The unique ownership structure of a company owned, in whole or in part, by an employee stock ownership plan and trust (ESOP) enhances the fiduciary duties of the board of directors of a corporation. The directors are subject to (1) the traditional duties of care and loyalty under state law (which is generally a reasonable person standard and the directors are afforded the benefits of the business judgment doctrine) and (2) the duty to monitor the ESOP trustee under the Employee Retirement Income Security Act of 1974, which is generally an oversight duty subject to a prudent person standard and the directors are not afforded the benefits of the business judgment doctrine.
Traditionally, the duty of care requires the directors to act in an informed and deliberate manner, ensuring that they gather relevant information and make decisions that serve the corporation’s interests. The duty of loyalty requires the directors to avoid conflicts of interest, to place the interests of the company above their own personal gains and to act in good faith, honestly and conscientiously in service of their corporate responsibilities. In the seminal Caremark decision, the Delaware Court of Chancery set forth the principles related to the duty of oversight, which is part of the duty of loyalty. The court ruled that the directors’ lack of oversight would result in a breach of the fiduciary duty under two principles:
(i) Monitoring protocols. The directors utterly failed to implement protocols regarding any reporting, information system, or controls over key corporate actions; or
(ii) Acting on monitoring protocols. The directors consciously failed to oversee the monitoring protocols implemented to inform the directors of the risks or problems requiring the directors to take action.
In the context of ESOP companies, these duties take on heightened significance as set forth in the Su v. Bensen decision, with the duty to monitor being the focal point. Since an ESOP is a qualified retirement plan that is permitted to borrow funds and purchase the stock of the sponsoring company (which is a permitted related party transaction governed by ERISA and the Internal Revenue Code), the directors of ESOP companies are tasked with the following general principles:
- the directors are responsible for selecting a qualified and independent ESOP trustee (free of conflicts of interest) who has the fiduciary duty to exclusively act on behalf of the ESOP (which includes the selection of the ESOP trustee’s advisors), and
- the ESOP trustee cannot purchase stock from shareholders of a privately held company for more than fair market value (as determined by the ESOP trustee’s independent valuation firm along with the ESOP trustee’s legal firm performing due diligence for items that impact the value of a company).
In Bensen, the judge focused generally on three areas: (1) the directors’ selection process for the corporation’s expert (which was a high profile–high volume national ESOP investment banker), the corporation’s lawyer experienced with ESOPs, and the ESOP trustee, (2) the directors’ process of monitoring the ESOP trustee’s selection process for the ESOP trustee’s valuation firm and the ESOP trustee’s lawyer (the ESOP advisor) and (3) the directors’ actions in addressing conflicts of interest of the ESOP investment banker, the ESOP trustee, the corporate law firm and the ESOP advisors that compromised the independence and integrity principles that are the basis of the rules relating to ESOPs. The relevant facts in our view that were generally important to the judge were as follows:
- The directors engaged an ESOP investment banker, recommended by the corporation’s lender, who historically had a business referral relationship, as the corporation’s expert to structure a transaction in which the ESOP purchased 100 percent of the company’s stock without performing any reasonable due diligence.
- The materials and discussions with the directors provided by the ESOP investment banker describing the scope of its services, including the ESOP investment banker, will (a) quarterback and control all aspects of the ESOP transaction, eliminating any risk of closing and changes to transaction terms (along with engineering the ESOP transaction in a way that the selling shareholder retains control of the corporation); (b) recommend partners (the ESOP trustee and the ESOP advisors) that will represent the interests of the ESOP and that will be pliable and easy to negotiate the terms of the transaction; (c) guide the ESOP trustee and the ESOP advisors to accept the transaction valuation and transaction terms; (d) guide the ESOP trustee and the ESOP advisors to a transaction closing on an abbreviated timeframe (superior timing); and (e) create the proper optics to reflect that the ESOP trustee and the ESOP advisors are documenting the process in preparation of a potential DOL audit.
- The directors passively and blindly followed the ESOP investment banker’s recommendation, participated in an illusory pro forma process in selecting the ESOP trustee and corporate legal counsel, and failed to monitor the ESOP trustee’s selection of the ESOP advisors and ignored the apparent intertwined business relationship among the parties.
- The directors permitted the ESOP investment banker to influence the ESOP trustee and the ESOP advisors in estimating the fair market value of the stock purchased by the ESOP and closing the ESOP transaction on incomplete business terms (which violated the ESOP trustee’s internal approval policy).
The judge in Bensen held that the directors breached their fiduciary duties and was critical of the following:
Selection of the ESOP Investment Banker, the ESOP Trustee and the ESOP Advisors
The judge recognized that the directors may rely on experts in making decisions, so long as the directors (1) select the expert with reasonable care by performing reasonable due diligence, (2) reasonably believe the matter is within the expert’s professional competence and (3) rely in good faith, not blind reliance, on the expert’s guidance, provided that the expert’s guidance is reasonably justified under the circumstances and free of conflicts. The judge further indicated that the directors must more closely scrutinize an expert’s guidance if red flags arise that indicate that the expert’s guidance is unsound or comingled with conflicts of interest that interfere with providing reasonable guidance to the directors. In the context of ESOP companies, the directors often select experts, such as the ESOP investment banker, a corporate lawyer with ESOP experience or an ESOP trustee (experienced in carrying out the rules and fiduciary duties applicable to ESOPs). Following the selection of the ESOP trustee, the ESOP trustee then normally selects a qualified independent valuation firm free of conflicts to perform a valuation of the corporation, issue a fairness opinion to the ESOP trustee, and legal counsel to assist the ESOP trustee in satisfying its fiduciary duty under ERISA (including the negotiation of the transaction, performing due diligence and overseeing the ESOP trustee’s process).
The judge was critical of the directors for disregarding several glaring red flags. The directors engaged the ESOP investment banker and blindly followed the guidance of the ESOP investment banker in selecting the ESOP trustee (who engaged an ESOP valuation firm and an ESOP legal firm) without performing any reasonable due diligence on the ESOP investment banker, the ESOP trustee and the ESOP advisors. The directors ignored the fact that the ESOP investment banker, the ESOP trustee and the ESOP advisors had current and past business relationships and regularly worked on each other’s transactions, which generated significant income for each of them. The judge noted that a partner from the corporation’s CPA firm assured the directors that the ESOP trustee recommended by the ESOP investment banker “won’t balk at what we want” to complete the ESOP transaction structured by the ESOP investment banker. The directors admitted that they “did not investigate the conflict process the ESOP trustee … performed, nor did [they] investigate the extent of the [ESOP investment banker, the ESOP trustee and ESOP advisors’] relationships and incentives to accept … [the ESOP investment banker’s] positions.” The court further stated that the evidence was undisputed that the ESOP investment banker, the ESOP trustee and its valuation firm and legal firm had past and ongoing business relationships, the parties previously worked together on opposite sides of ESOP transactions and they had worked together on the same side of the ESOP transactions (historically, this group had an incestuous intertwined business referral relationship), the ESOP investment banker had previously discussed the ESOP transaction months prior to the selection of the ESOP trustee and the ESOP advisors, and the directors participated in an illusory and pro forma selection process.
Bensen provides directors with several important lessons relating to selecting its experts to complete an ESOP transaction. Directors need to be watchful for red flags that arise in the selection process, particularly when (1) the ESOP investment banker represents that it will be the quarterback of both sides of the ESOP transaction, (2) the ESOP investment banker holds itself out as having significant influence over the ESOP trustee and the ESOP advisors (and serves as a valuation firm for ESOP trustees on other ESOP transactions) and (3) the ESOP trustee is blindly selected by the directors and the directors permit the ESOP trustee to select the ESOP advisors solely upon certain representations made by the ESOP investment banker. Directors should be attentive and aware of situations where the ESOP investment banker, the ESOP trustee and the ESOP advisors have an intertwined and incestuous business relationship. While it is common for the directors to rely on outside advisors, Bensen highlights the need for more rigorous vetting and oversight of the professionals involved in the ESOP transaction.
Oversight of and Monitoring of the ESOP Investment Banker and the ESOP Trustee’s Process
Since the directors have oversight responsibilities over the ESOP investment bankers’ actions and monitor responsibilities over the process of the ESOP trustee (and the ESOP advisors), the directors need to be watchful for any red flags arising that appear to compromise the independence of the ESOP trustee and the ESOP advisors. The judge points out that the directors were (or should have been) aware of the following red flags: (1) the ESOP trustee approved and consummated the ESOP transaction before the completion of due diligence, closed the ESOP transaction without agreement on certain material transaction terms in violation of the ESOP trustee’s internal approval policy (which was disclosed to the directors and the ESOP investment banker, and none of the ESOP advisors attempted to pause the transaction) and (2) the ESOP investment banker used its self-proclaimed relationship with the ESOP trustee and the ESOP advisors to close the ESOP transaction within 22 days following the engagement of the ESOP trustee. In addition (which was most troubling), the directors were aware that the ESOP investment banker, the ESOP trustee, and the ESOP advisors were running an illusory pro forma process to complete the ESOP transaction. The directors were informed during the ESOP trustee selection process by the ESOP investment banker and the corporation’s CPA firm that the ESOP trustee and ESOP advisors were solely playing a role in the transaction and needed to show a record of some negotiations.
Bensen provides the directors with several important lessons relating to the directors’ oversight and monitoring responsibilities. The directors either failed to establish any monitoring protocols or failed to take action to address the red flags that arose. Benson demonstrates that directors need to be watchful for red flags that arise and cannot passively accept the guidance of ESOP investment bankers without engaging in a meaningful review of their guidance, considering the conduct of the ESOP investment banker, the ESOP trustee and the ESOP advisors that arose throughout Bensen. In that case, the directors blindly followed the ESOP investment banker’s guidance and permitted the ESOP transaction to close, (1) knowing the ESOP trustee and its advisors were clearly not in a position to close a transaction within the abbreviated timeline, (2) knowing the ESOP investment banker was using its close-knit, incestuous business relationship with the ESOP trustee and the ESOP advisors to influence them to close the ESOP transaction with a number of incomplete material terms, (3) knowing the ESOP trustee and ESOP advisors were compromising their independence and objectivity, (4) knowing the ESOP investment banker was in control of both sides of the negotiations and was running a questionable abbreviated illusory process and (5) approving a transaction despite the fact that the directors had limited direct contact and discussions with the ESOP trustee throughout the transaction process.
While it is common for the directors to rely on outside advisors, Bensen highlights the need for the directors to be more attentive to the conduct of their expert and to be attentive to any red flags that suggest that the ESOP trustee and the ESOP advisors have compromised their independence and objectivity (in that case, their mutual interests were closely aligned with the interests of the ESOP investment banker to close the ESOP transaction regardless of the terms). It is important that the ESOP investment banker, the ESOP trustee and the ESOP advisors are genuinely independent of each other and that their conduct serves the best interests of their respective constituency rather than merely facilitating the transaction to generate fees.
Conclusion
The unique rules associated with an ESOP expand the responsibilities of the directors of ESOP companies (and companies considering the implementation of an ESOP ownership structure). Because of the higher standard of duties and the higher level of scrutiny on ESOP transactions, since they are related-party transactions governed by ERISA and the Internal Revenue Code, directors will normally engage experts with ESOP experience. As reflected in Bensen, the directors must (1) select experts (the ESOP investment bankers, the ESOP trustee and the ESOP advisors) with a focus on conflicts of interest and cannot blindly rely on their guidance, (2) address situations arising that compromise the independence, objectivity and integrity of the process and (3) oversee the process and conduct of the ESOP trustee (and the ESOP advisors) with an eye on the ESOP trustee and the ESOP advisors compromising their independence to placate the corporation’s expert (the ESOP investment banker).
Bensen reveals the dangers of completing an ESOP transaction that involves the selection of a close-knit group of ESOP professionals who are willing to disregard conflicts of interest rules that compromise their independence to complete an ESOP transaction. In addition, Bensen sends a strong message to directors involved in ESOP transactions that they need to take a more proactive role in (1) selecting company-side ESOP advisors, (2) selecting the ESOP trustee and being watchful of who the ESOP trustee selects as its advisors and (3) participating in a transaction free of any pro forma illusory processes instituted by the ESOP professionals, which compromises the independence and integrity principles mandated by ERISA.
In light of Bensen, the directors of ESOP companies need to realize that corporate governance frameworks have evolved to incorporate stronger risk management practices. Bensen highlights the importance of the following:
Develop Monitoring Protocols. The directors need to implement monitoring protocols that identify red flag risks (such as conflicts of interest) and timely act to ensure that the ESOP transaction is not compromised by any of the parties.
Prioritize fiduciary duties over financial gains. Bensen was particularly critical of the directors, the ESOP investment banker and the ESOP trustee’s rush to complete the ESOP transaction for the sake of completing a transaction (along with the ESOP advisors’ failure to pause the transaction).
Scrutinize professional advice. The directors must critically evaluate the guidance they receive from the ESOP investment banker and its advisors and be aware of any red flags that compromise the independence and integrity of the process. The directors should immediately act and not participate in illusory pro forma processes.
Monitor fiduciary processes. Bensen underscores that the directors have an ongoing duty to monitor the ESOP trustee (and its ESOP advisors), particularly in transactions that impact ownership structures. Bensen serves as a reminder that the directors cannot rely solely on outside experts without maintaining direct oversight. The directors are reminded that they are required to address any red flags that appear to compromise the independence and integrity principles associated with completing an ESOP transaction.
Bensen reinforces that all directors must be disciplined, vigilant and active participants in all aspects of an ESOP transaction to ensure that the independence and integrity principles are not compromised. The directors need to recognize that their interests and fiduciary duties are not always aligned with those of the ESOP investment banker (who is providing them guidance), the ESOP trustee and the ESOP advisors.
John Kober is a partner at the law firm of Morgan Lewis & Bockius.