Introduction to ESOPs and Related ERISA Litigation Thursday, September 17, 2015 11:20 am - 12:05 pm...

Introduction to ESOPsand

Related ERISA Litigation

Thursday, September 17, 201511:20 am - 12:05 pm

Texas Lawyer’s In-House Counsel SummitCityplace Conference Center

2711 N. Haskell Avenue, Dallas, Texas

David R. JohansonPresented by

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• Alternative Exit Strategies

• Criteria for Evaluating Alternatives

• Introduction to ESOPs

• Profile of an Ideal ESOP Candidate

• ESOP Corporate Governance

• How Does an ESOP Work?

• Plan Design Considerations

Overview

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• What is a “Repurchase Obligation”?

• Corporate v. ERISA Fiduciary Standards

• General Regulatory Framework

• ESOPs and Other Retirement Plans

• Summary of Pros and Cons of an ESOP

• ERISA Fiduciary Exception to the Attorney-Client Privilege

• Financial Advisor Privilege

Overview (continued)

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• Unintended ERISA Fiduciary and Prohibited

Transaction Claims involving Service on a

Plan or ESOP Committee

• Monitoring Obligations

• ERISA Indemnification and Contribution

Rights: Indemnification

• Sponsor Liability

• Concluding Remarks

Overview (continued)

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Alternative Exit Strategies

• Sell to a Strategic Buyer• Sell to a Financial Buyer • Sell to an ESOP

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• Purchase Price• Personal and Corporate Tax Considerations • Form of Consideration (Cash, Stock and/or

Combination)• Wealth Diversification and Liquidity Concerns

− Partial or Complete Ownership Transition • Legacy

− Preservation of Organization and Employees• Alignment of Management and Employee

Incentives• Time to Close

Criteria for Evaluating Alternatives

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• An ESOP is an employee benefit plan subject to the applicable provisions of the Internal Revenue Code of 1986, as amended (the “Code”), the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and the regulations issued thereunder.

• ESOPs are designed to invest primarily in employer securities (“Company Stock”):- Not subject to the 10% limitation in investments in

employer securities that apply to other ERISA plans; but- Participants have diversification rights under either

Section 401(a)(28) or 401(a)(35) of the Code.

Introduction to ESOPs

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• ESOPs are not subject to the minimum funding requirements under Section 412 of the Code:- Although planning for future payment obligations to

terminated employees is highly recommended.

• Subject to certain conditions, selling shareholders of a C corporation may elect to defer taxes on the sale of Company Stock to an ESOP under Section 1042 of the Code.- If the seller makes a Code Section 1042 tax-deferral

election, then certain allocations to the ESOP Accounts of the selling shareholder in a transaction to which Code Section 1042 applies, his family members, and any other 25% or more shareholder are then prohibited under Section 409(n) of the Code.

Introduction to ESOPs (Continued)

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• ESOPs can be leveraged, which effectively doubles the limit on deductible contributions (for C corporations only):- Contributions for general plan administration purposes are

deductible under Section 404(a)(3) of the Code

- Contributions to enable an ESOP to service its Company Stock acquisition debt are deductible under Section 404(a)(9) of the Code

- Not subject to the minimum funding requirements under Section 412 of the Code, although planning for future repurchase obligations with respect to terminated vested ESOP participants is highly recommended


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• Benefits to Participating Employees

− No deduction from their wages is required or permitted

− Value of their ESOP benefits (primarily dependent on the fair market value of Company Stock) may grow over time

− Potentially very good retirement benefit based upon performance of Company Stock


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• Participating Employees only have a “beneficial ownership” interest in shares of Company Stock allocated under the ESOP.

− The ESOP Trust is the legal or record owner.

− The ESOP is not a direct stock purchase plan.− An ESOP is not an Employee Stock Purchase Plan (“ESPP”)

under Section 423 of the Code.

− The ESOP is not a stock option plan (which grants participants the rights to acquire Company Stock at a future date).


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Advantages of Selling to an ESOP:Selling Shareholder• Non-recognition of gain on sale (with an election under

Section 1042 of the Code) for C corporation− If a 1042 election is made, the plan must own at least 30% of the

company’s stock immediately following the sale to the ESOP• Can be used to facilitate partial or complete ownership

transition


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Advantages of Selling to an ESOP (cont.):

C Corporation• Tax deductible funds transfers to the ESOP Trust

− Tax savings can be used productively – debt repayment, capex, acquisitions, etc.

− Employer Contributions deductible under:− Section 404(a)(3) of the Code

− Up to 25% of the eligible “Compensation” − Aggregated with employer contributions to other defined contribution plans

− Section 404(a)(9) of the Code− Up to 25% of the eligible “Compensation”− Only if contribution used to make exempt loan payments− Interest payments excluded

− Dividends deductible under Section 404(k) of the Code− Subject to certain conditions and restrictions


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Advantages of Selling to an ESOP (cont.):S Corporation• All future corporate income is “passed through” to the ESOP

Trust, which is tax-exempt• Tax deductible funds transfers to the ESOP Trust

− Tax savings can be used productively – debt repayment, capex, acquisitions, etc.

− Only the deduction for employer contributions under Section 404(a)(3) of the Code is available

− S Corporation distributions may still be declared, and the ESOP Trust may use such proceeds to make exempt loan payments, however, the S distributions are not deductible.

Introduction to ESOPs (continued)

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Advantages of Selling to an ESOP (cont.):Either C or S Corporation• Positive impact on corporate cash flow:

• Employer Contributions to the ESOP may be made in shares of Company Stock

• Employer Contributions to the ESOP used to acquire shares of Company Stock (pre-tax dollars) in lieu of stock redemption proceeds (after-tax dollars) may significantly impact the Company’s cash flow availability on a post-transaction basis

• Particularly helpful if the Company is trying to maximize tax deductions while complying with any financial covenants with senior lenders.


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Advantages of Selling to an ESOP (cont.):Employees• Retirement plan with substantial benefits• Typically, independent studies have shown that ESOP

corporations provide greater compensation and benefits• Aligns incentives of management and employees through

ownership interest- powerful tool for recruitment and retention


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Selling Shareholder Characteristics• Desires Fair Market Value• Seeks personal wealth diversification• Would like to take some value out of corporation

on a tax-deferred basis• Seeks to preserve corporation and employee

legacy• Wishes to provide employees with economic

benefits

Profile of an Ideal ESOP Candidate

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Sponsoring Corporation and Employee Characteristics• Sufficient balance sheet strength to absorb ESOP

acquisition debt (if any anticipated)• Sufficient cash flow from operations to cover all

ESOP acquisition debt and other long-term debt service requirements Historical and projected profitable operating performance (i.e., revenue generation and profit margins)

Profile of an Ideal ESOP Candidate (continued)

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Sponsoring Corporation and Employee Characteristics (continued)• Sufficient payroll to meet contribution requirements• 15 to 20 employees or more• Management depth and established plan for

succession • Participatory management environment• Effective communications exist between

employees and management• S corporation or C corporation

Profile of an Ideal ESOP Candidate

(continued)

Corporate Governancein an ESOP Corporation

BOARD OF DIRECTORS

ESOP TRUSTEE

ESOP TRUST

OFFICERS

NON-ESOP SHAREHOLDERS

BOARD OF TRUSTEES

ESOP ADVISORY

COMMITTEE

Shareholders elect Board of Directors

Board of Directors appoints officers and…

appoints ESOP Board of Trustees Board of Trustees

appoints ESOP Advisory Committee (optional)

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ESOP Trustee• Elects Board of Directors• Responsible for ESOP Administration• Establishes Fair Market Value for Company Stock

Board of Directors• Responsible for Major Corporate Actions• Strategic Planning• Appoints Officers and Board of Trustees

Corporate Officers• Responsible for Day-to-Day Management of

Corporation

Brief Description of Respective Roles

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ESOP Advisory Committee (Optional)• Responsible for Learning How ESOP Functions and

Communicating that to Corporation Employees

Other Committees of the Board of Directors (Optional)• Suggested Committees:

− Nominating Committee – Responsible for evaluating current directors and identifying and vetting potential new directors

− ERISA Fiduciary Committee – Responsible for the selection and monitoring of ERISA fiduciaries of all employee benefit plans that the company maintains

− Audit Committee – Responsible for the oversight of the annual audit of the company’s financial statements (if applicable)

− Executive Compensation Committee – Responsible for the evaluation of the compensation packages awarded to executives (including the engagement of an independent analyst, as appropriate)

Brief Description of Respective Roles (Continued)

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• ESOP-owned corporations have up to two additional governance layers:- ESOP Trustee (Board of Trustees or institution)- ESOP Committee or Independent Fiduciary

• ERISA governs the ESOP Trust• Employees have expectations as beneficial

owners of the corporation through the shares of Company Stock held in their ESOP Accounts

• The interaction between governance systems can enhance value

ESOP Corporate Governance (Continued)

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• Success in an ESOP-owned corporation encompasses:- Business survival & growth;- Increase in Company Stock value;- Repurchase of Company Stock from departing

employees;- Adequate provision for employee retirement; and- Employee fulfillment of operational improvement initiatives

to increase quality, productivity, profitability and value.


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• What is different for ESOP-owned corporations?- ERISA fiduciaries must protect participant interests as

retirees—not as employees—and therefore, the sale of Company Stock may “trump” or override not selling and retaining employees’ jobs; however, there is a presumption that ERISA fiduciaries may continue to hold Company Stock;

- Board of Directors and ESOP Trustees-Independent Fiduciaries must seriously consider bona fide purchase offers; and

- Sub-S corporations that are 100% owned by an ESOP Trust have tax advantages that create value for the ESOP not easily matched by conventional buyers.


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• Special considerations for ESOP-owned corporations:- Voting of Company Stock and the direction “pass-through”

to ESOP Participants with respect to significant issues;- Tender or sale of Company Stock;- Valuation of Company Stock;- Effects of ERISA on corporate governance;- Role of ESOP fiduciaries in corporate governance;- Directors’ & Officers’ and ERISA fiduciary liability

insurance;- Indemnification Agreements; and - Potential ERISA fiduciary conflicts.


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How Does an ESOP Work?(Non-Leveraged)

1. Corporation makes annual tax deductible cash and/or stock contributions to ESOP Trust; and/or

2. ESOP Trust uses cash contributions to acquire stock from existing shareholders or the Corporation.

3. ESOP Trust allocates stock or cash to Participant accounts and tells employees how much stock has been allocated to their accounts and how much such stock is worth.

4. Employees receive stock or cash when they leave Corporation and must sell stock back to Corporation, which must purchase such stock.

Other Shareholders

ESOP Trust

ESOP Accounts

Corporation

Terminated Employee- Participants

SpendSave:IRA

1.

2.

2.

3.

4.

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How Does an ESOP Work?(Leveraged)

1. Bank loans funds to the Corporation, which loans funds to the ESOP Trust.

2. ESOP Trust uses loan proceeds to acquire stock from existing shareholders or the Corporation.

3. Corporation makes annual tax deductible cash contributions to the ESOP Trust; ESOP Trust makes payments on the loan; Corporation makes payments on the Bank loan.

4. ESOP Trust allocates stock to Participant accounts and tells employees how much stock has been allocated to their accounts and how much such stock is worth.

5. Employees receive stock or cash when they leave Corporation and must sell stock back to Corporation, which must purchase such stock.

CorporationBank

Other Shareholders

ESOP Trust

ESOP Accounts

Terminated Employee- Participants

SpendSave: IRA

1.

3.

4.2.

2.

1.

3.

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Tax-Deferred Reinvestment under

Section 1042 of the IRC C Corporations Only

Qualified Replacement

Property(“QRP”)

ESOPTrust

Selling Shareholder

QRP: Debt or Equity in a Domestic Operating Corporation(Stepped-up basis upon death)

QRP Excludes:• REITs• Mutual Funds• Passive Investment Companies• Municipal Bonds

Qualifying Employer Securities

Cash/Note

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Qualifying Employer Securities

• If not readily tradable on an established securities market, then:− Common stock (best dividend and best voting rights); or− Convertible preferred stock

• Selling shareholder did not receive pursuant to an incentive program

• Long-term capital gain

• Three-year holding period

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Illustration of Potential Tax Savings

• Assuming the conditions of Section 1042 of the Code are satisfied, and the purchase price listed below:

To the Company or Third Party

To the ESOP with 1042 Election

Purchase Price $1,000,000 $1,000,000

Combined Federal and State Long-Term Capital Gains Taxes (assumed blended rate of 37%)

($370,000) N/A

Down Payment on QRP(assumed 18% required)

N/A ($180,000)

Net Proceeds $630,000 $820,000

Additional Benefits None QRP to pass to heirs on a stepped-up basis

Feasibility Study Recommended to Evaluate the Following:• Eligibility to Participate (Broad base or

narrowly tailored?)• Minimum age cannot be set above 21• Service requirement cannot exceed 1 year

(with 1,000 Hours of Service)• Gradual, immediate, or cliff vesting?• Leveraged or non-leveraged?

Plan Design Considerations

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Feasibility Study (continued)• Internal Board of Trustees or

Institutional/Independent Trustee?• Independent fiduciary?• What will the repurchase obligation be

under the different variables?

Plan Design Considerations

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Repurchase Obligation or Liability: The obligation of a corporation to provide a market for employer securities that are allocated under and distributed or distributable from the ESOP

What is a “Repurchase Obligation”?

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• If the employer securities are publicly traded, a market exists and the corporation does not have to repurchase Company Stock distributed to ESOP Participants.

• In all other cases, the employer or the ESOP Trust must repurchase the employer securities under “a fair valuation formula”. Section 409(h)(1)(B) of the Code.

What is a “Repurchase Obligation”?(continued)

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• Corporate law generally presumes good faith by members of the Board of Directors making a Business Judgment, applying a gross negligence standard of review.

• ERISA holds fiduciaries to the highest standards of prudence, skill and care; ERISA fiduciaries must act solely in the interests of plan participants and beneficiaries.

Corporate v. ERISA Fiduciary Standards

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• A person serving as both a member of Board of Directors and an ESOP Fiduciary remains subject to the corporate standards when acting as a “grantor” – terminating or amending a plan – or when reviewing purely corporate functions.− This is not a bright line rule.

• ERISA fiduciaries are personally liable for breaches of their ERISA duties.

Corporate v. ERISA Fiduciary Standards (Continued)

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• Named “fiduciary” in the plan document or trust instrument.- ESOP Trustee(s): Directed and independent or insiders.

• Anyone who exercises any discretionary authority & control over management or disposition of plan assets. Section 3(21) of ERISA.- Could, in theory, include:

- Board of Directors- ESOP Advisory Committee- Plan Administrator- Company Executives (not typically)- Outside advisors (but only if s/he makes a fiduciary decision

ERISA Fiduciaries

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ERISA Fiduciary Duties:• Follow the Plan document (unless ERISA requires

fiduciary to override the Plan)• Protect the Plan from non-exempt prohibited

transactions by being sensitive to potential and real conflicts of interest

• Assure that the ESOP Trust pays no more than fair market value for company stock (or any other asset that the ESOT acquires)

• Ensure that the ESOP is administered fairly without discrimination as provided by the Code and ERISA

ERISA Fiduciaries (Continued)

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ERISA Fiduciary Duties (Continued):• Ensure that ESOP participants receive all required

information and disclosures as provided by the Code and ERISA

• Ensure that the ESOP and ESOP Trust obtain and retain their legal qualifications under the Code and are amended as required under applicable laws and regulations, from time to time

• Vote the shares of company stock held by the ESOP Trust when not required to be “passed-through” to ESOP participants

ERISA Fiduciaries (Continued)

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• Conflicts of Interest may arise:- Between the company and the ESOP- Between managers and the ESOP- Between Board of Directors’ members and the ESOP- Between the ESOP and the other shareholders

• When and how does it arise?• Why do people overlook it?• Ways to address it include:

- Resignation of conflicted individuals- Appointment of independent advisors, outsiders, or

committees- Abstention from action

Conflicts of Interest

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General Regulatory Framework

Tax Matters Fiduciary and Other Matters

Agency U.S. Department of Treasury (“DOT”)

U.S. Department of Labor (“DOL”)

Primary Division

Internal Revenue Service (“IRS”)

Employee Benefits Security Administration (“EBSA”)

Primary Sources

Code (Title 26 of the United States Code) and case law

ERISA (Title 29 of the United States Code) and case law

Secondary Sources

- Treasury Regulations, IRS Notices, Revenue Rulings, and Revenue Procedures

- IRS Technical Advice Memos, General Counsel Memos, Private Letter Rulings (Not Precedential)

- Labor Regulations, Interpretive Bulletins, Field Assistance Bulletins, Administrative Exemptions

- Advisory Opinions (Not Precedential)

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Confirmation of Tax Qualification of ESOP• IRS is the sole responsible agency• Not absolutely required but highly recommended• Consequences if the ESOP is not qualified or

treated as disqualified:• Loss of deductions for contributions and distributions to

the ESOP;• Loss of rollover eligibility of ESOP distributions;• Immediate inclusion in income of all ESOP account

balances for each participant;• Excise taxes; and/or• Penalties and interest thereon.

General Regulatory Framework (cont.)

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Confirmation of Tax Qualification of ESOP• IRS issues a “Determination Letter” for

individually-designed plans:• 5-year application cycle (based on sponsor’s

EIN)• Application Fee (may be waived under certain

circumstances)


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Confirmation of Tax Qualification of ESOP (cont.):• Recent Development: IRS Rev. Proc. 2015-36 has

expanded the pre-approved program to include ESOPs• 6-year application cycle (based on type of plan)• Application Fee (greatly reduced)• IRS issues a “Opinion Letter” or “Advisory

Letter”• Details of conversion from individually-designed

plan to pre-approved plan still under review


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Annual Return (Form 5500 Series):• Due by the last day of the 7th month following the

end of the plan year, unless Form 5558 is filed by such date for the automatic 2.5 month extension

• E-filing has been mandatory since 2009 (www.efast.dol.gov)

• Regulated by the DOL Office of the Chief Accountant

• Sanctions for late or non-filing but may be reduced or abated under certain circumstances


http://www.efast.dol.gov/

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Other Required Disclosures:• Summary Plan Description

• Upon plan implementation, then periodically thereafter, depending on frequency and substance of plan amendments;

• Summary Annual Report (summary of Form 5500)• Annual statement of accounts (aka “Participant

Statement”)• Plan Documents and certain related documents with a

reasonable period of time upon written request• EBSA provides regulatory oversight through its general

investigative authority


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Prohibited Transactions:• Both the Code and ERISA generally prohibit

transactions between certain parties and the ESOP that directly or indirectly involve ESOP assets unless exempted. Section 4975(c) of the Code; Section 406 of ERISA.

• Exemptions:• Statutory: Section 4975(d) of the Code and Section 408 of

ERISA• Regulatory: The DOT and DOL regulations promulgated

thereunder• Administrative: On an individual or class basis as granted

by the DOL in its sole discretion


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Prohibited Transactions (cont.):• Penalties for prohibited transaction violations include:

• Plan Disqualification;• Excise Taxes on parties to the transaction;• Civil and/or criminal sanctions on the plan sponsor;• Corrective contribution to the ESOP (or rescission of the

transaction); and/or• Interest on any the taxes and penalties above.


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Corrections Programs Available:• IRS Employee Plans Compliance Resolution System,

Rev. Proc. 2013-12, as amended by 2015-27:• Self-Correction Program• Voluntary Correction Program• Audit Closing Agreement Program (“Audit CAP”)

• DOL Delinquent Filer Voluntary Compliance Program (“DFVCP”)• Form 5500 late or non-filers

• DOL Voluntary Fiduciary Correction Program (“VFCP”)• 19 listed transactions• Updates pending


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• ESOPs can be in addition to other retirement plans or part of a hybrid plan

• Compatibility with other plans:• Combined with Money Purchase Pension Plans (prior to

2002, due to a change in the deductibility of ESOP contributions);

• Combined with 401(k) Plans (“KSOP”); or• Separate from the 401(k) Plan, but accepting matching

contributions (to satisfy 401(k) Plan safe harbor requirements) made to the ESOP

• Arrangements must satisfy limitations under the Code, so careful coordination with record keepers is required

ESOPs and Other Retirement Plans

Summary of ESOP Pros and Cons

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• From the Shareholder’s Perspective:Pros Cons

- Potential Tax Deferral for electing, selling shareholder (C corporation only)

- Viable Exit Strategy

- Dilution to shareholders (if less than 100% is sold to the ESOP)


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• From the Corporation’s Perspective:Pros Cons

- Tax Deductions- Employer Contributions- Certain Dividends (C

corporations only)

- A good to exceptional tool for:

- Cash Flow Management- Recruitment and

Retention of Employees- Business Succession

Planning- Mergers & Acquisitions

- Plan Administration Costs and Expenses

- Typically higher than for other retirement plans due to need for independent ESOP advisors and independent valuation of Company Stock

- Balance Sheet Impact- Contra equity account

(leveraged ESOPs only)


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• From the Participating Employee’s Perspective:Pros Cons

- Benefits provided without wage reductions or deductions

- Opportunity to provide input on certain corporate matters

- ESOP Voting Requirements- Open book management (potentially)

- Benefit payments eligible for favorable tax treatment upon distribution (rollover to an IRA or other eligible retirement plan)

- Value of benefits subject to fluctuations of the Fair Market Value of Company Stock

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Background• When attorneys advise plan fiduciaries, the advice

that they provide and the attorney’s work product is not subject to the attorney-client privilege because the attorney’s services to the fiduciary are rendered for the benefit of the plan participants and beneficiaries; the fiduciary cannot assert a privilege to restrict access by the plan participants and beneficiaries to such advice.

ERISA Fiduciary Exception to the

Attorney-Client Privilege

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Relevant Case Law: • Washington-Baltimore Newspaper Guild, Local 35 v. Washington

Star Co., 543 F. Supp. 906 (D.D.C 1982) addressed the ERISA fiduciary exception to the attorney-client privilege in the context where a law firm represented both the plan and the plan sponsor. At issue was work product and communications relating to a plan amendment. The adoption of the plan amendment by the employer was not challenged as a settlor function that did not involve ERISA fiduciary conduct. The interpretation and application of the amendment by the plan itself involved ERISA fiduciary conduct. The court found that the ERISA fiduciary exception permitted the disclosure of the communications because the law firm engaged in multiple representations---both a non-fiduciary representation as the employer sponsoring the plan and the ERISA fiduciary representation as the employer administering the plan.

• Solis v. Food Employers Labor Relations Ass'n, 644 F.3d 221 (4th Cir. 2011), allows the DOL to assert the ERISA fiduciary privilege.


Attorney-Client Privilege (continued)

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The DOL’s Position: • The DOL is actively trying to expand the Washington Star

holding to circumstances where the representation of an ERISA plan sponsor is conducted by attorneys in the capacity as non-fiduciaries. The DOL is utilizing its theories on the broad monitoring obligations of these plan sponsors to attempt to apply Washington Star. Thus, in a fact setting where a plan sponsor is represented by legal counsel and a plan trustee is separately represented by its own independent legal counsel, the DOL is seeking access to attorney-client communications and work product not only of the trustee’s counsel but of the plan sponsor’s counsel as well.


Attorney-Client Privilege (continued)

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Background: • While an accountant-client privilege has rarely

been recognized by the courts addressing the evidentiary laws of the states, the concept of the inclusion of a financial advisor in the privileged communications of attorney and client have long been recognized; particularly in case law in the Second Circuit where there is a large body of financial dispute case law. Attention to the application of the financial advisor privilege can be critical to the development of an effective defense in ERISA investment cases.

Financial Advisor Privilege

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Relevant Case Law: • Federal courts have consistently held that the attorney-client

privilege protects communications between corporations and financial advisors who are the “functional equivalent” of employees. See In re Bieter Co., 16 F.3d 929, 936-37 (8th Cir. 1994); Ross v. UKI Ltd., 2004 U.S. Dist. LEXIS 483, No. 02 Civ. 9297 (S.D.N.Y. Jan. 15, 2004); Twentieth Century Fox Film Corp. v. Marvel Enters., 2002 U.S. Dist. LEXIS 22215, No. 01 Civ. 3016 (S.D.N.Y. Nov. 15, 2002). Indeed, communications between a company’s independent contractors merit protection if, by virtue of assuming the functions and duties of employees, the contractor is a de facto employee of the company. See In re Bieter Co., 16 F.3d at 936-37.

Financial Advisor Privilege (continued)

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Relevant Case Law:• In United States v. Kovel, 296 F.2d 918 (2d Cir. 1961), the U.S. Court of

Appeals for the Second Circuit extended the attorney-client privilege to communications between a client and an accountant hired to assist the attorney in representing the client. Id. at 922. Kovel recognized a privilege derivative of the attorney-client privilege where a third party clarifies or facilitates communications between attorney and client in confidence "for the purpose of obtaining legal advice" from the attorney. Id. at 922. The Kovel court recognized that the privilege would extend to communications by an attorney's client to an accountant hired by the attorney to assist the attorney in understanding the client's financial information. See also Export-Import Bank of the United States v. Asia Pulp & Paper Co., 232 F.R.D. 103, 113 (S.D.N.Y. 2005) (finding an agent, such as a financial advisor, may have communications with an attorney that 'are covered by the attorney-client privilege if the financial advisor's role is limited to helping a lawyer give effective advice by explaining financial concepts to the lawyer).


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• In ECDC Envtl., L.C. v. N.Y. Marine & Gen. Ins. Co., No. 97CIV.6033, 1998 U.S. Dist. LEXIS 8808 (S.D.N.Y. June 4, 1998), the plaintiff attempted to protect documents from, or disclosed to, plaintiff's environmental consultants in the litigation, arbitration, and administrative proceedings that were generated as a result of a maritime oil spill. Plaintiff submitted an affidavit averring that all communications with and among the independent contractors were confidential and that the contractors had been instructed not to disclose these communications to any person unrelated to plaintiff. The court held that although "[v]oluntary disclosure to a party outside the privilege destroys the attorney-client privilege because it destroys the confidentiality of the communication," disclosure here did not constitute a waiver in that these contractors were not only plaintiff's agents . . ., they were the principal conduit through which plaintiff communicated with counsel.


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The DOL’s Position: • The DOL is actively resisting the application of the

financial advisor privilege in the context of ESOP valuation claims as the DOL’s focus on valuation issues in general and projections of future financial performance can be aided by access to such confidential information. This is particularly true where the rationale for the revision of such documents is not articulated in detail.

Financial Advisor Privilege (Continued

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Background: • Plan fiduciaries addressing valuations in the course of their ERISA fiduciary

duties, such as in the context of an ESOP acquisition or sale of securities, are obligated to follow the general fiduciary rules under ERISA to act:

• Solely in the Interest of plan participants and beneficiaries;• For the Exclusive Purpose of providing benefits to participants and beneficiaries;• With the Care, Skill, Prudence and Diligence under the circumstances then

prevailing that a Prudent Person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims.

• In conformance with the Plan and Trust documents so long as the documents are consistent with ERISA (ERISA § 401(a); 29 U.S.C. §1104(a)).

• Protect the plan from non-exempt prohibited transactions by being sensitive to potential and real conflicts of interest (ERISA §§ 3(14), 406-408; 29 U.S.C. §§ 1002 (14), 1106 –1108)

• Protect the plan from non-exempt prohibited transactions by being sensitive to potential and real conflicts of interest (ERISA §§ 3(14), 406-408; 29 U.S.C. §§ 1002 (14), 1106 –1108)

Unintended ERISA Fiduciary and Prohibited Transaction

Claims involving Service on a Plan or ESOP Committee

64

• The case law regarding the actions of ERISA trustees with respect to the valuation process typically shows fact patterns that diligent trustees can avoid through diligent ERISA fiduciary procedures. Recent Complaints filed by the DOL against institutional trustees arguably contrast with this case law and casts internal members of a Plan or ESOP Committee subject to parallel claims even though they properly delegated their ERISA fiduciary responsibilities.

Unintended ERISA Fiduciary and Prohibited Transaction Claims

involving Service on a Plan or ESOP Committee (continued)

65

Relevant Case Law: • In Chao v. Hall Holding Company, 285 F.3d 415, 430 (6th

Cir. 2002) the Sixth Circuit affirmed the finding below that an ERISA fiduciary breach had occurred where the valuation upon which the employee stock ownership trust (ESOT) trustees relied was for the wrong company, did not take into account that the purchase was by an ESOT, and was based upon incomplete information that the seller provided. The ESOP trustees in Chao had little to no involvement with the decision to hire the independent valuation expert or with the ESOT’s purchase of the stock, the purchase price was seemingly determined by the seller, and a corporate officer unilaterally rounded up the purchase price by almost $50,000 “for purposes of communication”.

•



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Relevant Case Law: • In Donovan v. Cunningham, 716 F.2d 1455, 1466

(5th Cir. 1983) the Fifth Circuit affirmed the district court’s finding that the ERISA fiduciaries had failed to act prudently where they relied upon two independent valuations that were “made 13 and 20 months before the ESOP transactions”, were based on optimistic financial projections that were demonstrated not to have been met at the time of the ESOP transaction, and which did not take into account the establishment of the ESOP, and the concurrent funding obligations of the plan sponsor.



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Relevant Case Law: • In Christopher v. Hanson, 2011 WL 2183286 (D. Minn. 2011), the

selling shareholder/trustee argued that he was not an ERISA fiduciary because he recused himself from the sale to an ESOT two weeks prior to closing. Id. at 5. The court nonetheless found the defendant liable for breaches of ERISA fiduciary duty where the defendant: (1) unilaterally determined the price of $275 per share and provided that target price to the independent appraiser; (2) withheld information from the independent appraiser that would have resulted in a lesser valuation amount; (3) directed the trustee’s independent counsel not to speak to the independent appraiser; (4) told one of the acting ESOT trustees “that she would be fired if she did not make the transaction happen” at the desired price; and (5) generally “strong-armed and manipulated” the ESOT trustees into agreeing to the transaction.



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The DOL’s Position: • The case law regarding the actions of trustees with respect to the valuation process

typically shows fact patterns that diligent internal trustees can confidentially avoid. Recent Complaints filed by the DOL against institutional trustees arguably contrast with this case law.

• Compare the cases above with the recent DOL allegations regarding trustee review of the valuation process:

• The valuation report performed by independent appraiser also contained additional errors which Defendant Institutional Trustee knew, or should have known, made reliance upon the valuation report improper. For example, valuation report improperly calculated the discount rate in connection with its application of two “income approach” valuation methods by assuming, without explanation or basis in fact, that the capital structure of the plan sponsor would be 50% equity and 50% debt. The plan sponsor’s capital structure before (zero debt) and after the ESOT transaction, however, was never 50/50 debt to equity and none of the comparable companies identified by independent appraiser had a capital structure with this high a level of debt (i.e., 50%).

• The DOL is targeting the valuation issues with great specificity in its recent filings and the pending battle of the experts on these topics will be material to this case law development.



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Background: • The power to appoint or remove an ERISA plan fiduciary includes a

limited obligation to monitor the plan fiduciary to determine if the continued appointment is appropriate. DOL guidelines (DOL Interpretive Bulletins (codified at 29 C.F.R. § 2509.08-2, et seq.), other DOL regulations, Field Advisory Bulletins, etc.) suggest ERISA Trustees monitor corporate management and Board of Director actions, including:• Independence and expertise• Executive compensation policies• Policies regarding mergers and acquisitions • Long term business plans • Worker training and workplace practices

• The Board of Directors of the plan sponsor, in turn, needs to monitor the conduct of the Trustee.

Monitoring Obligations

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• When the Board of Directors of a plan sponsor is making decisions on behalf of the corporation, it is held to the “Business Judgment” rule standard, which applies a “gross negligence” standard of review. When the Board of Directors of a plan sponsor makes ERISA fiduciary decisions for a qualified plan, it is held to the highest standards of prudence, skill and care. When the Board of Directors acts as an ERISA fiduciaryies, it must act solely in the interests of plan participants and beneficiaries. When a Board Member acts in an ERISA fiduciary capacity, the Board Member will be personally liable for breaches of their ERISA duties.

Corporate vs. ERISA Fiduciary Standards for the Board of Directors

important Distinctions

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• Relevant Case Law: • A person with the power to appoint ERISA fiduciaries has a limited

duty to monitor the actions of his appointees. Leigh v. Engle, 727 F.2d 113, 133-35 (7th Cir. 1984). The duty to monitor exists where the monitoring fiduciary has "notice of possible misadventure by their appointees”. In Re Enron Corporation Securities and ERISA Litigation, 284 F. Supp. 2d 511, 555 (S.D. Tex. 2003) (quoting Newton v. Van Otterloo, 756 F. Supp. 1121, 1132 (N.D. Ind. 1991))

• Liss v. Smith, 991 F. Supp. 278, 310, 311 (S.D.N.Y. 1998) ("It is by now well-established that the power to appoint plan trustees confers fiduciary status"; "the duty to monitor carries with it, of course, the duty to take action upon discovery that the appointed fiduciaries are not performing properly") (emphasis supplied).

Corporate vs. ERISA Fiduciary Standards for the Board of

Directors important Distinctions (continued)

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The DOL’s Position: • The DOL is utilizing the concept of monitoring broadly to

allege that virtually all aspects of fiduciary conduct subject to challenge is coupled with an independent violation of ERISA through the failure of the plan sponsor or its board of directors to monitor the fiduciary. Boards of Directors that have appointed institutional fiduciaries for their expertise to acquire employer securities for an ESOT transaction, for example, are confronted not only with a claim that the ERISA fiduciary violated the fiduciary obligations under ERISA applicable to the acquisition; however, that Board of Directors also violated ERISA through the failure to monitor the institutional fiduciary.

Corporate vs. ERISA Fiduciary Standards for the Board of

Directors important Distinctions (continued)

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• Background: • Section 413 of ERISA states: • [A]ny provision in an agreement or instrument which purports to relieve a

fiduciary from responsibility or liability for any responsibility, obligation, or duty under this part shall be void as against public policy. Nothing . . . shall preclude—

• (1)a plan from purchasing insurance for its fiduciaries or for itself to cover liability or losses occurring by reason of the act or omission of a fiduciary, if such insurance permits recourse by the insurer against the fiduciary in the case of a breach of a fiduciary obligation by such fiduciary;

• (2) a fiduciary from purchasing insurance to cover liability under this part from and for his own account; or

• (3) an employer or an employee organization from purchasing insurance to cover potential liability of one or more persons who serve in a fiduciary capacity with regard to an employee benefit plan

ERISA Indemnification and Contribution Rights:

Indemnification

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Relevant Case Law: • Delta Star, Inc. v. Patton, 76 F. Supp. 617, 641 (W.D. Pa.

1999) found indemnification impermissible when the court determined that ERISA fiduciary’s liability to plan “was clearly the result of his own willful misconduct.”

• Fernandez v. K-M Indus. Holding Co., 646 F. Supp. 2d 1150, 1156 (N.D. Cal. 2009) (voiding trustee engagement agreement because it provided indemnification to trustee “unless the breach involved gross negligence or willful misconduct”).


Indemnification (continued)

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• Harris v. GreatBanc Trust Company, et al. (E.D. Cal. March 15, 2013):

• An Institutional Trustee who receives an advancement of fees or expenses from ESOP Sponsor pursuant shall make arrangements reasonably satisfactory to ESOP Sponsor to ensure that such Institutional Trustee will reimburse ESOP Sponsor for such advancement in the event that it is determined that the Institutional Trustee is not entitled to retain such amounts.

• Judge Real concluded his approval of an advancement in GreatBanc stating:

• “If the Secretary is concerned about [Institutional Trustee’s] ability to reimburse advanced defense costs in the event that a court ultimately determines that [Institutional Trustee] breached its duties under ERISA, the Secretary may seek a bond. Setting aside the indemnification agreement is not necessary or appropriate.”



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The DOL’s Position: • The DOL is litigating the same issues as

addressed in GreatBanc in two cases in the Southern District of New York.



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Background: • Where multiple ERISA fiduciaries are determined to have breached

ERISA duties to a plan or to plan participants and beneficiaries, the issue of whether a right of contribution under ERISA exists to address the obligations of these fiduciaries

Case Law:• The Ninth Circuit does not recognize a right of contribution (Kim v.

Fujikawa, 871 F.2d 1427, 1432-33 (9th Cir. 1989)) while the Second Circuit has historically recognized such a right. (Chemung Canal Trust Company v. Sovran Bank/Maryland, 939 F.2d 12, 16 (2d Cir. 1991)).

The DOL’s Position: • The DOL is actively advocating the right of contribution in litigation

as part of its effort to assign responsibility to those ERISA fiduciaries it deems culpable.

•


Contribution (continued)

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Background: • Plan sponsors may have ERISA liability for any funding deficiencies (if Section 412 of

the Internal Revenue Code of 1986, as amended, and Section 301, et seq. of ERISA require the plan sponsor fund the plan). Plan sponsors, however, typically also serve as plan administrators and in some limited circumstances, plan sponsors may take actions as ERISA fiduciaries, which may then expose plan sponsors to additional ERISA liability. For example, plan administrators have obligations to furnish plan participants with required disclosures and file annual reports under Section 101, et seq. of ERISA. Penalties for failure to comply with the ERISA reporting and disclosure requirements typically range from $10 per day to $1,100 per day. If the plan sponsor is a “party in interest” (as defined in Section 3(14) of ERISA) who participates in a prohibited transaction (described in Section 406 of ERISA) to which no exemption applies, the plan sponsor’s liability may include, without limitation, payments to the plan to restore the plan to the position it would have enjoyed but for the prohibited transaction, penalties that the DOL may assess under Sections 502(i) and (l) of ERISA (up to 5% of the “amount involved” in the transaction (typically the purchase price) and up to 20% of the “applicable recovery amount” (typically the “amount involved” plus any additional amounts paid to the plan as part of a settlement with the DOL), respectively), and disgorgement of profits realized from the prohibited transaction.

Sponsor Liability

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Relevant Case Law: • Plan adoption and amendment are settlor functions generally subject to the

standard of care applicable to corporate and not ERISA fiduciary decisions. See, e.g., Armstrong v. Amsted Industries, Inc., 2004 WL 1745774 (N.D. Ill. 2004).

• Some courts view plan administrators as indispensable parties to any action for breach of fiduciary duties under ERISA. Fisher v. Metropolitan Life Ins. Co., 895 F.2d 1073 (5th Cir. 1990). A plan sponsor may be deemed a plan administrator, even if the terms of the plan state otherwise. See, e.g., Rosen v. TRW, Inc., 979 F.2d 191 (11th Cir. 1992); Marcum v. Zimmer, 887 F. Supp. 891 (S.D. W. Va. 1995) (when officers of a plan sponsor exert control over the administration of the plan, the plan sponsor is a proper defendant). Certain third-party plan administrators, however, may not be proper parties to a claim for breach of ERISA fiduciary duties. Mote v. Life Insurance Co., 502 F.3d 601 (7th Cir. 2007) (plan documents did not refer to the plan and plan administrator interchangeably, the plan administrator was not the plaintiff’s employer, and the plan’s insurance policy for long-term disability benefits distinguished between the plan, the employer, and the plan administrator).

Sponsor Liability (continued)

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• While the Ninth Circuit has limited suits for breaches of ERISA fiduciary duties “only against ERISA defined fiduciaries” (Kyle Rys. v. Pacific Admin. Servs., Inc., 990 F.2d 513, 516 (9th Cir. 1993), the United States Supreme Court has acknowledged (albeit in dicta) that nonfiduciaries may be sued and required under Section 502(a)(5) of ERISA to disgorge plan assets or profits obtained through participation in prohibited transaction (Mertens v. Hewitt Associates, 508 U.S. 248 (1993)).

• Outside of ERISA, plan sponsors may have liability for the following: (1) failure to timely adopt required plan amendments, which may constitute a plan disqualification issue that may or may not result in the Internal Revenue Service assessing penalties; and (2) actions that relate to an ERISA plan but that do not constitute the acts of a plan fiduciary and thus are not subject to ERISA pre-emption. Bricker v. Paytag Co., 450 N.W.2d 839 (Iowa 1990) (state law claims for misrepresentation not pre-empted by ERISA). Murphy v. Heppenstahl Co., 635 F.2d 233 (3d Cir. 1980), cert. denied, 454 U.S. 1142 (1983) (breach of contract claim where the promised benefits payable under a collective bargaining agreement are greater than payments actually paid from the plan not pre-empted by ERISA).


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The DOL’s Position: • The DOL typically seeks to characterize a plan sponsor’s

actions as fiduciary actions subject to the ERISA prudent person standard of care, as evidenced in recent amicus curiae briefs submitted to contest the applicability of the Moench presumption (which provides that ESOP fiduciaries are presumed to have satisfied their ERISA fiduciary duties by following the directive of the ESOP plan document to invest in employer securities, unless the plaintiffs can overcome such presumption and demonstrate that the ESOP fiduciaries acted arbitrarily and capriciously).


If, after careful analysis, the Company’s Board of Directors decides to implement an ESOP:

• Establish and document procedural prudence in all decisions

• Educate key decision-makers with respect to corporate and ERISA fiduciary standards

• Consult experts (legal, accounting, valuation, etc.), as needed

• Maintain adequate directors’ and officers’ and ERISA fiduciary liability insurance

• Read and understand the ESOP plan documents

Concluding Remarks

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Questions?

Thank you

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David R. Johanson, the Partner-in-Charge of the Napa office and a Partner in the San Francisco, Los Angeles, and New York offices of Hawkins Parnell Thackston & Young LLP, has helped hundreds of corporations form ESOPs and create effective employee ownership through other equity incentives during the past almost 30 years. Mr. Johanson assists clients in designing ESOP and equity incentive plans and accomplishing ESOP-related transactions, including mergers and acquisitions of all kinds. Mr. Johanson also defends ERISA fiduciary actions in Federal Courts throughout the U.S and is actively involved in defending regulatory and enforcement actions by the Internal Revenue Service and the U.S. Department of Labor. Recognized nationally for his experience and expertise in the ESOP and executive compensation field, Mr. Johanson is a past chair (1993-1995 and 2005-2007) of the legislative and regulatory advisory committee of The ESOP Association. He also is a past chair of The ESOP Association’s advisory committee chairs council and is a former member of its board of directors. Mr. Johanson was honored at the 17th annual conference of The ESOP Association as the outstanding committee chair for 1993-94. Mr. Johanson served for more than ten years as General Counsel to The National Center for Employee Ownership and on its board of directors. Mr. Johanson writes and speaks frequently about employee ownership throughout the U.S.

David R. Johanson – Brief Bio

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Contact Information

David R. Johanson

Hawkins Parnell Thackston & Young LLP

E-mail: [email protected]

1776 Second StreetNapa, CA 94559(707) 226-8997

345 California StreetSuite 2850San Francisco, CA 94104(415) 766-3238

445 S. Figueroa StreetSuite 3200Los Angeles, CA 90071(213) 486-8010

600 Lexington Avenue8th FloorNew York, NY 10022(212) 897-9655

mailto:[email protected]

Introduction to ESOPs and Related ERISA Litigation Thursday, September 17, 2015 11:20 am - 12:05 pm...

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Transcript of Introduction to ESOPs and Related ERISA Litigation Thursday, September 17, 2015 11:20 am - 12:05 pm...