Legal & Fiduciary Considerations When Selling an ESOP Company
May 9 & 10, 2013
Washington, D.C.
Allison Wilkerson
Stephen D. Smith
Richard C. Mapp III
IRS Circular 230 Disclosure
To comply with requirements imposed by the Internal Revenue Service
“(IRS”), K&L Gates, LLP, Krieg DeVault LLP, and Kaufman & Canoles,
P.C. must inform the reader and participants that any U.S. Federal Tax
advice contained in this communication is not intended or written to be
used, and cannot be used, for the purpose of: (i) avoiding penalties under
the IRS; or (ii) promoting, marketing or recommending to another party
any transaction or matter addressed herein.
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Why consider selling an
ESOP Company?
• Timing/Maximizing Value of ESOP’s Investment
• Liquidity needs
– Non-ESOP shareholders
– Unable to re-pay debt from operating cash flows
– Repurchase obligation
•
•
•
•
Changing risk profile
Receive an unsolicited offer
Market conditions
Other?
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Whose involved in the sale and what
roles do they play?
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Case Study – The Stakeholders
Trustee
Participants ESOP
Non‐ESOP
Shareholders
ESOP Loan:
$20M (original)
$10M (owed)
Holding Company
Operating Subsidiary A
Bank/
Financing Source
Board of Directors
Management
Operating Subsidiary B
Board of Directors
Management
Buyer
Equity Holders
Investors (PEG)
Board of Directors Management Options:
• Buyer purchases Holding Company in its entirety
• Buyer purchases the assets of Holding Company (including the ownership of the subsidiaries)
• Buyer purchases Operating Subsidiary B
• Buyer purchases the assets of Operating Subsidiary B
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Board and ESOP fiduciary subject to
different standards
• Board of Directors:
– Duty of good faith and reasonable standard of care (protection under state
law “business judgment rule”)
• ESOP trustee/ERISA fiduciaries:
– “Highest standard known to law” (no protection under the business judgment
rule)
• Fiduciary conflicts: Donovan v. Bierwirth and Howard v. Shay1
– “Inside” vs. “outside” trustee
– “Discretionary” vs. “directed” trustee
– Trustee engagement agreement issues
– ESOP Trust Agreement issues
2. Under ERISA, the fiduciary must act “solely in the interest of the plan participants and beneficiaries” and “for the exclusive purposes of: (i) providing benefits to participants and their beneficiaries; and (ii) defraying the reasonable expenses of administering the plan”. [ERISA §404(a)(1)(A), 29 U.S.C. 1104(a)(1)(A)]. In considering whether the trustees had breached their duty of loyalty to the pension plan participants, the court found that “when a fiduciary has dual loyalties, his independent investigation into the basis for an investment decision which presents a potential conflict of interests must be both intensive and scrupulous and must be discharged with the greatest degree of care that could be expected under all the circumstances by reasonable beneficiaries and participants of the plan.” [Bierwirth, 538 F. Supp. 463 at 470]. In Howard v. Shay, the court said, "To enforce [ERISA's fiduciary duties], the court focuses not only on the merits of the transaction, but also on the thoroughness of the investigation into the merits of the transaction." [100 F.3d 1484, 1488 (9th Cir. 1996)]. A fiduciary need not become an expert in valuation. Rather, the fiduciary is required to make an honest, objective effort to read the valuation, understand it, and question the methods and assumptions used when they do not make sense.
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Corporate fiduciary standards
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•
•
•
•
•
•
Business judgment rule
Value to shareholders
Company culture and independence
Employees, employment, motivation, productivity
Alternative purchasers
Continuity of business
No less than fair cash value under state corporate
law
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ERISA fiduciary standards
•
“Exclusive Benefit Rule”
•
Optimize value for plan participants
– Short vs. long term (“sell” vs. “hold”)
– Cannot consider factors under business judgment rule
– Financial “fairness” issues
– Kuper v. lovenko and Robertston v. Moench on investment policy 2
(applicable to “directed” trustees)
3.
The Kuper/Moench presumption attempts to strike a balance between competing statutory goals, namely, the encouragement of employee ownership of stock and the need to safeguard retirement income from imprudent decisions and excessive risk. Under the "presumption of prudence" approach, a directed trustee or fiduciary will be presumed to act prudently when he or she executes directions to purchase and hold qualified employer securities as part of an ESOP. Plaintiffs can overcome the presumption of prudence by showing that stock had become so risky that the plan sponsors would not have intended continued investment or holding of such stock. Courts adopting the presumption of prudence acknowledge that ERISA requires, under certain limited circumstances, that trustees and other fiduciaries disregard plan language or co‐fiduciary directives to invest and/or hold employer securities. [Kuper v. lovenko, 66 F. 3d 144‐7 (6th Cir. 1995) and Moench v. Robertson, 62 F. 3d 553, 571‐72 (3rd 1995).]
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ERISA fiduciary standards (cont.)
• “Adequate consideration” rules
– IRS Ruling 59-60
– Internal Revenue Code Section 401 (a)(28)(C)
– ERISA Section 3(18)(B) and Proposed Reg. 29 CFR
2510.3-18(b)
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ERISA fiduciary standards (cont’d)
• Kroy standards for trustees3:
– Good faith
– Diligent investigation
– Independent judgment
– “Prudent expert”
4. Reich v. Valley National Bank of Arizona, 1993 U.S. Dist. LEXIS 11837 (Aug. 19, 1993).
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Getting an Offer
– Who received the offer?
• Management
• Board of Directors of the Company
• ESOP Trustee
– Who decides if Company is to be sold?
• 100% owned by an ESOP
• Non-ESOP Shareholders
– Who is responsible for negotiating the offer?
– Does this put the company “in-play”?
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Corporate Governance
Threshold Questions
• Does the Board of Directors have an “acquisition
policy”?
• Can the company be “not for sale”?
• When does the Board of Directors inform the
trustee? Management? Employees?
– Does the Board of Directors have to inform anyone?
• Can the Board of Directors negotiate the Letter
of Intent without the trustee?
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Alternatives Upon Receipt of an Offer
– Ignore
• Bona fide offers must be taken seriously!
– Ask for Clarification
– Consider the Offer
• Who considers the offer?
• Conflicts of interest?
– Inform the Board of Directors
• Establish a review committee?
– Inform the ESOP Trustee
– Hire an Investment Banker
–
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Types of Sale Transactions
• ESOP Trustee considerations as to structure
– Pass-through voting
– Cost of particular structure
– Time necessary to dispose of ESOP
• Sale of assets
• Sale of stock
– Stock for cash
– Stock for stock
• Merger
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Types of considerations/buyer protections
• Consideration to seller
–
–
–
–
Stock
Cash
Notes
Any Combination of the Above
• Protections for buyer
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–
–
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Earn-outs
Holdbacks/Clawbacks
Escrows
Indemnification
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Is trustee required to sell if offering price is
greater than most recent ESOP value?
• Trustee Considerations:
– ESOP fiduciaries must manage plan assets prudently and
in sole interest of plan participants
– Trustee need not automatically sell to capture “premium”
– Whether sale is in economic interest of ESOP and
participants
– ESOP designed to provide retirement income
– Loss of S corporation benefits (if applicable)
– Practical experience – process must begin with Board of
Directors
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Is trustee required to sell if offering price is
greater than most recent ESOP value? (cont’d)
• Joint Department of Labor/Department of Treasury
Statement on Pension Investments (January 31, 1989)
– ESOP Trustee is not obligated to sell stock solely because price
is at premium to fair market value
– Can look at long-term prospects of company
– Weigh offer against underlying intrinsic value of company and
likelihood of value being realized over long term by current
management or by later sale
– Weigh long term value of the company against value presented
by offer and ability to reinvest sales proceeds in diversified
investments
– Analyze long term business plan of the target company’s
management
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What are fairness issues relating to sale of
an ESOP company?
• Key to Trustee’s analysis:
– “Absolute” vs. “relative” fairness
• ESOP trustee will ask its financial advisor to render opinion to effect
that:
– Consideration to be received for the ESOP shares is at least equal
to their fair market value (absolute fairness); and
– Terms of transaction are fair to ESOP from a financial point of view
(relative fairness)
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What are fairness issues relating to sale of
an ESOP company? (cont.)
• Typical relative fairness issues:
– Employment agreements for management
– “Bonuses”
– Severance agreements. Change in control payments (e.g., SARs,
options, “parachutes”)
– Payments by company of legal and other fees incurred by other
shareholders and/or executives
– “Contingent” payments (escrows, earn outs and post-closing
adjustments)
– Scope of ESOP’s representations and warranties
– Liability of ESOP for indemnification
– “Baskets” and “caps”
– Representations and warranties insurance
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Can ESOP agree to “earn out” or contingent
payment?
• Most institutional trustees treat earn outs and
contingent payments as having no value in
judging absolute fairness
• Key fiduciary issue:
– Whether contingent payment (especially an earn out)
is, in effect, extension of credit to buyer to allow it to
defer payment of part of purchase price; if so, it is
likely a “prohibited transaction”
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Use of “hold back” or escrow to cover
potential indemnity liabilities
• Purchaser may require portion of sales price be either held
back or deposited in an escrow account to cover damages for
breach of representations and warranties by ESOP, company
and/or other shareholders
• If there are other shareholders, Trustee may be able to
negotiate out of escrow agreement by assigning its rights to
escrow to other shareholders in exchange for higher cash
payment at closing
• While financial advisor may give some value to contingent
payments, many ESOP trustees treat them as having no
value for purposes of absolute fairness analysis
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Trustee cannot, on the record, consider nonfinancial factors such as continuing job security of
ESOP participants
• Would violate exclusive benefit rule
• ESOP provision that permits consideration of
non-financial factors violates Trustee’s duty of
prudence
Joint Department of Labor/Department of Treasury Statement on Pension Investments (January
31, 1989)
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What is approval process for asset sale or
merger?
• Statutory voting instruction pass through
• Prior notice (as required by state law) with comprehensive
“disclosure” statement from ESOP sponsor to participants
(through trustee)
–
–
–
–
Includes relevant information regarding transaction
Refers to “preliminary” fairness opinion
Includes voting instruction procedures and documents
Describes disposition of ESOP and timing of distributions
• Issuance of confidential voting instructions
• Tabulation of instructions/communication to Trustee
• Shareholders and participants meeting/voting by trustee
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What is approval process for asset sale or
merger? (cont.)
•
Issue: Trustee duty to “override” instructions
– Arises in context of whether “directed” trustee is required to follow written
instructions
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•
•
A directed trustee is subject to proper directions of a named
fiduciary (e.g., ESOP participants on pass through voting matters)
A direction is proper only if it is “made in accordance with the terms
of the plan and [is] not contrary to [ERISA]”4
Focus of directed trustee’s inquiry:
– Whether direction is consistent with all relevant documents and
instruments governing the plan
– Confirm taking action would not result in a prohibited transaction or be
imprudent
•
No direct obligation to determine prudence of an action or
transaction (e.g., where trustee has material, non-public information
that action directed to be taken is imprudent or would result in a
prohibited transaction)
4. ERISA §403(a)(1).
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Disposition of ESOP
• Applies to stock sale or merger
• Future of ESOP will be subject of negotiation at beginning of
sales process
• ESOP may be terminated and all benefits distributed or
merely “frozen” (extremely rare)
• ESOP may be merged into the acquirer’s plan (extremely
rare)
• Where ESOP is to be terminated, and escrow involved,
distribution to participants may involve distribution of cash and
“scrip” evidencing interests in escrow (distribution of scrip is
rare)
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Disposition of ESOP (cont.)
• Typically, ESOP is maintained until all post-closing
payments received
• Consider “spin off” of ESOP to newly formed company
just before closing
• ESOP may be “paid off” at closing where it is not 100%
shareholder
• Minority ESOPs often redeem all shares for single cash
payment before closing
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Will proceeds from sale of unallocated stock be
used to repay balance of ESOP debt?
• ESOP should negotiate such that the allocation of cash from
sale of suspense account shares is not “annual addition”
• Trustee must confirm unallocated shares were pledged at time
loan incurred (even if not pledged, payment of loan is likely
enforceable)
• Trustee may be able to obtain final company contribution
and/or dividend payment and use it to pay loan (helpful to new
and recent participants)
• Issues under Internal Revenue Code Section 415 (limits on
annual additions) may arise if limit is reached because of prior
contributions for the year
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Alternatives to disposition of unallocated
shares
• Forgiveness of all or part of debt and allocation
of shares to participants
• Surrender of unallocated shares at deal price,
but not less than fair market value, in exchange
for cancellation of debt (concern if ESOP owns
less than 100%)
• Substitution of buyer stock for company stock
and continuation of ESOP (extremely rare)
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What issues should be considered postclosing?
• Disposition of ESOP and plan assets
– Escrows and contingent assets
– Stock of acquiring corporation
– Spin off or transfer to newly formed corporation
• Monitor and enforce reps, warranties,
contingencies, indemnifications, etc…
• Find a job (the party is over)
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Allison T. Wilkerson K&L Gates, LLP
1717 Main Street, Ste 2800
Dallas, TX 75201
214.939.6282
[email protected]
Allison Wilkerson joined the Dallas office of K&L Gates as a Senior Associate in 2011. Over the course of her ten year career, Ms. Wilkerson has focused her practice in the area of ERISA with respect to employee benefits including qualified plans, non‐qualified plans, and executive and deferred compensation arrangements. Ms. Wilkerson advises employers in the design, implementation, and administration of tax qualified and nonqualified retirement plans and commonly represents clients before the Internal Revenue Service and the Department of Labor in audit and correction matters. Ms. Wilkerson has extensive experience in advising employers with respect to issues raised in connection with corporate mergers, acquisitions and divestitures as they relate to the various benefit plans maintained by the affected corporate entity or entities and also has extensive experience in employee stock ownership plans (ESOP). She has been involved in numerous ESOP transactions including leveraged buy‐outs, mergers, acquisitions, and the structuring and financing of ESOPs using private equity and has represented both companies and fiduciaries in the course of such transactions. Ms. Wilkerson also has an executive compensation practice that focuses on counseling clients regarding the compensation, benefits and severance of directors, executive officers and other employees. Ms. Wilkerson has worked with multiple forms of executive compensation and benefit plans, including the design and administration of stock plans, incentive plans, and nonqualified deferred compensation arrangements.
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Stephen D. Smith Krieg DeVault LLP
One Indiana Square | Suite 2800
Indianapolis, IN 46204‐2079
Phone: 317‐238‐6218
[email protected]
Since 1984, Mr. Smith has dedicated his private law practice primarily to employee stock ownership plans (“ESOPs”), structuring ESOP transactions and designing equity and non‐equity based executive compensation programs. Mr. Smith has structured over 300 ESOP transactions for public and private companies throughout the U.S. and is Chairman of the firm’s ESOP Practice Group. He is the Chairman of the ESOP Association Interdisciplinary Advisory Committee on Fiduciary Issues. Mr. Smith was directly involved in drafting the legislation that allowed S corporations to sponsor ESOPs. In 1984, he structured the first ESOP to be approved by the Federal Reserve as a registered bank holding company; and, in 1998, he structured the first S corporation ESOP. He is a partner with the law firm of Krieg DeVault LLP. He holds AB and JD degrees from Indiana University and an LLM in Taxation from Georgetown University Law Center. Mr. Smith served on active and reserve duty with the U.S. Air Force as a Judge Advocate; he retired with the rank of Colonel.
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Richard C. Mapp III Kaufman & Canoles, P.C.
150 W. Main Street, Suite 2100
Norfolk, VA 23510‐1665
(757) 624.3285
[email protected] Rick Mapp is the Chairman of the Employee Benefits, ESOPs & Executive Compensation Practice Group at Kaufman & Canoles, P.C. and is also a member of the Mergers, Acquisitions & Strategic Alliances Group. Rick is also the President of Equity Strategies, LLC, a consulting subsidiary of Kaufman & Canoles, established to provide ESOP Feasibility Studies and other services related to ESOP succession planning.
Rick’s employee benefits practice includes plan design, leveraged employee and/or management buy‐outs, business succession planning, executive compensation, banking and finance, and tax planning.
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