The board of directors responsibility in addressing ESOP repurchase liability

By Kim Blaugher, VP Consulting, Principal Financial Group® ​and Philip J. Carstens, Foster Pepper PLLC

ESOP repurchase liability is an obligation of a corporate sponsor of an Employee Stock Ownership Plan​1 (ESOP). This obligation is to repurchase shares from plan participants after termination of employment and to provide liquidity for plan participant diversification rights. In order to plan for ESOP repurchase liability, the corporation must quantify the liability and implement a strategy to fund it. These functions are the responsibilities of the board of directors of the corporate sponsor of the ESOP.

This article will summarize director duties in determining and funding ESOP repurchase liability.

Duties of the board of directors

The duties and responsibilities of corporate directors is largely a function of state law. While specific corporate statutes vary from state to state, there are fundamental principles that are generally found in all corporate statutes.

State corporate laws invest the power and impose the responsibility for conducting a corporate enterprise on a corporation’s board of directors. Typically, directors owe four basic duties to the corporation and its shareholders—the duties of care, loyalty, good faith and disclosure. In practice these duties may overlap. When considering the quantification and funding of ESOP repurchase liabilities, directors must carefully evaluate the circumstances in light of the conflicting interest of those to whom duties are owed – the company, its shareholders (both the ESOP trustee and others), and ESOP participants.

Duty of care

Generally stated, the duty of care requires directors to act in an informed and considered manner. Accordingly, prior to making a business decision, directors must inform themselves of all material information reasonably available to them and then act with due care in discharging their duties. Directors will be liable for breach of duty of care if they are found to have been grossly negligent with respect to, recklessly indifferent to, or to have disregarded the interest of shareholders or to take actions outside the bounds of reason.

Duty of loyalty

The duty of loyalty generally requires directors to act without material self-interest. Directors must refrain from fraudulent conduct, self-dealing, and actions that serve to “enrich them in office.” This duty requires directors to act without personal financial self-interest and without personal or private motive, even if the decision is non-financial in nature. It further requires that directors be disinterested so that their decision making is based on the merits of the matter before the board, rather than on outside influences.

Duty of good faith

The duty of good faith is sometimes stated as a subset of the duty of loyalty. It requires directors to act in accordance with what they obviously believe to be in the best interests of the company and its shareholders, without being influenced by any personal or private motives even if not financial in nature.

Duty of disclosure

The duty of disclosure (sometimes referred to as the duty of candor) requires directors, under appropriate circumstances, to make full and fair disclosure to shareholders of pertinent information within the board’s control. The board must refrain from disseminating false or inaccurate information that results in corporate injury or damage to shareholders. The duty of disclosure prevents insiders from using special knowledge that they have to their own advantage and to the detriment of the company’s shareholders (or plan participants). Directors must be particularly careful not to mislead ESOP fiduciaries or participants regarding the corporation’s ability to meet its ESOP repurchase liability.

Standard of review

With this general statement of director fiduciary liability in mind, it is helpful to next examine the standard of behavior generally used by courts when directors’ actions are being reviewed. The conduct of a corporation’s directors is generally reviewed by courts with reference to the standard known as the business judgment rule.

The business judgment rule provides that directors are presumed to have satisfied their fiduciary duties—that is, they are presumed to have acted on an informed basis, without self-interest, in good faith, and in the honest belief that actions taken are in the best interests of the company. Where the business judgment rule is satisfied, directors will be presumed to have satisfied their duties without “second guessing” by courts, and courts will not substitute their judgment for the board. The business judgment rule presumption may be rebutted by evidence that the directors have violated their fiduciary duties or have an interest in the outcome of a particular board decision that is different from the corporations or its shareholders. In effect, the business judgment rule presumption puts the burden of proof in the first instance on plaintiff shareholders asserting that directors have breached their duty. Such plaintiffs must present concrete evidence of wrongdoing. Mere allegations not supported by evidence will not be sufficient to pursue the claim.

Procedural diligence

Directors should not just rely on the business judgment rule to demonstrate their duty to determine and fund ESOP repurchase liability. Directors should establish a process that assures that their decisions will survive scrutiny. The process should be designed to demonstrate that the directors fulfilled their duties of care, loyalty, good faith, and disclosure and should memorialize the actions and decisions of the directors.

In fulfilling the directors’ responsibilities, ESOP legal counsel and ESOP trustees advise that an ESOP company’s directors understand:

  • Corporate objectives relating to employee ownership
  • ESOP repurchase liability forecast
  • Corporate objectives and approach to funding the ESOP repurchase liability
  • Long-term business objectives of the board
  • Current and projected cash flow of the company
  • The ESOP distribution policy

In order for the directors to effectively evaluate the foregoing factors, it will be necessary for the directors to consult with management, outside advisors, and the trustee.


The management team, which is appointed by the chief executive officer, makes the day-to-day operational decisions.

The company’s management, preferably associates from finance or accounting (controller, CFO, VP of finance), should either prepare the repurchase liability analysis or work closely with an ESOP advisor to prepare it. The funding of the repurchase liability is one of the largest cash out flows for most ESOP companies. Consequently, the projected repurchase liability cash flow impact should be included in the company’s financial budgeting.

The management team will need to determine the best methodology for projecting the repurchase liability. For companies with a limited number of employees, such as fewer than 50 employees, this projection may be most efficiently accomplished by estimating when each employee will terminate. For larger companies, it is a best practice to use an actuarial model that projects participant terminations and their account balances given assumptions made as part of the study.

To fulfill its due diligence requirement, the board should require that management present an Executive Report on at least an annual basis. The report should summarize the repurchase liability analysis and provide managements’ recommendation on how the company should fund the repurchase liability. The board may require this more often if there is a significant change in the business, such as a proposed acquisition, downsizing of the workforce, or loss of a significant client.

The outcome of this presentation should be:

  • Incorporation of the presentation and discussion of this important topic into the board’s minutes
  • A clearer understanding of repurchase liability
  • Knowledge of how other ESOP companies handle similar issues
  • A strategic plan for addressing and funding repurchase liability that can be executed by management  

Outside advisors

Management’s involvement is imperative. They have the best grasp on the company’s cash needs and vision for the future. ESOP advisors supplement management’s business knowledge by providing their expertise in working with numerous ESOP companies. ESOP advisors can help companies understand the best practices in the ESOP community for addressing repurchase liability and implementing these practices.

Look to choose an ESOP advisor with broad experience working with ESOP companies. The repurchase liability analysis requires an understanding of:

  • Internal Revenue Code and ERISA
  • Financial statements and income taxes
  • ESOP recordkeeping and distribution policies
  • Valuation methodologies
  • Business knowledge in working with ESOP companies
  • Corporate governance
  • ESOP repurchase liability funding alternatives

Utilizing an ESOP advisor who has experience in preparing repurchase liability analyses helps the board assure that they have met their due diligence requirements.

Each company will need to decide the level of involvement of its ESOP advisor. You may merely ask the ESOP advisor to review management’s projections and analysis. In this case, the ESOP advisor might provide input on whether your:

  • Methodology utilized in the analysis appears to be appropriate
  • Results are consistent with the company’s history and assumptions
  • Results are consistent with the advisor’s experiences with other ESOP companies
  • Report appears to reach appropriate conclusions (it will be provided to the board)

If the outside advisor is asked to prepare the repurchase liability study, management needs to be involved to assure that the advisor understands your business environment and provides certain assumptions for the study. For instance, the most critical assumption is the projected stock value. The CFO or controller should understand the methodology that the ESOP valuation firm utilizes to project the stock value. For this reason, the ESOP advisor will request that the CFO or controller provide the stock value projections.

It is a best practice to involve the ESOP valuation firm in the analysis. The valuation firm should provide input regarding the impact of the future repurchase liability on the estimated values used in the study. The valuation firm can also determine whether the methodology used in arriving at the projected value for the repurchase liability study seems appropriate. For instance, most ESOP companies are valued primarily based upon the discounted cash flow method. The valuation firm would provide input on whether the stock values utilized in the study are appropriately projected based upon that methodology.


A key function of an ESOP company’s board is appointing the ESOP trustee and reviewing the trustee’s performance. This function makes the board subject to ERISA’s fiduciary requirements. In order for the board to meet its fiduciary requirements, it needs to make sure that the ESOP trustee is monitoring the repurchase liability process.  

The ESOP trustee’s role is a review function and is not an active participant in the decision-making process. The board is responsible for assuring the company has the funds to pay ESOP participants their account balances when due. Management is tasked with preparing the repurchase liability analysis. The ESOP trustee needs to be informed about the repurchase liability process to assure that management and the board have implemented a policy to fund the repurchase liability. To do this, the trustee:

  • Reviews the repurchase liability executive report to determine if he/she agrees with its conclusions and actions steps
  • Participates in the presentation of the repurchase liability study by management. Normally, this would be a joint meeting with the board of directors.

Difficult issues can arise if the trustee feels that the repurchase liability is not being adequately addressed by the board and management. The trustee would need to take action in this situation. An initial step would be to inform the board of its concern whether the repurchase liability is being properly addressed. The trustee should ask the board for a report (if one has not already been prepared) that summarizes the analysis of how the company will address funding the repurchase liability. The ESOP trustee would involve its legal counsel as necessary.

If the board receives notification from the ESOP trustee (as a shareholder) that it has not adequately addressed the repurchase liability, the board should act on this notification. The board should be able to resolve it by presenting a report to the trustee discussing how the company is addressing the ESOP repurchase liability. If this does not satisfy the ESOP trustee, the board needs to consult its ESOP legal counsel regarding further action it should take. This might include retaining ESOP experts such as a repurchase liability expert, valuation firm, and advisor to help resolve the issues.

Funding the ESOP repurchase liability

The method of funding the ESOP repurchase liability is unique to each company. There is a perception in the ESOP community that setting aside funds for repurchase liability is a best practice standard. For instance, many ESOP companies make additional contributions or pay an S corporation earnings distribution to the ESOP to accumulate funds within the ESOP for future repurchase liability. Other companies set aside cash in a sinking fund or purchase corporate owned life insurance to pre-fund the repurchase liability.

In highly cyclical industries such as the construction industry, setting aside excess cash that is generated in the good years may be advisable to assure the funds will be available when the fortunes turn south. When a business contracts, the company will likely reduce its workforce, which will result in future ESOP repurchase liability. The timing of a future repurchase liability depends on the company’s ESOP distribution policy. Contracting businesses normally suffer from limited available working capital. Because the increase in terminations coincides with the decline in the business’ working capital, it may be appropriate for these industries to have funds set aside.

Maximizing the use of the company’s working capital should be a goal of management. Setting aside funds that the company could utilize to expand the business, diversify into other product lines, upgrade facilities, reduce outstanding debt, and so on, may not be the best use of the working capital. Management should view the ESOP repurchase liability in a similar light to other working capital requirements. Management should have a vision of how best to apply the company’s resources to move forward and remain a stable and profitable company.

One way to do this is to have the board require management to provide an ESOP repurchase liability funding policy. The board should review this policy and come to its own conclusion of whether it is appropriate. It is a best practice to have the ESOP repurchase liability consultant and the ESOP valuation firm provide their insights on the funding policy as well.

The ESOP trustee should receive a copy of the funding policy from the board. The ESOP trustee should also be present when the policy is presented by management and the ESOP advisors.

It’s all about the process

Recent court cases have shown that the process the company goes through to address repurchase liability carries the most weight in protecting the board from ESOP participant claims of fiduciary breach. The court focused on the process employed by the company even though the company could not fund the repurchase liability without adversely affecting the value of the company. It is likely that following the best practices discussed above will demonstrate that the board has gone through the appropriate process.

1 This corporate obligation finds its genesis in the qualification requirements found in IRC Section 409(h)(1)(b) and 401(a)(28)(B). Ultimately the obligation becomes a contractual obligation within the ESOP plan document.

Philip J Carstens and Foster Pepper PLLC are not an affiliate of any member of the Principal Financial Group®.

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

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