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.\u00a0 In this blog, I thought I would discuss some of the pitfalls of being an ESOP trustee.\u00a0 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.<\/p>\n
Before discussing the pitfalls, I would like to say that ESOP trustees are held to the highest fiduciary standard<\/strong> under the law and are responsible for what they know or should have known<\/em>.\u00a0 The \u201cshould have known<\/em>\u201d component of that sentence is the tricky part.\u00a0 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.\u00a0 In addition, an ESOP trustee must be able to anticipate<\/em> where the various \u201cESOP pitfalls\u201d might be located and then take action to correct or, better yet, avoid the missteps.\u00a0 Of course, a competent ERISA attorney is indispensable to an ESOP trustee\u2019s team of experts.\u00a0 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.\u00a0 ERISA law is a different breed and requires a real specialist.\u00a0 In my opinion, you do not want to take shortcuts when it comes to ESOPs.\u00a0 An ERISA attorney acts as the trustee\u2019s counsel but is actually paid by the plan sponsor or by the trust itself. It is also important to hire a good business appraiser.<\/p>\n 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\u2019s stock.\u00a0 On this issue the reader might assume that the business appraiser retained by the trustee sets the price of the stock.\u00a0 That assumption is both right and wrong.\u00a0 The trustee will typically rely on the appraiser\u2019s expertise, but the ultimate responsibility for setting the stock price<\/strong> remains with the trustee.\u00a0 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.<\/p>\n 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.\u00a0 It is a fact that the determination of the fair market value of a closely held entity is highly subjective.\u00a0 As is often said of the valuation profession, \u201cIt is more art than science.\u201d\u00a0 Therefore, it is important to show that a reasonable process is followed in arriving at the value conclusion.\u00a0 In other words, clearly demonstrate that you, as trustee, put some serious work into coming up with the new stock price.\u00a0 In fact, case law has established that ESOP trustees will not<\/span> be shielded from liability for overvaluing or undervaluing employer stock when it has been determined that the trustee passively<\/em> accepted a valuation report.<\/p>\n 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 \u201cwith an eye single to the interests of the ESOP participants and beneficiaries\u201d:<\/p>\n \u2022\u00a0\u00a0\u00a0 Failing to allow employees to vote their shares on required issues There certainly are pitfalls to watch out for as an ESOP trustee.\u00a0 However, there is help!\u00a0 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<\/span>.\u00a0 Much like the real estate profession\u2019s mantra of \u201cLocation, location, location,\u201d professional ESOP trustees have a favorite mantra of their own, \u201cProcess, process, process.\u201d<\/strong>\u00a0 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.<\/p>\n
\n\u2022\u00a0\u00a0\u00a0 Failing to give employees appropriate information on which to base a decision when they vote
\n\u2022\u00a0\u00a0\u00a0 Failing to distribute benefits according to plan rules
\n\u2022\u00a0\u00a0\u00a0 Acting in a discriminatory manner in honoring the put option
\n\u2022\u00a0\u00a0\u00a0 Failing to ensure the filing of reports when such failure could result in the plan losing its qualified status<\/p>\n