So, You're An ESOP Trustee

So, You're An ESOP Trustee by Chris E. Best an ESOP Advisor.

So, You’re An ESOP Trustee

By Tracy E. Woolsey and Glenn W. Ball

Many trust companies and departments find themselves acting as trustees for a relatively small number of employee stock ownership plans (ESOPs). These plans are highly regulated and require a trustee to be very knowledgeable about all aspects of plan design and administration as well as the fiduciary duties trustees are expected to fulfill. Many ESOP trustees do not realize the liability they are assuming by acting as trustees. ESOP trustees are held to the highest fiduciary standard under the law and are responsible for what they know or should have known. In this article, we will present a three-dimensional perspective of common fiduciary risks facing an ESOP trustee: First, we will describe the risk itself; second, we will discuss the fiduciary obligations involved; and third, we will outline actions the trustee can take to mitigate the risk going forward.


Noncompliance with Plan Documents or ERISA

As a “named fiduciary,” an ESOP trustee must act for the “exclusive benefit of plan participants and beneficiaries,” act prudently, and act in accordance with plan documents. One caveat to this last duty: A trustee must act in accordance with the documents governing the plan only to the extent that the documents are consistent with Title I of the Employee Retirement Security Act of 1974 (ERISA). It is incumbent upon the fiduciary to have a sufficient understanding of ERISA to determine whether plan documents are in compliance.


The ESOP trustee must become familiar with the documents underpinning an employee stock ownership trust, such as the plan document and the trust agreement. As mentioned earlier, the trustee is held responsible for ensuring that the plan is operated in accordance with the plan document as well as with the rules set forth in ERISA. Even in the case of a “directed” trustee, whereby the trustee is subject to the direction of another named fiduciary such as the plan administrator, care must be taken to ensure that the instructions from the other fiduciary are consistent with the plan. For example, if the plan prohibits a certain kind of investment, the directed trustee should not make the investment, even if so instructed.


The ERISA directive to ensure that “the plan is operated in accordance with plan documents and ERISA” is very broad. The ESOP trustee’s role can include a variety of decision-making activities with respect to ERISA, and the trustee could be sued for a fiduciary breach of conduct with regard to the following, among others:


  • failing to allow employees to vote their shares on required issues
  • failing to give employees appropriate information on which to base a decision when they vote
  • failing to distribute benefits according to plan rules
  • acting in a discriminatory manner in honoring the put option
  • failing to ensure the filing of reports when such failure could result in the plan’s losing its qualified status


Beyond a trustee having a good understanding of the plan documents and ERISA, another way to reduce risk is to retain legal counsel (independent of the plan sponsor) that acts as the trustee’s counsel but is paid by the plan sponsor or trust. In fact, ERISA states that an ESOP fiduciary has an obligation to seek the assistance of an expert to satisfy the prudence requirement referenced in the preceding paragraph. Trustee’s counsel is typically called upon sporadically, on an as-needed basis, for issues ranging from ERISA compliance questions to helping the trustee navigate the waters of a terminated participant lawsuit.


Setting the Share Price

One of the most important functions an ESOP trustee of a closely held company performs is setting the fair market value of the plan sponsor’s stock. Federal law stipulates that appraisals of ESOP company stock should be performed, at a minimum, on an annual basis, corresponding to the end of each plan year. The trustee will normally retain an independent financial advisor (a valuation expert) to perform an in-depth stock analysis and issue a written report. The trustee will typically rely on the appraiser’s expertise, but the ultimate responsibility for setting the share price remains with the trustee. It is not uncommon for the trustee to recommend changes in the appraiser’s methodology, assumptions, or even conclusion of value. Ultimately, the trustee can be held liable for claims that the share price was either over- or undervalued. The best way to mitigate this risk is for the trustee to have a good understanding of the valuation discipline, play an active role in the valuation process, and thoroughly document the process used to arrive at fair market value. The determination of the fair market value of a closely held entity is highly subjective. Therefore, it is important to show that a reasonable process was followed in arriving at the value conclusion.


Many institutional (i.e., independent) trustees specializing in ESOP trusteeships have committees─consisting of legal, financial, and retirement plan specialists within their organizations─that review all valuation reports and are charged with setting the share price. Although they are known as valuation experts, appraisers are not infallible, and it sometimes takes the critical eye of the trustee to point out flaws or incorrect assumptions embedded in the appraiser’s analysis.


Case law has established that ESOP trustees will not be shielded from liability for overvaluing or undervaluing employee stock when it has been determined that the trustee passively accepted a valuation report. The key risk mitigator in ESOP valuations appears to be the soundness of the trustee’s review process, which includes investigating the appraiser’s qualifications at the outset, performing a thorough due diligence review of the plan sponsor (including a site visit), providing the appraiser with complete and accurate information, and making certain that reliance on the appraiser’s advice is reasonably justified under the circumstances. There may be rare occasions when a trustee, unable to get comfortable with the appraiser’s value conclusion, will retain a second independent expert to either review the first valuation or go so far as to perform a second appraisal.


Valuation issues are one of the primary causes of significant ESOP problems. Sudden changes in price can lead to participants’ bringing suit against the trustee. Also, in recent years the Department of Labor (DOL) has increased its scrutiny of ESOP valuation reports. In closely held businesses, the best defense a trustee can offer is a well-documented process for determining the share price.


Verifying the Share Release Calculation for a Leveraged ESOP

The DOL has indicated that it is a fiduciary obligation to verify that the share release calculation performed by the plan’s administrator was performed correctly. Simply put, failure to verify this number could result in legal exposure for the trustee. Specifically, the trustee must verify that the ESOP record keeper’s share release calculation is correct in the context of a leveraged plan. Most ESOP companies retain third-party administrators to handle the plan accounting and retirement plan compliance requirements [e.g., 409(p) testing]. One of the record keeper’s responsibilities is to calculate the number of shares to be released from the suspense account (if any) and allocated to individual participant accounts, as of the end of each plan year based on loan payments made during the prior year. The suspense account holds shares that are owned by the trust but not yet allocated to individual accounts. While the trustee must verify that the number of shares released from the suspense account is correct, fiduciary duty does not extend to verifying the accuracy of allocations to individual accounts. In general terms, an ESOP trustee’s responsibility rests with the plan’s assets as a whole.


Potential Conflicts of Interest

Conflicts may arise when the institutional trustee (often a bank or trust company) has other bank or trust products with the plan sponsor, its shareholders, or its management. A common potential conflict of interest seen with ESOPs is when the trustee (i.e., bank) is also asked to play the role of lender to the ESOP or the company. The DOL has interpreted the requirement that fiduciaries of an employee benefit plan must act “solely in the interest” of the plan participants and of their beneficiaries as prohibiting a bank that has loans outstanding with a particular company for serving as the trustee of that company’s ESOP. However, there have been several federal court of appeals decisions that found the dual role of lender/trustee to be acceptable.


A similar example of a conflict of interest, though seemingly innocuous, is when a sponsor company chooses as its trustee a financial institution with which it has an existing relationship, such as demand deposit accounts. While ERISA does not expressly prohibit conflicts of interest, allegations of improper conduct (by the ESOP trustee) will be given the benefit of the doubt. To avoid any appearance of impropriety, many institutional ESOP trustees systematically avoid any potential conflicts of interest.


In general terms, fiduciaries with conflicts of interest are required to subordinate their personal interests to the interests of the participants in the plan. Back in 1982, the U.S. Second Circuit Court interpreted the “exclusive benefit rule” to mean that a fiduciary’s decisions must be made “with an eye single to the interests of the participants and beneficiaries.”


Another court has developed a test consisting of three questions that the court must answer to determine whether a plan fiduciary has violated the exclusive benefit requirement:


  • Was the conflict of interest so great that it was virtually impossible for the fiduciary to discharge his or her duties in a manner for the benefit of participants or beneficiaries?
  • If there was a potential conflict of interest, was the fiduciary engaged in an intense and independent investigation of options to ensure that the action taken was in the participants’ best interests?
  • To what extent did the use of the plan assets track the best interests of another party (other than the plan participants)?


Penalties for Noncompliance

A breach of fiduciary duty may constitute a prohibited transaction under ERISA Section 406, Code Section 4975, or both. Code Section 4975 imposes an excise tax equal to 15 percent of the amount involved in the prohibited transaction for each year, or part of a year, in which the transaction remains uncorrected. An additional tax equal to 100 percent of the amount involved is imposed if the prohibited transaction is not corrected within the correction period.


Can a plan trustee be reimbursed for the legal expenses incurred in defending a lawsuit charging breach of fiduciary duties? With the exception of a recent prominent court case decision (Johnson v. Couturier), the answer is yes. Prior to the Couturier decision, the company typically reimbursed a fiduciary’s legal expenses, according to provisions in standard engagement agreements. However, as we’ve learned from the Couturier decision, at least one court appears willing to override indemnification provisions when the case’s fact set dictates. It is too soon to tell what impact the Couturier case will have in terms of case law precedent and the future risk landscape for ESOP trustees, but it has already been cited in another case as a reason not to honor indemnification. It is important to also note that if a fiduciary is found to have acted willfully or negligently, the company would need to be reimbursed by the trustees for these expenses.


Insurance Coverage

Strict standards are in place for fiduciaries and any breach of their responsibilities can result in lawsuits and statutory penalties. A first line of defense against risk exposure for an ESOP trustee is insurance coverage. Many wrongly assume that this type of coverage is included in their D&O policies. In fact, most D&O policies exclude fiduciary liability exposures as well as exposures pertaining to ERISA. There are two types of coverage available to ESOP trustees:


  • a fiduciary liability policy
  • a fidelity bond


Fiduciary liability insurance provides protection for losses that the insured is legally obligated to pay because of a claim made for a wrongful act. Most policies define this to include any violation of the responsibilities, obligations, or duties imposed on fiduciaries by ERISA. The policy also typically includes coverage for defense costs in connection with a covered claim. A common misconception about fiduciary liability insurance is that a fidelity bond will cover your fiduciary exposure. The ERISA/fidelity bond protects the plan assets from misuse or misappropriation, but it does not protect the fiduciaries.


Also, it is often assumed that fiduciary liability insurance provides blanket coverage. In some policies, ESOPs are actually specifically excluded from coverage, or any external trustee is excluded. If you act as an ESOP trustee, you should verify that your insurance policy does not exclude ESOPs and that you are not relying on coverage that applies only to the company.


A final point on insurance coverage: There has been a lot of confusion regarding the differences between fiduciary liability insurance and employee benefits liability insurance. The latter normally applies only to claims rising out of administrative errors and is very limited. Many insureds think that by having employee benefits coverage, they do not need fiduciary liability coverage. That is definitely not true!



The following is a list of take-away points from this article that will guide you in your work as an ESOP trustee:


The DOL expects ESOP trustees to verify the share release calculation performed by the plan’s administrator.

  • ESOP trustees are held to the highest fiduciary standard under the law and are responsible for what they know or should have known.
  • An ESOP trustee has as its general duties to act for the “exclusive benefit of plan participants and beneficiaries,” to act prudently and to act in accordance with plan documents, but only to the extent that the documents are consistent with ERISA.
  • An important way to mitigate fiduciary risk is to retain legal counsel (independent of the plan sponsor) that acts as the trustee’s counsel, typically called upon on an as-needed basis.
  • One of the most important functions an ESOP trustee of a closely held company performs is the setting of the fair market value of the plan sponsor’s stock. The best way to mitigate valuation-related risk is for the trustee to have a good understanding of the valuation process, and thoroughly document the process used to arrive at fair market value.
  • While not expressly in violation of ERISA, conflicts of interest present real risk to the ESOP fiduciary. Allegations of improper conduct by the ESOP trustee will normally be given the benefit of the doubt. Many institutional ESOP trustees systematically avoid even an appearance of a conflict of interest.
  • A first line of defense against risk exposure for an ESOP trustee is insurance coverage, including a fidelity bond policy and a fiduciary liability policy.


Remember, nothing can totally prevent lawsuits and regulatory scrutiny, but proper management practices and a complete insurance program can go a long way in limiting your risk.

Tracy E. Woolsey is a vice president and employee benefits officer with Horizon Trust & Investment Management, a division of Horizon Bank. She heads the bank’s national ESOP practice.


Glenn W. Ball, a former ESOP relationship manager at Horizon Trust & Investment Management, is a manager for Acclaro Valuation Advisors.


This article was first published in the Jan./Feb. 2011 issue of ABA Trust & Investments.