The Code requires that company stock in the ESOP must have full voting rights. In this video, we discuss who votes the shares held in the ESOP.
ESOP Trustee Duties and Shareholder Rights
Since the ESOP trustee is the corporate shareholder of record, the trustee is required by state law and has a fiduciary duty under ERISA, to vote the shares in the plan. The ESOP trustee votes the shares in any situation where a shareholder vote is required. In any context, the ERISA duties of prudence and the exclusive benefit rule govern the trustee’s voting decision.
The participants do not have shareholder rights under ERISA or the Code. Under many state corporations codes beneficiaries of a trust holding shares have “beneficial shareholder” rights. This may allow participants to bring suit against the company and potentially against the trustee under state law, and not just under ERISA. However, these rights do not extend to voting stock under state law.
The fundamental voting right is to annually elect the board of directors (Board). The trustee will vote for any proposition that the Board calls for a shareholder vote. These will include any action that would affect the rights of shareholders and the rights and attributes of the class of shares the ESOP trustee owns. Shareholders are allowed to vote on any fundamental changes to the company that affect its structure such as changes to its charter or bylaws.
Technically, shareholders don’t legally own the company. Instead, they own stock (securities) that give them a claim on the company’s equity and dividends paid to common shareholders. It’s also important to note that shareholders aren’t responsible for managing the company. That role is explicitly given to the Board, which then appoints executive officers to run the company’s day-to-day business operations.
As owners of a stock, shareholders can bring legal action against the company, Board members, executive officers, or other shareholders. It’s important to note that losing money on a stock isn’t a sufficient reason for making a lawsuit. Ordinary business decisions of the Board are not sufficient reasons. The Board is held to the business judgment rule for their actions, not the higher fiduciary standard under ERISA. The shareholders must be able to prove that a wrongful act took place. Wrongful acts are generally defined as a breach of duty, neglect, error, misstatement or misleading statement, or error of omission.
Annual Shareholder Meetings
Under state law, corporations are generally required to hold annual meetings. The annual meeting of shareholders is often the one time per year that shareholders can meet directly with corporate executives. In more practical terms, the annual meeting is the culmination of the voting process. Shareholders who didn’t already submit votes may cast their vote in-person or express their concerns about matters presented for shareholder approval.
Pass-Through Voting
In ESOPs that hold publicly traded stock, the internal revenue Code requires the ESOP trustee to “pass-through” the voting right to the ESOP participants. The term “pass-through” is a common term used in the ESOP community, however, the pass-through is a request to direct the trustee to vote the shares. The participants still do not actually vote the shares.
In private companies, pass-through voting rights are very limited. The ESOP generally must permit participants to direct the voting of the securities allocated to their accounts regarding any matter that involves the approval or disapproval of any corporate merger or consolidation, recapitalization, reclassification, liquidation, dissolution, or sale of substantially all assets of a trade or business. These are terms that are defined in the state corporations codes. If the event or transaction does not meet these state law criteria, no pass-through is required.
If there are no directions from participants for voting shares allocated to their accounts, those shares will be voted by the trustee as directed. The trustee will also vote any shares that are held in an ESOP suspense account which have not yet been allocated to participants’ accounts.
The overwhelming majority of ESOPs are sponsored by private companies. In public companies, shareholders have been given limited rights to vote on issues that private companies do not.
Voting Rights in Public Companies
Public companies allow shareholders the following more expansive rights, including to participants in the ESOP due to the all-inclusive pass-through voting rights:
The Right to Nominate Directors
The SEC adopted new “proxy access” rules in 2010, which allow shareholders to nominate candidates for the Board. Nominating shareholders are required to hold shares representing at least 3% of the voting power of the company’s securities, with the shares being held for at least three years. Shareholders may nominate no more than one nominee or a slate of nominees representing up to 25% of the company’s Board, whichever is greater.
The Right to Provide an Advisory Opinion on Executive Pay
As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), publicly traded companies are required to provide shareholders with an advisory vote on executive compensation (also known as “say-on-pay”) at least once every three years. Shareholders are asked to vote on the pay of the company’s chief executive officer, chief financial officer, and at least three other of the most highly compensated executive officers. However, say-on-pay votes are non-binding; the company or Board does not need to take any specific action based on these votes.
The Right to Submit a Proposal for a Proxy Vote
Shareholders who own a minimum amount of the company’s stock ($2,000 for at least three years, $15,000 for at least two years, or $25,000 for at least one year) may submit a proposal to be included on the company’s proxy statement. There are various limitations on what type of proposals may be submitted, and any proposals that end up on the proxy are typically subject to a non-binding advisory vote.
Sometimes this creates confusion in the minds of ESOP participants in private companies who believe or assume the trustee has more rights than accorded under state law, such as nominating directors and reviewing executive pay, as a matter of course. It is not unusual for trustees and participants to believe that these types of rights are in the hands of the trustees. Should the Trustee be concerned about these issues? Certainly yes, they need to be actively monitoring these matters and interface with the Board as needed. The fundamental right to elect the Board, however, is the statutory avenue for the trustee to attempt to assert this type of influence over the corporation.
Finally, the most pervasive blind spot we see in private companies with ESOPs is the lack of clarity regarding who comes up with the slate of director candidates for the annual election of the Board. Many form bylaws that do not specify a nomination mechanism. Presumably the Board will come up with the candidates, as in a public company. However, we uniformly recommend that this ambiguity be addressed with an explicit procedure in the bylaws. This may also be developed in a governance charter adopted by the Board under the provisions of the company bylaws. Trustees would do well to ensure these procedures are clear and in place at the time they accept their appointment as ESOP trustee.
