Mid-Atlantic Chapter ESOP Breakfast
Meeting
Red Hot and Blue ESOP Topics for Chili Weather
February 4, 2014
Presenters
Paul Horn, WorkPlace Consultants, LLC
David R. Bogus, ASA, Ellin & Tucker, Chartered
Michael R. Holzman, Dickinson, Wright
Ben F. Wells, Dinsmore & Shohl, LLP
Best ESOP Governance Practices
Trustee (or ESOP Committee Directing Outside
Trustee)
Annual valuation
Joint engagement letter
Review of draft
Compare w/ prior year assumptions
Meet w/ executives to discuss
Draft to auditor?
Formal adoption
Best Governance Practices
Annual SH meeting
Directed? Pass-thru?
Recordation
Interaction with BOD
Attendance? Minutes? # Meetings?
Does % ownership matter?
Contributions
Checking balance statements / OIA
Release of shares
409(p) testing?
Best Governance Practices
Distributions
Is TPA list correct? Diversifications?
In accord w/ distribution policy? Thresholds?
Delegation
Drafting and sending out election forms?
Cutting checks and doing tax w/h? Form 945?
Issuing 1099-Rs?
Best Governance Practices
Filings
Review Form 5500
Including auditor’s report (if over 100 participants)
Plan documents
Have latest version plan, SPD, SMM, IRS DL
Have stock certificate(s) / updated for share release
Wall Street Closes 2013 at Record Highs
Standard and Poor’s 500
Dow Jones Industrial
Average
Up 29.6% for the Year
Up 26.5% for the Year
Largest gain in 16
years
Largest gain in 18 years
Confidence Returns to the Market
 Quantitative easing floods the market with cheap cash and
buoys asset prices
 “U.S. stock surge… driven almost entirely by P/E multiple
expansion rather than higher earnings.” -- Goldman Sachs
 Boeing (P/E: 24.16)
Price  77%
Earnings  11%
 American Express (P/E: 18.59)
Price  48%
Earnings  4.6%
Defense and Government Services
For 2013, the Government Services stocks
were up 58.2%, ahead of the S&P 500 and the
NASDAQ, which are up 29.6% and 38.3%,
respectively, and ahead of the Defense stocks,
which are up 57.2% for the year.
Federal IT Services
Comparable Analysis
Company
Price/Earnings Ratio
CY 2012E
CY 2013E
Booz Allen Hamilton
8.9
10.8
CACI International
Holdings
9.2
12.3
Dynamics Research
Corp.
8.5
22.4
Engility Holdings,
Corp.
NM
11.4
ICF International
NM
17.5
Leidos Holdings, Inc.
9.9
41.7
ManTech
International Corp.
10.8
14.6
NCI, Inc.
7.8
12.0
VSE Corp.
6.6
10.3
1
Looking Forward Towards 2014
 “The S&P 500 is going to
2014 in 2014” -- Adam
Parker, chief U.S. equity
strategist at Morgan Stanley
 "The economy’s underlying
growth rate will accelerate
further in 2014 to near +3.5%
and risk is growth could be
closer to 4%...”– Joseph
LaVorgna, chief U.S.
Economist at Deutsche Bank
 Tailwinds
 Inflation
 Has ben low due to slow wage
growth, excess capacity, and
reduced lending activity
 Interest Rates
 Introduction of Janet Yellen as
Chairman of the Fed indicates
dovish future policy
 Improving Fundamentals
 Earnings are projected to improve
on the back of economic growth
 Risks
 European Rebound
 Fiscal Policy Uncertainty
 Emerging Markets
1
Vetting Client Projections
Vetting by valuation firm
Understanding how they were developed by
management
Options when management does not prepare
forecasts
Comparison to past performance
Forecasted growth vs. historical growth
Trends / changes in margins
Balance sheet assumptions
Capital spending plans
12
Vetting Client Projections
Vetting by valuation firm (cont’d.)
Year on Year forecast comparisons to actual results
How good is management at forecasting?
Consistency with management interview and external
factors
Adjustments to forecast
Cyclicality/risk profile of different businesses
Reasonableness in light of all factors
13
Utilization of Projections
Utilization in Valuation
Relationship of forecast to other inputs to valuation
Relationship of value conclusions to other methods
Conclusions of various methods should
generally reconcile
When methods yield materially different
results – ask questions
Sensitivity to changes in assumptions
Weighting of approach based on
confidence/judgment
14
DOL Enforcement of Projection Use
 DOL Enforcement – Company Projections
 Issue: The FMV of the company is typically based on future projections
of the company’s business. A common valuation method is the
discounted cash flow method, which relies on management
projections.
 The cases raise issues such as:
Appraiser’s role and their ability to rely on management’s
projections.
Fiduciary’s duties in checking and vetting projections.
What is reasonable and supportable in context?
What is the risk and appropriate discount rate in light of
the projections and the business circumstances
surrounding those projections?
How much of this is hindsight based on the economic
downturn from the Great Recession?
None, according to DOL.
15
DOL Enforcement of Projection Use
DOL Enforcement – Company Projections
Some issues raised in DOL’s litigation:
Are recent good years representative of
future expectations?
Consideration/incorporation of bad years
(mean reversion)
Realistic assumptions on future growth in
light of company and economic
circumstances?
16
Legal Update
Status of proposed DOL Fiduciary regulations
Final Rules on Net Investment Income Tax
Distributions from qualified plans, including ESOPs,
are tax exempt
404(k) dividends are not subject to tax nor is Net
Unrealized Appreciation (“NUA”)
People Care Holdings ESOP Lawsuit Settlement
with DOL ($10M)
Scrutiny of financial projections in light of loss of a
key contract
Legal Update (continued)
Ries Enterprises, Inc. v. Commissioner
Court found 409(p) violation, came to correct
conclusion although disqualified person analysis is
flawed
Larry E. Austin et al. v. Commissioner
Written up in the WSJ as “A Novel Way to Skirt Taxes”
A pre 409(p) (pre 2001) arrangement to have the
ESOP own 100% of the issued and outstanding stock
while 95% of synthetic equity is issued to the two
founders
Motion for summary judgment was denied
Legal Update (continued)
Fifth Third Bank v. Dudenhoeffer
Deals with Moensch holding that ESOP investment in
employer stock is presumed to be prudent
Plaintiffs alleged breach of fiduciary duty due to
failure to sell bank shares in 2007
District court dismissed since plaintiffs did not plead
facts sufficient to overcome presumption
6th Circuit reversed, holding that presumption is not
applied at the pleading stage
Also held that ESOPs are not subject to a different standard
Holding conflicted with other circuits (2nd, 3rd & 11th)
Legal Update (continued)
Fifth Third Bank v. Dudenhoeffer
Result of holding: ESOPs must go through discovery
process before they are able to have a case
dismissed
Defendants appealed to US Supreme Court.
Cert. granted 12/13/2013
Arguments scheduled for 4/2/2014
DOL filed amicus brief with Supreme Court
Supported grant of cert.
But argued that Moensch presumption should not apply at
any stage of litigation
Legal Update (continued)
Perez v. PBI Bank
Complaint filed 1/2/2014 in USDC, ND Indiana
ESOP purchased company shares for $40 million
DOL alleged overpayment due to
“earn out” agreement
Incentive stock options (ISOs)
Seller note interest rate
Governance agreement
Flaws in valuation methodology
Legal Update (continued)
Perez v. PBI Bank (cont’d)
Earn out agreement
Entered into before ESOP transaction
Company redeemed 20% of shares in exchange for earn out
payment
Payment was 40% of earnings over projections
Payable after seller notes repaid
Valuation did not mention
ISOs
 Plan allowed issuance of ISOs to management
Up to 20% interest in company
Valuation reduced by approx. 2%
Legal Update (continued)
Perez v. PBI Bank (cont’d)
Seller note interest rate
“One day loan” transaction
Seller note carried 12% interest rate
DOL argued rate was excessive
Compared to “inside” loan rate of 5%
Bank loan rate of 8.25%
Governance agreement
Specified Board members as selling shareholders and
certain company officers
Applied so long as seller notes remained outstanding
DOL argued was not reflected in valuation and transfer of
rights was a PT
Legal Update (continued)
Perez v. PBI Bank (cont’d)
Valuation methodology
No marketability discount
No discount for lack of control
Failure to account for earn-out
Failure to adequately account for ISOs
No answer filed yet
QUESTIONS?