In a nutshell, an ESOP is a defined contribution retirement benefit plan that is designed to invest exclusively in the employer's stock.

ESOPs are often the subject of litigation when plan participants lose retirement benefits due to a decline in the value of the employer's stock. These suits typically involve two types of allegations–claims of conflict of interest, and claims of breach of the duty to diversify.

ESOPs suffer from inherent conflict of interest.

There are many reasons why companies establish ESOPs. The stated reason is often to encourage employees to have a stake in the company's fortunes or simply to provide retirement benefits to employees. However, the primary motivation for establishing an ESOP often has little to do with the employees, or even providing benefits.

ESOPs offer many advantages to the employer, including:

o Enhanced cash flow and tax benefits derived from contributing stock rather than cash to a pension plan.

o A vehicle for raising capital through sales of stock to the ESOP.

o A market for the securities of a privately-held company.

In short, ESOPs serve two purposes–they provide employees a retirement benefit and they support the employer's corporate finance strategy. Therein lies the problem.

ERISA requires the fiduciaries of a plan to act solely in the best interests of the plan's participants. Because the primary goal behind the establishment of an ESOP is often not the provision of benefits, ESOPs are fundamentally at odds with this principle.

The potential for conflict between the participants' interests and the employers' are even greater for a privately-held company. Since there is no public market for the company's stock, a value must be established when the ESOP acquires stock at inception, when additional stock is purchased, and when distributions are made to participants.

Assigning a value to an asset with no public market presents the potential for manipulation, which is often at the heart of claims against ESOP fiduciaries. When the ESOP purchases its shares from an insider, the value put on those shares may come under intense scrutiny if the company's shares are subsequently assigned a different value in connection with another transaction.

While ERISA requires an annual valuation of private securities held by an ESOP, a valuation should really be done in connection with every major transfer of shares. The valuation should be performed by an independent expert, not by a company insider or a firm that has another relationship with the company (such as an accounting or banking relationship).

To help establish the independence of the valuation and validate the number ultimately reached, the valuation document should address the following:

o Credentials of the individual(s) performing the valuation and disclosure of any other services performed for the employer.

o What information was analyzed to arrive at a value–company financials, income tax returns, interviews with company personnel, etc.

o Valuation methodologies used.

o What discounts to value were applied and why (such as discount for lack of marketability, or discount for minority interest).

Obtaining an independent stock valuation will not completely insulate the ESOP and its fiduciaries from allegations of breach of duty, but it will go a long way toward establishing that the trustees acted prudently with respect to a particular transaction.

Lack of diversity is the cause of many ESOP claims.

Another area of potential risk for ESOPs is their inherent lack of diversity. Any employee benefit plan that invests a high percentage of its assets in one investment presents increased risk and violates ERISA's mandate to diversify pension investments.

When that one investment is shares of the sponsoring employer's stock, the employees' future retirement income becomes disproportionately dependent on the fortunes of the employer.

This lack of diversity would clearly be a violation of ERISA's duty to diversity for any plan but an ESOP. ERISA specifically exempts ESOPs from the diversity requirement. As a result, many ESOP fiduciaries trust that the risk of litigation is minimal.

That trust may turn out to be misplaced, however. The exemption from the diversity requirement is not absolute. There have been a handful of courts that have applied the duty to diversify to ESOPs, finding that fiduciaries who failed to diversify in the face of rapidly declining stock values breached their fiduciary duty and abused their discretion by maintaining the ESOP's investment in the employer's stock.

ESOP fiduciaries are often officers of the employer who possess information on the employer's financial status and future prospects. As in the cases involving employer stock in 401(k) plans, possession of that information may trigger an obligation to advise plan participants to refrain from purchasing stock. Worse, it may dictate that the ESOP divest its shares or refrain from purchasing more, even if that is in contradiction with the plan document.

Just as it has in the context of employer stock in 401(k) plans, the Department of Labor takes an active role in examining allegations of conflict of interest and lack of diversity in ESOP cases. The allegations in ESOP cases bear a striking resemblance to those in the 401(k) cases and their outcome may have a significant impact on ESOPs.

The moral of the ESOP fable is don't judge a book by its cover. While ERISA does grant ESOPs exemption from the requirement of diversity, there is still considerable risk–especially if the ESOP is the only pension plan an employer offers.

Prudence dictates that ESOP fiduciaries take an extra degree of care to avoid costly litigation. Agents, brokers and underwriters of fiduciary liability insurance should be fully cognizant of the potential risks of insuring companies with ESOPs.

Carrie Brodzinski is a product manager for Beazley USA in Farmington, Conn. Ms. Brodzinski leads Beazley USA's employment practices liability, private company D&O and fiduciary liability insurance division. She can be reached at [email protected]

“ERISA requires the fiduciaries of a plan to act solely in the best interests of the plan's participants. Because the primary goal…of an ESOP is often not the provision of benefits, ESOPs are fundamentally at odds with this principle.”

Carrie Brodzinski

The idea that ERISA grants ESOPs an exemption from the requirement of diversify investments is nothing more than a comforting fable in some cases–especially when fiduciaries are company officers who know of some financial information that might prompt a stock value decline.