9/22/ IRS CIRCULAR 230 DISCLOSURE AGENDA. ESOP Transactions: Fiduciary Duty & New Guidance from the DOL

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1 Southwest Chapter of the ESOP Association Fall Conference Houston, Texas September 19, 2014 ESOP Transactions: Fiduciary Duty & New Guidance from the DOL Allison Wilkerson Phone: Lance Studdard Phone: Copyright 2014 by K&L Gates LLP. All rights reserved. IRS CIRCULAR 230 DISCLOSURE To comply with requirements imposed by the Internal Revenue Service (IRS ), K&L Gates, LLP must inform the reader and participants that any U.S. Federal Tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of: (i) avoiding penalties under the IRS; or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. 2 AGENDA Fiduciary obligations What are they? To whom do they apply? Holding shares of company stock The evolution of the presumption of prudence Fifth Third Bancorp v. Dudenhoeffer Background on DOL enforcement Review of the DOL complaint filed against GreatBanc in its capacity as Trustee of the Sierra Aluminum ESOP The Settlement and its implications on future ESOP Transactions 3 9/22/2014 1

2 THE FIDUCIARY DUTY RULES Duty of Loyalty Act solely in the interest of the participants and beneficiaries for the exclusive purpose of providing benefits Adhere to plan documents, unless contrary to applicable law Avoid prohibited transactions Duty of Care 4 DUTY OF CARE Strict Standard of Care Fiduciaries must carry out their duties with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. No More Moensch Presumption of prudence is no longer viable defense but generally did not apply with respect to private company ESOP transactions 5 WHO IS A FIDUCIARY? An individual or entity that: Exercises any discretionary control over plan administration Exercises any control over plan assets (whether or not discretionary) Renders investment advice to a plan for a fee Named fiduciary such as Trustee and/or Plan Administrator Board of Directors when appointing, monitoring, or removing other ERISA fiduciaries. Selling Shareholders (even if not Board Members or otherwise fiduciaries) Service providers advising any party (knowing participation in a fiduciary violation will create liability even if not a fiduciary per se) 6 9/22/2014 2

3 FIFTH THIRD BANCORP V. DUDENHOEFFER An ESOP is designed to invest primarily in shares of company stock Exclusion from the general diversification rule Presumption of prudence Driven by plan language requiring investment in employer securities A fiduciary will be presumed to act prudently when purchasing and holding qualified employer securities as part of an ESOP Plan fiduciaries start with a presumption that their decision to remain invested in employer securities was reasonable An ESOP fiduciary who invests the [ESOP s] assets in employer stock is entitled to a presumption that it acted consistently with ERISA Kuper/Moench Presumption Overcoming the presumption of prudence Evidence that purchasing or continuing to hold employer securities had become so risky that the plan sponsor could not have intended continued investment in or holding of such stock Serious threat to viability Substantial impairment of the purpose of the plan Prudent fiduciary acting under similar circumstances would have made a different investment decision 7 FIFTH THIRD BANCORP V. DUDENHOEFFER In our view, the law does not create a special presumption favoring ESOP fiduciaries. Rather, the same standard of prudence applies to all ERISA fiduciaries, including ESOP fiduciaries, except that an ESOP fiduciary is under no duty to diversify the ESOP s holdings. - The Supreme Court 8 FIFTH THIRD BANCORP V. DUDENHOEFFER After the Supreme Court decision in Fifth Third Bancorp v. Dudenhoeffer Public company impact Securities laws vs ERISA Public market as the best indicator of the stock price Financial/market impact of stopping purchases or publicly disclosing negative information Private company impact????? Presumption of prudence no longer protects the investment in shares of employer securities must prove prudence/sound investment Possible actions? Periodic review of the performance of the company Actions/documentation in light of decreases in stock price or negative information Review/receive recommendations of investment advisors Document decisions and discussions surrounding continued investment in employer stock 9 9/22/2014 3

4 NONFIDUCIARY LIABILITY Harris v. Roorda, et al. (DSS ESOP) Nonfiduciaries may be liable where they knowingly participate in a fiduciary breach. Roorda merely plan auditor; however, his name appears in several earlier complaints against other fiduciaries. Potential avenue to address valuators even if no fiduciary rule change. Financial advisors to sellers may take on fiduciary role if determining other fiduciaries. See Solis v. First Bankers Trust, et al., (The Maran ESOP) and Solis v. First Bankers Trust, et al., (Rembar ESOP) 10 DOL ENFORCEMENT In 2012, DOL started a campaign to address perceived abuses in ESOP transactions Two pronged attack: Proposed fiduciary rule to bring valuators and financial advisors under the fiduciary standard Initiated litigation to address perceived overvaluations of stock purchased by ESOPs 11 WHERE IS THE DOL NOW? Proposed fiduciary rule tabled for now (to be reintroduced?) The National Enforcement Project for ESOPs is ongoing Employee Stock Ownership Plans - The Employee Stock Ownership Plan (ESOP) project is designed to identify and correct violations of ERISA in connection with ESOPs. ESOPs are designed to invest primarily in employer securities. Due to their unique nature, ESOPs can have distinct violations, as well as violations that might occur in any employee benefit plan. One of the most common violations found is the incorrect valuation of employer securities. This can occur when purchasing, selling, distributing, or otherwise valuing stock. Other issues involve the failure to provide participants with the specific benefits required or allowed under ESOPs, such as voting rights, ability to diversify their account balances at certain times, and the right to sell their shares of stock when received. EBSA will also review the refinancing of ESOP loans following EBSA's issuance of FAB See /22/2014 4

5 2014? ESOP valuations have been an area of chronic problems and that the DOL is pursuing a big number of cases for ~ Tim Hauser of EBSA at the ABA Conference, February 2014 Valuation is the first, second, third, and fourth problem of ESOP deals. ~ Tim Hauser of EBSA in the WSJ Focus of DOL in ESOP Transactions Was the transaction designed primarily to benefit the employees (and their retirement)? ~ OR ~ Was it merely a capital financing tool to enrich the sellers? 13 DOL V. GREATBANC & SIERRA ALUMINUM September 28, 2012, DOL filed complaint in relation to the ESOP s purchase of stock in June 2006 Allegations included: ESOP overpaid for stock due to aggressive projections, improper discount for seller notes, unreasonable view of capital expenses and projected growth Settlement GreatBanc agreed to settle the claims by paying $5.25m for the benefit of the participants and beneficiaries and Agreeing to future conduct as outlined in Exhibit A to the Settlement (the focus of our further discussion) 14 AGREEMENT ON PROCESS Agreement between GreatBanc and DOL Technically applies only to GreatBanc BUT the Head of EBSA indicated that the Exhibit should inform future ESOP transactions Addresses many valuation issues, but process places burden on the Trustee, not the valuation advisor Applies in transactions Including smaller liquidity transactions Not annual updates 15 9/22/2014 5

6 SELECTION OF VALUATION ADVISOR Prudently investigate the valuation advisor s qualifications No Conflicts of Interest Cannot have performed work (including preliminary valuation) for or on behalf of the ESOP sponsor Any counterparty to the ESOP involved in the transaction Any other entity that is structuring the transaction (such as an investment bank) for any party other than the ESOP or its Trustee No familial or corporate relationship to the above Trustee will obtain written confirmation 16 DOCUMENT SELECTION PROCESS Reason for selecting the particular valuation advisor List of all the valuation advisors considered Discussion of qualifications of the valuation advisors that were considered List of references checked and discussion of the references views on the valuation advisors Whether the valuation advisor was the subject of prior criminal or civil proceedings Full explanation of the basis for concluding that the Trustee s selection of the valuation advisor was prudent If Trustee maintains a roster of approved valuation advisors, then the above analysis should be updated every 15 months 17 PROJECTIONS Identify individuals responsible for providing projections & document whether there are any conflicts of interest Document in writing an opinion as to the reasonableness of the projections. Compare to historical averages/medians over 5 years Compare to industry averages/medians over 5 years If projected to exceed historical, document all material assumptions and why they are reasonable If not reasonable, document in writing any adjustments made to projections 18 9/22/2014 6

7 VALUATION CONCLUSIONS Opinions? Analyze and document in writing the factors considered and conclusion regarding: Whether the sponsor will be able to service the ESOP debt Whether the transaction is fair to the ESOP from a financial point of view Whether the transaction is fair to the ESOP relative to the other parties to the transaction Whether the terms of the financing of the transaction are marketbased, commercially reasonable, and in the best interests of the ESOP The financial impact of the proposed transaction on the ESOP sponsor 19 FINANCIAL STATEMENTS Audited financials for five years If unaudited, then Trustee will determine whether it is prudent to rely on unaudited financial statements and document the basis for its belief If Trustee does not believe that it can reasonably rely on the financials, then the Trustee will not proceed with the transaction 20 FIDUCIARY REVIEW Take reasonable steps necessary to determine the prudence of relying on the ESOP sponsor s financial statements Critically assess the reasonableness of any projections and if the valuation report does not document the reasonableness of the projections, then the Trustee will prepare supplemental documentation Document in writing basis for concluding that the information supplied to the valuation advisor was current, complete, and accurate 21 9/22/2014 7

8 FIDUCIARY REVIEW OF VALUATION ANALYSIS Marketability discounts Minority discounts & control premiums Reasonableness of projections Analysis of strengths & weaknesses Cost of capital, including reasonableness of debt/equity ratio Adjustments to financial statements Consistency of economic & industry analysis with valuation analysis 22 FIDUCIARY REVIEW OF VALUATION ANALYSIS Reliability & timeliness of historical financial data Comparability of guideline companies Material assumptions and any testing and analysis of the assumptions Reasons for using average, median or outlying comparable company valuation multiples Treatment of corporate debt Whether methods are standard or why there are departures 23 FIDUCIARY REVIEW OF VALUATION ANALYSIS ESOP sponsor s ability to service any debt or liabilities to be taken on in connection with the transaction Proposed transaction s reasonably foreseeable risks as of the date of the transaction Any other material considerations or variables that could have a significant effect on the price of the employee securities 24 9/22/2014 8

9 TRUSTEE RELIANCE ON VALUATION The Trustee will do and document in writing Read and understand the valuation report Identify and question the valuation s underlying assumptions Make reasonable inquiry as to whether the information in the valuation report is materially consistent with information in the Trustee s possession Analyze whether the valuation report s conclusions are consistent with the data analysis Analyze whether the valuation report is internally consistent with the data analyses 25 TRUSTEE RELIANCE ON VALUATION Trustee will document in writing: Identities of Trustee personnel responsible for the transaction, including who participated in decisions whether to proceed or the price of the transaction Any material points as to who disagreed and why Whether any such personnel expressed the belief prior to the Trustee s approval of the transaction that the valuation report s conclusions were inconsistent with the data and analysis therein or that the valuation report was internally inconsistent If Trustee believes that the valuation report s conclusions are not consistent with the data and analysis or that the valuation report was internally inconsistent in material respects, then the Trustee will not proceed with the transaction 26 PRESERVATION OF DOCUMENTS Trustee will maintain for six years: Name and contact information each member of Trustee s Fiduciary Committee The vote (yes or no) of each member who voted Signed certification of each voting member that they have read & evaluated the valuation report All notes and record created by the Trustee All documents that the Trustee relied on All electronic & written communications between the Trustee with valuation advisor, service providers, ESOP sponsor, non-esop counter parties, and any advisors retained by sponsor or non- ESOP counterparties 27 9/22/2014 9

10 TRANSACTION FEATURES Treatment of ESOP Debt The DOL states that the principal amount of the debt financing the transaction, irrespective of the interest rate, cannot exceed the securities fair market value Claw-Backs The Trustee will consider whether it is appropriate to request a claw-back arrangement or other purchase price adjustment to protect the ESOP against the possibility of adverse consequences in the event of significant corporate events or changed circumstances 28 TAKEAWAYS Cautionary Items Transactions vs. Updates Review continued investment in employer stock How will this impact practice? Increased cost of transactions Document, document, document 29 Thank you Any Questions? 9/22/