Esops And Lesops. - What Risk Do Fiduciaries Have??

[fidu]

can we try to create a "top ten" list of the risks associated with being a fiduciary of a LESOP or ESOP?

[QDROphile]

Conflicts of interest if the fiduciary is not an independent person/institution.

[BeckyMiller]

fidu - I think you would get a better response to this question if you posted it under ESOPs, rather than 401(k) plans.

I agree that conflict of interest is the number 1 risk.

For a private company, tracking cash flow or doing your distribution planning is also a huge risk.

Next?

[mbozek]

How about continuing to purchase/allocate stock of a company careening toward bankruptcy (Enron/ KMart/Global Crossings)?

[fidu]

thanks all.

so if plan documents have standing instructions to buy company stock, but market says that would be imprudent, how can you act solely on behalf of the plan participants?

follow the plan documents and buy?

or breach the trust documents in the name of acting prudently?

arent you running the proverbial (and oft actionable )risk of being dammed if you do and if you dont?

[BeckyMiller]

But, remember, ERISA binds the fiduciary to the terms of the plan only to the extent that those terms are not otherwise inconsistent with the law. ERISA Section 404(a)(1)(D).

I am not sure that this is as helpful as it sounds. But, I would definitely argue that the fiduciary is relieved of the obligation to invest in company stock, if that company stock is a known loser. (You decide what a "known loser" is.)

[fidu]

interesting.

but that wouldn't be inconsistant w/ the law, but rather it would be in conflict with market savvy and thus not a prudent investment, however, the trust agreement requires the purchase of company stock. solutions besides resigning????

[BeckyMiller]

Now - I think Enron illustrates another substantial fiduciary risk. Let's assume that you are a fiduciary for a public company plan that includes participant direction and you know that the company is at serious risk of failure. But, that is just a risk, not a certainty. Public knowledge of this problem could significantly increase the risk.

Are you required to advise the plan participants of this risk, so they can decide to sell or hold with full knowledge? Or, are you required to keep quiet, so the participant's fearful response to the knowledge doesn't trigger the proverbial "run on the bank" that destroys any chance the company might have had of weathering the storm?

I guess it goes back to the first comment - conflict of interest.

[BeckyMiller]

fidu - goes to the definition of "known loser." I was thinking in the context of no hope of recovery, not just currently undervalued.

[fidu]

thanks

agreed. is there anything particularly applicable to ESOPS in this regard or is is the same issues regardless of plan type?

(and equally important - how's the fishin up in crow wing co. this year?)

[BeckyMiller]

An ESOP is still an ERISA plan. It has some PT exemptions and the diversification exemption. But it is not otherwise exempt from fiduciary conduct, exclusive benefit, etc. Almost all ESOPs are confronted with a concentration of risk in the plan sponsor - it is investment risk and cash flow risk. As such, the potential consequences of any fiduciary decisions seem more dramatic.

I guess that is the primary difference. It sometimes feels like an all or nothing decision, rather than just fine tuning.

Not sure about the fishing in Crow Wing. Rochester is over 100 miles south and east of Brainerd. But, isn't Minnesota fishing always good? Just sometimes better than others.

[fidu]

thanks Becky.

I appreciate your insight and look forward to future conversations.

best regards

[mbozek]

There are a number of considerations here that are not easily resolvable:

1. Under the federal securiites laws (which is not preempted by ERISA) a person cannot give out information or act for some shareholders on the basis of material non public information. I see a problem with any person acting on behalf of the plan making decisions as to the wisdom of investing in a publicly held company based upon non public information regardless of ERISA's exclusive benefit rule. A person who has such non public information can only refrain from acting on it or make the information public to all shareholders. Whether or not the person having the information benefits personally from the information is irrevalent.

2. An ESOP is a plan which is exempt from the diversification reqirements of ERISA. If the plan documents do not provide for any discretion to refrain from purchasing the stock of the company then there can be no fiduciary liability because the decision to purchase the stock is a settlor decision which is outside the scope of the prudent investor rules. This is case law from the US Supreme Ct. Persons who perform ministerial functions for the plan in carring out these instructions are not subject to fiduciary liability. This logic would also extend to a 401(k) plan which contains an provision to purchase employer stock as an investment option as opposed to a provision allowing a fiduciary to select investments.

3. A person (fiduciary or non fid) who makes an independent decision not to purchase stock as required under the terms of the plan becomes a fiduciary and can be held personally liable for losses, e.g., if the company does not tank and the stock price climbs there would be a loss equal to the difference to the price the stock was selling at when purchase was suspended and the cost to the plan at a later date when the purchases resume. Having a benevolent motive to protect employees is no defense.

4. There is no such thing as a known loser. Many of the most profitable companies, Citigroup, IBM, Walmart, P&G have gone through periods when the stock was out of favor for various economic reasons( e.g. Citigroup was selling for about $2 a share in 1990, now it is $44). ERISA does not require a fiduciary to know the future performance of a stock before making an investment decision. A fiduciary cannot be judged by hindsight.

[BeckyMiller]

point 4. Unfortunately, I have had the unhappy experience of trying to help out the employees and administrators of several private company ESOPs, where the share value has, in fact, gone to zero. The good news is that is quite rare, the bad news is that it has happened.

[Kirk Maldonado]

Continuing to pay down the debt when you know the stock is a "known loser." (It's like pornography; you can't define it, but you can recognize it when you see it.)

[mbozek]

Kirk/Becky/fidu: Your comments give rise to the question of when does a company become a known loser other than after filing for bankruptcy?

Was Polaroid a known loser in 1989 when it overpaid for the purchase 14% of its stock to set up a leveraged ESOP to prevent a hostile takeover? The burden of paying off the debt reduced the amount of cash available for R & D/operations and contributed to the company's bankruptcy last year. Some ESOPs established in certain industries with declining markets (steel) or poor management are known losers from day one. Yet there is nothing in ERISA to prevent such companies from establishing an ESOP because a decision to establish an ESOP is a settlor decision.

If establishing an ESOP is an investment decision by the owners of the company, when does it become a fiduciary decision to terminate the ESOP and what is the risk to the person (fiduciary/trustee) who makes such a decision?