esop fiduciary duties & corporate governance: compliance & litigation perspectives

Daniel N. Janich Robert Rachal Kevin Kolb

ESOP Fiduciary Duties & Corporate Governance:

Compliance & Litigation Perspectives

April 14, 2016

Presented by:

Presentation Goals• Understanding Corporate

Governance Risks in ESOP Owned Companies

• Learn Best Practices to Reduce Litigation & Increase Business Success

• Explore Ways to Manage Potential Corporate Governance vs. ESOP Administration Conflicts

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What Do We Mean By Corporate Governance?

• Allocation of duties among shareholders, BOD & management to achieve continued company growth and success

• Subject to state corporate law and corporate bylaws

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Roles of Company Players• Shareholders: elects BOD; vote on

extraordinary corporate matters• BOD: hires and evaluates

management; appoints ESOP trustee; makes strategic business decisions

• Management: runs day-to-day company operations

• Governed by State Corporate Law

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Additional Corporate Governance in ESOP Companies

• Two additional governance layers ESOP Trustee(s) BOD’s ESOP Committee

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Role of ESOP Trustee

• Governed by ERISA Law• Overriding Duty to Protect Interests

of ESOP Participants & Beneficiaries • Represents Participants and

Beneficiaries by virtue of shareholder status

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Role of BOD’s ESOP Committee• Governed by Corporate Law &

ERISA Law• Adopt, Amend or Terminate ESOP

Plan• Determine Company Contributions

to ESOP• Oversee ESOP Plan Administration;

Appoint Trustee(s)

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Corporate Governance Standards

• BOD must act in “good faith” exercising reasonable care

• Business Judgment Rule (gross negligence standard of review)

• BOD & Management must act in best interest of corporation and its shareholders, not solely in self-interest (duty of loyalty)

• Do Corporate Employees also have ESOP responsibilities?

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ERISA Fiduciary Standards• Applicable to ESOP Plan

Administration• Fiduciaries must act with “highest

standards of prudence, skill, care” and solely in interest of plan participants

• Fiduciary standard (highest level of care standard of review)

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ERISA Fiduciary Duties• Duty of Prudence: Act with care,

skill, prudence and diligence of Prudent Person in like circumstances

• Duty of Loyalty/Exclusive Purpose: Act exclusively in the interest of plan participants and beneficiaries

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ERISA Fiduciary Duties (cont’d)

• Follow Plan Documents provided they are consistent with ERISA

• Protect Plan from Non-Exempt Prohibited Transactions by Inadvertent Conflict of Interest

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Who Is An ERISA Fiduciary?• Who Does the Plan or Trust Identify

as Fiduciary?• Fiduciary is anyone who exercises

discretionary authority & control over management or disposition of plan assets. ERISA §3(21)(A). Includes Plan Administrator and Trustee

• Trustee may be “directed & independent” or “corporate insider”

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The Plan Administrator: ESOP Fiduciary’s Primary

Responsibilities• ERISA Compliance To Ensure Tax-

Exempt Status• Administer ESOP Fairly• Is the Plan Administrator also a

Corporate Employee?

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Trustee: ESOP Fiduciary’s Primary Responsibilities

• Shareholder representative who elects BOD & votes shares • Pass Through Voting by Law or Plan

• Monitor corporate management and BOD to ensure no harm to ESOP plan participants’ interests

• Stock Valuation• Due Diligence for Hire of Outside

Advisors• Is the Trustee also a Corporate

Employee?

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The Danger of Wearing Multiple Hats• Settlor v. Fiduciary Functions• When Corporate Decision Conflicts

With Fiduciary Responsibilities • Conflicts Arise Between

• Company/ESOP • BOD/ESOP • Management & ESOP

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ESOP Fiduciary Duties and Corporate Governance:

Some Teachings From the Cases

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The basic structure: Grindstaff v. Green approved ESOP structure in which ESOP trustees and company directors appoint each other. • Does that create enhanced duties on ESOP trustees to

protect interests of participants?

Hot topic issues creating blurred lines: • Executive compensation – when does it become an

ERISA fiduciary issue for the ESOP trustees?• Husvar v. Rapoport and Eckelkamp v. Beste – courts

deferring to plaintiffs’ choice of claim and forum. • Johnson v. Couturier – protecting ESOP from self-dealing in

corporate pay.

Fiduciary & Corporate Governance- Litigation Examples

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Hot topic issues creating blurred lines (cont): • Corporate events impacting ERISA fiduciary duties:

Armstrong v. LaSalle Bank and corporate merger’s impact on stock valuation and repurchase obligations.

• Breakdown of roles in ESOP acquisitions: Perez v. Bruister as a cautionary tale.

• Fraud or malfeasance: Canale v. Yegan and ERISA trustee’s need to bring derivative action to protect the company.

Fiduciary & Corporate Governance- Litigation Examples

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• ESOP had a common structure in which the board selected and controlled the ESOP that then elected the directors pursuant to a board committee’s recommendation. • Union struck over acquiring “pass through” voting rights so that each

participant could vote for directors, but lost. • Court rejected the various challenges to the ESOP’s refusal to

implement “pass through” voting:• Management entrenchment is a common and known feature of ESOPs,

and Congress has not seen fit to upset this. • Contrary to the DOL’s claim, voting in regular board elections is not a

“plan asset.” • Amending the ESOP plan to add “pass through” voting is settlor, not

fiduciary conduct.

Query: Does management entrenchment create enhanced duties on ESOP trustees to protect the interests of participants?

Grindstaff v. Green, 133 F.3d 416 (6th Cir. 1998). Approving Board Self-Perpetuation and Control of ESOP

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• In theory the normal operation of a business is typically a corporate, not ERISA, function subject to corporate fiduciary duties. • For corporate fiduciary duties the standards and burdens, e.g., the

“business judgment rule,” illustrate court’s general unwillingness to interfere with or second-guess business decisions.

• In an ESOP, however, executive compensation can sometimes be a fraught area. Employee-participants may resent the pay of senior executives, while entrenchment and control of the ESOP can lead to claims of self-dealing. • Husvar v. Rapoport and Eckelkamp v. Beste suggest a plaintiff can bring

claims under either state corporate law or ERISA fiduciary law. • Johnson v. Couturier illustrates the ERISA exposures if a court

concludes executive compensation rose to the level of self-dealing.

Executive Compensation in an ESOP: A Corporate or ERISA Fiduciary Duty – or Perhaps Both?

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• Husvar v. Rapoport , 430 F.3d 777 (6th Cir. 2005) – executive compensation as corporate fiduciary duty: • ESOP participants alleged breach of corporate fiduciary

duties when the company’s executives granted themselves substantial compensation even though the company was not doing well financially.

• Court found plaintiffs did not plead an ERISA claim – they instead challenged business decisions made by the company’s directors.


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• Compare Eckelkamp v. Beste, 315 F.3d 863 (8th Cir. 2002) – executive compensation can trigger ERISA fiduciary duties: • Defendants were both ESOP trustees and corporate

officers. Plaintiffs claimed they breached their ERISA fiduciary duties by overcompensating themselves.

• Court rejected ERISA claim on the merits: Company was extraordinarily successful ,and critique of their compensation failed to factor this in.

• State law derivative claim was also preempted by ERISA: • Same facts, same parties, seeking same relief as ERISA

fiduciary claim. Allowing participants to assert rights granted to ESOP trustees would alter plan administration.


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• Former president, and in-house and outside counsel were both corporate directors and ESOP trustees. • Over a period of several years outside counsel created

several very generous executive compensation plans for the president.

• Pursuant to a merger of the ESOP-owned company into a shell company, the president received a buy-out valued at $35 million, or what appears to be about two-thirds of the value of the ESOP-owned company.

Executive Compensation in an ESOP: Johnson v. Couturier, 572 F.3d 1067 (9th Cir. 2009) & ERISA Exposures From Claims of Self-Dealing

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• Court noted difficulty in distinguishing between corporate and ERISA fiduciary roles in the area of executive compensation. • Held it was appropriate to impose ERISA fiduciary duties

on transactions in which the individual could self-deal at the expense of the ESOP.

• Court enforced preliminary injunction (i) freezing former president’s assets and (ii) barring the ESOP-owned company from advancing anyone’s defense costs. • Found it likely that fiduciary breach occurred.• Found that company’s assets were effectively ESOP

assets.

Executive Compensation in an ESOP: Johnson v. Couturier, 572 F.3d 1067 (9th Cir. 2009) & ERISA Exposures From Claims of Self-Dealing

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• Amsted Industries cashed out its participants at once when they left the plan. Valuation was as of September 30th and was locked in for nine months, up to June 30th.

• Court believed Amsted may have been primed for a run on redemptions: • Recently acquired a similar sized company with $800 million in

debt. • 800 employees were at least 55 years old and held $300 million

in ESOP stock. • Stock market in general was falling.

• Amsted’s trustee set redemption price at $184 for 2000, had 32% redemptions instead of prior rates of around 10%. • Created liquidity problem because much of debt limit had been

used for corporate acquisition. • Stock dropped to $90 the next year and company restricted

ESOP redemptions, now paid out over multiple years.

Armstrong v. LaSalle, 446 F. 3d 728 (7th Cir. 2006)Corporate Events & ERISA Fiduciary Duties

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• Court said it would give deference to the ESOP trustee’s setting of the stock’s redemption price, but required proof that the trustee actually exercised its discretion by considering the risk of a run on the ESOP.• Suggested that lowering redemption price to reflect marketability

discounts would have dampened redemptions.

Court noted that inherent risk of ESOPs may require a more watchful eye by ESOP trustees to lower risk where they can.

Query: Amsted has professional outside directors. But what happens with an insular board? Does this same heightened analysis apply when an insular structure for board and trustees creates the risk of conflicts between managers and the ESOP owners?

Armstrong v. LaSalle, 446 F. 3d 728 (7th Cir. 2006)Corporate Events & ERISA Fiduciary Duties

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• ESOP acquired 100% of the company (a DirecTV installer) from the founder (Bruister) in multiple transactions over several years. Bruister, his employee, and his outside CPA served as the ESOP trustees.

• Judge Jordan found Bruister to be a fiduciary, and thus on both sides of the transactions, for the sales: • Although Bruister abstained from voting, he did not abstain from the

process, e.g., he attended trustee meetings and gave his opinions to his employee and his CPA.

• Bruister had undue influence over his employee, and Bruister was a friend and major client of the CPA.

• Bruister’s attorney had substantial influence over the nominally independent valuator, who was supposed to be working for the ESOP.

Perez v. Bruister, 54 F. Supp. 2d 629 (S.D. Miss. 2014)

Breakdown of Roles in an ESOP Acquisition

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• Judge Jordan also found that the valuator was not independent:

• The valuator had offered to cut his appraisal fee if Bruister first retained him to do a feasibility study. Even Bruister’s expert conceded that would impact his independence.

• The valuator was eager to please the seller’s attorney, including discussing providing future work for him. He also regularly emailed Bruister to tout the advantages of an ESOP transaction.

• The valuator shared drafts exclusively with Bruister and his attorney, and raised his valuations based on their input.



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• Judge Jordan’s telling comments:

“The duty of loyalty was breached from start to finish. The initial structure of the ESOT provided three trustees—Bruister and two individuals loyal to him. There were no independent or professional fiduciaries. . . .In sum, these were not arms length transactions.”. . . “The Court feels compelled to say that Defendants seem like decent people; they are certainly likable. But the ESOP and ESOT were structured in a way that offered little protection for participants. The ESOT board was comprised of the seller and two lay trustees who worked for and were personally loyal to him. None had sufficient knowledge about business valuation, and there was no independent fiduciary (something Defendants’ expert Kaplan said he would have recommended).”



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• Insurance company owned by ESOP failed because of fraud and malfeasance.

• Although corporate acts were not subject to ERISA fiduciary duties, trustees knowledge of their bad actions imposed a duty on them to act to protect the ESOP: • E.g., they should have brought a derivative

action on behalf of the ESOP as shareholder.

Canale v. Yegen, 782 F. Supp. 963 (D.N.J. 1992)ESOP Trustees Need To Protect from Fraud and Malfeasance

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• When the matter is “pressure tested” in litigation, courts are going to expect high standards from ESOP trustees.

• Courts are often skeptical of trustee action and judgment when conflicts are present.• Courts expect to see evidence the trustee acted in

ESOP’s interests, not management’s or own interests. • Independent professional trustee can be very helpful to

ameliorate or eliminate conflicts. • Courts also impose high standards of care and

prudence: If not have expertise, trustees need to acquire it by retaining professional outsiders.

Some Take-Aways From the Cases

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• Fiduciary Duty solely to the ESOP Participants (as retirees, not as employees)

• Appointed and monitored by the Board of Directors (search committee, interview process, references?)

• Elects Board of Directors- At shareholder meeting or via shareholder consent- Nominating Committee- Review qualifications

• Monitor Senior Management

ESOP Trustee

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• Valuation of stock held in ESOP trust• Analysis of proposed transactions – protecting

ESOP from paying more than FMV for company stock, or selling for less than FMV.

• Voting of ESOP shares-Directed or Discretionary?-How to vote unallocated or undirected

shares?• Follow the Plan document!

Key ESOP Trustee Duties

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• Officer / Employee – Familiar with the Company• Do not charge a fee• May already have trust and respect of participants• May not have sufficient experience with ESOPs

and related valuation or transaction issues• Typically have full-time day job; may not have

enough time to devote to trustee duties• Heightened level of scrutiny by DOL and the

courts

Inside Trustee

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• Independent from Plan Sponsor• Expert at ESOP related issues and managing

ESOP Trust as full “daytime” job• Lack of in-depth knowledge of Company but

possesses extensive ERISA knowledge• Fee service• Better positioned to protect plan sponsor from

unanticipated expense and potential substantial liability

• CRITICAL: Should use outside trustee where purchase offer, etc. might personally affect inside trustee or is beyond competence of insiders

Outside Trustee

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• Conflicts can arise where there is overlap of Directors, Officers and Trustees:• Stock Valuations • Corporate Acquisitions – Risk > Reward?• Bona fide purchase offers • Executive Compensation

- Compensation Committee- Compensation Study- Necessary to attract and retain key

management- Excessive compensation is the problem

Potential Conflicts Involving Inside Trustees

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• Other Recurring Matters

- Trustee attendance at Board meetings

- Attendance at annual shareholders’ meeting

- Review of financial statements (times of crisis)

Trustee – BOD Interaction Issues

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• Typically the most important trustee activity (aside from transactions)

• Choosing Valuation Firm-reasons for selecting-list of those considered, and qualifications-background check (civil/criminal)-Independence (reports to the trustee, not the Company or the BOD)

Annual Stock Valuation

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• Comprehensive Diligence Process including meetings with management

• Confirming adequacy, accuracy & reasonableness of company financial data provided to valuation firm (Audit?)

• Reviewing assumptions & methodologies used by appraiser for reasonableness (standard approaches? consistency?)

• Document!!!• Communication with Board of Directors and ESOP

Participants

Annual Stock Valuation (cont)

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• Purchases and Sales are most common• Engage in a diligent, independent investigation

(interview management, understand business and reasons for transaction, projections)

• Independently negotiate price and terms• Engage advisors and ensure documents reflect

terms which have been agreed to• Document process!!

Analysis of Proposed ESOP Transaction

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• Is Trustee required to sell if the offering price is greater than the current appraised value of the company?• In a word, NO• Look long term, not short (retirement plan)• Projected value of shares in future vs. net cash

received at closing (value of losing “S” corp tax deferral)

• CRITICAL: Trustee should rely on guidance from the Board of Directors – if they believe they can deliver greater value long term than is provided for in the offer, why sell?

Sale of ESOP Company

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• Run the Company

• Make Management / Strategic Decisions

• Set Compensation (but *do* monitor)

• Look for Acquisitions / Sale Opportunities

What doesn’t a Trustee do?

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• Size of ESOP ownership does not affect trustee fiduciary duties to participants – same process whether 1% or 100% ESOP

• Size CAN impact influence ESOP trustee has over the Board and corporate governance in general.

• Where ESOP is in a majority ownership position and can vote to replace one or more board members, then the ESOP trustee can be catalyst for corporate change.

ESOP Size Does Matter

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• Truth, honesty and open dealing with all relevant people and facts when making decisions that may affect stock value.

• Taking care to maintain ESOP independence when conflicts of interest arise within the BOD or Trustee(s).

• Using Plan Sponsor’s company assets in a manner consistent with the best interests of shareholder(s).

• Providing the ESOP Trustee(s) with sufficient information and independent resources to protect ESOP participants.

Key Factors for Governance Success

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Some Key Takeaways• Understand significant risks of wearing

multiple hats• Understand the role that process and

procedures play to protect individuals in corporate governance and ESOP administration

• Understand the need to document all decision making

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PresentersDaniel N. Janich

Holifield Janich & Associates PLLC(312) 332-4222 - [email protected]

Robert RachalProskauer Rose

(504) 310-4081 - [email protected]

Kevin KolbGreatBanc Trust Company

(630) 810-4514 - [email protected]

mailto:[email protected]



Thank You

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