Can ESOPs Take Outside Debt to Fund the Repurchase Obligation?

The repurchase obligation remains one of the most persistent and legally complex challenges confronting mature employee stock ownership plans, or ESOPs, sponsored by companies whose stock is not readily tradable on an established securities market. As participants retire, terminate employment, or otherwise become entitled to distributions, the sponsoring employer must ensure the availability of liquidity sufficient to repurchase employer securities and distribute such benefits in cash.

ESOP sponsors have developed multiple strategies to address this obligation. Many are commonly used and mostly structurally conservative, such as employer contributions, corporate redemptions, and releveraging transactions structured within the ESOP stock-acquisition framework (see below). However, there is a distinct approach that superficially achieves the same result of generating repurchase liquidity but raises significant ERISA fiduciary and prohibited transaction concerns. This strategy involves the ESOP borrowing directly from a third-party lender and pledging plan assets as collateral.

ESOPs that undertake the plan sponsor’s repurchase obligation and need to generate repurchase liquidity may consider borrowing directly from a third-party lender. While loans to ESOPs through defined channels designed with recognizable safeguards are not inherently improper, a third-party loan to the ESOP for the purpose of financing repurchase liability—particularly where the loan is secured by plan assets—falls outside those channels and lacks those safeguards.

The concerns are compounded when the employer guarantees this ESOP loan, because the guarantee may be characterized as an extension of credit involving a disqualified person (or party in interest), and reinforces the apparent narrative that the ESOP is being used as a conduit for financing a corporate liquidity obligation. The prohibited transaction rules explicitly treat lending and other extensions of credit between a plan and a disqualified person as prohibited, absent an applicable exemption.

This article reviews established repurchase obligation funding strategies, maps the legal pathways under which direct ESOP trust borrowing can be lawful, and then examines the structural risks present when ESOP-level borrowing is secured by plan assets. The article also considers how these structures may be evaluated in litigation, particularly in light of recent case law clarifying the burden-shifting framework applicable to prohibited transaction claims.

The Repurchase Obligation

The repurchase obligation is meant to address two essential ESOP realities:

• the distribution and put-option mechanics applicable to non-publicly traded employer stock; and
• the need for cash liquidity to satisfy those distributions when no established market exists for the employer securities.

The repurchase obligation is principally a corporate liability. Whether the liquidity needed to satisfy this corporate obligation is supplied by the employer, the ESOP, or some combination depends on plan design and corporate policy. A frequently overlooked but legally significant point is that the company (i.e. plan sponsor) does not act in its ERISA fiduciary capacity when managing its repurchase obligation. Projecting future repurchase costs, managing liquidity, and choosing among funding vehicles are business decisions made by the company in its corporate capacity and not as a fiduciary of the ESOP. However, once the ESOP is involved in facilitating the repurchase, the trustee’s (and, often, the plan sponsor’s) fiduciary duties to the plan and its participants are directly engaged. A structure may be commercially reasonable from an employer’s perspective and still be imprudent and impermissible for the trustee.

Established Strategies for Funding the Repurchase Obligation

This section describes and unpacks the primary methods ESOP sponsors use to fund the repurchase obligation, most of which keep the credit risk at the corporate level rather than transferring it to the plan, or rely on a statutory exemption under the prohibited transaction rules.

Employer contributions and redemptions. The most straightforward approach is for the sponsoring employer to use its own cash to fund repurchases by making contributions to the ESOP or by redeeming shares directly from participants. This structure keeps the financial responsibility entirely with the employer and avoids introducing third-party creditor rights against plan assets.

Employer-level borrowing. Alternatively, a company may borrow from a third-party lender and use those proceeds to meet repurchase obligations in one of two ways:

• contribute the borrowed proceeds to the ESOP (subject to applicable tax and plan limits), enabling the ESOP to satisfy distribution obligations using those funds; or
• use the proceeds to redeem shares directly at the corporate level, externalizing the financing and leaving the plan insulated from lenders.

Releveraging transactions. Some sponsors manage repurchase liability by “releveraging” an existing ESOP. In a releveraging transaction, the company effectively causes the ESOP to incur a new internal loan (often paired with external financing at the corporate level) in exchange for employer stock. The transaction generates liquidity at the corporate level that can be used to satisfy the repurchase obligation. The leveraged shares are held in a suspense account and allocated over time as the internal loan is repaid. Releveraging transactions operate within the established statutory framework for exempt ESOP stock-acquisition loans. As a result, they are a recognized method for managing repurchase liability.

Employer-to-plan loans are not automatically permissible. A loan from the employer to the ESOP is not rendered permissible simply because the employer first borrows the funds from a bank. ERISA and the Internal Revenue Code treat a direct employer-to-plan loan as a prohibited extension of credit unless a statutory or administrative exemption applies. Where sponsors intend a direct cash advance to the plan rather than a contribution, practitioners must evaluate whether the arrangement fits within an available exemption, such as PTE 80-26 (see below), or whether an individual exemption is required.

Use or liquidation of ESOP assets. Many ESOPs hold cash or diversified investments, particularly following participant diversification elections. Using existing plan cash or liquidating plan investments to fund distributions is typically not problematic if consistent with the plan terms and fiduciary prudence. The critical distinguishing feature is that the ESOP is not incurring any debt and is not pledging plan assets to an outside creditor.

Loans Made Directly to an ESOP Trust

As previously noted, ERISA and the Code do not categorically prohibit lending arrangements involving ESOPs. Rather, the prohibited transaction rules begin by establishing a default prohibition on extensions of credit with parties in interest and disqualified persons, and then carve out specific narrow pathways where lending is permitted under defined safeguards.

Exempt ESOP stock-acquisition loans: ERISA §408(b)(3); Code §4975(d)(3); Treas. Reg. §54.4975-7. The most clearly sanctioned ESOP borrowing channel is a loan to an ESOP for the acquisition of qualifying employer securities. Treasury regulations provide that such a loan includes loans made or guaranteed by a disqualified person, with “guarantee” defined broadly to encompass the use of a disqualified person’s assets as collateral.

Congress expressly designed this exemption to facilitate employee ownership while imposing structured constraints. The loan’s purpose must be defined, the transaction documented as part of an ESOP leverage structure, and the plan’s economic exposure intended to align with the acquisition of employer stock rather than the satisfaction of a general corporate financing obligation.

Individually exempt loans: ERISA §408(a); Code §4975(c)(2). For a transaction that does not fit within a statutory class exemption, the Code authorizes an administrative exemption procedure under which the Department of Labor or IRS may grant relief upon finding that the transaction is administratively feasible, in the interest of the plan, and protective of participants and beneficiaries.

This pathway is available, but inherently transaction-specific, and there is no guaranteed outcome that the individual exemption will be granted.

Plan Liquidity Loans Under PTE 80-26. PTE 80-26 is a DOL class exemption that permits certain interest-free loans from parties in interest (including the employer) to a plan experiencing a cash shortage, subject to conditions that include a 0% interest rate, no other fees, and a requirement that the funds be used for ordinary operating expenses. Subsequent DOL amendments expanded PTE 80-26’s flexibility while adding conditions, including a written requirement for longer term loans. These developments reflect that PTE 80-26 was intended to support ESOP sustainability, not as a permanent financing mechanism for structural repurchase obligations.

The exemption’s core requirement that the party in interest may not profit through interest or fees materially reduces the inherent conflict in a plan/party-in-interest credit relationship, and makes this pathway comparatively safe.

Common safeguards across permissible ESOP trust loans. The following protections are consistently present within the lawful pathways for ESOP-level loans:

• a clearly identified exemption (statutory, class, or individualized);
• tight limitations on purpose (stock acquisition or short-term operational liquidity); and
• structural guardrails designed to prevent the ESOP from being used as a general corporate financing vehicle.

The repurchase liability scenario where the ESOP borrows directly from a third-party lender to fund cash distributions typically lacks these features, or requires strained analogies to reach them. For example, proponents of such a structure might attempt to analogize a repurchase liability loan to a stock acquisition loan (and its loan exemption principles) by arguing that the transaction indirectly supports the ESOP’s ownership of employer securities. Similarly, efforts to situate the repurchase liability loan arrangement within PTE 80-26 requires expanding that exemption beyond its intended role as a short-term liquidity bridge for operating expenses, rather than a mechanism for addressing recurring liabilities.

ESOP Borrowing to Finance Repurchase Liability

When framed through the lens of the lawful loan pathways, the issues with ESOP borrowing for repurchase liability are easier to identify. The concern is not that loans to ESOPs are inherently suspect, but that this particular loan does not fit naturally within any of the established safe channels.

Encumbrance versus expenditure. Using plan cash or liquidating plan investments is fundamentally different from pledging plan assets to a third-party creditor. Encumbering plan assets introduces outside creditor rights and subjects retirement assets to default-remedy leverage. This creditor imposition on the plan is absent when the ESOP is merely using existing plan funds.

Prohibited transaction pressure points. A loan or extension of credit between a plan and a disqualified person falls squarely within the prohibited transaction definition, absent an applicable exemption. If the ESOP borrows from a third-party bank, the bank itself may not be a party in interest merely by virtue of lending. However, the transaction’s structure can implicate prohibited transaction theories depending on who is involved, what guarantees are provided, and whether plan assets are being deployed for the benefit of a party in interest.

Risk-transfer narrative. The most litigation-sensitive fact pattern arises where the employer faces a corporate liquidity problem in the form of a repurchase obligation, the ESOP incurs debt and pledges plan assets to satisfy that obligation, and the employer’s balance sheet gets preserved while plan assets bear new creditor risk.

Congress, the DOL, and the IRS expressly accommodated the risk-transfer inherent in ESOP leverage when the purpose of the loan is for the ESOP to acquire employer stock. That is a congressionally favored goal. They did not extend an accommodation to third-party ESOP loans used to fund cash distributions. When a plaintiff frames the transaction as a transfer of employer liquidity risk to the plan, the absence of a recognized statutory basis for the transfer is a significant vulnerability. ERISA §406(a)(1) focuses not only on the form of a transaction but also on whether plan assets are being used, directly or indirectly, for the benefit of a party in interest.
In this context, the plaintiff need not demonstrate that the employer receives an immediate economic benefit. Rather, it may be sufficient to allege that the plan has assumed risk that would otherwise have remained at the corporate level, inviting the argument that the loan to the ESOP benefitted the employer, without the protection of a recognized exemption.

Employer Guarantee Makes the Risk Worse

While certain employer guarantees are expressly permitted, such as in the case of an exempt ESOP loan where the regulations broadly define “loan” to include guaranteed loans, not all loan guarantees in any loan context are benign.

Guarantee reinforces prohibited transaction theories. Extensions of credit or transfers of plan assets for the benefit of a disqualified person are prototype instances of prohibited transactions. If the ESOP borrows and the sponsor provides a guarantee, absent a clearly applicable exemption plaintiffs may characterize the arrangement as an impermissible extension of credit or a plan-related transaction for the benefit of a disqualified person. This characterization would typically be grounded in ERISA §406(a)(1)(B) or (D), which prohibit extensions of credit between a plan and a party in interest and transfers of plan assets for the benefit of a party in interest. A guarantee, particularly where it is economically necessary to secure the loan, may be viewed as linking the plan’s borrowing to the sponsor’s financial obligations, thereby strengthening the argument that the transaction operates for the employer’s benefit rather than the benefit of the plan.

Guarantee undercuts the “plan purpose” argument. From an optics and pleading perspective, a sponsor guarantee signals that the lender is underwriting the employer’s obligation rather than the ESOP’s investment activity, and that the ESOP is being used as a corporate instrumentality to solve a sponsor problem. This framing increases the likelihood that a court would view the transaction as corporate finance dressed in ERISA clothing. Courts evaluating fiduciary prudence and prohibited transaction claims frequently consider the economic substance of a transaction in addition to its formal structure. In a context where the employer’s liquidity need is evident and the ESOP assumes incremental risk without a clear plan-level investment rationale, a “substance over form” analysis may weigh against the transaction.

Litigation risk increases even if merits defenses exist. In Cunningham v. Cornell University, the US Supreme Court clarified that a plaintiff alleging a prohibited transaction need only plead facts showing a transaction that facially falls within ERISA’s prohibited transaction provisions. After that, the burden shifts to the defendant to establish an applicable exemption as an affirmative defense.
Under this framework, an employer guarantee heightens the transaction’s risk profile, increases the likelihood that a prohibited transaction claim survives a motion to dismiss, and creates discovery risk, even where the plan sponsor believes its defenses are ultimately meritorious. In particular, the presence of a guarantee may make it easier for a plaintiff to plead a facially prohibited transaction by connecting the plan’s borrowing to a party in interest’s financial interests, thereby shifting the burden to the defendant to establish the applicability of an exemption.

Lender Enforcement Complications

While there is limited reported case law addressing lender enforcement against ESOP-collateralized loans in the repurchase liability context, lenders evaluating an ESOP-collateralized loan should be aware that ERISA plans are not ordinary commercial debtors. Several features of ERISA create practical complications for collateral enforcement that do not arise in conventional secured lending.

The DOL’s general protective posture toward preservation of plan assets, and specifically ERISA’s anti-alienation provisions, can motivate participant litigation or generate regulatory intervention designed to prevent creditors from reaching plan assets. For example, participants may seek injunctive relief under ERISA §502(a)(3) to prevent the disposition of plan assets, and the DOL may intervene or informally engage where it perceives a risk to retirement assets, even if no enforcement action is ultimately brought.
Efforts to obtain such equitable relief can cause a material delay or otherwise impair a lender’s ability to realize on collateral. Thus, even the possibility of such actions may introduce timing uncertainty, which lenders may factor into underwriting decisions. Aside from the legal and economic concerns, the reputational risks associated with being named in an ERISA enforcement proceeding should factor into a lender’s cost-benefit analysis. These considerations should inform the credit decision and any collateral or guarantee structure.

Planning Takeaways

Several planning principles follow from this analysis:

Identify the applicable safe lane before proceeding. If a direct loan to the ESOP trust is under consideration, the threshold question is whether the transaction fits within a recognized exemption. The primary examples are a stock-acquisition exemption under ERISA §408(b)(3), the interest-free operational liquidity exemption under PTE 80-26, or an individual exemption obtained through the DOL’s administrative process. If no exemption is clearly available, the transaction should be approached with caution and either restructured or abandoned.

Treat repurchase-liability borrowing as structurally high-risk. A third-party loan to the ESOP to fund cash distributions lacks the purpose limitations and structural guardrails built into permissible ESOP loan pathways, particularly when compared to the detailed regulatory framework governing stock-acquisition loans and the narrowly tailored scope of PTE 80-26. Sponsors and trustees should approach this structure with substantial caution and independent legal advice. The trustee’s fiduciary obligation to evaluate the transaction on the plan’s terms is particularly acute in this context.

Recognize that employer guarantees typically worsen the problem. An employer guarantee does not bring a deficient transaction within a recognized exemption. It deepens prohibited transaction exposure, amplifies the inference that the ESOP is being used to finance an employer obligation, and increases litigation risk particularly due to the holding in Cunningham. Sponsors who believe a guarantee is necessary to make the transaction commercially viable should view that necessity as a signal that the structure presents meaningful legal concern, as it may indicate that the transaction’s viability depends on the credit support tied to the employer’s financial position rather than on the intrinsic merits of the transaction from the plan’s perspective.

Precautionary Measures

The regulatory and litigation risks are meaningful in isolation, and become exacerbated when an employer guarantee is layered on top. Plan sponsors and trustees considering this structure should identify a clear exemption pathway, obtain independent fiduciary analysis, and fully understand the exposure they are accepting. Lenders considering financing such an arrangement should first confirm that such safeguards are in place. Without these precautionary measures in place, the risks inherent in such an arrangement will, in many cases, outweigh the anticipated benefits.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Zachary Wertheimer is an attorney in Buchalter’s Los Angeles office. As a member of the corporate, tax, benefits and estate planning groups, his practice encompasses all matters of employee benefits, executive compensation, and ESOPs.

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