Are ESOPs required to purchase fiduciary liability insurance?
While these policies aren’t a regulatory mandate, many ESOPs purchase a policy to address ESOP fiduciaries’ risk exposure for claims of mismanagement or plan errors.
That doesn’t necessarily mean that ESOP leadership has a straight “yes/no” choice over whether it buys a fiduciary liability policy. Some professional trustees require insurance coverage as a term of their service agreement. So, over the past several years, we’ve seen ESOP negotiations increasingly including fiduciary liability insurance as a term of the sale.
ESOPs with their own internal trustees may have greater choice over whether or not to buy a policy, but newer ESOPs increasingly find themselves purchasing insurance as part of the ownership transition process.
In this article, we take a closer look at what fiduciary liability insurance typically covers, and why it’s often — but not always — part of the ESOP journey.
What is Fiduciary Liability Insurance, and Why Do Some ESOPs Buy These Policies?
Fiduciary liability insurance, sometimes called fiduciary responsibility insurance, is designed to cover legal costs and to help protect ESOP fiduciaries against personal liability, should a claim arise.
An employee stock ownership plan (ESOP) is an employee retirement benefit plan regulated under the Employee Retirement Income Security Act (ERISA). ERISA-related claims fall within the area of fiduciary liability, something every plan sponsor and fiduciary needs to understand.
Under ERISA, fiduciaries can be sued and held personally liable for mismanaging the plan. Fiduciary insurance provides protection in case of claims such as:
- Improper management of ESOP plan assets
- Failure to provide required information to plan participants
Other insurance policies, such as Directors’ and Officers’ (D&O) coverage, often exclude fiduciary liability coverage, and D&O policies don’t cover non-officer fiduciaries. ESOP fidelity bonds protect the plan against risk of loss due to fraud or dishonesty — but fidelity bonds don’t cover the people who may be alleged to act dishonestly or negligently.
ERISA’s provisions address fiduciary responsibilities. They require fiduciaries, including plan trustees and administrators, to protect the interests of the plan participants and beneficiaries.
Fiduciary liability insurance is designed to address the risk to the individual fiduciaries themselves.
What Does ERISA Require of ESOP Fiduciaries?
ERISA is a federal law. It sets minimum standards of conduct for fiduciaries — those who make decisions about, manage, and administer the ESOP and its assets — to protect plan participants.
Plan fiduciaries are obligated by law to act solely in the interests of participants, and to run the plan solely to provide benefits and pay reasonable plan expenses. They’re mandated to adhere to the standards of care and loyalty, which means they’re required to:
- Act prudently
Diversify plan investments
- Follow the plan documents
- Avoid conflicts of interest
ESOPs are allowed to purchase insurance for themselves and/or their fiduciaries “to cover liability or losses occurring by reason of the act or omission of a fiduciary,” in 29 USC 1110: Exculpatory provisions; insurance:
(a) Except as provided in sections 1105(b)(1) and 1105(d) of this title, any provision in an agreement or instrument which purports to relieve a fiduciary from responsibility or liability for any responsibility, obligation, or duty under this part shall be void as against public policy.
(b) Nothing in this subpart  shall preclude —
(1) a plan from purchasing insurance for its fiduciaries or for itself to cover liability or losses occurring by reason of the act or omission of a fiduciary, if such insurance permits recourse by the insurer against the fiduciary in the case of a breach of a fiduciary obligation by such fiduciary;
(2) a fiduciary from purchasing insurance to cover liability under this part from and for his own account; or
(3) an employer or an employee organization from purchasing insurance to cover potential liability of one or more persons who serve in a fiduciary capacity with regard to an employee benefit plan.
ESOP fiduciaries include directors, officers, trustees, and can include some other employees of the plan sponsor as well as third-party administrators (TPAs).
What About our D&O Policy and ERISA Fidelity Bond?
D&O policies often cover those individuals as they are acting in their D&O capacity, not in a fiduciary capacity, and explicitly exclude from coverage claims that arise from alleged or actual ERISA violations.
The ESOP fidelity bond required by ERISA Section 412, as mentioned above, is designed to protect the plan — not the individual fiduciaries involved with the plan.
Vulnerabilities ESOP Fiduciaries Need to Keep in Mind
It’s important to keep in mind that the Department of Labor’s (DOL’s) Employee Benefit Security Administration (EBSA) offers its Voluntary Fiduciary Correction Program (VFCP) that allows fiduciaries to self-identify and self-correct certain violations to protect the plan’s tax-qualified status and make plan participants whole, and with correct documentation of acceptable corrections, the plan can receive a no-action letter from EBSA.
Remember, documentation of all plan processes — and of fiduciaries’ actions in following those processes — is crucial to limiting liability.
ESOP fiduciaries may face key legal vulnerabilities that can include:
- Employer securities not sold on the open market can be vulnerable to claims of improper valuation
- Company sale transactions can give rise to fiduciary liability claims
- High equity-based executive compensation can give rise to claims of dilution by rank-and-file employee-owners
- ESOP-related stock sales (for example, repurchases of distributed shares from plan participants) must take particular care to ensure the ESOP pays fair market value as of the transaction date
- Plan participants may make claims of misrepresentation or inadequate disclosure of documents and/or plan communications
- Investment losses or notably low returns can give rise to allegations of imprudent investments or failure to diversify plan assets
- Plan participants may allege “unreasonable” plan expenses such as fees for services, or that services are paid for but not provided.
Are You an ESOP Fiduciary?
ESOP fiduciaries should always take steps to ensure the ESOP is designed, implemented, operated, and administered in compliance with ERISA regulations and with its own plan document. That’s why it’s so essential to get expert help:
- Developing your ESOP plan document and policies in compliance with ERISA
- Ensuring all plan documents and policies are followed
- Documenting and reporting to maintain qualified plan status under ERISA
Working closely with an ESOP Partners expert can help you ensure a compliant plan in the first place, with proper plan documents and the help you need to follow them. Don’t wait to start talking with our experts. Click below to request your free consultation.