Analysis of IRC Section 401(a)(35) Proposed Regulations – Definition of Publicly Traded and the Impact on Other ESOP Provisions

The latest ESOP Law Blog post, Treasury Proposes New ESOP Regulations And Invites Public Comment, discusses proposed Treasury Regulation - REG–136701–07 - Diversification Requirements for Certain Defined Contribution Plans.

Definition of Publicly Traded

The post discusses the existing IRS position on the meaning of publicly-traded under Treasury Regulation Section 54.4975-7(b)(1)(iv) - Other statutory exemptions – Publicly Traded. Even though the language was later changed to "readily traded on an established securities market", "publicly traded" has essentially remained the standard. Stock quoted on foreign stock exchanges and thinly traded stock, such as stock traded over the counter (OTC) on the Pink Sheets or the Over the Counter Bulletin Board (OTCBB), has historically been considered to not be publicly traded for ESOP purposes.

The post notes that the proposed regulations appear to have confirmed the position that OTCBB is not considered publicly traded and that stock quoted on foreign stock exchanges, for IRC Section 401(a)(35) diversification purposes, “will be treated as publicly-traded, even though the foreign exchange is clearly not registered under the '34 Act.”

Impact on Other ESOP Provisions

The post discusses how the definition of publicly traded impacts other ESOP provisions:

• Desire for Certainty in Legal Compliance – The definition of publicly traded has an impact on the implementation of the following provisions:
  
  o IRC Section 401(a)(28)(C) - Use of independent appraiser
  o IRC Section 409(h)(1)(B) - Right to demand employer securities; put option
  o IRC Section 409(l)(1) - Employer securities defined
  o IRC Section 1042(c)(1) - Sales of stock to employee stock ownership plans or certain cooperatives - Qualified securities
  
  
• The Two Value Problem – The rules could create some challenges for thinly traded companies:
  
  "The "bright-line" approach could create some difficulty for an OTCBB company with a relatively liquid market by requiring it to obtain an annual stock valuation. The Company and the ESOP may believe that the quoted price for the stock properly reflects the stock's fair market value. Nevertheless, the Company's ESOP would need to obtain an annual valuation. Further, the exercise of a "put option" by a participant at a time when the market price is substantially lower than the prior year-end ESOP valuation could create difficulties for the ESOP and plan sponsor."
  
  
• Coordination with the Adequate Consideration Definition – The post discusses the definition of adequate consideration under ERISA Section 3(18), 29 U.S.C. Section 1002 – Definitions – adequate consideration for purposes of determining whether an ESOP stock transaction is exempt from the prohibited transaction rules under ERISA Section 408, 29 U.S.C. Section 1108 - Exemptions from prohibited transactions - Acquisition or sale by plan of qualifying employer securities; acquisition, sale, or lease by plan of qualifying employer real property. The post concludes with the following:
  
  “It would be helpful if the Department of Labor could coordinate its position under Section 3(18) of ERISA with any final regulations published by IRS."