ESOP Governance Basics

ESOP Governance Basics by Jack Veale an ESOP Advisor.

In the world of corporate tax returns, there are about 6 million tax returns filed each year with about half being C-Corps and the other S-Corps.  There are about 15,000 publicly held companies, which means the vast majority of companies are privately held.  If you remove the companies with less than 30 employees, the count is less than 3 million. Of this group, there are about 7,000 companies that file IRS form 5500 that states they have a benefit plan called an “ESOP” or Employee Stock Ownership Plan.  As such, they are subject to a heightened level of governance rules that are not so much different than a Securities Exchange Commission ("SEC") or Office of the Comptroller of Currency ("OCC") regulated company.

Before we jump into the ESOP governance basics, we need to cover a brief understanding of how ESOPs exist.  In the 1950’s, a lawyer named Louis Kelso helped a San Francisco newspaper work through its family ownership issues by applying the rules of a Stock Bonus Plan.  The process was to have the Stock Bonus Plan rules apply to privately held companies in allowing companies to finance the sales of stock without a tax liability.  In 1984, Congress amended the Internal Revenue Code to add new Section 1042, including a tax deferral benefit to selling shareholders if they sold their shares to an ESOP Trust under certain conditions.  There are detailed rules for forming the trust, and how it benefits employees.  If you have a 401k or Profit Sharing Plan in your company, you have a similar trust structure as an ESOP.  For example, all three require a trust be formed, there are assignments for trustee and administration of the trust, it must be funded by the company in some way to get a tax deduction, and there are bonding and fiduciary insurance policies needed.

A business owner usually decides to sell shares to an ESOP for a number of personal reasons.  One is the owner's desire to “share the wealth” with the employees, as a reward for helping the company grow profitably.  Another is to sustain the company through an ownership transition, which could likely be damaging if the company were sold to an outside party.  Another is the tax benefit of a “1042 Rollover” whereby those shares are sold to the ESOP Trust, using a fair market valuation, and using the sale proceeds from those shares to purchase Qualified Replacement Property (QRP), thus no tax liability.  Without having a family successor in the business and where the management team cannot afford to buy out the owner, these owners will use an ESOP to develop a qualified buyer when the owner decides to divest his/her shares.

The governance of an ESOP company may not be any different than any other privately owned company with a minority owned ESOP.  The owners, who are now in majority control, can behave, in most cases, like any other private company with regard to freedom to manage the company.  However, with ERISA rules in play, the company’s board will need to stay abreast with typical governance best practices.  Duties of care, loyalty and prudence will require the owners to make sure they keep good minutes, avoid conflicts of interest in decisions, and have regularly scheduled meetings set up in advance.

If you become a director of an ESOP company, there are a number of things you should know that often times trip up ESOP companies. 

1)      Are you an Independent Director or Internal?  This is very important because the need for independent directors of ESOP companies is high.  In most ESOPs, the company board consists of the founder, the company’s key employees, and family members and/or close friends.  If you are the token independent director, you may find yourself in mess if the DOL (U.S. Department of Labor) initiates an audit. To avoid problems, make sure the board minutes are properly maintained, and the company has both Fiduciary and Directors & Officers Insurance.  With the company board being the primary fiduciary of the ESOP Trust, you want to be sure the company has a good Trustee and plan Administrator.

2)      Is the ESOP Trustee an independent or internal trustee?  An ESOP company board selects the trustee, which in turn, votes their shares for the directors as directed by members of an ESOP Committee consisting of corporate insiders.  If the company is minority owned by the ESOP Trust, then the trustees are most likely members of the board or include the company’s key employees, such as the CFO.  If the company has an independent trustee, the board’s fiduciary risks are mitigated in several ways to avoid getting dragged into a DOL claim.  The role of the trustee is very important to the board because they are the shareholders of the company stock.  Therefore, the trustee, not the board, must hire the valuation firm, and critically evaluate the annual stock valuation report.  Thus, selecting the stock price of the company for valuation purposes rests solely on the trustee.  Another role for the trustee is when there is “pass through voting” on selective proxy votes.  For example, if the company receives an unsolicited offer from a qualified buyer, both the board and the trustee must engage together in the process.  When the offer is agreed to, if it involves a merger or sale of assets, the participants are entitled to vote the shares allocated to their accounts and a disclosure statement must be prepared for them regarding the transaction.  The trustee must then manage the distribution, communication and voting process.

3)      Is the ESOP record keeper/administrator independent or internal?  The board, as the Plan Sponsor and a fiduciary of the trust, is required to maintain proper records, much like the company’s 401k and Profit sharing plan.  However, ESOP administration has a number of quirky and complex rules that only those firms with separate ESOP departments should be processing the participant records and statements.  One messed up participant statement may cause a huge DOL claim against the board and company.  The laws change frequently, so if your internal administrator is not up to speed, push for an independent administrator. 

4)      Did you have a chance to read the latest valuation report?  One of the most common DOL Claims is having an improper valuation to arrive at a fair market value.  IRS Rules for valuation normally require at least 3 different methods for valuing companies: Asset values, comparative values with other companies in the same industry, and discounted cash flows (DCF).  The challenge of the company’s trustee is to really understand the methodology and assumptions used, such as growth rates, comparative selection, and real values for the assets.  A report must have been prepared by people with valuation credentials with ESOP experience.  A typical question for the director to ask is “Can the valuation firm prove their independence and that they can successfully defend their valuation in a court of law?” 

5)      Did the company leverage itself to fund the ESOP Trust’s purchase of stock?  This is a very common condition for young ESOPs.   The owner may have personal guarantees on the ESOP loan, so therefore will not give up control, nor authority, until such time the debt is paid off.  Once the debt is paid off, there may be a second round of financing (Tranche) that would again continue the role of the owner to stay in the business.  This may be helpful or harmful to the company and its key employees if not properly managed.  As an independent director, you should prepare yourself for conflicts to rise the longer the former owner stay around.

6)      Did the company get a favorable IRS determination letter in the last 5 years?  This is very important because the tax benefits of having an ESOP can quickly go away if the plan document is not kept up to date, and the plan rules are not being followed.

7)      Has the company developed a recent “Repurchase Obligation Study” to determine their future liabilities for funding retired beneficiaries?  In the ESOP Plan document, a typical provision is the “Put” option.  This “Put” option requires the participant to sell his/her shares to the company, which in turn requires the company to buy back those shares.  A repurchase study will evaluate the retirement profiles and allocations, as well as diversification issues that are required by law.  A company without a repurchase study may have a huge unplanned for liability that may harm the company.

Being on an ESOP Board is not as complex or scary as the above information may create.  In the vast majority of conditions, ESOPs are very successful companies with great management, excellent cash flow, and superior entrepreneur culture.  In our next article, we will cover more advanced topics relating to prohibited transactions, mergers and acquisition issues, and the role of the board in majority owned ESOP companies.