Introduction to ESOPs
and
Related ERISA Litigation
Thursday, September 17, 2015
11:20 am - 12:05 pm
Texas Lawyer’s In-House Counsel Summit
Cityplace Conference Center
2711 N. Haskell Avenue, Dallas, Texas
Presented by
David R. Johanson
Overview
•
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
1
Overview (continued)
•
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 AttorneyClient Privilege
•
Financial Advisor Privilege
2
Overview (continued)
•
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
3
Alternative Exit Strategies
• Sell to a Strategic Buyer
• Sell to a Financial Buyer
• Sell to an ESOP
4
Criteria for Evaluating Alternatives
• 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
5
Introduction to ESOPs
•
•
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.
6
Introduction to ESOPs (Continued)
•
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.
7
Introduction to ESOPs (Continued)
•
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
8
Introduction to ESOPs (Continued)
•
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
9
Introduction to ESOPs (Continued)
•
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).
10
Introduction to ESOPs (Continued)
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
11
Introduction to ESOPs (Continued)
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
12
Introduction to ESOPs (continued)
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.
13
Introduction to ESOPs (continued)
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.
14
Introduction to ESOPs (continued)
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
15
Profile of an Ideal ESOP Candidate
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
16
Profile of an Ideal ESOP Candidate
(continued)
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)
17
Profile of an Ideal ESOP Candidate
(continued)
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
18
Corporate Governance
in an ESOP Corporation
ESOP TRUSTEE
Shareholders
elect Board of
Directors
NON-ESOP
SHAREHOLDERS
ESOP TRUST
Board of
Directors
appoints
officers
and…
OFFICERS
BOARD OF
DIRECTORS
appoints
ESOP
Board of
Trustees
BOARD OF
TRUSTEES
ESOP
ADVISORY
COMMITTEE
Board of Trustees
appoints ESOP
Advisory
Committee
(optional)
Brief Description of Respective Roles
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
20
Brief Description of Respective Roles
(Continued)
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)
21
ESOP Corporate Governance
(Continued)
•
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
22
ESOP Corporate Governance
(Continued)
•
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.
23
ESOP Corporate Governance
(Continued)
•
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.
24
ESOP Corporate Governance
(Continued)
•
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.
25
How Does an ESOP Work?
(Non-Leveraged)
Other
Shareholders
ESOP
Trust
2.
3.
ESOP
Accounts
2.
1.
Corporation
4.
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.
Terminated
EmployeeParticipants
Save:
IRA
Spend
26
How Does an ESOP Work?
(Leveraged)
Other
Shareholders
ESOP
Trust
2.
4.
2.
1.
1.
Bank
3.
Corporation
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.
3.
ESOP
Accounts
Terminated
EmployeeParticipants
Save:
IRA
Spend
27
Tax-Deferred Reinvestment under
Section 1042 of the IRC
C Corporations Only
ESOP
Trust
Cash/Note
Selling
Shareholder
Qualifying
Employer
Securities
QRP: Debt or Equity in a Domestic Operating
Corporation
(Stepped-up basis upon death)
QRP Excludes:
• REITs
• Mutual Funds
• Passive Investment Companies
• Municipal Bonds
Qualified
Replacement
Property
(“QRP”)
28
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
29
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
N/A
($180,000)
$630,000
$820,000
None
QRP to pass to heirs on a
stepped-up basis
Down Payment on QRP
(assumed 18% required)
Net Proceeds
Additional Benefits
30
Plan Design Considerations
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?
31
Plan Design Considerations
Feasibility Study (continued)
• Internal Board of Trustees or
Institutional/Independent Trustee?
• Independent fiduciary?
• What will the repurchase obligation be
under the different variables?
32
What is a “Repurchase Obligation”?
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
33
What is a “Repurchase Obligation”?
(continued)
•
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.
34
Corporate v. ERISA Fiduciary Standards
•
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.
35
Corporate v. ERISA Fiduciary Standards
(Continued)
•
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.
36
ERISA Fiduciaries
•
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
37
ERISA Fiduciaries (Continued)
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
38
ERISA Fiduciaries (Continued)
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 “passedthrough” to ESOP participants
39
Conflicts of Interest
•
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
40
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)
41
General Regulatory Framework (cont.)
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.
42
General Regulatory Framework (cont.)
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)
43
General Regulatory Framework (cont.)
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
44
General Regulatory Framework (cont.)
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
45
General Regulatory Framework (cont.)
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
46
General Regulatory Framework (cont.)
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
47
General Regulatory Framework (cont.)
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.
48
General Regulatory Framework (cont.)
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
49
ESOPs and Other Retirement Plans
•
•
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
50
Summary of ESOP Pros and Cons
•
From the Shareholder’s Perspective:
Pros
Cons
- Potential Tax Deferral for
electing, selling shareholder
(C corporation only)
- Dilution to shareholders (if
less than 100% is sold to the
ESOP)
- Viable Exit Strategy
51
Summary of ESOP Pros and Cons
•
From the Corporation’s Perspective:
Pros
Cons
- Tax Deductions
- Employer Contributions
- Certain Dividends (C
corporations only)
- 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
- A good to exceptional tool
for:
- Cash Flow Management
- Recruitment and
Retention of Employees
- Business Succession
Planning
- Mergers & Acquisitions
- Balance Sheet Impact
- Contra equity account
(leveraged ESOPs only)
52
Summary of ESOP Pros and Cons
•
From the Participating Employee’s
Perspective:
Pros
Cons
- Benefits provided without wage reductions
or deductions
- Value of
benefits subject
to fluctuations of
the Fair Market
Value of
Company Stock
- 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)
53
ERISA Fiduciary Exception to the
Attorney-Client Privilege
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.
54
ERISA Fiduciary Exception to the
Attorney-Client Privilege (continued)
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 nonfiduciary 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.
55
ERISA Fiduciary Exception to the
Attorney-Client Privilege (continued)
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.
56
Financial Advisor Privilege
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.
57
Financial Advisor Privilege (continued)
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.
58
Financial Advisor Privilege (continued)
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 ExportImport 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 attorneyclient privilege if the financial advisor's role is limited to helping a lawyer give
effective advice by explaining financial concepts to the lawyer).
59
Financial Advisor Privilege (continued)
•
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.
60
Financial Advisor Privilege (Continued
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.
61
Unintended ERISA Fiduciary and
Prohibited Transaction Claims involving
Service on a Plan or ESOP Committee
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)
62
Unintended ERISA Fiduciary and Prohibited
Transaction Claims involving Service on a Plan
or ESOP Committee (continued)
•
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.
63
Unintended ERISA Fiduciary and Prohibited
Transaction Claims involving Service on a Plan
or ESOP Committee (continued)
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”.
•
64
Unintended ERISA Fiduciary and Prohibited
Transaction Claims involving Service on a Plan
or ESOP Committee (continued)
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.
65
Unintended ERISA Fiduciary and Prohibited
Transaction Claims involving Service on a Plan
or ESOP Committee (continued)
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.
66
Unintended ERISA Fiduciary and Prohibited
Transaction Claims involving Service on a Plan
or ESOP Committee (continued)
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.
67
Monitoring Obligations
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.
68
Corporate vs. ERISA Fiduciary Standards for the
Board of Directors important Distinctions
•
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.
69
Corporate vs. ERISA Fiduciary Standards
for the Board of Directors important
Distinctions (continued)
•
•
•
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).
70
Corporate vs. ERISA Fiduciary Standards
for the Board of Directors important
Distinctions (continued)
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.
71
ERISA Indemnification and Contribution
Rights: Indemnification
•
•
•
•
•
•
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
72
ERISA Indemnification and Contribution
Rights: Indemnification (continued)
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”).
73
ERISA Indemnification and Contribution
Rights: Indemnification (continued)
•
•
•
•
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.”
74
ERISA Indemnification and Contribution
Rights: Indemnification (continued)
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.
75
ERISA Indemnification and Contribution
Rights: Contribution (continued)
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.
•
76
Sponsor Liability
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.
77
Sponsor Liability (continued)
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).
78
Sponsor Liability (continued)
•
•
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).
79
Sponsor Liability (continued)
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).
80
Concluding Remarks
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
81
Questions?
Thank you
82
David R. Johanson – Brief Bio
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.
83
Contact Information
David R. Johanson
Hawkins Parnell Thackston & Young LLP
E-mail: djohanson@hptylaw.com
1776 Second Street
Napa, CA 94559
(707) 226-8997
345 California Street
Suite 2850
San Francisco, CA 94104
(415) 766-3238
445 S. Figueroa Street
Suite 3200
Los Angeles, CA 90071
(213) 486-8010
600 Lexington Avenue
8th Floor
New York, NY 10022
(212) 897-9655
84