Common Pitfalls of Being an ESOP Trustee

By Glenn Ball, CPA/ABV, ASA

If you have spent time around the ESOP world, you know that, in addition to all of the wonderful benefits an ESOP brings to a sponsor company, there are complexities and various pitfalls to be aware of as well.  In this article, I thought I would discuss some of the pitfalls of being an ESOP trustee.  In one of my past lives, I acted as an ESOP trustee for plans which ranged from ones as small as 20 participants to ones with nearly 1,000 participants.

Before discussing the pitfalls, I would like to say that ESOP trustees are held to the highest fiduciary standard under the law and are responsible for what they know or should have known.  The "should have known" component of that sentence is the tricky part.  What it means is that an ESOP trustee must be very well versed in the nuances of plan documents and ERISA rules as they apply to the ESOP in question.  In addition, an ESOP trustee must be able to anticipate where the various "ESOP pitfalls" might be located and then take action to correct or, better yet, avoid the missteps.  Of course, a competent ERISA attorney is indispensable to an ESOP trustee's team of experts.  From my experience, it is clearly worth the added expense of retaining an attorney who is well versed in ERISA law and who has actual real world experience with ESOPs, as opposed to hoping (and wishing) that the local attorney whom you have known and trusted for years will be up to the challenge.  ERISA law is a different breed and requires a real specialist.  In my opinion, you do not want to take shortcuts when it comes to ESOPs.  An ERISA attorney acts as the trustee's counsel but is actually paid by the plan sponsor or by the trust itself. It is also important to hire a good business appraiser.

One of the most important functions performed by an ESOP trustee of a closely held company is to set the fair market value of the plan sponsor's stock.  On this issue the reader might assume that the business appraiser retained by the trustee sets the price of the stock.  That assumption is both right and wrong.  The trustee will typically rely on the appraiser's expertise, but the ultimate responsibility for setting the stock price remains with the trustee.  The biggest pitfall of being an ESOP trustee is undoubtedly the scenario wherein the trustee is held liable for claims (frequently by current or former employees) that the stock price was either over- or undervalued. 

The best way to mitigate this risk is for the trustee to have a good understanding of the valuation discipline, play an active role in the valuation process, and thoroughly document the process used to arrive at fair market value.  It is a fact that the determination of the fair market value of a closely held entity is highly subjective.  As is often said of the valuation profession, It is more art than science.  Therefore, it is important to show that a reasonable process is followed in arriving at the value conclusion.  In other words, clearly demonstrate that you, as trustee, put some serious work into coming up with the new stock price.  In fact, case law has established that ESOP trustees will not be shielded from liability for overvaluing or undervaluing employer stock when it has been determined that the trustee passively accepted a valuation report.

Other than the perils surrounding the ever-important task of setting the new annual stock price, the following are potential pitfalls an ESOP trustee faces in his or her goal to, as a judge in a 1982 U.S. Second Circuit Court ERISA case stated, make decisions with an eye single to the interests of the ESOP participants and beneficiaries:

-    Failing to allow employees to vote their shares on required issues
-    Failing to give employees appropriate information on which to base a decision when they vote
-    Failing to distribute benefits according to plan rules
-    Acting in a discriminatory manner in honoring the put option
-    Failing to ensure the filing of reports when such failure could result in the plan losing its qualified status

There certainly are pitfalls to watch out for as an ESOP trustee.  However, there is help!  Based on statements contained within numerous judicial opinions published over the years, the common theme in these statements appears to be that the best defense a trustee has in the face of legal and/or regulatory scrutiny is the existence of a well-documented process.  Much like the real estate profession's mantra of Location, location, location, professional ESOP trustees have a favorite mantra of their own, Process, process, process.  A sound, thorough, and well-documented process will go a long way toward demonstrating that an ESOP trustee has indeed made a good-faith effort to look out for the exclusive benefit of the plan participants and beneficiaries involved.

For more information on how to avoid the common pitfalls of being an ESOP trustee, read So, You're an ESOP Trustee, an article I co-authored with Tracy Woolsey of Horizon Trust & Investment Management.  In addition, Aaron Juckett of ESOP Partners has a good blog on the Ongoing Duties of an ESOP Trustee.