A corporate Swiss Army Knife: The Employee Stock Ownership Plan, Part 2: Shareholder transactions - navigating ERISA risks

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Part 2: Shareholder Transactions – Navigating ERISA Risks

An ESOP is a paradox – an ERISA-covered tax-qualified retirement plan, which benefits employees, designed to invest primarily in securities of the ESOP sponsor, which benefits the sponsor. Given this dual nature, there are many ERISA risks. Giving short shrift to these issues can lead to significant liability. This article provides a framework for navigating these perilous waters and mitigating risk.

Brief refresher: How to sell a company to an ESOP

At a very high level, the typical shareholder – ESOP transaction occurs generally as follows:

  • The employer establishes an ESOP, obtains financing, e.g., from a bank, and makes an “acquisition loan” to the ESOP (the employer gets a loan and then makes a loan of the same amount to the ESOP).
  • The ESOP uses the acquisition loan proceeds to buy stock of the employer (commonly from a founding shareholder), and holds the stock in “suspense” subject to a security interest.
  • Annual funding cycle:
    • The employer provides the ESOP with funds (contributions and dividends or S-Corporation distributions.)
    • The ESOP pays the annual installment on the acquisition loan (returning funds to the employer). This results in a proportional release of shares from the security interest and allocation of these shares to participant accounts in the ESOP.
    • The employer pays the annual installment on its loan.

ERISA Complications

1. “Watch out, you might be a fiduciary!” 
ERISA imposes a litany of requirements and prohibitions on anyone who is a fiduciary with respect to a plan and defines “fiduciary” very broadly. In simplified terms, a fiduciary with respect to a plan is any person:

  • To whom “fiduciary authority” has been granted (an “appointed fiduciary”), and
  • Any person who in fact exercises “fiduciary authority” without a grant of that authority (a “de facto fiduciary”).

“Fiduciary authority” is discretionary authority or discretionary control respecting the management of a plan or any authority or control over the disposition a plan’s assets, i.e., investing assets, distributing benefits, and paying administrative expenses. Acts and omissions involving or relating to fiduciary authority – “fiduciary conduct” – will be subject to ERISA scrutiny.

“Fiduciary authority” is discretionary authority or discretionary control respecting the management of a plan or any authority or control over the disposition a plan’s assets, i.e., investing assets, distributing benefits, and paying administrative expenses. Acts and omissions involving or relating to fiduciary authority – “fiduciary conduct” – will be subject to ERISA scrutiny.

There are three important limitations to this:

  1. “Settlor” decisions, such as plan design and funding, are not subject to ERISA.
  2. “Ministerial” conduct, such as applying eligibility rules or calculating benefits, will not make the individual a fiduciary.
  3. Clearly defined scope of delegated fiduciary authority can limit that fiduciary’s potential exposure; for example, a person delegated authority to manage a plan’s fixed income portfolio will not be responsible for the plan’s equity portfolio.

    Fiduciary Framework – First Inquiry: Is there a fiduciary decision or issue? If so, who is the fiduciary with authority over the matter?

    Risk Mitigation: Document all fiduciary appointments with clearly defined scopes of fiduciary authority and written acceptances. Make sure fiduciaries understand the allocation of fiduciary authority. If it is unclear who has fiduciary authority over the matter, clarify and document before proceeding.

2.  ERISA Fiduciary Duties – The Big Two
In the context of ESOP transactions, the critical two fiduciary duties are the Duty of Loyalty and the Duty of Prudence. ERISA’s fiduciary duty provision states that a fiduciary shall discharge their duties with respect to a plan “solely in the interest of the participants and beneficiaries” and (a) for the “exclusive purpose” of providing benefits and defraying reasonable expenses of plan administration (the Duty of Loyalty), and (b) with “the care, skill, prudence, and diligence under the circumstances then prevailing” that a prudent expert would use in the conduct of “an enterprise of a like character and with like aims” (the Duty of Prudence).

The Duty of Loyalty is concerned with conflicts of interest and the Duty of Prudence is concerned with a fiduciary’s decision-making process. Courts have consistently ruled that the Duty of Prudence is an ongoing duty that requires regular monitoring. Thus, it is not enough to conclude that an investment is prudent at the time of the initial investment; the fiduciary must ensure that the investment remains prudent over time, thus requiring regular monitoring and evaluation.

3. Prohibited Transactions – “Thou Shall Not!”
ERISA includes a list of prohibited transactions – transactions that are per se forbidden – that fall into two categories, namely (a) transactions between a plan and a party-in-interest, and (b) fiduciary self-dealing. ERISA has a detailed list identifying who is a party-in-interest but the most common include the employer, owners of 50% or more of the employer’s equity, fiduciaries, and service providers.

4. Prohibited Transactions Exemptions – “Yes We Can!”
Because Congress recognized that there are many situations where prohibited transactions should be allowed for the benefit of the plan, it enacted statutory exemptions and authorized the Department of Labor to issue “class” and individual exemptions. Most important for an ESOP are the statutory exemptions in ERISA sections 408(b)(3) and 408(e), which, respectively, allow for ESOP acquisition loans and the acquisition or sale of “qualifying employer securities,” e.g., stock of the employer, so long as the transaction is for “adequate consideration” and no commission is charged. Where there is no market for the asset, “adequate consideration” is “the fair market value of the asset as determined in good faith by the trustee or named fiduciary . . .” The tax-qualification standards require valuations by an “independent appraiser.”

Courts have given the definition of “adequate consideration” a great deal of attention. While courts decide each case based on the unique circumstances involved, common elements include selecting an independent and qualified valuation firm, avoiding conflicts of interest, and documenting the process by which the value was determined.

Fiduciary Framework – Second Inquiry: Does any fiduciary have any actual or potential conflicts of interest? Is the action solely for the purpose of providing benefits or defraying reasonable administrative expenses, or both? What does a prudent decision-making process require? Do the fiduciaries have the necessary expertise (either their own or through an engaged expert consultant)? Are they considering relevant information, including about available alternatives? Is there a prohibited transaction? If so, is there an exemption that would permit the transaction?

Fiduciary Risk Mitigation: Have conflicted fiduciaries recuse themselves from involvement in the matter. Obtain independent expert advisors to assist in ensuring a thorough review and decision-making process. Contemporaneously document actions taken through meeting summaries, minutes, and retaining reports reviewed. Confer with legal counsel to determine whether there is a prohibited transaction and if so, an available exemption, along with what the exemption requires.

Applying these Concepts to an ESOP Transaction

  • The employer establishes an ESOP.

    Fiduciary Framework: Is this a fiduciary decision or issue? No – The decision to establish a plan is a settlor decision. However, a plan document has to identify a “named fiduciary” who can delegate fiduciary functions but who is, ultimately, responsible for the delegations. It is generally preferable for the named fiduciary to be a committee, so that the responsibility is limited to an identified group of individuals (as opposed to the whole company or Board). The same is true as to the ERISA plan administrator – ideally, it is a committee, rather than “the employer” since it is a fiduciary role.

  • The employer makes an “acquisition loan” to the ESOP and the ESOP uses the acquisition loan proceeds to buy stock of the employer.

    Fiduciary Framework: Are there fiduciary decisions? Yes – the decisions on behalf of the ESOP to enter into the loan and to purchase stock involve the disposition of plan assets and are thus fiduciary decisions.

    Are there conflicts of interest? It depends on the identity of the fiduciaries– if they are employees, conflicts are generally presumed. If they are independent fiduciaries, then (by definition) conflicts do not exist. In this situation, conflicts are probably best resolved by recusal by conflicted fiduciaries and engagement of an independent fiduciary – itself a fiduciary decision, meaning, the selection of an independent fiduciary must be the result of a prudent search and selection process that must, to some extent, be monitored without actually or appearing to pressure or influence the independent fiduciary.

    Are there prohibited transaction? Yes – both the acquisition loan and the stock purchase are party-in-interest transactions and may implicate fiduciary self-dealing (for example, if the selling shareholder is a fiduciary). Are there a prohibited transaction exemptions to allow them? Yes – ERISA sections 408(b)(3) and 408(e) are available.

    Whoever serves as the ESOP Trustee will need to engage an independent qualified valuation firm that has no conflicts of interest. That selection is itself a fiduciary decision by the ESOP Trustee, who then needs to assure itself that the valuation uses prudent methodologies and assumptions, that the data is accurate and the math correct, and that the conclusions follow from the analysis.

    In practical terms, it is not realistic to expect that the company or its Board or designated employees can be isolated from all fiduciary responsibility. Some clients are tempted to appoint multiple layers of independent fiduciaries but this is unwieldy, expensive, and of limited practical effect.

    A more useful approach: Ultimately, whether a fiduciary has satisfied their ERISA fiduciary duties depends on all of the facts and circumstances. The fiduciary needs to satisfy the fiduciary’s duties of loyalty and prudence and document the procedures undertaken to do so. Carefully and thoughtfully appointing fiduciaries, assessing whether they have conflicts of interest and how any conflicts can be addressed, and documenting these deliberations demonstrate compliance with the duties of loyalty and prudence. The conflicted fiduciaries deciding to recuse themselves, doing a diligent search for and selecting a prudent independent fiduciary and then giving the independent fiduciary a broad delegation of authority, including over the selection of a valuation firm and its own legal counsel, and engaging in arm’s length negotiations (for example, as to Board representation) are additional steps in fulfilling the duties of loyalty and prudence. Having the independent fiduciary serve as ESOP Trustee on an ongoing basis demonstrates continued compliance with prudence and loyalty. Ultimately, this is the most useful approach to risk mitigation.

There are a myriad of potential ERISA landmines that can create significant exposure, and related personal liability, for ESOP fiduciaries. Fortunately, taking actions grounded in and keeping in mind fundamental ERISA fiduciary duty principles can enable the parties to navigate the risk successfully and get to the desired outcome with a high degree of risk mitigation.

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