaction so as to allow the bank to guarantee the ESOP's debt without running afoul of section 332.1.
The facts surrounding the *** Bank ESOP must be examined in this light. Paragraphs two and four of the proposed agreement provide that the bank will make payments to the ESOP in an amount equal to the sum payable by the ESOP to the lender.3 These provisions constitute a direct and primary obligation upon *** Bank to remit a designated sum to the ESOP (or to the lender). Inasmuch as it is supported by a valid consideration4 , this obligation is legally enforceable, providing the contract is executed in the proper legal fashion.5 Moreover, because the proposed agreement does not include a guaranty by the bank of the ESOP's debt, there is no violation of section 332.1.
Even if the proposed agreement did include a guaranty by *** Bank of the ESOP's debt, section 332.1 would not be violated. This is because the obligation of the bank to pay the designated sum to the ESOP (or to the lender) would constitute a "substantial interest" by the bank in the overall transaction so as to qualify as an exception to the general prohibition against bank guaranties.
1 The plan must comply with section 4975(e)(7) of the Internal Revenue Code. 26 U.S.C. § 4975(e)(7). Go back to Text
2 This exception has been impliedly incorporated into section 332.1. The Comptroller of the Currency's regulations explicitly incorporate the exception in 12 C.F.R. § 7.7010(a). Go back to Text
3 A copy of the proposed agreement is attached. Go back to Text
4 Paragraph one of the proposed agreement contains a legally recognizable consideration. Go back to Text
5 We do not believe there is any substantial legal question as to the bank's authority to commit itself to make periodic payments to an ESOP. In this regard, an ESOP appears to be no different from other employee benefit plans, such as pension or profit-sharing plans or health and welfare plans. Go back to Text