I have an interesting relationship with ESOPs, both as a matter of my personal preference for corporate designs that place at least some of the value of a company in the hands of those who create that value, and from the perspective of a lawyer who has spent many years litigating ESOP disputes. The two perspectives I hold tend to run counter to each other, or at least to not overlap, because while a well-run ESOP tends to by definition involve the former, it is typically a poorly – or even an intentionally deceptively – run ESOP that ends up the target of litigation (not to suggest, however, that only bad actors in the ESOP space get sued, as obviously that is not the case with ESOPs or anything else).

I often try to capture this dichotomy in the comment that ESOPs are only as good as the good faith of those who run them. By this, I mean that the inherent structure provides many opportunities for insiders and advisors to profit at the expense of participants. When those running an ESOP are acting in good faith, mistakes may happen, but overall, the goals of the ESOP structure (a fair exit for selling insiders and wealth creation for employees) are accomplished. Otherwise, questionable occurrences and actionable misconduct tend to occur.

One of the central aspects of the ESOP undertaking is valuation of the company stock (I am discussing here private company ESOPs), which is central to operating an ESOP for many reasons. Valuation is a regulated activity in this regard, but it also is, in many ways, subject to the honor system – with much of the litigation involving ESOPs originating from someone trying to manipulate valuation under those circumstances.

The central role of valuing private company stock, and doing it in a manner satisfactory to the Department of Labor, is discussed by Rick Pearl of Faegre Drinker in this excellent piece, “Thinking ESOPs: Amicus Brief Argues that DOL has been Misinterpreting the Adequate Consideration Exemption.” Right there, in that question of the central concept of how company stock in an ESOP needs to be valued, is the primary issue both in most ESOP litigation and in avoiding litigation in the first place by properly running an ESOP. As you see in the article, there are many factors to consider in analyzing a valuation and that should be thought about in considering whether a challenged valuation has been done correctly. For almost every one of those factors, there is both a way to look at it which can justify litigation and a way to do it that will decrease the likelihood of litigation arising – but so much of the process is amorphous, and the propriety of different considerations so often in the eye of the beholder, that seeing which one is which isn’t always obvious.

And that, in a nutshell, is why the key to a well-run ESOP rests in the unadulterated good faith of those in charge. That amorphousness means it is easy for a plan to run off kilter, and in particular for stock to be unfairly valued, and the only real protection against that is the desire of those running the ESOP to get it right, for the benefit of both exiting company founders/owners and the employees taking on an ownership interest in the company.