All posts by Glenn Ball

Common Pitfalls of Being an ESOP Trustee

If you have spent time around the ESOP world, you know that, in addition to all of the wonderful benefits an ESOP brings to a sponsor company, there are complexities and various pitfalls to be aware of as well.  In this blog, I thought I would discuss some of the pitfalls of being an ESOP trustee.  In one of my past lives, I acted as an ESOP trustee for plans which ranged from ones as small as 20 participants to ones with nearly 1,000 participants.

Before discussing the pitfalls, I would like to say that ESOP trustees are held to the highest fiduciary standard under the law and are responsible for what they know or should have known.  The “should have known” component of that sentence is the tricky part.  What it means is that an ESOP trustee must be very well versed in the nuances of plan documents and ERISA rules as they apply to the ESOP in question.  In addition, an ESOP trustee must be able to anticipate where the various “ESOP pitfalls” might be located and then take action to correct or, better yet, avoid the missteps.  Of course, a competent ERISA attorney is indispensable to an ESOP trustee’s team of experts.  From my experience, it is clearly worth the added expense of retaining an attorney who is well versed in ERISA law and who has actual real world experience with ESOPs, as opposed to hoping (and wishing) that the local attorney whom you have known and trusted for years will be up to the challenge.  ERISA law is a different breed and requires a real specialist.  In my opinion, you do not want to take shortcuts when it comes to ESOPs.  An ERISA attorney acts as the trustee’s counsel but is actually paid by the plan sponsor or by the trust itself. It is also important to hire a good business appraiser.

One of the most important functions performed by an ESOP trustee of a closely held company is to set the fair market value of the plan sponsor’s stock.  On this issue the reader might assume that the business appraiser retained by the trustee sets the price of the stock.  That assumption is both right and wrong.  The trustee will typically rely on the appraiser’s expertise, but the ultimate responsibility for setting the stock price remains with the trustee.  The biggest pitfall of being an ESOP trustee is undoubtedly the scenario wherein the trustee is held liable for claims (frequently by current or former employees) that the stock 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.  It is a fact that the determination of the fair market value of a closely held entity is highly subjective.  As is often said of the valuation profession, “It is more art than science.”  Therefore, it is important to show that a reasonable process is followed in arriving at the value conclusion.  In other words, clearly demonstrate that you, as trustee, put some serious work into coming up with the new stock price.  In fact, case law has established that ESOP trustees will not be shielded from liability for overvaluing or undervaluing employer stock when it has been determined that the trustee passively accepted a valuation report.

Other than the perils surrounding the ever-important task of setting the new annual stock price, the following are potential pitfalls an ESOP trustee faces in his or her goal to, as a judge in a 1982 U.S. Second Circuit Court ERISA case stated, make decisions “with an eye single to the interests of the ESOP participants and beneficiaries”:

•    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 losing its qualified status

There certainly are pitfalls to watch out for as an ESOP trustee.  However, there is help!  Based on statements contained within numerous judicial opinions published over the years, the common theme in these statements appears to be that the best defense a trustee has in the face of legal and/or regulatory scrutiny is the existence of a well-documented process.  Much like the real estate profession’s mantra of “Location, location, location,” professional ESOP trustees have a favorite mantra of their own, “Process, process, process.”  A sound, thorough, and well-documented process will go a long way toward demonstrating that an ESOP trustee has indeed made a good-faith effort to look out for the exclusive benefit of the plan participants and beneficiaries involved.

For more information on how to avoid the common pitfalls of being an ESOP trustee, read So, You’re an ESOP Trustee, an article I co-authored with Tracy Woolsey of Horizon Trust & Investment Management.


Statistics Indicate that ESOPs Provide a Higher Rate of Return

In another blog post by Acclaro, we looked at why ESOPs (employee stock ownership plans) make very good business sense.  Today’s post provides an addendum and explores why ESOPs provide a higher rate of return to employees than do other retirement plans.

There has been much written lately about how ESOP companies have fared better during the latest recessionary period than their comparable non-ESOP counterparts.  A recent study published by Douglas Kruse and Joseph Blasi of Rutgers University found that ESOPs increase sales, employment, and sales per employee by approximately 2.3% to 2.4% per year over what would have been expected absent an ESOP.  In addition, Kruse and Blasi found that ESOP companies were somewhat more likely to still be in business several years later and were much more likely to offer other kinds of retirement plans.  This last finding flies in the face of conventional wisdom held by economists through the years that ESOPs must be a tradeoff for other wages or benefits.  That is, it is commonly assumed that they must be a substitution for other retirement plans or employee benefits.  Kruse and Blasi found that the introduction of an ESOP into a company was an overall net addition, not a substitution, to the company’s employee benefits offerings.

Another recent study also highlighted the attractiveness of an ESOP as a retirement plan.  The U.S. Department of Labor’s Employee Benefits Security Administration (EBSA) compiled statistics in 2012 on 401(k)s and other retirement plans and found that ESOPs provided higher aggregate rates of return than 401(k) plans.  EBSA took a look at retirement plans with 100 or more participants from 1996 to 2010 and found that ESOPs provided, on average, a 12.9% higher return to an employee’s overall retirement plan than 401(k) plans.

As good as the results are in the various studies conducted in the last 10 years which point to the “ESOP advantage,” the performance metrics gleaned from the studies really get a bounce when an ESOP company puts particular stress on participative management.  In other words, performance results for ESOP companies which actively encourage management participation by its employee-owners are superior to the operating results of those ESOP companies where management participation is not encouraged.   Specifically, employee influences on new products, work design, and marketing were strongly correlated to performance outcomes such as total sales and earnings.  In other words, as employees became more directly involved with decisions regarding the details of work design, the design and implementation of new products and marketing campaigns, company performance improved.

This point is corroborated by another study, published by the Great Place to Work Institute which conducts the annual “100 Best Companies to Work For in America” competition, which showed that an ESOP alone has a very limited impact on the sponsor company’s financial performance (as measured by the Return on Assets ratio) but, when combined with high employee engagement (participative management) scores, an ESOP has a significant impact on a Company’s total sales and earnings.

The research by the Department of Labor shows that ESOPs have provided a higher rate of return to employee-owners than have 401(k) plans.  Not only do ESOPs make great business sense, but they can prove to be a great retirement investment, as well.

Information contained in this blog came from the NCEO and the DOL (table E23).


ESOPs Make Very Good Business Sense

It has been common knowledge for quite some time that ESOPs (Employee Stock Ownership Plans) make very good business sense. This statement is backed up by research.  Study after study has shown that businesses which are employee owned usually have a definite advantage over those that are not.

ESOPs are essentially retirement plans in which a trust that forms the legal structure of an ESOP purchases employer stock of the company sponsoring the ESOP. Most ESOPs are leveraged, which means that the ESOP is allowed to borrow money to finance its purchase of employer stock.  Loan payments made by the ESOP are funded through employer contributions to the ESOP, much like a company would contribute to a 401(k) or profit-sharing plan.

Let’s took a quick look at recent major research on ESOPs since they first were conceptualized and implemented by Louis Kelso in 1956:

National Center for Employee Ownership (NCEO) Study, 1986

A first look at how employee ownership impacts corporate performance, this study by Michael Quarrey and Corey Rosen of the NCEO tracked company performance for a period five years before and five years after the creation of an ESOP.  The key findings:

  • ESOP companies had annual sales growth rates that were 3.4% higher and annual employment growth rates 3.8% higher in their post-ESOP periods than would have been expected based on pre-ESOP performances.

U.S. General Accounting Office (GAO) Study, 1987

Another “before and after” look at employee-owned firms, the GAO survey was a bit controversial because of an assumption in its research methodology.  However, its conclusions again pointed favorably towards the net benefits of ESOPs:

  • An ownership culture is key to increased productivity in an ESOP company.  Participatively managed employee-owned firms increased their annual productivity growth rate by 52%.  For example, what would have been a 10% annual growth rate became a 15% growth rate in an ESOP company in which there existed a strong ownership culture, i.e. one in which a broad base of employees feel empowered as co-owners.

Washington State Department of Community, Trade, and Economic Development/University of Washington Study, 1998

Peter Kardas, Jim Keogh, and Adria Scharf found that substituting stock for wages or benefits can have a very positive impact.  Their study found that employees are significantly better compensated in ESOP companies than are employees in comparable non-ESOP companies.  The key findings:

  • The median hourly wage in the ESOP firms was 5% to 12% higher than the median hourly wage in the comparison companies.
  • The average value of all retirement benefits in ESOP companies was equal to $32,213, with an average value in the comparison companies of only about $12,735.
  • The average corporate contribution per employee per year was between 9.6% and 10.8% of annual pay, depending on how it is measured. In non-ESOP companies, this measure was only between 2.8% and 3.0%.

Rutgers University Study, 2000

One of the most significant studies to date on ESOPs, the Rutgers study looked at the performance of ESOPs in closely held companies.  The researchers, Douglas Kruse and Joseph Blasi, looked at sales, employment, and sales per employee for ESOP firms and comparable non-ESOP firms.  The key findings:

  • ESOPs increase sales, employment, and sales per employee by about 2.3% to 2.4% per year over what would have been expected without an ESOP.
  • ESOP companies were also somewhat more likely to be in business several years later.

Brent Kramer Study, 2008

Brent Kramer’s study, “Employee Ownership and Participation Effects on Firm Outcomes,” pointed again to the positive impact of employee ownership.  Matching 328 majority ESOP-owned companies to 328 non-ESOP companies of similar sizes and from similar industries, Kramer found that:

  • ESOPs had sales per employee that were 8.8% greater than in the comparable non-ESOP companies.

Alex Brill Study, 2012

A former advisor to the Simpson-Bowles deficit reduction commission, Alex Brill analyzed the ten-year performance of S-Corporation ESOP companies.  His assessment indicates that ESOPs clearly increase employment opportunities.  The key findings:

  • S-ESOP companies showed substantially more employment growth in the pre-2008 recession period than non-ESOP businesses.
  • S-ESOP companies regained momentum faster than other private firms after the recession.
  • S-ESOP companies in the manufacturing sector particularly benefited from the S-ESOP business structure, which buffered manufacturers through the recent, especially challenging economic times.

These studies provide a drum beat of evidence that ESOPs make very good business sense.  Most well-managed employee-owned companies, those which allow their employees an active role in the firm, realize higher sales and profit levels, are more productive, and create more widespread wealth than comparable non-employee-owned companies.

Information contained in this blog came from the NCEO, ESCA, and The ESOP Association.