Directors’ Fiduciary Duties and Standard of Care in an ESOP Owned Company

This is the first of three blog posts that will address certain key issues that the Board of Directors of an Employee Stock Ownership Plan (“ESOP”) owned company need to focus on: (1) Fiduciary Duties and Standard of Care; (2) Conflicts of Interest and Independent Directors; and (3) Unsolicited Offers.  The focus of these blog posts is on the difference between issues in ESOP owned companies, compared to privately owned companies.

Introduction

Each member of the Board of Directors of a corporation owes fiduciary duties to the shareholders of that corporation.  These fiduciary duties exist under the laws^[1] of the State, under which the corporation exists. 

In many privately owned companies, the shareholders and directors are identical.  As a result, the fiduciary duties of directors owed to the shareholders may not be paid much attention. 

In contrast, an ESOP owned company is similar to a public company, in that the ESOP (as shareholder) and the Participants in the ESOP (as beneficiaries of the ESOP) are not the same as the members of the Board of Directors.  As a result, directors of an ESOP owned company need to pay more attention to their fiduciary duties to shareholders. 

Separately from and in addition to fiduciary duties under state law, in performing certain functions, the Board of Directors has additional fiduciary duties under the federal Employee Retirement Income and Security Act of 1974, as amended (“ERISA”).  ERISA imposes a higher standard of care with respect to these duties. 

Fiduciary Duties Under State Law

The corporate laws of each state vary.  Generally, directors have a fiduciary duty to treat all shareholders- including the ESOP- fairly.  “Fairly” has been interpreted to mean that the Board must satisfy (1) a duty of care; and (2) a duty of loyalty.

• Duty of Care (the “Reasonable Person” standard):  The Board must act with the care, skill, prudence, and diligence under the circumstances then prevailing that a reasonable person would use in the conduct of an enterprise of a like character and with like aims.
•  Duty of Loyalty:  The Board must act without conflict of interest^[2].

Directors who fulfill the duties of Care and Loyalty are protected by the Business Judgment Rule: they are immune from personal liability, and a court will not intervene in their decisions.  A shareholder (including an ESOP trustee), or ESOP participant, seeking damages against Board members for an alleged breach of fiduciary duty, has the burden of proving that the Business Judgment Rule should not apply.

In contrast, if a plaintiff succeeds in defeating the Business Judgment Rule, then under the Entire Fairness doctrine, the Board members have the burden of proving that their actions were “entirely fair” to shareholders.

Fiduciary Duties Under ERISA

ERISA fiduciaries are subject to “Exclusive Benefit Rule” which requires that they shall discharge their duties solely in the interest of the participants and beneficiaries of the ESOP, for the exclusive purpose of (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan.

In carrying out that duty, ERISA fiduciaries are subject to a higher standard of care known as the “Prudent Expert” standard.  Under the Prudent Expert standard, ERISA fiduciaries must act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”

The words “and familiar with such matters” distinguish ERISA’s Prudent Expert standard of care, from the state corporate law Reasonable Person standard of care.

So, why are we discussing the standard of care applicable to ERISA fiduciaries, in a blog about directors’ duties?  The answer is that, in performing (or failing to perform) certain actions related to the ESOP, the Board of Directors is an ERISA fiduciary.  These actions include:

• Appointing, monitoring, and – if necessary – removing the ESOP Trustee.
•  Serving as ESOP *Plan Administrator, or designating another person or committee, as Plan Administrator. 

*Note that the ESOP Plan Administrator is not the same as the third-party administrator (“TPA”) or the “ESOP Communications Committee” (if one exists).  The TPA performs the plan recordkeeping function.  The ESOP Communications Committee is an HR function.  The Plan Administrator ‘s responsibilities are defined by ERISA and the ESOP Plan document and include the administration and interpretation of the Plan.

• The ESOP Plan may provide that the Trustee is a “directed trustee,” with respect to specific issues or most issues.  If so, in directing the Trustee, the Board is acting as an ERISA fiduciary.

Takeaways

•  Board members owe fiduciary duties to all shareholders, including the ESOP.
•  Board members have (i) a duty of care, applying the Reasonable Person standard; and (ii) a duty of loyalty, to act without conflict of interest.
•  In performing (or failing to perform) certain actions, Board members are also ERISA fiduciaries, subject to Exclusive Benefit Rule and the Prudent Expert standard.

ABOUT STEVEN GREENAPPLE

Steven Greenapple has extensive experience in transactions involving employee stock ownership plans (ESOPs).  He has represented ESOP plan sponsors, shareholders selling to an ESOP, and ESOP trustees, in transactions establishing ESOPs, increasing ESOPs’ share ownership, acquiring other businesses, and terminating and buying out ESOPs.  Steven received his JD from Cornell Law School, and his BSc from Cornell University.

This material is provided as a general informational service.  It should not be construed as, and does not constitute, legal advice on any specific matter. The delivery of this material does not create an attorney-client relationship. This material may be considered ATTORNEY ADVERTISING in some states. Readers must not rely on this general information in making decisions.