Let’s kick this blog off right away with a little trivia. Do you know what ESOP stands for? If you don’t, I’ll help you out. ESOP is the acronym for Employee Stock Ownership Plan, and Investopedia.com defines an ESOP as “…a qualified defined-contribution employee benefit (Employee Retirement Income Security Act of 1974 [ERISA]) plan designed to invest primarily in the stock of the sponsoring employer.”
That’s a mouthful. To break it down, ESOPs are a great way to grant ownership opportunities to top performing employees as an extra employee benefit, transition ownership of a company from retiring owners, and provide valuable tax benefits for the company and its shareholders. Studies have shown that ESOPs improve company and employee performance. It makes perfect sense. Employee compensation is tied to company performance which results in higher performing employees that take more ownership (literally) in their work product.
A little bit of a history lesson on this…ESOPs have actually been in existence in the U.S. since the 1950s, but they became much more prevalent following certain tax reform and the advent of ERISA law in the 1970s. A study by the National Center for Employee Ownership (NCEO) shows there were 6,717 ESOPs covering over 14.1M employee owners in the U.S. as of 2014.
But, as with all good things, ESOPs come with a warning label. Although intentions may be genuine and for the best interest of the employees and the company, the very nature of an ESOP structure creates potential heightened exposures. ESOPs create inherent conflicts of interest between leadership of a company and the ESOP trustees (AKA fiduciaries). Directors and officers of organizations must act with a duty of loyalty, care, and obedience toward the company. ERISA law requires plan fiduciaries to comply with various duties to the plan including: prudence, loyalty, disclosure, diversification of investments, monitor, and obedience. Whenever the fiduciary’s interests to the plan sponsor conflict with the interest to the plan participants, they must direct their duty of loyalty to the plan, not the sponsor. In these cases where the fiduciary is wearing “two hats,” the courts look at whether the fiduciary investigated alternative actions and relied on outside advisors. A fiduciary may be held personally liable for any losses resulting from the fiduciary’s breach of duty.
The following are some common claims scenarios related to ESOP companies:
- Fiduciaries having a conflict of interest and failing to put participants’ interests first
- Fiduciaries failing to monitor service providers and ensure fair market value is paid for services
- Fiduciaries failing to disclose material information or misleading participants through deceptive communications
- Fiduciaries acting imprudently by allowing continued investment of plan assets in company stock when stock price was artificially inflated, or divesting the plan of company stock when the stock price was low
- Suffering an uncovered loss which leads to stock price decline and could have been prevented by prudent risk management and insurance protections
ESOPs also present unique exposures for coverages such as: Directors & Officers Liability, Employment Practices Liability, Fiduciary Liability, Cyber Liability, and Crime Insurance. It’s imperative all of these coverages work together, and coverage is crafted to respond when needed.
At Holmes Murphy, we work closely with ESOP companies and tailor coverage to provide essential protections for their specific exposures. We have expertise dedicated to ensuring the broadest coverage at the lowest cost. If your company’s executive risk insurance program isn’t written correctly, it could leave you bare when you need it the most. It’s vital these coverages are crafted correctly to maximize protection for the leaders of the organization and the organization itself.
I realize this subject isn’t the easiest to understand. So if you have questions, aren’t sure if what you have in place is working or written right, or just need help getting started, don’t hesitate to reach out. We are here to help!
