When an ESOP company files for bankruptcy, ESOP participants are at risk of losing everything because they are, at most, unsecured creditors. Bret Keisling explains why ESOP participants should be treated like secured creditors, not shareholders, and why the solution lies with Congress.
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Mini-cast 77 Transcript
Announcer: 00:03 Welcome to The ESOP Mini-cast. A great way to wrap up the week.
Bret Keisling: 00:15 Hello, my friends. Thank you for listening. My name is Bret Keisling and as it says on my business cards, I'm a passionate advocate for employee ownership. Today I want to spend a few minutes talking about what happens to participant accounts if employee owned companies, in this case specifically an ESOP, should go bankrupt.
Bret Keisling: 00:34 Oftentimes when a company goes bankrupt, whether employee owned or not, at the end of the bankruptcy, the shares have no value and essentially the shareholders are just completely wiped out. Unfortunately, that's the result often with ESOPs as well. If you only equate ESOP participants to company shareholders generally, then I suppose this result makes sense, but if you look at ESOP participants and how they differ from normal shareholders in lots of respects, you may agree with me that ESOP participants should be treated differently in a bankruptcy. Let's take a moment, go back to ESOP 101 and define our terms.
Bret Keisling: 01:13 We often use shorthand to call ESOP companies "ESOPs" and similarly the participants are often called "employee owners". Although this makes it easier to communicate, it's technically inaccurate. If the company's created an ESOP, then the shares of the company are owned by a trust called an employee stock ownership trust or ESOT. Even though we call ESOP participants owners, they don't actually own any of the shares. The trust does. The participants are beneficiaries of the trust according to the plan but the participants do not own the shares themselves. They're assigned the value of a certain number of shares each year in their participant ESOP account which will reflect the number of shares assigned by whatever the annual value is to give the participant a sense of their value. By the way, you're going to hear me talk about ESOP participants. As a former trustee, my fiduciary duty was to participants and they are defined as anybody who participates in the plan, notably current and former employees.
Bret Keisling: 02:18 In order to track the annual value, each year participants are given account statements which reflect the total value of their ESOP account: the shares assigned to them multiplied by the value of the share as of the valuation date. The duty to pay participants is what is known as the repurchase obligation. And I will draw a distinction, every ESOP plan I've ever seen includes some vesting period, normally five years might be a few years less. So we are talking about those who have worked for the company long enough to be vested. That's one of the major differences 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 real problems if they didn't pay the repurchase obligation.
Bret Keisling: 03:10 So in the event of a bankruptcy by an ESOP company, shareholders stand to lose everything but participants, and again especially those that are vested, would have a claim as creditors in the bankruptcy. Regular shareholders at non-ESOP companies don't usually become creditors of the company.
Bret Keisling: 03:28 Unfortunately, the status of creditor doesn't help in a bankruptcy because under current law, ESOP participants are unsecured creditors. Let me give you an example that might help you relate. Let's say you have $200,000 worth of personal debt broken up in the following ways: You owe $150,000 on your home and it's almost always a secured debt, secured by the mortgage. In other words, the home or the property is the collateral to borrow the money. You also have $40,000 worth of credit card debt, which generally is often unsecured. In other words, you owe the credit card company the money, but it's not like they're going to come take the lamp you bought on your credit card. You just have to pay the dollar amount that's owed. And let's say you also have a $10,000 loan from a friend or a family member. It's just a personal loan that you borrowed. If you find yourself in bankruptcy, your assets will essentially be liquidated and all the proceeds from the liquidation will go first to the secured creditor, which is most likely the mortgage company. So if through the bankruptcy there's not enough funds to pay off the secured debt completely, then the unsecured lenders, in this example, the credit card companies and the friend or family member who loaned you $10,000, they're not going to have any recourse whatsoever because it's unsecured debt.
Bret Keisling: 04:44 Now, let's say that that $10,000 loan from a friend or family member that you took actually, let's say you took the time to work through lawyers and it is a secured loan. It's a process and it's not my place to share what the process is, but let's say it's held up legally that this $10,000 personal loan is a secured debt. Now, let's say in the bankruptcy that $155,000 worth of proceeds are generated. $150,000 is going to go to the mortgage company. 5,000 will go towards that secured $10,000 debt, meaning your friend or family member will lose five grand and they'll get five grand. And the credit card companies we talked about are going to have all of their debts discharged through the bankruptcy. They won't see a penny.
Bret Keisling: 05:27 Ultimately, in a bankruptcy, secured debt is paid off first and then unsecured debt is paid off if there are any proceeds. In the example above. I didn't even bother differentiating between how many credit card companies were owed because more often than not, there's little to no money going towards unsecured creditors, so it doesn't matter whether it's one credit card company or five, they're left to fight over probably non-existent dollars.
Bret Keisling: 05:51 The problem for ESOP participants is that currently under the law of the repurchase obligation is simply treated unsecured debt. In the past when I was a trustee, I was involved with a bankruptcy proceeding of an employee owned company. At that time, there was no case law at all about whether repurchase obligations were secured or unsecured debt. Since then, a single United States district court, I believe in New York, has found that ESOP participants are unsecured creditors, meaning they're in line after all the secured creditors are paid off.
Bret Keisling: 06:22 I don't think this is a good result for a couple of reasons. First, unlike most shareholders who become shareholders after making an investment, an ESOP participant usually had no say in creation of the trust. At some point, they came to work and were simply told that the company was now employee owned. Similarly, if you own shares in a stock, oftentimes you're able to sell them. If it's a publicly traded company, you just say sell them. If it's privately held company, you might have more efforts, but generally you're allowed to sell your shares. You can't do that with an ESOP. ESOP participants usually don't have the right to cash in any of their company shares. Most importantly to me, I believe very strongly that when an ESOP participant vests, they should be able to rely on that obligation to them being met. Particularly if other secured creditors are receiving something in the bankruptcy.
Bret Keisling: 07:13 For this change to occur, it would require Congress to pass legislation or the courts to start accepting the argument that ESOP repurchase obligations should be treated as secured debt in a bankruptcy. Unfortunately, I'm not sure who would be in a position to make that argument to the court. In my experience, the trustee works hard during a bankruptcy to make sure all the rules are followed, but it doesn't necessarily give the trustee the means to make this argument in court.
Bret Keisling: 07:39 One possible solution would be for our major employee ownership organizations to adopt protecting participants in a bankruptcy as a major plank as they go and talk to Congress about all of the important issues involving employee ownership. Certainly our advocacy organizations, The ESOP Association and NCEO do a great job as well as the state centers and lots of other folks in the country, but I've never seen any of the organizations push for rights of ESOP participants during bankruptcies. I think were they to adopt this and make this a push in Congress. That's how it's going to get on folks' radar.
Bret Keisling: 08:16 I hope that if you're listening to this, it's out of curiosity and not that your company's in trouble. I know during the national pandemic we are not sure what things are going to look like in the United States or around the world in three months or six months, regardless of when our economy opens up again, we're going to be assessing the damage and that sort of thing. So I just wanted to share. It's not good news. Unfortunately in a bankruptcy, as I've described, ESOP participants are likely to lose everything and that's a fact. But I'm hopeful that as ESOP world figures out all of our next steps that we can add protecting participants in a bankruptcy as something that is not just important but the right thing to do.
Bret Keisling: 09:02 Thank you so much for joining me today and I hope you'll be back next Tuesday for our primary podcasts, The EsOp Podcast, and meanwhile in this time of pandemic, as we've been saying for a few weeks, please take care of yourself and if you can do something nice for someone who needs some help, that'd be great too. This is Bret Keisling. Have a nice day.
Bitsy McCann: 09:25 We'd love to hear from you! To contact us, find us on Facebook at KEISOP, LLC and on Twitter @ESOPPodcast. To reach Bret, with one "T", email Bret@KEISOP.com, on LinkedIn at Bret Keisling, and most actively on Twitter at @EO_Bret. Again, that's one "T". This podcast has been produced by The KEISOP Group, technical assistance provided by Third Circle, Inc. and BitsyPlus Design. Original music composed by Max Keisling, archival podcast material edited and produced by Brian Keisling, and I'm Bitsy McCann.
Standard Disclaimer: The views expressed herein are my own and don't represent those of my own firms or the organizations to which I belong. Nothing in the podcast should be construed as guidance or advice of any kind in any field and the fact that I mentioned an organizational website or an advocate or a company on a podcast does not reflect an endorsement, but if you've heard your name or your group's name mentioned on this podcast, I'd love to have you come on and talk about it yourself.