Often, when business owners begin investigating exit strategies and discover the benefits of an employee stock ownership plan (ESOP), they’re running companies without a board of directors in place.
In fact, it’s common for the business owner to essentially serve all board responsibilities, while also serving as president and/or chief executive.
Other companies may have a board in place that doesn’t actually fulfill the responsibilities of a board of directors. Instead, they’re often operationally focused, making shorter-term business decisions rather than governance decisions with a longer-term, strategic focus.
But making the transition to an ESOP company changes more than the ownership of the business. ESOPs are subject to the Employee Retirement Income Security Act of 1974 (ERISA), which describes fiduciaries and their obligations to ESOP shareholders (in other words, employee-owners).
At the same time, ESOP participants’ ownership doesn’t necessarily mean they have voting rights over the board. This can lead to many questions, for example:
- Does ERISA specify requirements for ESOP company boards?
- How should an ESOP board of directors be selected?
- What are board members’ most important responsibilities?
In this article, we’ll answer these questions and more about requirements and best practices for ESOP corporate governance.
Company Ownership and ESOP Control
Shareholders are the owners of a company. The laws of the state in which the company is incorporated define the shareholders’ legal rights. These rights are also described in the articles of incorporation and company bylaws.
The articles of incorporation define the legal purpose of the business, the number of shares issued, and shareholders’ voting rights. Bylaws provide more detail and depth on how to govern the company, hold shareholder meetings, and elect or remove members of the board of directors.
Company shareholders elect the board of directors to run the company in terms of strategic and long-term oversight, essentially serving as the highest level of company management. The board approves and amends articles and bylaws. It also approves significant corporate transactions.
The board is responsible for protecting the interests of the shareholders, and has a fiduciary obligation under state law to those shareholders.
It’s important to note that for most legal purposes, the ESOP trustee acts as shareholder of the ESOP. That is to say, the trustee serves on behalf of the employee owners.
How is an ESOP Company Board of Directors Selected?
Your ESOP plan design and documents include board and trustee governance charters, which detail selection and inclusion of directors on the company board, as well as the processes and requirements for the board and trustee in their mutual oversight of one another.
In many companies, shareholders elect their board of directors. This is certainly possible in an ESOP company, but it’s not a requirement. In fact, the board of directors can select replacements; the ESOP trustee is expected to oversee those selections within the scope of his or her fiduciary responsibilities.
The process of making decisions, and documenting those processes, is of the utmost importance, so it’s vital to take thorough notes and keep them on file. Maintaining minutes and internal memos is a recommended practice. Prepare and include resolutions to document the board’s work.
The ESOP trustee is an important part of ESOP corporate governance, but he or she should not be included on the board, due to many potential conflicts of interest. Remember, the trustee acts as the legal shareholder of the shares held by the ESOP trust — in other words, the ESOP trustee exercises shareholder control by voting to select members of the board.
In practice, the trustee typically doesn’t nominate candidates or fulfill management duties. Rather, the trustee acts in a consulting and oversight capacity, ensuring that the board is serving the shareholders’ best interests. The board can recommend removal or replacement of an ESOP trustee, and the trustee can do the same with directors.
What’s Unique About an ESOP Company’s Board of Directors?
ERISA doesn’t define specific requirements for boards of ESOP companies; neither do securities laws. State laws vary in terms of specific requirements, and any board of directors is subject to state corporate law.
But it’s particularly important to understand that, as part of the transition to an ESOP company, the board of directors often plays a much more active and influential role than it may have before the ESOP sale. If the board of directors was nominal before, your team could experience quite a learning curve in the transition. A third-party administrator with a team of ESOP experts can help you navigate the changes.
A properly functioning board addresses these three major areas of responsibility:
1. Growing shareholder value
ESOP shareholders are plan participants, so the future value of company shares is foundational to the value of this unique qualified benefit plan. As fiduciaries, board members have a duty of care to act prudently in steering the company. They have a duty of loyalty to act in good faith and in the interest of the company and all of its shareholders. And their duty of obedience requires them to stay faithful to the purpose of the company.
2. Succession planning
The board is responsible for making sure a succession plan is in place for the CEO and key members of senior management. This responsibility includes identifying, developing, and training replacements internally, as well as searching for and selecting external candidates when appropriate.
3. Advising the CEO
The board of directors advises the CEO and sets strategic goals by approving financial statements, and making significant cash decisions and other strategic decisions, including:
- Selecting, monitoring, evaluating, setting compensation for, and replacing the CEO and other key senior executives
- Reviewing and approving financial statements, plans, forecasts, and projected capital expenditures
- Reviewing, approving, revising, and updating the corporate philosophy and mission, business plan, and strategic plan
- Reviewing and approving significant transactions that fall outside business operations
- Creating and upholding an ethical environment in compliance with regulations, information security, and business practices
- Fulfilling responsibilities in accordance with state law, articles of incorporation, bylaws, and any other applicable regulations and/or governing documents
While 100% employee-owned S corporations are not subject to federal or state income tax, C corporation ESOPs that are less than 100% employee-owned may be subject to federal income taxes. In these cases, the board of directors may play a critical role in overseeing tax risk and tax strategies, as well.
Evaluate Your ESOP’s Processes to Maximize the Benefits
As you can see, the potential benefits of employee ownership often go hand in hand with complex regulatory requirements, significant fiduciary responsibilities, and detailed administrative demands. The guidance of an experienced team of ESOP experts can help you achieve your corporate vision while delivering a meaningful retirement benefit to employee-owners.
You can quickly and easily get a clear review of your ESOP processes and recordkeeping practices as they compare with industry best practices, to help you make sure you’re getting the greatest possible benefit from your plan. Just take a moment to request a free review by clicking the link below.