The Fiduciary Trustee's Role in ESOP Governance

By Anthony Mathews

In previous editions of the newsletter, we have looked at the roles of management and the board of directors in governing ESOP companies. In this issue, we close the loop on the triangular governance structure that supports ESOP companies and discuss the role of the ESOP itself as reflected in the duties and functions of the ESOP fiduciary (the trustee).

When first taking on the role of the ESOP fiduciary, a surprising realization for many of the uninitiated is that shareholders have very little direct influence on the running of the company, at least not in their capacity as shareholders. In fact, in terms of the usual operating life of the corporation involved, shareholders don't do much at all. Shareholders, as investors in the enterprise, are protected by the board's and management's fiduciary duty to develop and provide value to their investment, and as a result, as long as everything is going well, shareholders are the passive recipient of what is created. Hence came the term "passive income," which some of us consider the two most beautiful words in the English language.

As a result of this, the trustee of the ESOP, as shareholder of record and fiduciary for the plan has a clear and straightforward job when acting in that capacity – act exclusively in the best interest of the ESOP and its participants and beneficiaries. Of course, the difficulty in that sort of clear directive is the devil in the details – that is, determining exactly what is in the best interest of the ESOP in any given circumstance. In one seminal ruling, the court created an unambiguous (if somewhat ghoulish) directive, in this regard, that an ESOP trustee must have an "eye singular" to the best interest of the ESOP – a monocular and focused attention to the best interest of the ESOP as a whole.

The dimensions of the job are simultaneously very specific and enormous, and the responsibility is both absolute and personal. That is, where a fiduciary violates his or her (or its) responsibility, the beneficiary (the ESOP ) will have to be made whole and the fiduciary will have to be willing to use personal assets to accomplish that, if that is necessary. Recently, the dimensions of this job have been reduced in the public discussion to a checklist of particular behavioral choices, but I believe that the subtleties of the role are too complex to reduce to a checklist. The fiduciary must first have and then use independent judgment to, in every way possible, assure the ESOP's ability to meet its obligations to participants consistent with the terms of the plan. It is by nature a subjective and thoughtful obligation.

So, let's see how that plays out in two key areas of fiduciary responsibility.

Setting stock value: Most people in the ESOP world know that the question, "Who sets the value of stock in an ESOP?" is not answered, "the appraiser." The correct answer is, "the trustee sets the value." But, unless the stock is readily tradable on an established public market, the trustee is obligated to do so with the advice and counsel of an independent financial advisor (appraiser). The trustee's role in setting the value, then, is really a two-part job: part one, select a reliable and competent advisor who can act on behalf of the ESOP without any active conflict of interest, and, part two, use his or her advice wisely.

Selecting the right appraiser is really a matter of common sense. Candidates must be highly experienced - specifically with a range of ESOP appraisals. After that, there are several specifics the trustee should investigate including: the appraiser's independence; the appraiser's formal qualifications; the appraiser's reputation within the ESOP community; the appraisal firm's resources and their internal review processes.

The selection should always include a comprehensive interview process. The appraisers' opinions on controversial ESOP issues are important for the trustee to know. Fees are last on the list, because this is not a place to cut corners. All other things being equal, though, fee can be a decider, but it should definitely not be the first criterion.

Given that, the appraisal process itself requires the trustee's continual involvement. First, the trustee is responsible to see that the data provided to the appraiser present a realistic picture of the company and that the appraiser uses them effectively in developing his or her advice. Reviewing and approving the appraisal report is a combination of knowledge and process, which is too detailed to recount here, but which is well documented many other places.

In the end, the appraiser's report should include: a detailed and specific statement of the purpose of the appraisal; the standard(s) of value applied; results of a due diligence site visit; results of interviews with management; a review of the economy as it might relate to the valuation; a review of the industry specifically; reviews of company historical and current financial statements; reviews of management projections of future earnings streams and analysis of risk of achieving them; a description of selected valuation approaches and documentation of the results of their applications; analysis of weighting of any approaches that are included in the final valuation answer; and an executive summary of the report.

In transaction circumstances, the appraiser's advice might range from giving an exact opinion of fair market value to opining on whether a particular price exceeds fair market value. The appraiser might also be asked to provide an opinion that a transaction is fair overall to the ESOP. In every case, though, the ultimate decision rests with the trustee, so trust of the advisor is critical.

Voting ESOP stock: In every case, the trustee/fiduciary also acts as the "holder of record" of ESOP stock and will, therefore participate in shareholder meetings, make transaction and investment decisions, and vote all shares held by the ESOP. With regard to certain matters that by law require a shareholder vote and are identified by the Internal Revenue Code as requiring participant voting instructions, the fiduciary will survey the participants for instructions. But, though we call this a voting pass-through, in reality the vote is always cast by the trustee, and, notwithstanding the instructions received, the trustee must make an independent decision on the wisdom of the choice and vote according to its fiduciary judgment where that judgment diverges from the directions of participants.

In soliciting instructions, the trustee must develop a process that guarantees each participant an anonymous method of making his or her instructions known. Communication about the decision at hand should be developed in plain language and should include enough information that the participants can make an informed decision. This information might include: the proposed action; the technical elements of the action; the perceived benefit to the company/shareholders; materiality of the ESOP's vote; management and/or trustee endorsement; significant risks; etc.

In these two areas, the functional influence of the trustee is clear.

Oversight of the board: Since the shareholders elect the board of directors, where the ESOP fiduciary controls an amount of stock that can influence the composition of the board, the trustee will have to give proper thought to the performance of the board and its members. Of course, that is a subjective analysis, and, while it does not require the trustee to get actively involved in details of running the business, it does require that the trustee remain continually in touch with and engaged with the progress of the company toward achieving its strategic goals to create wealth for the employees who benefit from the ESOP trust.

As these examples of fiduciary involvement illustrate, collaboration among the board of directors, management of the company and the ESOP fiduciary is critical to each in successfully fulfilling their responsibilities. Even more fundamentally, a collaborative, transparent atmosphere is the basis upon which successful ESOP companies are built.