What the Disqualification of an ESOP Illustrates About ESOPs In General

Here’s a great little story by lawyer and blogger Jeffrey Cairns on the IRS disqualifying a professional practice’s ESOP based on significant operational defects, not the least of which was a failure to comply with the plan’s terms concerning eligibility. I like the post because it lays out the nature of the ESOP, the defects, and how those defects led to disqualification clearly and carefully. Often, stories about these types of events tend to speak in broad generalities, or else take the disparate problems in a particular ESOP and the multiple causes of a disqualification and treat them as one undifferentiated mass. Cairns doesn’t do that here, and instead explains exactly what errors were made that led to the disqualification.

The reason the story caught my eye – beyond its clarity – is that it relates to a point of contention I often find myself in with lawyers and financial advisors who tout the wonders of the ESOP form. ESOPs certainly have their place, and can, when used correctly and with the right intentions on the part of a company’s owners or founders, be a very important tool. I have found over the years, however, that some ESOP advocates, and especially lawyers who defend them against suits by participants or regulators, sometimes seem to have a “see no evil” approach to ESOPs and to treat all criticisms of the form as illegitimate. I have always thought that this view goes too far. It has always been my opinion that ESOPs are wonderful in theory, but in practice, they are only as good as both the intentions of those who found them and the competency of those who run them. When ESOPs are put in place properly, run competently, and installed with the interests of the plan participants at heart, they are a wonderful thing. However, as the case of disqualification depicted in Cairn’s post reflects, this isn’t always the case. No matter what promoters of that corporate form argue, ESOPs are not the be all and end all unless they are run right and with the right intent. Cairn’s story of the disqualification of one small firm’s ESOP well illustrates that point.