Current ESOP Fiduciary Issues. Ohio Employee Ownership Center Annual Conference Friday, April 29, 2011

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1 Current ESOP Fiduciary Issues Ohio Employee Ownership Center Annual Conference Friday, April 29, 2011

2 Presented by: Robert E. Brown, Esq. Founding Partner Boylan, Brown, Code, Vigdor & Wilson, LLP 2400 Chase Square Rochester, NY Mark R. Fournier, CFA Director, Valuation & Financial Opinions Stout Risius Ross, Inc Greensboro Drive, Suite 600 McLean, VA Richard A. Schlueter, ASA President ComStock Advisors 1 Levee Way Suite 3109 Newport, KY rschlueter@comstockadvisors.com Neil M..Brozen, CPA Vice President & Managing Director BTC ESOP Services Bankers Trust Company of South Dakota 701 South Fourth Avenue, Suite 500 Minneapolis, MN nbrozen@bankerstrust.com 2

3 Who is a Fiduciary? An individual or entity is a fiduciary if they: (1) Exercise any discretionary authority or control with respect to management of the ESOP or exercise any authority or control with respect to the management or disposition of the assets of the ESOP; (2) Render investment advice as to the ESOP s assets for a fee or other compensation, direct or indirect, or have any authority or responsibility to do so; or (3) Have any discretionary authority or responsibility in the administration of the ESOP. ERISA 3(21) Examples: trustees, plan administrators, plan sponsors, and board of directors 3

4 Are there any Limitations? A person is a fiduciary with respect to an ESOP only to the extent that the person performs a fiduciary function. E.g., employers who are plan administrators are fiduciaries to the plan only when and to the extent they function in that capacity. Note: generally adoption, modification or termination of an ESOP is a non-fiduciary function of the employer. 4

5 ERISA Fiduciary Responsibilities (1) Duty to act solely in the interest of plan participants and their beneficiaries; (2) Duty to act prudently; (3) Duty to act in accordance with the plan documents; (4) Duty to diversify plan assets. 5

6 (1) Solely in the interest of plan participants & their beneficiaries. A fiduciary must discharge its duties solely in the interest of the plan participants & their beneficiaries for the exclusive purpose of; (a) Providing benefits to participants and their beneficiaries; and (b) Defraying reasonable expenses of administering the ESOP. ERISA 404(a)(1)(A) 6

7 (2) Duty to Act Prudently A fiduciary must discharge its duties 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 a like character and with like aims. ERISA 404(a)(1)(B) 7

8 (A) Procedural Prudence Process used to make a decision Fiduciary must independently investigate; procedural due diligence (B) Substantive Prudence Good faith is not sufficient. a pure heart and an empty head is not enough The prudence of a fiduciary s actions are evaluated from the perspective of the time of his/her actions, and not with the benefit of hindsight. Armstrong v. Amsted, 2004 U.S. Dist. LEXIS (ND Ill 2004). 8

9 (3) In accordance with the plan documents A fiduciary must discharge its duties in accordance with the documents and instruments governing the plan, insofar as they are consistent with provisions of ERISA. ERISA 404(a)(1)(D) Fiduciaries must read & understand the following documents: Plan Trust Summary Plan Description 9

10 DOL Proposed Rule for the Definition of Fiduciary Current definition of fiduciary specifically excludes ESOP valuation firms. Proposed rule includes ESOP appraisers of closelyheld corporation within the definition of investment advisors who are subject to ERISA s fiduciary rules. Potential consequences of proposed rule: Fewer qualified ESOP valuators Increased costs for appraisals Companies may react to higher prices by not retaining other independent fiduciaries 10

11 DOL Proposed Rule for the Definition of Fiduciary Potential consequences (continued): Legal fees to plaintiff s firms (contingent fees) and defense fees will likely increase Transactions may artificially be restructured to avoid the rule Current state of proposed rule: Formal Prediction 11

12 DOL Proposed Regulation Proposed Regulation Benefits Discourage harmful conflicts of interest Improve service value Enhance DOL s ability to redress abuses and more efficiently allocate resources 12

13 DOL Proposed Regulation Proposed Regulation expands definition of fiduciary Would make valuation advisor a fiduciary Reverses 35 year old policy that maintained independent appraisers valuing closely held ESOP stock are NOT considered ERISA fiduciaries Proposed regulation states, a common problem identified in the DOL s recent ESOP national enforcement project involves the incorrect valuation of employer securities. DOL feels this will align the duties of individuals who provide such opinions with those of fiduciaries who rely on them 13

14 DOL Proposed Regulation The Proposed Regulation reverses a longstanding and widely accepted principle of law in the ESOP context 1976 DOL Advisory Opinion Fairness opinion in M&A transactions There is no evidence that conflicts of interest are prevalent in the marketplace for ESOP valuations Are biased appraisals a common problem? 14

15 DOL Proposed Regulation Fiduciary status for appraisers is inconsistent with Internal Revenue Code and professional appraisal practices Relationship between ESOP Trustee and appraiser becomes confusing 15

16 DOL Proposed Regulation DOL has not made the case that the Proposed Regulation would lead to improved service value DOL has not demonstrated poor service value $900 billion detriment to ESOP savings Incorrect or faulty valuations are not a chronic problem No underlying or empirical data ESOP valuation litigation Fear of being sued 16

17 DOL Proposed Regulation Imposing fiduciary status on appraisers would have far-reaching, adverse consequences Higher costs Less qualified appraisers Lower quality valuations Less ESOPs 17

18 Recommendations DOL withdraw Proposed Regulation Carve out valuations and fairness opinions for ESOPs Provide guidance on critical valuation issues Exclude annual valuations Expand seller s limitation to include providing valuation advice to sponsoring ESOP company 18

19 DOL Viewpoint DOL indicates that there are abusive appraisals in ESOP transactions Views transaction valuations as being influenced by the selling stockholder Fees paid (indirectly) by selling stockholder Appraiser motivated to obtain annual updates Indicates that currently there is no way to regulate appraisers by DOL Believes fiduciary status would allow DOL to regulate appraisers and would create a more level playing field 19

20 Impact of Proposed Regulation Fewer new ESOPs will likely be created especially for smaller companies The cost of existing ESOPs will increase ESOP litigation will likely increase would add appraisers as defendants litigation between appraisers and other plan fiduciaries over apportionment of liability Disruptions to your existing plan changes in the roles and responsibilities of service providers (trustee and appraiser) 20

21 Impact on Appraisers Increase risk of being included in a litigation as a fiduciary Require training to understand fiduciary duties Higher insurance costs due to adding fiduciary insurance coverage in addition to E&O coverage Some may choose not to do ESOP work to avoid being a fiduciary Some may be unwilling to work with internal trustees due to concern about co-fiduciary risk Will be represented by counsel especially in transactions Fees and expenses will increase Some may modify new business acceptance and report review procedures Could result in business combinations between appraisers and professional fiduciaries 21

22 Indemnification Due to recent court decisions there is a risk that fiduciaries may not be able to obtain indemnification from the plan sponsor Johnson v. Couturier If the appraiser is a fiduciary then only source of repayment, if liability is established, could be insurance or corporate assets Most appraisers are small businesses and do not have deep pockets 22

23 Other Issues No insurance for appraisers fiduciary risk currently exists. What happens if insurance has limited availability, high cost, or high deductibles? Uncertainty as to whether appraisals for ESOP updates would result in fiduciary status Likely loss of experienced appraisers to provide ESOP valuation and fairness services Service providers in which ESOP services represent a small percentage of their overall business Service providers that may not be able to afford insurance or choose not to be fiduciaries 23

24 Conflicting Roles of Appraiser Several of the requirements under the Code of Ethics of USPAP appear on their face to conflict with the duty of loyalty by a fiduciary USPAP Code of Ethics Appraiser must perform assignments with impartiality, objectivity, and independence and without accommodation of personal interest Appraiser must not perform his role with bias Appraiser must not advocate the cause or interest of any party or issue Appraiser must not accept an assignment that is contingent on a direction in assignment results that favors the cause of the client 24

25 Conflicting Roles of Appraiser Fiduciary A fiduciary is a person, committee, or organization that has agreed to accept legal ownership or control and management of an asset or group of assets belonging to someone else In spelling out fiduciary duties with regard to employee benefit plans, ERISA covers the duty of loyalty, the duty to use prudence, and the duty to comply with the plan The duty of loyalty means that fiduciaries must act in the best interests of the plan and its participants Plan fiduciaries are under an obligation not only to use their special skills and expertise, but also to engage qualified advisers and managers if they lack the expertise themselves 25

26 Conflicting Roles of Appraiser Internal Revenue Code the DOL proposal, if finalized, would on its face create a contradiction with Internal Revenue Code 401(a)(28)(c) A plan meets the requirements of this subparagraph if all valuations of employer securities which are not readily tradable on an established securities market with respect to activities carried on by the plan are by an independent appraiser Can a fiduciary who must act in the best interests of the plan and its participants at the same time be considered independent? 26

27 Alternative Solutions to Rule Require accreditation of appraisers by professional organizations Adopt rules and penalties similar to IRS Define independence requirements and finalize the proposed Adequacy of Consideration Regulation Withdrawal the proposed rule and continue with existing standards used over the past 34 years 27

28 Qualified Appraiser IRS defines the term qualified appraiser to mean an individual who (I) has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations prescribed by the Secretary, (II) regularly performs appraisals for which the individual receives compensation, and (III) meets such other requirements as may be prescribed by the Secretary in regulations or other guidance. 28

29 IRS Regulation Secretary of the Treasury may: (1) regulate the practice of representatives of persons before the Department of the Treasury; and (2) before admitting a representative to practice, require that the representative demonstrate A. good character; B. good reputation; C. necessary qualifications to enable the representative to provide to persons valuable service; and D. competency to advise and assist persons in presenting their cases. 29

30 IRS Regulation After notice and opportunity for a proceeding, the Secretary may suspend or disbar from practice before the Department, or censure, a representative who (1) is incompetent; (2) is disreputable; (3) violates regulations prescribed under this section; or (4) with intent to defraud, willfully and knowingly misleads or threatens the person being represented or a prospective person to be represented. 30

31 IRS Regulation The Secretary may impose a monetary penalty on any representative described in the preceding sentence. If the representative was acting on behalf of an employer or any firm or other entity in connection with the conduct giving rise to such penalty, the Secretary may impose a monetary penalty on such employer, firm, or entity if it knew, or reasonably should have known, of such conduct. Such penalty shall not exceed the gross income derived (or to be derived) from the conduct giving rise to the penalty and may be in addition to, or in lieu of, any suspension, disbarment, or censure of the representative. 31

32 BTC ESOP Services Provided ESOP trustee services since 1981 Experience: Transaction trustee for 75 ESOP transactions Discretionary or directed trustee for 55 ESOPs Will review 65 to 75 valuation reports a year Work with 20 valuation firms Approved list of ESOP valuation firms Will not accept engagement if valuation firm is not qualified

33 Selecting a Financial Advisor Independent (does not have a conflict of interest) Academic and professional qualifications Professional certifications (CFA, ASA, CPA/ABV) ESOP experience (# of annual updates and transaction per year) Industry experience Depth and capacity of firm Membership in ESOP organizations ESOP articles and speaking engagements References Timeliness/responsiveness Interviews Philosophy and approach Communication skills 33

34 Trustee s Principals for Valuation Trustee determines value, not the Appraiser Donovan vs. Cunningham Good faith is not sufficient A pure heart and an empty head is not enough Blind reliance of legal counsel Active involvement Process- define and follow Document 34

35 Johnson v. Couturier and Solis v. Couturier Retain appropriate independent appraiser (IA) and financial advisor (FA) Carefully investigate the IA and FA qualifications Make certain that reliance on the IA and FA's Opinion Letter, valuation report or other advice is reasonably justified under the circumstances 35

36 Johnson v. Couturier and Solis v. Couturier (continued) Cannot justify reliance on views of the IA and FA unless: - Read valuation report, Fairness Opinion or any other requested report or advice and supporting document - Identified, questioned and tested the underlying financial data and underlying assumptions - Verified conclusions are consistent with data and analysis - Verified that valuation report, Fairness Opinion or any other requested report or advice was internally consistent and made sense Hire additional expert support to assist the ERISA fiduciaries in understanding and addressing any problems with the valuation report, fairness opinion, or any other requested report or advice and supporting documents 36

a formal allocation of responsibilities May eliminate the role of the

37 Not defined Co-Fiduciaries Who s in charge Who is ultimately responsible for the investment decision Total or limited to valuation process May need a formal allocation of responsibilities May eliminate the role of the independent trustee Will undermine relationship between trustee and appraiser 37

38 Sources of Additional Info DOL Proposed Regulation aspx?docid=24328&agencyid=8&documenttype=1 DOL Hearings HearingTranscript2.html DOL Public Comments DOL Fact Sheet 38

39 Questions? 39

ESOP Feasibility and Valuation Basics

ESOP Feasibility and Valuation Basics Ohio Employee Ownership Center Akron/Fairlawn Hilton Fairlawn, Ohio April 21, 2006 Richard A. Schlueter rschlueter@comstockvaluation.com C VA 1 Levee Way, Suite 3109