April 12, 2004 1

Employee Ownership Legal

Update[Executive Summary]

David R. JohansonJohanson Berenson

LLP707.226.8997

drj@esop-law.com

18th Annual Ohio Employee Ownership

ConferenceApril 16, 2004, 10:30 am to 12:00

NoonAkron/Fairlawn Hilton, Akron, Ohio

Joseph E. MarxThe Principal

Financial Group877.262.4608

marx.joseph@principal.com

James G. SteikerSES Advisors

866.316.ESOP(3767) x22

jim@sharedequity.com

Moderator: Ed Schmitt, Riesbeck Food Markets, Inc.

Presented By:

April 12, 2004 2

Significant Areas of Attention During

Past Several Years“S” Corporation Anti-Abuse Regulations“Abusive” “S” Corporation ESOPs“S” Corporation Distributions and IRAsSarbanes Oxley Act of 2002The Jobs and Growth Tax Relief Reconciliation Act of 2003 Proposed ADP/ACP RegulationsScope of ESOP Fiduciary DutyESOP Loan RefinancingRepayment of ESOP LoanFASB Statement 150Payment of Plan ExpensesUnanswered Questions

April 12, 2004 3

What We Have Learned

“S” Corporation Anti-Abuse Regulations Issued on July 21, 2003Extraordinarily broad

definition of “Synthetic Equity” includes ordinary deferred compensation

Normal “buy-sell” arrangements among existing shareholders not synthetic equity

April 12, 2004 4

What We Have Learned

Any right to receive compensation for services performed for S corporation (or certain related entities) that is deferred beyond 2½ months after year in which services are performed is considered “synthetic equity”.

To determine synthetic equity equivalent of non-qualified deferred compensation, temporary regulations provide that present value of deferred compensation is converted into number of shares of stock in corporation based on fair market value of S corporation shares on determination date, which may be any date during plan year. This calculation must be made on annual basis.

April 12, 2004 5

What We Have Learned

By requiring a synthetic equity calculation of non-qualified deferred compensation on an annual basis, a company could unwittingly run afoul of Section 409(p) of IRC in year in which its stock price suffers substantial decline in value.

Non-qualified deferred compensation would equate to much larger number of shares that could push disqualified persons over the 50% limit.

April 12, 2004 6

What We Have Learned

Regulations also emphasize that right to acquire interests in “related entity” is deemed to be “synthetic equity”. An entity is considered “related entity” if it is only significant asset of S corporation and S corporation is only significant holder of stock of “related entity”.

“Synthetic equity” is counted only if it would cause individual to be “disqualified person”, or company to have “nonallocation year”.

April 12, 2004 7

What We Have Learned

Status of each individual tested without regard to other individuals’ synthetic equity holdings.

Regulations applicable for plan years ending after October 20, 2003.

Section 409(p) of IRC was grandfathered and is not applicable until plan years ending after December 31, 2004, for S corporation ESOPs in effect prior to March 14, 2001.

Regulations provide another grandfathering rule which provides that if any non-qualified deferred compensation is paid out by July 21, 2004, it will not be treated as synthetic equity for purposes of testing anti-abuse provision.

April 12, 2004 8

What We Have Learned

“Abusive” “S” Corporation ESOPsOn January 23, 2004, in

Revenue Ruling 2004-4, U.S. Treasury Department and IRS issued comprehensive ruling to shut down certain identified abusive transactions involving S corporation ESOPs.

Revenue Ruling 2004-4 also makes these transactions “listed transactions” for tax-shelter disclosure purposes.

April 12, 2004 9

What We Have Learned

Benefit of “S” Corporation ESOPs cannot accrue primarily to shelter deferred executive compensation

IRS views “S” Corporation ESOPs as potential tax shelters that can be easily abused

Apparently, compliant arrangements at edge of line will be attacked

More than insubstantial benefits must be provided to ESOP participants

April 12, 2004 10

What We Have Learned

“S” Corporation Distributions and IRAs IRS will permit “S” Corporation

stock distribution to IRA and immediate sale back to company w/o endangering “S” Corporation Status

Revenue Procedure 2003-23 Requirements

ESOP participant elects to have stock directly rolled over to IRA,

terms of ESOP require “S” Corporation to immediately repurchase stock from IRA,

“S” Corporation actually repurchases stock on same day as distribution, and

no income, loss, deduction or credit attributable to “S” corporation stock is attributed to IRA.

April 12, 2004 11

What We Have Learned

Structuring and Limiting Warrants For Sub Debt in an S CorporationLenders that agree to be subordinated to company’s senior lender usually demand much higher interest rate on their loans. In addition, to enhance their rate of return on these loans, the sub debt lender usually demands an “equity kicker” for the extra risk they take. Often, the equity kicker is in form of warrant to buy stock for nominal purchase price ($0.01).

April 12, 2004 12

What We Have Learned

Synthetic Equity and S Corporation Single Class of StockUse of warrant to enhance rate of return creates two planning challenges. First, structure must not create second class of stock for S corporation purposes. Second, structure must be designed to avoid IRC Section 409(p) excise tax.

April 12, 2004 13

What We Have Learned

Sarbanes Oxley Act Corporate Governance for

Private CompaniesPublic Companies going

PrivateBlackout Notice

RequirementsAccelerated SEC Reporting

Requirements (Public Companies Only)

April 12, 2004 14

What We Have Learned

The Jobs and Growth Tax Relief Reconciliation Act of 2003 Reduced maximum income tax rate

imposed on long-term capital gains Applies to dividends paid by most

domestic and foreign corporations Exception for dividends described

in Section 404(k) & dividends distributed from qualified retirement plans (e.g. 401(k) plans, IRAs, etc.)

These exceptions continue to be taxed at ordinary income tax rates

Generally, applies to taxable years beginning after December 31, 2002

April 12, 2004 15

What Have We Learned

Proposed ADP/ACP Treasury Regulations Issued July 17, 2003Under present law ESOPs are

required to be disaggregatedProposed regulations

eliminate required disaggregation for purposes of ADP/ACP testing.

Disaggregation still applies for other nondiscrimination testing

Effective no sooner than first plan year beginning 12 months after publication of final regulations

April 12, 2004 16

What We Have Learned

Scope of ESOP Fiduciary Duty – the Case LawNo general affirmative duty to

diversify out of company stockUnclear whether company

officers or board members will be considered fiduciaries

Directed fiduciaries generally exculpated unless following instructions violates ERISA

Empty head and pure heart still not enough

April 12, 2004 17

What We Have Learned

Focus on process not taken under time or third-party pressure

Evolving law on duty of trustees with inside information – conflict between ERISA and SEC

Duty to follow plan termsDuty to monitor actions of

board of directorsFiduciary status of

independent appraisers, financial advisors & directed trustees

April 12, 2004 18

What We Have Learned

Existing case law generally protective of ESOP fiduciaries and directed fiduciariesPost-Enron environment seems more hostile; cases pending may point the way in the future

April 12, 2004 19

What We Have Learned

ESOP Loan RefinancingsOn September 26, 2002,

U.S. Department of Labor (the “DOL”) released its first “Field Assistance Bulletin” (“FAB”), which addresses refinancing of ESOP loans.

The DOL announced that FABs would be used in future to publicize technical guidance that it provides to its field enforcement staff.

April 12, 2004 20

What We Have Learned

In FAB 2002-1 (the “FAB”), the DOL addressed obligations of plan fiduciary under Sections 404(a) and 408(b)(3) of Employee Retirement Income Security Act of 1974, as amended (“ERISA”), when considering refinancing of an ESOP’s existing securities acquisition loan.

DOL focuses on ensuring that ESOP loan refinancings benefit plan participants.

April 12, 2004 21

What We Have Learned

Loan extensions that delay stock allocations while good under traditional finance theory (longer loans are better for borrower) viewed as bad for ESOP participants because they reduce company contributions

Consider whether company has contribution obligation

April 12, 2004 22

What We Have Learned

The FAB identifies various inducements commonly offered in ESOP loan refinancings:

(1) “event protection” which means that shares of company stock that are held in the ESOP loan suspense account longer than they would have under terms of original loan may not be sold and proceeds used to repay outstanding portion of ESOP refinanced loan if ESOP is terminated;

April 12, 2004 23

What We Have Learned

(2) additional diversification rights to ESOP participants;(3) increased employer contribution to either ESOP or another employer plan; or(4) payment of “dividend make-whole” to compensate ESOPs participants and beneficiaries for dividends to repay ESOP loan after original maturity date of loan.

April 12, 2004 24

What We Have Learned

Repayment of ESOP Loan With Proceeds of Sale of Company StockTypically company stock

purchased with exempt loan serves as collateral

Even if unallocated company stock is not collateral, the courts view is that can still repay ESOP loan with proceeds of sale of company stock that was purchased

April 12, 2004 25

What We Have Learned

FASB 150On May 15, 2003, the

Financial Accounting and Standards Board (“FASB”) issued Statement No. 150

Recently promulgated rules that thought might apply to ESOP puts

Liability vs. EquityGenerally does not apply to

ESOP stockFuture rules may change this

result

April 12, 2004 26

What We Have Learned

Payment of Plan ExpensesField Assistance Bulletin

2003-3 IRS Revenue Ruling 2004-10Proper & Reasonable

ExpenseWhat does the Plan

Document & SPD say? Individual vs. General Plan

ExpensesSignificant Detriment

April 12, 2004 27

Some Things We Would Like to Know

Scope of Prohibited Transaction Analysis when ESOP Acts as ShareholderEGTRRA Determination Letter ApplicationsEffect of Cash Build-up on ESOP Status

April 12, 2004 28

Some Things We Would Like to Know

Boundaries on ESOP Loan Terms and Effect on DistributionsDiversification Time Frames and Compliance with Statutory RequirementsSegregation of Terminated Participant AccountsRebalancing of Participant Accounts