Company Stock in ESOPs: What Should a Fiduciary Do?
Brad Henschen, Senior Consultant
A Look Two Years Post-Dudenhoeffer and the Great Banc Settlement
Companies nationwide highly praise the benefits of employee stock ownership plans (ESOPs). Both privately-held and publicly-traded companies use the unique attributes of ESOPs to benefit their employees. For privately-held companies, ESOPs are a way to deliver retirement benefits to employees, often at no cost to employees, while creating an exit strategy for existing owners. Publicly-traded companies often include company stock as one of the investment options offered to employees in the company’s retirement plan. In both cases, employees can receive an ownership interest in the company by acquiring company stock in the retirement plan, which can be a powerful employee motivation, recruitment and retention tool.
ESOPs are subject to the requirements of the Employee Retirement Income Security Act (ERISA), specifically, the fiduciary duties for choosing and monitoring investments within a qualified retirement plan. During 2014, there were two significant developments affecting ESOP fiduciaries with respect to investing in company stock. The crux of these developments arose predominantly from claims that ESOP fiduciaries were not acting prudently in evaluating the circumstances surrounding the valuation of company stock, both in the public market and the private stock sector, which includes a valuation process by an independent appraiser. These types of claims are often brought when the value of company stock declines in an ESOP or when the employees suspect that an ESOP trustee paid too much to the former owners for the company stock purchased by the ESOP.
No Presumption of Prudence
In June 2014, the Supreme Court of the United States ruled in Fifth Third Bancorp v. Dudenhoeffer that a long-standing presumption of prudence that ESOP fiduciaries enjoyed in determining whether the company stock held in an ESOP was a prudent investment was inapplicable. Prior to the Dudenhoeffer decision, lower courts had ruled that an ESOP fiduciary had a presumption of prudence for investing in company stock in an ESOP because ESOPs were designed to be primarily invested in company stock. The initial case identifying this presumption of prudence was a 1995 Third Circuit case, Moench v. Robertson. Many other lower courts followed what came to be known as the Moench presumption, which served as the cornerstone for ESOP fiduciaries to defend their decision to purchase, hold and/or offer company stock in an ESOP. The Dudenhoeffer decision eliminated this defense mechanism and requires ESOP fiduciaries to demonstrate a prudent decision-making more important the process for evaluating the company stock investment. Even though the Dudenhoeffer decision involved a publicly-traded company, it is clear that the decision is also applicable to privately-held companies with qualified retirement plans holding employer stock investments.
Around the same time that the Supreme Court was deciding the Dudenhoeffer case, the Department of Labor (DOL) was negotiating a settlement agreement with an ESOP trustee (GreatBanc Trust Company) in a case involving claims that the ESOP trustee acted imprudently by purchasing privately-held company stock at a price that was too high (more than fair market value). While settlement agreements are typically only applicable to the parties involved (they are not usually made public or set any precedence for other litigants), the DOL and GreatBanc agreed to publicly share and discuss the terms of the settlement agreement as a way to provide a roadmap for other ESOP trustees to implement and document a prudent process for evaluating an independent appraiser’s valuation report and the decision to purchase privately-held company stock. The DOL made it clear that they intend the safeguards found in the settlement agreement to apply to other ESOP fiduciaries and their decision to purchase privately-held company stock.
In the aftermath of the Dudenhoeffer decision and the GreatBanc settlement agreement, ESOP trustees must consider the higher level of diligence required in evaluating their existing processes to ensure adherence to the guidance. In response to the Dudenhoeffer decision, ESOP trustees of publicly-traded companies are making sure that they are reviewing publicly available information regarding their company stock, including any SEC filings. ESOP trustees are then documenting their findings, analysis and considerations in the minutes of regularly held trustee meetings in the event questions are raised in the future.
Court cases decided subsequent to the Dudenhoeffer decision and the elimination of the presumption of prudence have frequently applied a heightened level of pleadings for plaintiffs claiming that company stock was imprudent and/or overvalued. Courts have required plaintiffs to demonstrate that the fiduciary’s actions were imprudent, and that there were no special circumstances warranting fiduciary action based upon publicly available information. While some cases have been settled, and the settlement amounts can be significant, they have often been considered less costly than ongoing litigation.
ESOP trustees of plans holding privately-held stock are also reviewing the documentation process of their decisions when evaluating an independent appraiser’s valuation report. The process requirements outlined in the GreatBanc settlement agreement focus on the elimination of conflicts of interest, reliability of projections and documentation of the decision process. One specific item to note as part of the documentation process is the requirement that ESOP trustees consider plan provisions regarding benefit distributions along with the age and tenure of ESOP participants. This is further confirmation that ESOP repurchase liability is an important consideration for ESOP trustees to take into account when evaluating the independent appraiser’s valuation report.
Additional Best Practice Considerations
After the Dudenhoeffer decision and the GreatBanc settlement agreement, ESOP trustees are compelled to consider additional steps to help manage their fiduciary liability, including:
- Avoid Conflicts of Interest – Whether the stock is publicly traded or privately held, appointment of independent (non-company) fiduciaries can help protect the integrity of the ESOP trustee’s decision process. In addition, for publicly- traded companies, independent trustees can avoid the potential for possession of insider information that often exists with company trustees.
- Align Competent Financial Advisors – In cases where the ESOP trustee is less qualified to perform the necessary analysis, whether with publicly-traded or privately-held stock, providing access to qualified financial advisors with independent advice, guidance and education to ESOP trustees can help support the integrity of the decision making process.
- Acquire Fiduciary Insurance – The purchase of fiduciary insurance may help cover decisions made by ESOP trustees that cannot be covered by indemnification provisions. ERISA allows fiduciary insurance to be acquired. Frequently, policy costs and coverage limitations are impediments to satisfactory results.
- Plan Design – Publicly-traded companies may want to review their plan design and consider placing limits on the amount of company stock available for participants to acquire. These limits may be on the money sources available for investing in company stock within a qualified retirement plan or a maximum percentage of a participant’s total account balance.
- Communication Strategies – Publicly-traded companies with company stock as an investment option may want to monitor their participant investment activity and provide communications on the merits of diversification to those participants with investments heavily weighted in company stock.
- Document, Document, Document – ESOP trustees should take great care to document the steps they have taken in evaluating company stock investments.
They should document not only the reasons for their decision, but also other considerations that they chose not to follow and why.
All ESOP fiduciaries and trustees should address the ramifications of the Dudenhoeffer decision and the process requirements outlined in the GreatBanc settlement agreement. Following a regimented process for both publicly-traded and privately-held stock investment decisions will help establish and support a prudent decision-making process.
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.
Investing involves risk, including possible loss of principal.
Asset allocation and diversification do not ensure a profit or protect against a loss.
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.