Indemnification. Keeping Your ESOP and Employee poyeebenefits e tson Track. Keeping Your ESOP and Employee Benefits on Track. Agenda SESSION TITLE

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1 Employee poyeebenefits e tson Track Presented by Larry Gwaltney Moore & Van Allen PLLC (704) larrygwaltney@mvalaw.com Bill Whitehurst Womble Carlyle (336) Wwhitehurst@wcsr.com Agenda Indemnification the Process Agreement Trends in DOL Activity Prohibited Transaction - Utilizing i Incorrect Share Release Methodology International ESOP Participants Employee Benefits on Track Indemnification 1

2 Indemnification Recent Cases Perez v. PBI Bank, 2014 U.S. Dist. LEXIS (N.D. Ind. Nov. 20, 2014 ) (Miller s Health Systems ESOP) Perez v. Mueller, 2014 U.S. Dist. LEXIS (E.D. Wis. Oct. 15, 2014) (Omni Resources ESOP) Past Cases to Remember Johnson v. Couturier, 572 F.3d 1067, 1080 (9th Cir. 2009) Harris v. GreatBanc Trust Co., 2013 WL (C.D. Cal. 2013) (Sierra Aluminum ESOP) Perez v. PBI Bank, 2014 U.S. Dist. LEXIS (N.D. Ind. Nov. 20, 2014 ) The Department of Labor brought suit against PBI Bank alleging that as ESOP trustee, the Bank overpaid for company stock. PBI Bank filed a 3d-party complaint for indemnification, contribution, and reformation against the company and six individuals involved in the transaction. Company and individuals moved to dismiss indemnification as contrary to the contractual indemnification terms and as a violation of ERISA 410. Perez v. PBI Bank, 2014 U.S. Dist. LEXIS (N.D. Ind. Nov. 20, 2014 ) Court found that PBI s indemnification agreement did not allow for indemnification if PBI Bank were found to have violated ERISA; therefore, the indemnification did not violate ERISA 410. Court relied on Packer Engineering, Inc. v. Kratville, 965 F.2d 174, 176 (7th Cir. 1992) and on DOL Interpretive Bulletin

3 Perez v. Mueller, 2014 U.S. Dist. LEXIS (E.D. Wis. Oct. 15, 2014) The Department of Labor brought suit alleging that the ESOP trustees overpaid for company stock. Defendants brought 3d-party claims against Sponsor company for indemnification based on indemnification provisions in the ESOP. The DOL moved to dismiss the defendants 3d-party complaint, including the claims for indemnification. Perez v. Mueller, 2014 U.S. Dist. LEXIS (E.D. Wis. Oct. 15, 2014) ESOP stated that the trustees of the ESOP shall not be liable for any act or failure to act of the Employer or Administrator in the performance of their responsibilities under the Plan or ERISA. ESOP Loan and Pledge Agreement stated that the Trustee does not undertake, nor shall he have, any personal liability or obligation of any nature whatsoever by virtue of the execution and delivery of this Agreement or the ESOP Note or the representations, covenants, or warranties contained herein; and stated that the Company "will pay all reasonable costs, expenses and fees incurred by the Seller, the Trustee, and the ESOP in connection with this Agreement and the purchase of the Shares." Perez v. Mueller, 2014 U.S. Dist. LEXIS (E.D. Wis. Oct. 15, 2014) Court stated that these provisions could arguably form a basis for an indemnification claim; BUT ERISA "any provision in an agreement or instrument which purports to relieve a fiduciary [*9] from responsibility or liability for any responsibility, obligation, or duty under this part shall be void as against public policy." 29 U.S.C. 1110(a). Found that defendants were attempting to impose the burden of their fiduciary breaches on the plan sponsor; therefore, indemnification invalid. Court relied on Delta Star, Inc. v. Patton, 76 F. Supp. 2d 617, (W.D. Pa. 1999) and Johnson v. Couturier, 572 F.3d 1067, 1080 (9th Cir. 2009). 3

4 Employee Benefits on Track The Department of Labor brought suit against GreatBanc Trust Company as Trustee of the Sierra Aluminum Company ESOP in The Department of Labor challenged several aspects of the valuation in a 2006 transaction in which h the ESOP purchased shares of company stock from two founders. The Department of Labor also contended that ERISA did not permit indemnification agreements between plan sponsors and trustees, but in 2013 the court previously dismissed that claim and ruled in favor of GreatBanc that the indemnification was lawful. On June 2, 2014, GreatBanc and the DOL entered a settlement that included a lengthy set of procedures that GreatBanc would follow whenever serving as trustee or other fiduciary of an ESOP when the ESOP is purchasing or selling employer securities that are not publically traded. The fiduciary process agreement represents the Department of Labor s first public agreement of what constitutes a prudent process in connection with an ESOP stock transaction. The agreement provides several procedural steps. 4

5 Valuation Advisor Without Conflicts. GreatBanc will not use a valuation advisor for a transaction that has previously performed work, including a preliminary valuation, for or on behalf of the plan sponsor, any counterparty to the ESOP involved in the transaction or any entity that is structuring the transaction for any party other than the ESOP or the trustee. Reasonableness of Projections. Either the valuation advisor in its report or GreatBanc must provide a written opinion of the reasonableness of the projections considered in connection with the proposed transaction. The agreement provides a detailed description of how the trustee or the financial advisor must explain in detail why the projections may be reasonable and compare them to historical averages and performances. Plan Demographics and Duration of Loan. The valuation report or GreatBanc in a separate agreement must consider how the plan document, the distribution provisions, the duration of the ESOPs loan, the age and tenure of the participants may affect the prospective repurchase obligation, the prudence of the purchase and the fair market value of the purchase. Debt Service and Fairness Determination. The valuation report or GreatBanc must not only analyze whether the plan sponsor will be able to pay the transaction debt but whether the transaction is fair to the ESOP and fair to the ESOP relative to all the parties and the financial impact of the transaction on the plan sponsor. Audited Financials. GreatBanc must ask for unqualified audited financial statements prepared by a CPA firm for the preceding five fiscal years unless they are unavailable. The burden is placed on GreatBanc or the valuation advisors if they rely on unaudited or qualified financial statements. Trustee Report on Valuation Report. GreatBanc must document in writing its analysis of the final report addressing 16 different topics, providing written conclusions concerning the basis for accepting these issues. The 16 topics generally concern the reasonableness and propriety of the financial information and other data considered in the valuation as well as the valuation techniques applied. 5

6 Records Retention and Individual Opinions. GreatBanc agreed to document in writing the identities of the personnel primarily responsible for the transaction, including how each of those persons participated in the decision and whether there was any disagreement as to any issues in connection with approving the transaction. GreatBanc also agreed to retain notes and records for six years as to who was on the fiduciary committee, how they voted on the transaction and how they participated in the transaction. Clawback. GreatBanc agreed that when evaluating the proposed stock transaction it would consider whether it was appropriate to request a clawback agreement or other purchase price adjustments to protect the ESOP against the possibility of adverse consequences in the event of significant corporate events or changes in circumstances. As the first written agreement with the Department of Labor regarding procedural processes the settlement agreement may be fairly viewed as a template for what the Department of Labor will look for due diligence in connections with sales and purchases of non-publically traded stock. Employee Benefits on Track Trends in DOL Activity 6

7 DOL Enforcement Priorities Contributory Plans Criminal Project (embezzled contributions) Fraudulent MEWAs Rapid ERISA Action Team (employer bankruptcies) *ESOPs Consultant/Advisor Project (fee and compensation conflicts) Participant and Beneficiary Complaints Non-filing and delinquent filing of ERISA filings Meals, gifts, and entertainment What Does It Mean Increase in the number of DOL reviews and investigations Closer scrutiny of ESOPs Shift in type and depth of questions being asked Increase in DOL lawsuits and amicus brief filings Increased focus on review of valuation reports Related issue: possible regulatory changes to valuation experts fiduciary status DOL Issues Unrealistic growth projections Unreliable or out-of-date financials Inconsistent internal assumptions Failure to identify, examine, and test assumptions Failure to appropriately discount for company-specific risks (e.g., dependence on a single customer) Incomparable comparables Inappropriate adjustments to financial statements Narrative at variance with the valuation s conclusions Disregard of price in contemporaneous transactions Control premiums Marketability discounts Minority interests Weirdness, illogic, and heretofore unknown methodologies Employee Benefits on Track Prohibited Transaction - Utilizing Incorrect Share Release Methodology 7

8 IRS Guidance: Prohibited Transaction for Utilizing Incorrect Share Release Methodology In TAM the IRS examined an alleged prohibited transaction related to the use of the principal-only share release methodology The ESOP loan was originally for a five year term but then extended to ten years, although it did not provide for level amortization over that period. The plan allowed for either the principal and interest or principal only method of release, while the pledge agreement just allowed for the principal-only method IRS Guidance: Prohibited Transaction for Utilizing Incorrect Share Release Methodology During an audit, the Department of Labor concluded that the failure to use the principal and interest method violated a ERISA s fiduciary duty provisions and constituted t a prohibited transaction. ti The Company agreed to recalculate the share release using the principal and interest method, and the DOL agreed not to take any further action. IRS Guidance: Prohibited Transaction for Utilizing Incorrect Share Release Methodology Three IRS Conclusions The IRS concluded that a prohibited transaction occurred because the ESOP failed to follow the exempt loan regulation language in operation, even though the plan language was in compliance. The ESOP did not qualify to use the principal-only method in any event, so it did not matter whether the language in the plan and pledge agreement provided for principal-only release. 8

9 IRS Guidance: Prohibited Transaction for Utilizing Incorrect Share Release Methodology The IRS concluded that the 15% prohibited transaction excise tax applied from the date the prohibited transaction occurred until the day of the corrective allocation (not the day the correction was made as of). With respect to a prohibited transaction that is a loan, a new prohibited transaction occurs as of the first day of each taxable year. The IRS also concluded that the amount involved which is subject to the excise tax is the actual interest rate on the ESOP loan, which was lower than the prime rate. Since the employer was able to borrow money at the lower rate it used on the ESOP loan, the actual interest rate represented a fair market rate. Employee Benefits on Track International ESOP Participants IRS Issues PLR International ESOP Participants ESOP extended coverage to employees working outside U.S. Eligible employees are non-resident aliens of U.S. Generally performed all services in country of their citizenship 9

10 IRS Issues PLR International ESOP Participants Issues Presented: Is stock of U.S. parent qualified securities with respect to international employees? Are wages paid in foreign country compensation for purposes of IRC Section 415? Can the U.S. parent deduct ESOP contributions for international employees? IRS Issues PLR International ESOP Participants IRS Ruling: Qualified Securities: International employees were employed by unincorporated entities that were eligible for and elected disregarded entity status for U.S. tax purposes. IRC Section 415: IRS relied on its amended 415 regulations to find the foreign income qualified for U.S. pension plan purposes. Tax Deduction: Since direct employers were disregarded entities, U.S. parent was eligible for the tax deduction for contributions. Employee poyeebenefits e tson Track Presented by Larry Gwaltney Moore & Van Allen PLLC (704) larrygwaltney@mvalaw.com Bill Whitehurst Womble Carlyle (336) Wwhitehurst@wcsr.com 10