Employee Stock Ownership Plans (ESOPs) provide a welcome benefit for millions of Americans, but obtaining the right coverage to protect corporate directors and officers and trustees can prove complex. Fiduciary claims may also cross over into D&O, and missteps can prove costly as settlements run into the millions of dollars.
Millions of Americans work for employee-owned companies across the spectrum of American business, from brokerages to construction and engineering firms to supermarkets. While usually a welcome benefit for employees, disputes over the management of employee stock ownership plans (ESOPs) can carry significant risks for corporate officers and trustees who serve as plan fiduciaries. Settlements of class action lawsuits and claims brought by the U.S. Labor Department have reached into the tens of millions of dollars in recent years. Such actions often arise from allegations of mismanagement, lack of due diligence, conflict of interest, or overpaying corporate insiders for company shares.
Insurance coverage to protect against such claims can prove complex. Directors’ & Officers’ (D&O) coverage may exclude claims brought under the Employment Retirement Income Security Act (ERISA), and Fiduciary policies may have exclusions for ESOP plans. Because plan beneficiaries are shareholders, Fiduciary claims often cross over as D&O claims. Further complicating matters, limits for Fiduciary coverage may be significantly lower than for D&O coverage. These among other considerations, underline the importance of partnering with brokers who are highly knowledgeable of plan risks and the responsiveness of D&O and fiduciary policies to claims.
Approximately 14 million U.S. workers participate in about 6,600 ESOPs.1 These plans often serve as a means for the owner of a closely held company to transfer ownership to employees by selling shares to the plan, and then distribute them over time to the workers as a benefit. Valuing those shares is difficult because there is no open market for shares in privately held companies. Further, since the owner and other insiders are selling shares to a plan created by their company, conflicts of interest can easily arise. Executive compensation can become an issue if said compensation dilutes the value of the company shares held by employees.
ERISA claims fall under Fiduciary Liability and typically seek to recover benefits or seek redress for alleged breach of fiduciary duty. For instance, claims that the company stock was improperly valued or, in the case a stock declines, the fiduciaries acted imprudently or misrepresented the risks. Plaintiffs may allege incentive agreements reached with former company executives were excessive enough to constitute a breach of fiduciary duty, or the company failed to disclose payments to insiders.
Those issues make it imperative to engage an independent trustee, rather than appointing a corporate executive, such as a Chief Financial Officer, to act in that role. If claims arise, courts may look more favorably upon an independent trustee with in-depth knowledge of fiduciary responsibilities. Following large claims involving independent trustees, however, insurers are also subjecting those trustees to greater scrutiny.
Often clients do not see Fiduciary Liability as a pertinent coverage; however, for an ESOP it proves most critical. The insured should purchase Fiduciary coverage in tandem with the D&O coverage and with equal limits on both with one insurer. Given the potential for crossover claims involving an ESOP, insurers often seek to cap their liability to either the Fiduciary limit or the D&O limit.
A crucial step when placing coverage is to ensure the underwriters validate the company has an ESOP plan and the policy definition of fiduciary automatically extends to an ESOP. If the ESOP is not disclosed along with the proper underwriting material, the Fiduciary policy may not automatically cover the plan. Some policies do include ESOPs as employee benefit plans, but others require a specific endorsement. Without that endorsement where required, insurers may argue the ESOP is not covered in the event of a claim. Another consideration is whether there is coverage for the ESOP trustee. If a trustee has a sizeable ownership stake in the company, carriers may seek to exclude coverage. If the trustee has board representation, the insurance carrier should be willing to remove this exclusion.
Clients should understand that the retentions for an ESOP are generally higher than typical Fiduciary coverage for other benefit plans, which may have a zero retention. Many carriers will make the retention for claims involving an ESOP equal to the D&O retention given the potential for claims that impact both coverages. Retentions depend on several factors including the market value of the ESOP and the state in which they are located. A plan located in California, for instance, is likely to have higher retentions because of the legal climate in that state.
Carriers may also seek to impose a “hammer clause,” meaning they only cover a marginal portion of a lawsuit if the insurer opts to settle the case and the insured declines. Eliminating this clause prevents the insured from being penalized for continuing a lawsuit.
Valuation is Crucial
Unlike a 401k or health and wellness plan, the underwriting for an ESOP is likely to be more rigorous since the plan entails ownership of the company by employees and presents the risk of cross-over claims with D&O. Clients should expect underwriters to closely scrutinize the plan valuation along with required annual valuations, financial strength and leverage, and the company’s business outlook. Moreover, underwriters may seek details on ownership and board representation, particularly whether the trustee has a seat on the corporate board of directors. Today, the impact of the COVID-19 pandemic on the specific business and the industry overall may also be a consideration.
For a new plan, underwriters will want to ensure there are no conflicts of interest with existing corporate shareholders. They may also want to examine how the plan is structured, the extent to which debt is used to establish the plan, and whether the company can service that debt over time. Risks for a new plan could include whether the shares are sold to employees at more than their actual value.
The U.S. Labor Department requires all ESOPs to have an annual valuation. In reviewing that valuation, underwriters will assess current, past, and projected financial results, data on customers and competitors, and the number of employees included in the plan. Underwriters may want to meet with corporate management and the plan trustee, who sets the share price based on the recommendation from the valuation firm. Underwriters will assess share price variations over time, including whether it has fluctuated substantially. It is also crucial to know if the plan valuation was done by an independent third party and whether an independent firm will be performing the annual valuations.
ESOP Claims Examples
When placing Fiduciary coverage for an ESOP, having a complete submission including valuation details is important. Experience also counts both for brokers and carriers. It is best to work with insurers that have experience in covering and underwriting such plans and are familiar with the type of ERISA claims and class action lawsuits that may arise. Because of the complexities of ESOP coverage and claims, working with experienced wholesale specialists is also crucial. Brokers who know the risks, potential coverage pitfalls, and the Fiduciary marketplace can help obtain the most appropriate coverage. Contact your CRC Group producer for more information.
- Jay Horoshak is a Director in the CRC Los Angeles office and a member of the ExecPro Practice Group.
- Ashley Schmidt is a Director in the CRC Minneapolis office and a member of the ExecPro Practice Advisory Committee.
- Allyson Benda is located in CRC’s Nashville, TN office. Allyson is a Senior Broker and member of the ExecPro Practice Advisory Committee.
- Employee Stock Ownership Plan (ESOP) Facts, National Center for Employee Ownership, https://www.esop.org
- U.S. Department of Labor and First Bankers Trust Settle ESOP Lawsuits, U.S. Labor Department, https://www.dol.gov/newsroom/releases/ebsa/ebsa20171116
- Court requires fiduciaries to pay $2,225,000 to Vermont ESOP, U.S. Labor Department, https://www.dol.gov/newsroom/releases/ebsa/ebsa20180508
- Secretary of Labor reaches agreement requiring Wilmington Trust to restore $80 million to 21 employee stock ownership plans, U.S. Labor Department, https://www.dol.gov/newsroom/releases/ebsa/ebsa20200430
- WaWa settles stock option ERISA claim for $22 million, Pensions and Investments, July 13, 2020, https://www.pionline.com/courts/wawa-settles-stock-option-erisa-claim-22-million