I have spent a lot of time talking about the top benefits of implementing an ESOP for a company, the business owner(s), management and key employees, all employees, and the local community. These benefits include the tax and cash flow benefits and the many competitive benefits of building an ESOP ownership culture.
I talk to a lot of business owners and management that are considering implementing an ESOP and their #1 concern is control.
On one hand business owners appreciate the control premium that an ESOP can pay for a change in control.
On the other hand, they are very concerned about the unknown about what a change in control means and doesn’t mean.
Fast forward a few years and many business owners will tell you that moving to a more formal board with some outside board members was one of the top benefits of implementing an ESOP.
It is important to understand the corporate governance and ESOP stakeholders, what is an ERISA fiduciary, and the relationship between the ESOP Trustee, Board of Directors, and the ESOP Committee.
What is Corporate Governance?
Corporate governance is how corporations manage the business affairs of the company to achieve their corporate and shareholder objectives.
Who are the Corporate Governance Stakeholders?
- Shareholders– The shareholders are the owners of the company. The primary responsibility of shareholders is to elect the Board of Directors.
- Board of Directors– The Board of Directors are responsible for corporate governance and delegate authority to officers/management. The Board represents the Shareholders, is the highest level of management in a company, and is responsible for governing the company. The Board has a corporate fiduciary obligation under state law to the Shareholders. Advising the CEO and succession planning are other key responsibilities.
- Officers/Management– The officers/management are appointed by the Board to carry out the strategic direction of the company and are responsible for the day-to-day operations of the company. Management hires the employees for day-to-day operations and to carry out the operational plan.
Who are the ESOP Stakeholders?
- ESOP Plan Sponsor– The employer that establishes and maintains the ESOP.
- ESOP Plan Administrator– The individual(s) with authority and discretion over the management of the plan. Unless another individual or entity (e.g. ESOP Administrative Committee) is specifically assigned, the Plan Sponsor is the legal Plan Administrator and decisions are made by the Board of Directors. The Administrator(s) is an ERISA fiduciary.
- ESOP Administrative Committee– The ESOP Administrative Committee is usually appointed by the Board of Directors and serves as the Plan Administrator.
- ESOP Trustee- The ESOP assets, which primarily consist of the stock of the company, are held in a trust and managed by the ESOP Trustee. The ESOP Trustee is the individual(s) with authority and discretion over the plan assets. For most purposes the ESOP Trustee acts as the legal Shareholder of the ESOP. The ESOP Trustee is an ERISA fiduciary and has a fiduciary duty to act in the sole interest of ESOP Participants, maximizing the long-term value of the assets of the trust (the stock of the company). The ESOP Trustee will often vote according to the direction of the ESOP Administrative Committee. In addition to ERISA, the ESOP Trustee is governed by the Internal Revenue Code, the plan document, and trust document.
- ESOP Participants– The ESOP Participants are beneficial owners of the company and generally have limited legal authority. In most cases the ESOP participants as Shareholders are represented by the ESOP Trustee. 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, buying or selling stock, and exercising voting rights. In limited cases, such as a significant corporate event (e.g. liquidation, sale of all or substantially all the assets, recapitalization, merger), the ESOP Participants may have the right to have pass-through voting rights on all issues, including the election of the Board.
What is an ERISA Plan Fiduciary?
A plan fiduciary is a person that exercises discretionary authority or control over the management of the plan or plan assets. ERISA defines the 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 that a prudent man 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". You should also be aware of the ESOP diversification rules.
- Follow the Plan Documents – A fiduciary must act in accordance with the plan documents.
What is the Relationship between the ESOP Trustee, Board of Directors, and the ESOP Committee?
- The ESOP Trustee is selected by the Board of Directors.
- The ESOP Trustee generally votes the ESOP shares for the election of the Board of Directors. The ESOP Trustee will often vote according to the direction of the ESOP Administrative Committee.
- The ESOP Administrative Committee is usually selected by the Board of Directors and generally consists of members of management.
- This "circular" selection process often leaves the same people in charge of the company and the ESOP.
Many ESOP companies strive to build and sustain a strong ownership culture that will increase shareholder value. Developing an ownership culture is an ongoing process that evolves over time. A strong ownership culture can be driven by the CEO, sometimes referred to as the keeper of the culture, and the Board of Directors (“Board”) through corporate governance. This two-part article series will review the various stakeholders in the corporate governance of an ESOP company, explore their roles in the process, and things stakeholders can implement to strengthen the culture.
Many business owners that have implemented or are exploring an employee stock ownership plan (ESOP) may not have an active Board of Directors in place. Often times the Shareholder(s) are operating as the Director(s) of the company as they manage the day-to-day operations, and are not separately meeting as a Board to formally achieve the Corporate Governance responsibilities of the Board. Of those that do have a functioning Board, many operate the Board as an extension of the senior management team to make short-term operational decisions, rather than long-term, strategically focused decisions in line with corporate governance best practices.
At the time a business owner or company begins the process of exploring an employee stock ownership plan (ESOP) as a component of their Business Succession Plan, many have never established a functioning Board of Directors. More often than not, the shareholder serves as the only member of the Board, while also serving as the President of the company. Of those that do have a Board, many operate the Board as nothing more than an extension of the senior management team to make short-term operational decisions rather than long-term, strategically focused Corporate Governance.
We have often discussed the corporate governance conflicts that occur when the same person wears multiple hats (e.g. Seller, Board member, Trustee, etc.). One solution to reduce the conflicts is to engage an independent fiduciary.