In early conversations with selling business owners and leaders in management who are considering an employee stock ownership plan (ESOP), we often encounter questions and concerns about corporate governance and control.
In fact, governance changes and loss of control are the areas of greatest fear holding business owners back.
Ultimately, it boils down to a fear of the unknown. Fast forward a couple of years, and those same business owners will tell us that a more formal governance structure—including outside board members—was one of the greatest business benefits of implementing an ESOP.
In this article, we’ll take a closer look at corporate governance in general, as well as ESOP-specifics, including:
- ESOP corporate governance stakeholders
- ERISA fiduciaries in an ESOP
- Roles of the ESOP trustee, board of directors, and the ESOP committee
What is Corporate Governance and Who Does It Impact?
Broadly, corporate governance refers to the systems of practices, processes, and rules under which a company is managed and directed. It happens in every business, whether or not there’s a formal, documented structure or system in place. Formal corporate governance creates a framework for achieving the company’s objectives, and it affects nearly every aspect of management, from strategic plans to performance measurements.
Some refer to it as business oversight, administrative protocols, or simply corporate management. It’s the “who” and “how” behind the management of business affairs and alignment of company activities with business goals.
As a company expands or undergoes a transformation, governance structure becomes more important, helping to ensure streamlined operations and strategic alignment. Robust governance practices help manage complexity and uphold accountability.
Customers often view a company’s governance practices as a reflection of its values, integrity, and commitment to ethical practices—so strong governance can help foster trust and confidence among clients or consumers. Recent trends in environmental, social, and governance (ESG) investing criteria demonstrate rising stakeholder interest in sustainability and ethical business practices.
Generally, corporate governance stakeholders include:
Shareholders — These are the company owners. Their primary responsibility is to elect a board of directors.
Board of directors — The board holds accountability for governance and delegates authority to officers and/or members of management. The board’s duty is to represent the shareholders, and it has a corporate fiduciary obligation to those shareholders under state law. Other key responsibilities include advising the CEO and succession planning.
Officers and/or management — These individuals are appointed by the board to carry out the company’s strategic direction through day-to-day management activities. In turn, management hires employees for operational tasks, to ensure the ops plan is carried out.
ESOP Corporate Stakeholders
Because an ESOP is employee-owned, and because it’s a qualified retirement plan whose regulation falls under the Employee Retirement Income Act of 1974 (ERISA), corporate governance structure needs to meet specific requirements and answer to a particular set of stakeholders, including:
The ESOP plan sponsor is the employer that establishes and maintains the ESOP.
ESOP plan administrator(s) are the individuals with authority and discretion over plan management. Unless another individual or entity (such as the ESOP administrative committee) is specifically assigned, the plan sponsor is the legal plan administrator and decisions are made by the board of directors. The ESOP plan administrator is an ERISA fiduciary.
The ESOP administrative committee is typically appointed by the board of directors and serves as the plan administrator.
ESOP trustees (one or more) have authority over plan assets, and act as legal shareholders of the ESOP. An ESOP trustee is an ERISA fiduciary, and has a fiduciary duty to act in the sole interest of plan participants. That means maximizing long-term value of the assets of the trust (i.e., company stock). The ESOP trustee often votes according to the direction of the ESOP administrative committee. In addition to ERISA regulation, the ESOP trustee is governed by the Internal Revenue Code, the plan document, and the trust document.
ESOP participants are beneficial owners of the company. Generally, they have limited legal authority, and it’s the ESOP trustee’s job to represent them. The plan document articulates voting rules, and unless specified in the plan document, the ESOP Trustee is not required to pass-through decisions such as voting for the Board of Directors, buying or selling stock, and exercising voting rights.
In limited cases, such as a significant corporate event (like a liquidation, sale of all or substantially all assets, recapitalization, or merger), the ESOP participants may have the right to have pass-through voting rights.
The plan document specifies the voting rules. Unless provided by the plan document, the ESOP trustee is not required to pass-through decisions such as voting for the board of directors, selling the stock, etc., and generally exercises the voting rights.
What is an ERISA Plan Fiduciary?
A plan fiduciary is a person who exercises discretionary authority over the management of the ESOP or its plan assets. ERISA defines four primary duties of an ERISA fiduciary:
The Exclusive Benefit Rule — An ERISA fiduciary must act solely in the interest of the plan’s participants and beneficiaries while defraying reasonable plan expenses.
The Prudent Person Standard – An ERISA fiduciary must act with the care, skill, prudence, and diligence under the circumstances of a prudent person acting in a similar capacity.
Diversification – An ERISA fiduciary must diversify the investments of the plan unless it is clearly prudent not to, knowing that by definition, an ESOP is designed to invest primarily in qualifying employer securities, so it’s crucial to be aware of ESOP diversification rules.
Follow the Plan Documents – A fiduciary must act in accordance with the plan documents.
How Do ESOP Stakeholders Interact Within the Corporate Governance Structure?
The interplay among the trustee, board, and ESOP administrative committee can be understood as follows:
- The board of directors appoints the ESOP trustee.
- The ESOP trustee typically votes the ESOP shares when the board of directors is elected, often following the guidance of the nominating committee within the board of directors.
- The board of director selects the ESOP administrative committee, which is composed primarily of members of management.
As the above shows, this “circular” selection process means that implementing an ESOP often results in little change in leadership structure or governance practices, with the exception of bringing in a professional ESOP trustee.
Even so, most business leaders who implement an ESOP and bring in a professional ESOP trustee report improvements in governance — both structural and practical. The addition of an “outside” individual encourages more rational decision-making, along with transparency and accountability. In practice, the transition to an ESOP demands a level of excellence in governance that can help drive sustainable growth.
It’s Good to Have Questions About Governance Changes
If you’re a business owner or member of management considering whether an ESOP is right for your company’s ownership transition and you have questions, concerns, or worries about its potential impact on your governance, that’s a good thing. It demonstrates concern for your organization — and your stakeholders.
Let’s go back to those former business owners who’ve now become leaders of ESOP companies. Here are a few of the benefits they’ve realized with the addition of an ESOP trustee and a more formalized governance structure:
- Expertise and experience — Professional ESOP trustees understand regulatory demands and complexity to ensure plan compliance
- Objectivity — Unbiased decision-making, free from internal company politics or conflicts, can improve outcomes
- Risk mitigation — Adherence to fiduciary responsibilities helps minimize potential legal and financial risks associated with missteps
- Operational efficiency — A specialized source of knowledge can streamline processes involved in administration, valuation, and other ESOP-related tasks
- Trust — A professional trustee demonstrates commitment and lends credibility to the ESOP among employees and other stakeholders
- Continuous learning — It’s a professional trustee’s job to stay up-to-date with changing regulations and emerging best practices
Got questions about what selling to an ESOP would mean for your organizational governance? Our experts are here to help. Reach out today.