Moral of the story is not to ignore exposures should employeestock tank

These days it seems that everyone is talking about employerstock exposures in pension plans. The collapse of Enron and theresulting devastation to its pension plans has sparked much debateover whether employer stock is an appropriate investment option forretirement assets.

Curiously, however, much less attention is being paid toEmployee Stock Ownership Plans (ESOPs), which invest solely inemployer stock and can be even more risky–for the employer as wellas the employees.

ESOPs are a fairly common and often misunderstood type ofretirement benefit plan. In the days before Enron, ESOPs were whatcame to mind when someone mentioned employer stock in the contextof pension plans.

In a nutshell, an ESOP is a defined contribution retirementbenefit plan that is designed to invest exclusively in theemployer's stock.

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

ESOPs suffer from inherent conflict ofinterest.

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

ESOPs offer many advantages to the employer, including:

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

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

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

In short, ESOPs serve two purposes–they provide employees aretirement benefit and they support the employer's corporatefinance strategy. Therein lies the problem.

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

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

Assigning a value to an asset with no public market presents thepotential for manipulation, which is often at the heart of claimsagainst ESOP fiduciaries. When the ESOP purchases its shares froman insider, the value put on those shares may come under intensescrutiny if the company's shares are subsequently assigned adifferent value in connection with another transaction.

While ERISA requires an annual valuation of private securitiesheld by an ESOP, a valuation should really be done in connectionwith every major transfer of shares. The valuation should beperformed by an independent expert, not by a company insider or afirm that has another relationship with the company (such as anaccounting or banking relationship).

To help establish the independence of the valuation and validatethe number ultimately reached, the valuation document shouldaddress the following:

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

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

o Valuation methodologies used.

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

Obtaining an independent stock valuation will not completelyinsulate the ESOP and its fiduciaries from allegations of breach ofduty, but it will go a long way toward establishing that thetrustees acted prudently with respect to a particulartransaction.

Lack of diversity is the cause of many ESOPclaims.

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

When that one investment is shares of the sponsoring employer'sstock, the employees' future retirement income becomesdisproportionately dependent on the fortunes of the employer.

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

That trust may turn out to be misplaced, however. The exemptionfrom the diversity requirement is not absolute. There have been ahandful of courts that have applied the duty to diversify to ESOPs,finding that fiduciaries who failed to diversify in the face ofrapidly declining stock values breached their fiduciary duty andabused their discretion by maintaining the ESOP's investment in theemployer's stock.

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

Just as it has in the context of employer stock in 401(k) plans,the Department of Labor takes an active role in examiningallegations of conflict of interest and lack of diversity in ESOPcases. The allegations in ESOP cases bear a striking resemblance tothose in the 401(k) cases and their outcome may have a significantimpact 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 ofdiversity, there is still considerable risk–especially if the ESOPis the only pension plan an employer offers.

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

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

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

Carrie Brodzinski

The idea that ERISA grants ESOPs an exemption from therequirement of diversify investments is nothing more than acomforting fable in some cases–especially when fiduciaries arecompany officers who know of some financial information that mightprompt a stock value decline.