Originally published March 2016 and updated July 2018
In closely held companies, it is common for ownership interests and management positions to be held by the same parties. In these cases, it is clear that company control, or decision-making, rests with those individuals. However, when planning for business succession, some individuals may wish to exit ownership before exiting management. To the extent owners are considering using an employee stock ownership plan (ESOP) for ownership transition, it may be unclear how corporate governance might work after such a transaction since, historically, ownership and management have been aligned. Thus, a common question during planning for a potential ESOP is “who controls the company after the transaction?” Although stated as “control”, the common concern is usually with respect to who will be making day-to-day decisions about business operations.
Here we explore the role ESOP ownership plays in a corporation. Specifically, corporate decision-making might change in some respects, but in other ways, it will remain much the same.
ESOPs are overseen by a trustee who becomes the shareholder of record for the company stock held by the ESOP. In addition to the trustee, a plan administrator will have certain oversight and administrative roles with respect to the ESOP. The plan administrator may be the company, a third party designated as the plan administrator, or a committee or individual within the company,,that is either appointed in writing by the plan sponsor or specifically named in the ESOP plan document. Under ERISA, the plan administrator’s general responsibilities include ensuring the ESOP is operated in accordance with the plan document and required information is reported to the IRS and participants. This operation covers many of the annual accounting tasks, including tracking accounts and allocations, managing plan distributions and determining eligibility. Often, the company will hire a third party to provide many of these recordkeeping services, but someone at the company must provide the third party the applicable data on employee status, compensation, and other information needed to properly administer the plan. Even when a third party is used, the plan administrator retains ultimate responsibility for these duties and is generally also a named fiduciary to the ESOP, which means they are the party primarily responsible for the plan.
As is true with any trust, the trustee has a fiduciary responsibility to protect the assets of the trust for the beneficiaries, including the stock that represents a retirement benefit for employees. The trustee also has a number of duties to carry out on behalf of the trust, including negotiating the ESOP’s corporate stock purchase and engaging an independent third party to appraise the corporate stock each year.
The corporation’s board of directors (board) appoints the ESOP trustee. The party selected as the trustee may be a bank or outside institution that provides professional trustee services, or it may be someone who already has a relationship with the corporation (e.g., the chief financial officer). In choosing whether to use an external or internal trustee, the corporation needs to weigh the cost of an outside trustee with the benefit of receiving additional independence, and perhaps ESOP expertise, to manage the fiduciary responsibilities. In some cases, the corporation may appoint an external trustee who is directed by an internal ESOP committee with respect to certain corporate actions in which the external trustee does not have proper knowledge. A directed trustee must still act to protect employees’ retirement benefits when taking direction, but the internal committee can provide guidance. Even if the committee is not charged with directing the trustee, an internal ESOP committee is often formed within the board or management to undertake the corporate responsibilities with respect to the ESOP, including employee communication and plan administrative oversight. Depending on whether the committee makes decisions that affect the plan or directs the trustee, the committee may become a fiduciary to the plan.
As the legal shareholder, the trustee participates with any other corporate shareholders in electing the board. While this election creates a circular relationship for the trustee when carrying on its primary responsibilities with the business, who was appointed by the board, it rarely creates a problem. While the board is not held to the same fiduciary standards as the trustee, the board is generally required to act in the best interests of the corporation and shareholders, and thus, the parties’ interests are often aligned.
The board retains the same duties after an ESOP owns corporate shares, including appointing officers, approving budgets, accounting to shareholders, and governing broad corporate policies and objectives. The officers appointed by the board hire management, and management runs the day-to-day operations of the company. Again, these responsibilities are not altered after an ESOP acquires shares. Not only do the duties of management and the board stay relatively the same after an ESOP owns shares, but the individuals in management and on the board also usually stay mostly the same, maybe with the exception of adding an independent board member or members that the trustee believes will act as a neutral party when participating in board decisions.
With this structure, selling shareholders may be able to exit ownership while retaining essentially the same decision-making power over the company operations as when they held shares directly. While the trustee relationship is new, the trustee only has duties with respect to the share of the company stock it holds. Therefore, any shares still held outside of the ESOP still have the same rights as before the ESOP sale. Even in cases in which the ESOP holds all of the corporate shares, the management team and the board retain corporate decision-making responsibilities, with an added layer of oversight from the ESOP trustee to ensure those decisions are in the best interest of long-term share value.
In order to remain a qualified ESOP, the ESOP must be primarily invested in the employer’s publicly traded stock or, if the stock is not publicly traded, stock with voting power and dividend rights at least equal to the greatest voting power and dividend rights of all other classes of stock. Therefore, while the ESOP may hold non-voting stock, the ESOP will primarily hold voting stock.
The ESOP trustee votes for the shares held in the ESOP. When voting, the trustee must consider the fiduciary duty to protect the long-term value of the stock for employees’ retirement benefits, not necessarily what may affect short-term employee interests. The trustee may be directed by the board or an internal committee with respect to business transactions, but the trustee must evaluate that direction and act prudently.
In some instances, the vote is required to be passed through to ESOP participants (the employees). These instances include mergers, recapitalizations, reclassifications, liquidations, dissolutions, the sale of substantially all of the assets of a trade or business, or other similar transactions, as required by state law. Companies may choose to extend participant voting to other transactions, but it is not required. In all instances, the trustee, as the legal owner of the shares, has the final vote after soliciting instructions from participants, and the trustee must vote with a fiduciary interest in mind.
There is an important distinction to make here – while many business owners ask the question, “who controls the company after an ESOP transaction?”, it should be understood that the ESOP controls the shares it purchases. Control is an issue that the Department of Labor (DOL) has scrutinized in ESOP transactions. In a settlement agreement entered in 2017 with an ESOP trustee, the DOL stated that if, “the ESOP cedes any degree of control to which it would otherwise be entitled based on its ownership interest…”, then the trustee must maintain additional documentation of consideration received for that cessation. Control, here, relates to rights afforded to corporate stock ownership. No one other than the ESOP trustee should have control over the ownership rights of the ESOP’s stock, but nonetheless, what business owners are commonly thinking of is the day-to-day decision-making, not the control over ownership rights.
A common misunderstanding about ESOPs is that detailed financial information of the corporation will have to be provided to employees and that certain financial information in the hands of employees may be detrimental. For example, the corporation’s tax returns show officers’ compensation, which is not generally known by employees in private companies. There is no requirement to provide company financial information to the employees who participate in an ESOP. The only required financial information is an annual account statement to participants that shows their shares held, shares vested, and the value of the shares. Because the participants see share value on their statements, they will have some overall indication of the company’s performance from year to year.
While not required, it may be a best practice to provide some financial information to employees to help them feel connected to the company’s operations and understand how their efforts increase their retirement benefits. In addition, providing some information may help the employees understand the change in share value on their account statements each year. Research shows that, beyond employee ownership, participative management can help a company’s growth.2 Each corporation should consider what information is appropriate to disclose to employees and how best to incorporate employees in decision-making when they participate in the ESOP. An inclusive culture should benefit both the employees and the corporation.
Although financial information is not required to be released to employees, management needs to provide detailed information to an independent third-party appraiser for purposes of valuing the corporate stock. Therefore, the trustee is privy to certain information as the trustee must review and approve the valuation. If the board or management makes financial decisions that may not be in the best interest of shareholders, the trustee may exert some influence over corporate governance, either by replacing board members or forcing the current board to make better decisions. Instances in which these actions are necessary should be the exception to the rule, though, with the general rule being that the trustee will not interfere with corporate decision-making.
Operating in a fiduciary environment
ESOPs can be beneficial to selling shareholders, employees and corporations. However, ESOPs do routinely receive scrutiny from the IRS and DOL, which have concerns over conflicts of interest between the company, or its advisors, and the plan participants. In many cases, all parties are interested in protecting and growing share value, but the increased scrutiny and legal fiduciary requirements do introduce an increased need for care and diligence in some corporate actions. Best practices to implement when an ESOP owns corporate stock might include engaging outside parties for certain transactions with greater potential for conflicts of interest, implementing formal procedures for review and decision-making, using qualified experts for ESOP matters, and keeping detailed records of deliberations and final decisions with respect to board and trustee decisions. Another consideration may be the composition of the board. If the board members are all management, shareholders or former shareholders, adding independent, outside parties to the board may help support that decisions are made in the best interest of the collective shareholders, rather than management or non-ESOP shareholders who may have different interests than shareholders.
Selling shares to an ESOP can result in relatively little change in corporate governance, even in cases where an ESOP owns a majority of the company. While the ESOP trustee must oversee certain corporate actions to the extent they affect the share value that the trustee is charged with protecting, the board and management team retain the same duties over corporate actions. The trustee appoints the board and votes for the shares it holds, but in most cases, the interests of the trustee, the board and management are aligned. The trustee involvement should only interrupt corporate governance if the board is not acting in shareholder interests. Allowing employees to be involved with management to some extent and adding proper diligence procedures to support corporate decisions may make the ESOP more successful, but should leave corporate governance relatively unchanged.
Thus, an ESOP provides a selling shareholder the opportunity to exit ownership without simultaneously losing "control" of the company. When the individual is ready to fully step away, employment or board involvement can be terminated. Closely held business owners who are interested in diversifying their investment without handing over the company reins for all decisions should consider whether an ESOP is the right choice for their ownership transition.
 See Acosta v. First Bankers Trust Services., Inc., S.D.N.Y., No. 1:12-cv-08648-GBD, consent order and judgment, Sept. 21, 2017  National Center for Employee Ownership: Research on Employee Ownership, Corporate Performance and Employee Compensation.