As a follow-on to our previous article regarding incentive plans in Employee Stock Ownership Plans (ESOPs) and Employee Ownership Trusts (EOTs), this article will cover key governance issues in employee-owned businesses. This article is the third of a five-part series focusing on specific issues for EOTs and ESOPs.
So, what do we mean by governance, and why is it so important?
Governance structures in all companies is extremely important. Having a robust governance structure in place is just as important for an employee-owned business as for a large listed multi-national company, although clearly the formality of the systems are likely to be significantly different.
The UK Corporate Governance Code defines corporate governance as “the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.”’
In the US, ever since the Enron scandal and the passing of Sarbanes Oxley corporate governance has been a topic of increased scrutiny. The Sarbanes-Oxley Act requires public companies to strengthen audit committees, perform internal controls tests, make directors and officers personally liable for the accuracy of financial statements, and strengthen disclosure.
In our view, good governance provides investors and other key stakeholders the confidence that the business is being run in a balanced and sustainable way which considers the needs of all key stakeholders.
It should not be seen as a “one-off” policy but instead should be a long-term commitment to implementing policies and procedures that are testing and refreshed on a regular basis. Management and investors can be wary of companies that operate outside of key principles of good governance which can erode enterprise value and long-term employee commitment. It also ensures that the business is always able to respond to changes in market and regulatory environment.
Governance in employee owned businesses
In the UK and the US, there are many forms of employee-owned business, but for the purposes of this articles, we will focus on those owned and controlled by the trustee of an EOT or ESOP.
Structure and Governance in EOTs in the UK
For those not familiar with the EOT structure, this is where the company’s (or group’s) employees purchase a minimum of a controlling interest (but could be up to 100% of the company) in the holding company for full market value, via a special form of trust.
It is therefore extremely important, as part of the initial transaction planning, that the right governance policies and procedures are put in place both at the trading company level and at the trustee level.
There are many issues to consider when appointing the trustee of an EOT; some may be cost-related, while others relate to whether the board of directors of the EOT trustee should be wholly independent of the underlying trading company.
It should always be remembered that the trustee of an employee ownership trust should be someone that all parties will see as having a degree of independence from the trading company’s board of directors and be a body that all parties will be happy to work with in the long-term.
Although many trusts have individuals as trustees, usually the trustee of an EOT is a UK resident company. There are several key reasons for this. First, having a corporate trustee avoids any personal liability which may otherwise arise for individual trustees. Second, it is easier to replace a director of the trustee company than it is an individual trustee. It is important to maintain the optics of a stable and long-term structure of employee ownership. It is important, therefore, to think long term in the selection of the trustee.
It is, be possible to appoint a professional trustee but there may be reluctance on both sides. The professional trustees may not wish to take a controlling interest in a trading company with the responsibilities and risks that this may entail (e.g. reputational risks should the trading company get into difficulties).
Any trustee of an employee ownership trust would be duty bound to take an active interest in the trading company. The directors may not appreciate input from wholly independent trustee unless they have knowledge and expertise in the sector the trading company operates. This is an important consideration for selecting a trustee.
Many professional trustees are based offshore. One of the advantages of having a professional offshore trustee is that if the EOT is subject to a disqualifying event, no UK Capital Gains Tax liability should arise. However, the tax considerations should never rank ahead of the commercials and in particular, good governance.
BDO’s Share Plans & Incentives practice advises all employee-owned businesses of the set-up of governance structures in line with current best practice which reflect the new ownership structure of the company. For example, one of the key areas that we focus on is ensuring that there is a transition of control away from the selling shareholders to the employees from day one so that the employees can see that the ownership structure of the company has changed. To achieve this transition of power, we often advise on the set-up of:
i. operational agreements between the trustee company and the trading company, which sets the parameters as to what the board of directors of the trading company can and more importantly cannot do without the trustee’s consent; and
ii. employee counsels and other representative bodies which elect employees to become directors of the trustee company. These counsels will communicate the wishes and concerns of group employees at the highest level and, as a result, are able to shape and control the future direction of the business.
Structure and Governance in ESOPs in the US
In the US, like the UK, a trustee is either an individual trustee or an institutional trustee. The trustee has a fiduciary duty that is important both in practice and through law. It is important to remember that the employees in an ESOP receive beneficial ownership while the trustee is the sole owner of the shares sold to the ESOP. An individual trustee is someone, usually with a legal or accounting background, who acts as trustee for ESOPs. They can do this by getting proper fiduciary liability insurance. An institutional trustee on the other hand is usually a bank or trust company with a large balance sheet to help protect against liability against individual directors. They will still however have insurance plans to protect against any future claim.
The trustee is the fiduciary of a qualified benefit plan and will ensure that the retirement benefit is protected as best as they can. The trustee for an ESOP in the US does not take an active role in the company, but rather ensures that proper governance is set up when the shares are sold to the trustee. The trustee can be seen as a partner to the company and any experience within a particular industry would only help strengthen their position to be engaged as the trustee. Many companies will rely on the trustee for advice as they undergo the major transition from being a privately held company to an employee-owned company.
This proper governance can come in many forms. First, the trustee will require independent board representation. This will usually take the form of one or two independent board members on a 5-member board. Without a direct board seat, the trustee wants to ensure that independent thought and opinion, outside of the selling shareholders, is represented on the board. Second, the trustee may require the formation of a compensation committee chaired by one of the independent board members. Finally, the trustee may ask for a nomination committee which will also be required to be chaired by an independent board member. Overall, these requirements stop short of the trustee having direct control of the company but help to ensure that important decisions affecting the ESOP participants will be done in the best interest of all stakeholders.
At BDO, we are one of the leading advisers globally to companies that are owned by their employees and those companies that are looking to move towards employee-ownership structures.
This article was written by Mark Weisheipl, Senior Manager in the BDO USA ESOP Advisory team. Get in touch with Mark or your usual BDO contact if you would like to discuss any of the issues discussed in this article.