Inside fiduciaries for ESOPs have substantial legal responsibility and risk. Making sure an ESOP complies with the law and the plan document is the best insurance against costly legal problems, and at the same time it builds trust and credibility for employee ownership among plan participants. This book is meant to provide an overview of life as an inside ESOP fiduciary. It alerts the reader to the key issues, including ESOP basics, fiduciary issues, valuation scenarios fiduciaries may face, working with appraisers, board-trustee interactions, and fiduciary insurance.
The fourth edition has been updated throughout as of 2020 to reflect new information and guidance, including new court decisions and data on DOL investigations. The existing discussion of valuation in chapters 3 and 4 was reworked so that the expanded Q&A that now forms chapter 3 takes their place. Chapter 4 is now a new chapter, “Working with Valuation Analysts to Set ESOP Share Prices.” The appendix points to a number of forms and other documents that can be downloaded at the NCEO's website and are simply referenced there instead of being printed in the book.
The NCEO also offers a 90-minute remote traning program on fiduciary issues by the NCEO's founder, Corey Rosen.
Table of Contents
1. A Review of Basic ESOP Rules
2. The Role of the ESOP Fiduciary
3. Valuation Q&A for Inside Fiduciaries
4. Working with Valuation Analysts to Set ESOP Share Prices
5. Potential Penalties and How to Cover Them
6. Guidance from DOL Process Agreements with ESOP Fiduciaries
7. Best Practices in Interaction Between the Board of Directors and Trustees
8. Fiduciary Liability Insurance
Appendix: Additional Resources Online
About the Authors
About the NCEO
From Chapter 2, "The Role of the ESOP Fiduciary"
Most closely held ESOP companies still have an individual or committee act as fiduciary. Most often, an individual fiduciary is the CEO, CFO, or other officer of the company. In some cases, the seller to an ESOP is the fiduciary, or is on the fiduciary committee. This creates an obvious conflict of interest, however. An ESOP fiduciary is responsible for carrying out his or her duties with “an eye sole” to the interests of plan participants. A seller would have a hard time actively negotiating for the best deal possible for the ESOP, then running to the other side of the table to protect his or her own interests.
Many owners are reluctant to entrust fiduciary decisions to someone else, of course. That’s understandable, but so is the position of the courts when faced with a lawsuit from plan participants, most often over whether the ESOP overpaid for the shares the owner was selling or otherwise operated in a way that was more for the benefit of the owner than for the employees. It doesn’t matter if the plan ended up being good for employees too; it is the process that the court focuses on, not the results.
Fiduciary committees are very common. Typically, they have three to five people, but there is no magic number. Most often, they comprise groups of management-level employees, but they may include outsiders, such as an independent board member, financial or legal expert, or former employee. Some committees have nonmanagement employees on the committee as well. While anyone on a fiduciary committee needs to be well-schooled in legal, financial, and operational issues of the plan, this is especially true for nonmanagement employees, who may not be as sophisticated in any of these areas as management employees.
Tables 2-1 and 2-2 break down the prevalence of ESOP trustees by size, percentage of ownership, and S or C status.
From Chapter 4, "Working with Valuation Analysts to Set ESOP Share Prices"
Analysts frequently request a variety of documents and data from the company’s management team such as sales to the top five customers over the last five years, purchases by supplier over the last five years, forecasts, sales pipelines, and other items. These may be time-consuming to prepare, and management may question whether they are actually necessary. They are. The analyst’s “risk hunt” involves looking at all parts of the business to assess risk. For example, when looking at sales to top customers, analysts are looking for customer concentration risk. If one customer makes up a large portion of sales, the company may have a higher risk profile because it may go under if it loses that customer. Table 4-1 (see next page) presents the commonly requested items and the risk factors analysts look for. Spoiler alert: the word “risk” shows up many times.
The due diligence process is a great opportunity for the trustee (who understands both valuations and the subject company’s risk profile) to act as a mediator between management and analysts. Some of the requested documents may be difficult for management to produce. The trustee can assist with the due diligence process by explaining to management why the requested items are necessary.
From Chapter 6, "Guidance from DOL Process Agreements with ESOP Fiduciaries"
The FBTS Agreement also added another potentially controversial requirement that if the appraisal relies on unqualified financial statements (including interim financial statements), the stock purchase agreement must have a provision that any seller who is an officer, manager, or board member will compensate the ESOP for any losses related to these statements if they did not accurately reflect the company’s financial condition. How much this will apply to trustees in general as opposed to just FBTS is not clear (the FBTS Agreement grew out of a fact pattern not typical for ESOP transactions). The FNB agreement also requires that any valuation done for the seller in the prior 12 months be obtained and considered.
The FNB agreement required that the ESOP not pay for control unless it has control rights on a very long list of issues. Several of these are standard practices such as voting rights, but others are not normally required, such as the ability to appoint and remove company officers, executive compensation, acquiring assets, debt levels, dividends, and capital expenditures. These are normally board issues. A trustee might raise concerns over a particular decision or process, and could replace board members if dissatisfied, but would not normally have a direct say in them. It is not clear whether the DOL will pursue this line of argument in other cases and even less clear whether courts would agree.