Exercising fiduciary duties for ESOPs

August 2012  |  10QUESTIONS  |  PRIVATE EQUITY



J. Michael Keeling, president and chief staff officer of The ESOP Association, speaks with Colin M. Henderson, president of Strategic Investment Counsel Corporation, about fiduciary duties for ESOPs.

Keeling: What are the fiduciary responsibilities of an ERISA fiduciary from a trustee’s perspective, and how do they differ when involving an ESOP?

Henderson: A trustee of an ERISA plan has comparable duties to that of a trustee under the common law of trusts. The trust is a separate entity and the trustee must act with the sole interest of protecting the rights of the trust and its beneficiaries. ERISA spells out those duties as: to act for the exclusive benefit of plan participants and beneficiaries; act prudently; diversify the investment of plan assets; and act in accordance with plan documents. An ESOP is intended to be primarily invested in one investment, the stock of the sponsoring company. Therefore, the dissimilarity between ESOPs and other types of plans is the duty to diversify the portfolio against large losses.

Keeling: With the development of the S Corporation ESOP in 1998 and the growth of ESOPs that own a controlling ownership interest in the sponsor, what corporate governance matters come to mind for an ESOP trustee/fiduciary?

Henderson: Prior to 1998, many, if not most ESOPs held minority ownership interests of 49 percent or less. Generally speaking, the other party holding the controlling interest had a considerable influence over management and corporate governance. In a sense, this was not all bad as the controlling party had more ‘skin in the game’; and therefore more to lose. A minority ESOP could take some comfort in the fact that ‘big brother or sister’ would see to the proper conduct of the business. Today, with more and more S corporation ESOPs owning a controlling interest, the ESOP trustee would naturally want to take a different view. It is my opinion that a trustee in a control environment would want to monitor a robust corporate governance regime. 

Keeling: How important is it that a board of directors of an ESOP owned company be organised formally with standing committees for governance, audit, executive compensation, nominating or temporary special committees?

Henderson: I believe that it is very important and speaks directly to the value creation duty of the board. Small ESOP companies are often limited in their ability to establish and maintain such a structure from a resource limitation perspective, finding it difficult (but not impossible) to retain competent independent directors. Having said that, it is my belief that all ESOP companies should be aware of the objectives of these structures to deal with conflicts-of-interest and assure that decisions are made that are in the exclusive best interest of the shareholders. For example, it is my opinion that a primary duty of the board is to ensure the integrity of the company’s financial statements. To remove any question, the financial accounting employees of the company should not be empowered with their own oversight. An example is the engagement of the outside financial auditor. Where possible, this engagement should be performed by one or more independent (or independent-minded) directors with appropriate subject competence. Another example is that the CEO should not have the authority to establish the CEO’s compensation. This should be done using an independent party who bases its decisions on objective measures of performance and industry compensation studies, possibly with the aid of a compensation consultant.

Keeling: What are the typical voting responsibilities of an ESOP fiduciary and under what circumstances do those duties become intricate?

Henderson: A routine voting responsibility involves the election of directors. Often, this is an annual process in which the entire board is elected; or in the case where directors serve for staggered terms, the election of a term class of director. Otherwise, it would involve matters in which state law requires a shareholder vote. Examples may be significant corporate events like mergers, acquisitions, recapitalisations or the sale of a significant corporate asset. These voting decisions are more complex and require a considerable amount of investigation. ESOPs may allow the board or the ESOP Committee to direct the trustee as to the vote. While this is a proper plan provision, ERISA requires the trustee make a determination that the direction itself is proper and in the financial best interest of the plan. Another typical plan provision is the vote ‘pass thru’ provision, where the plan participant is permitted to confidentially direct the trustee on the vote. Again, before voting as directed, the trustee must perform an adequate investigation and make a determination that the vote is prudent and in the ‘financial best interest’ of the plan. If the trustee determines otherwise, it must vote in accordance with its determination.

Keeling: Do ESOP trustees ever have a requirement to disclose certain undertakings and what are the challenges that he or she may face in assuring the disclosures adequacy?

Henderson: As in the ‘pass thru’ example above, in order that the participant has the opportunity to make an informed decision, there must be sufficient disclosure of the facts of the matter under consideration such that the participant is well informed and not under the influence of others such as supervisors or managers. Preparing understandable disclosure documents, communicating and insulating the process from undue influence can be challenging. This may require group meetings and one-on-one discussions. The trustee is charged with tabulating and casting the vote at the shareholder meeting while maintaining confidential the individual participant votes.

Keeling: What should someone consider when being asked to serve as an ESOP trustee?

Henderson: After a brief period of indulgent honour and pride for having the respect to be considered for such an appointment, I would take considerable care to learn as much as possible about the duty and standard of care that such an appointment involves. I would also want to investigate the amount of time and resources that I would need to devote under various scenarios in order to achieve excellence in the execution of the duty. I would seek independent legal counsel to advise me on the exposure to which I am subjecting my personal wealth in the event of an after-the-fact controversy about decisions I will be making as trustee. Contractually, I want to have the ability to engage qualified independent legal (ERISA, corporate, tax), financial advisory, and accounting counsel of my choosing, when reasonably appropriate. I also want to investigate insurances and the costs that are available. 

Keeling: Have the Courts dealt differently with conflicted trustees and independent trustees?

Henderson: Yes. Where a conflict-of-interest is apparent, courts have placed the burden of proof on the defendant. In other words, the defendant must prove his or her innocence. Whereas in the case of an independent trustee, one without a conflict-of-interest, the courts have given deference to such defendants and the burden of proof is upon the plaintiff who must produce factual evidence showing that the defendant acted impudently, negligently, or with willful misconduct and therefore breached its duty under ERISA. 

Keeling: Describe the decision making process that you go through when considering to purchase company stock?

Henderson: The first step is to engage qualified independent legal and financial / valuation advisory counsel. Identify the parties to the transaction, the block being considered, the proposed deal structure, financing and timing. Determine that all parties are adequately represented and who is representing which party. Once the stage is set, a thorough investigation of the asset and its value is conducted. Legal counsel performs legal due diligence and begin the drafting and negotiation of transaction documents and terms. The valuator begins the valuation due diligence and analysis. The trustee’s job is to be fully engaged in both of these processes. These professionals are your staff. To get the maximum benefit from the investigations, you must keep yourself well informed along the way, assuring a thorough job. The last step in the process is the determination that the price to be paid by the ESOP is not more than ‘adequate consideration’ and, while looking at all of the components of the transaction, that the transactions are prudent and fair to the ESOP from a financial point of view, and that the terms of the financing are reasonable, prudent and qualify as a loan that is exempt from the ‘prohibited transactions’ under ERISA. 

Keeling: You have mentioned that a condition that someone considering an appointment as an ESOP trustee should make is that they be unfettered in their ability to engage competent independent legal counsel and financial advisors. How do you seek out and engage competent advisors?

Henderson: I think of it in terms of a very serious matter such as engaging a heart surgeon. You want the very best. In that case, your life depends on the experience, skill and integrity of the individual. Chances are that you are not personally acquainted with many ESOP professionals. I endeavor to embark on a deliberate quest to seek out the most qualified. While there are many good ERISA practitioners, I look for those who specialise in representing ESOP trustees, have experience with transactions and the various negotiations, have insight into the industry and are independent from the other party to the proposed transaction. There are a number of professional organisations such as The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO) whose memberships include practitioners. After initial inquiries to narrow the field, I recommend that a detailed ‘Information Request’ be submitted to each candidate, with references. Follow this up with face-to-face interviews and a ‘Request for Proposal’ from each candidate that makes the short list. Then pick the very best.

Keeling: What governmental agency is charged with enforcing the fiduciary standards of ERISA and what is their relationship to the ESOP community? Should it be an adversarial or a constructive relationship? 

Henderson: The United States Department of Labor, Employee Benefit Services Administration (DOL) is charged with enforcing the fiduciary standards of ERISA. In general, over the several decades since ERISA became law in 1974, the agency has had very little visibility within the ESOP community. For the past 16 years, TEA has held a Practitioners Federal Agency Forum in conjunction with its conferences, inviting participation by IRS, Treasury and DOL. Treasury and IRS have been regular participants, resulting in a healthy history of working on regulatory matters of mutual interest or concern to ensure understanding and compliance. In my opinion, in a legal and financial field as opaque, fluid and hazardous as the fiduciary duties under ERISA, where possible it is in the best interest of achieving a high degree of compliance to have a positive constructive dialogue between the regulated community and the enforcement agency. This does not exist today with respect to the DOL. It is something to which the ESOP community continues to aspire.


J. Michael Keeling, CAE, is the president and chief staff officer of The ESOP Association, a national trade association promoting the growth of employee ownership in America through Employee Stock Ownership Plans, or ESOPs He is also president of the Association’s affiliated 501(c)(3) educational and research foundation, the Employee Ownership Foundation. He is a graduate of Yale University and the University of Texas Law School. Mr Keeling can be contacted on +1 (202) 293 2971 or by email: michael@esopassociation.org.

Colin M. Henderson is the president of Strategic Investment Counsel Corporation. Mr Henderson has earned a national reputation as a leading expert in the management of complex investment fiduciary issues related to the administration of ‘qualified’ employee benefit plans. He has served, as an expert witness in litigation involving the Standard of Investment Prudence, has been a speaker at various ESOP Association conferences, the Texas Society of Certified Public Accountants and the Dallas Bar Association. His fiduciary decisions and financial opinions have been published in the Federal Register. Mr Henderson can be contacted on +1 (214) 328 2400 (ext. 100) or by email: chenderson@strinco.com.

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Colin M. Henderson

Strategic Investment Counsel Corporation

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