March 01, 2011

The Roles of the Board and ESOP Trustee

For most companies, the responsibility for ensuring that the management team makes decisions in the best interest of the shareholders falls on the board of directors. Directors are fiduciaries of the corporation, and in that capacity need to ensure that executives are managing the company in a way that seeks to maximize shareholder value.

For companies that are either partially or wholly owned by an Employee Stock Ownership Plan and Trust (ESOP), there are potentially two separate and distinct parties with this responsibility – the board of directors and the ESOP trustee. Under the Employee Retirement Income Security Act of 1974, as amended (ERISA), an ESOP trustee – no matter if the trustee is an individual employee of the company, a subcommittee of the board, or a third-party individual or institution – must discharge its duties for the exclusive purpose of providing benefits to ESOP participants with the care, skill, and diligence that a “prudent man” would use.

Historically, when adjudicating claims related to an ERISA fiduciary breach, the courts have focused on the ESOP trustee’s ability to remain invested in the stock of the sponsoring corporation without triggering fiduciary liability. Consequently, ESOP trustees have generally evolved into a passive investor class primarily focused on the process and procedure involved in setting the annual value for the company, despite the fact that many trustees are substantial shareholders in the sponsoring companies’ stock.

However, as ESOP companies begin to mature, and the “repurchase liability” (i.e., a company’s obligation to buy back participants’ shares when certain criteria are met) becomes a more significant use of corporate cash, both ESOP trustees and corporate boards – often in concert with each other – have started to take a more proactive approach to strategic planning in order to fulfill their shared duty to maximize shareholder value.

Underperformance: Symptoms and Causes

Corporate fiduciaries are typically inclined to take a more active approach to strategic planning in response to a sustained period of operational and financial underperformance, which can be characterized by:

  • Weak operating metrics (e.g., lower revenue growth, profit margins, and asset utilization) relative to peers
  • Depressed stock price performance relative to peers

Some instances of operational and financial underperformance can be explained by broader market or economic factors outside the company’s immediate control. Other instances of underperformance, however, might be symptoms of either a suboptimal capital structure or a suboptimal corporate structure. A suboptimal capital structure simply means that the company has too much debt or too much cash. A suboptimal corporate structure could refer to a situation where a company has disparate business segments with no unifying rationale or divergent performance among business segments, or where the value of a company’s excess or depreciated assets is unrecognized in the annual valuation for ESOP administration purposes.

Suboptimal Capital Structure

Many ESOP companies, as a result of the original ESOP transaction or subsequent acquisitions, currently face a substantial debt burden. The economic downturn of 2008 and 2009, which led to a decline in operating cash flow for many corporations and less liquidity in the capital markets, made this debt burden even more onerous.

Excessive leverage negatively affects the ESOP’s share value in a number of ways. Too much debt reallocates operating cash flow from productive uses, such as capital expenditures or strategic investments, to interest and scheduled principal payments on the debt. An overleveraged balance sheet also increases the year-to-year volatility of the ESOP share price – which makes the management and administration of the ESOP more difficult and may negatively affect employee morale. Finally, excessive leverage creates an environment in which management is focused on making scheduled debt payments and meeting financial covenants rather than on achieving growth and increasing profitability – in other words, managing the balance sheet rather than managing the business.

Although many overleveraged ESOP companies remain fundamentally strong despite their bad balance sheets, it is uncertain that these corporations will be able to “earn their way” out of debt through organic growth alone. For such companies, a minority equity investment or a debt refinancing may be viable options if the board and ESOP trustee have made corporate continuity and ESOP sustainability their primary objectives. If, on the other hand, they have prioritized immediate liquidity, the company may explore an outright sale.

At the other end of the spectrum are companies that have used the ESOP tax advantages to build up cash reserves over time without investing that cash in a value-maximizing way. This is not to say that companies should spend cash as fast as they earn it; as demonstrated by the 2008 credit crisis, it is always prudent to have some “dry powder.” However, ESOP corporations should periodically perform an analysis to identify potential investments that would provide shareholders with a better rate of return than the nominal yields offered by corporate bank accounts.

The board of directors of such a company could more actively explore potential acquisitions or strategic hires that would enable the company to offer a new product line, enter a new geographic market, or absorb a competitor, which could ultimately increase shareholder value. In the current market, such opportunities are especially worth exploring, as many companies are coming off years of record-low earnings and acquisition multiples are still subdued. Such an environment provides an attractive buying opportunity for companies with a strong balance sheet; the lower the price a company pays in an acquisition, the lower the risk to the company and the higher the potential return for shareholders.

Suboptimal Corporate Structure

Many ESOP companies were previously family-held businesses, and were not necessarily managed to maximize profitability or to optimize shareholder value. As such, some ESOP companies may own certain assets that are not necessary to support the corporations’ businesses, such as land held for development, nonoperating property, or personal aircraft. Furthermore, some corporations have large real estate and property holdings that continue to be used in core operations, but were bought decades ago. Even though these assets are often fully depreciated on a company’s balance sheet, the market value of these assets may have appreciated greatly since the original purchase. It is
unlikely that the true market value of either nonoperating assets or fully depreciated real estate is fully reflected in the annual ESOP valuation.

ESOP companies may also have unprofitable “legacy” business units that are unrelated to the corporations’ core operations. These business units can take up a disproportionate amount of management’s time and attention, and sap resources that could be used elsewhere in the corporation. Such noncore business units often serve as a drag on shareholder value.

With respect to nonoperating assets, fully depreciated real estate, and noncore business units, the board of directors and ESOP trustee should evaluate whether such assets could be divested in a manner that enhances shareholder value. With respect to noncore business units, the board could work to identify buyers that may place a higher value on a particular division for strategic or synergistic reasons. A noncore business unit could also be spun off into a separate ESOP company. Cash generated from nonoperating or noncore assets can then be used to repay debt or reinvested in the operations of the core business.

Strategic Assessment for Planning Purposes

For an ESOP company with a strong balance sheet and no noncore business units or nonoperating assets, the board of directors and ESOP trustee could nonetheless benefit from performing a strategic assessment to anticipate and properly plan for large cash outflows in the future. Corporate boards of ESOP companies are often caught off-guard when faced with large capital upgrades, a substantial near-term repurchase liability due to an aging workforce, or a need for liquidity by a non-ESOP shareholder. If a company defers planning for such large cash outflows until the need is imminent, the company’s bargaining position is weakened, which could force the company to secure financing at terms that are dilutive to all shareholders.

The board of directors should consider analyzing anticipated cash outflows, even if these cash needs are not immediate. The corporation can then use the analysis as a basis for identifying potential sources of financing well in advance of the actual cash needs, or modifying the ESOP’s repurchase strategies in such a way to mitigate the repurchase obligation burden. Securing debt or seeking a minority equity investment when the corporation is under no compulsion to do so allows the corporation to negotiate the most favorable terms and minimizes potential dilution to the ESOP and all other shareholders.

Long-Term Viability of ESOP Ownership Structure

Despite many companies’ stated objective to maintain continuous, sustainable ESOPs, some companies reach a point where the ESOP structure is no longer a value-maximizing strategy. Such situations could include:

  • A company that operates in a declining industry characterized by high fixed costs. For industries such as this, economies of scale are critical for survival, suggesting that a company operating in these industries may be worth more to a larger competitor than as an ESOP-owned going concern
  • A company with an aging workforce, an unfunded repurchase obligation, and limited access to debt capital
  • A company whose executives are approaching retirement with no clear management succession plan in place

For companies such as this, an outright sale may be the only viable option to maximize shareholder value. And while the ESOP trustee or the board of directors may have an emotional preference for sustaining the ESOP structure, doing so in spite of economic reality will lead to an erosion of shareholder value – an outcome that contradicts both parties’ fiduciary obligation.

Conclusion

As fiduciaries, both the board of directors and the ESOP trustee not only have an interest but also a duty to maximize shareholder value. While some factors that lead to financial and operational underperformance are outside a company’s immediate control, other factors, such as a suboptimal capital or corporate structure, can be addressed – as long as the board and ESOP trustee actively engage in a strategic planning process. With proper planning, a company can evaluate its strategic options – be it an equity infusion, an acquisition, a divestiture, or an outright sale of the company – from a position of strength. The corporate life cycle of an ESOP company need not be finite, but sustainable ESOP companies are increasingly characterized by an active board and ESOP trustee working in tandem to review the company’s strategic direction and taking action when appropriate to remain competitive and viable.