ESOPs: Invest in Good Governance

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Jerry Ripperger, VP of Consulting, the Principal Financial Group, Princor Registered Representative

DOL settlements. Supreme Court decisions. Proposed fiduciary rules. Stock-drop lawsuits.

Should business owners pause before considering implementing an Employee Stock Ownership Plan (ESOP)? If not, what should the company and selling owner do to protect themselves? Thoughtful planning and implementation can allow ESOPs to be an attractive choice for ownership succession.

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An ESOP is a qualified retirement plan and therefore is subject to the same fiduciary requirements as other types of retirement plans such as 401(k)s. These requirements include—but are not limited to—prudence, due diligence, documented processes and clear roles. All retirement plans should have a focus on governance and fiduciary requirements to make sure they operate in the best interests of the participants.

But ESOPs have an additional factor that must be factored in to the equation—the plan is primarily invested in the stock of the sponsoring company. There exists a very real possibility, particularly during any transaction involving the sale or purchase of stock, for a conflict of interest between the selling owner and the plan participants.

Most selling owners want to maximize the sales price. Plan participants want the sales price to reflect no more than the value of the company (which can be a moving target and include a range of potential values). How can these different positions reconcile?

First, plan sponsors should audit their processes, procedures and documentation to make sure they are fulfilling their fiduciary requirements for their retirement plans. Many times they will hire a consultant to help them with this review.

Best practice, and growing in popularity, is engaging an independent trustee for the ESOP. Trustees represent the interests of the plan participants and can negotiate on the plan’s behalf. Specifically:

  • Look for a trustee that is knowledgeable about ESOPs—not all retirement plan trustees understand ESOPs.
  • Engage the outside trustee for both transactions and ongoing plan operation.
  • Have the trustee vote the plan’s shares on behalf of the participants (they should not serve on the board of directors).

Having an independent trustee allows the board of directors and company management to focus on the operation of the business without the conflicts of also representing the plan participants.

Most of the time what is in the best interest of the business is consistent with what is best for participants. But occasions will arise when that may not be the case—it is best to avoid conflicts of interest.

The selling owner (and company) and trust should also consider hiring their own advisors. This has historically been done in larger transactions, but recent trends show this moving downstream to smaller transactions. Increasingly, the trust and the selling owner are engaging their own valuation companies when any transaction involving the sale or purchase of shares is included. They may also engage their own legal counsel and other advisors as appropriate.

This obviously adds to cost. However, the tax advantages of ESOPs can generally more than offset the added expense.

ESOPs remain an attractive way to transition ownership. Proper governance, fiduciary guidelines and processes help protect the parties involved.

In addition to blogging here, I also tweet regularly about topics of interest to ESOPs. Follow @twitter 

Affiliation Disclosures

Company stock is not a pooled investment. Stock may experience greater volatility and should not be directly compared to investment options that have a more diversified investment mix. It is not intended to serve as a complete investment program by itself.

The subject matter in this communication is provided with the understanding that The Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.

Insurance products and plan administrative services are provided by Principal Life Insurance Company a member of the Principal Financial Group (The Principal), Des Moines, IA 50392.