Tag Archives: employee stock ownership plan

The Great Recession And My Business

For many closely-held and family business owners, 2008 and 2009 was a stressful period. The volatile market followed by the Great Recession often produced

  • a contraction of business revenue;
  • the loss of profitability;
  • the reduction in value of their companies;
  • the aggressive and often not rapid enough implementation of business and personal cost-cutting measures;
  • the layoffs of far more employees than these companies imagined might be necessary;
  • the reduction of personal asset values;
  • the reduction of owner pay and employee pay levels;
  • the liquidating of owner personal assets to capitalize the business;
  • the development of tenuous relations with their banks;
  • a need to reinvent their business offerings in the marketplace; and,
  • the concern about being able to meet their future financial goals.

Plus, the stress of all the previous mentioned events produced the most burdensome time of our business and personal lives. I, in fact, can say there were several occasions in 2009 when I called to reach a business owner client mid-workday to find that I reached them at home while they were nursing a stiff drink. To compound all this, while most baby boomers do not own businesses, most of our clients who own businesses are baby boomers, and the age in relation to retirement, personal savings, and lifestyle spend factors that make retirement a challenge for most baby boomers are often compounded for our business owners.

I had many a conversation with an owner who confided in me that they built their company, and would build its value again, but they were tired. Because the recession induced exhaustion, they felt that they only had the energy to build it one more time. As a result, they wanted to be very proactive and intentional about planning to maximize the business' value and minimize taxes upon their transition out of the business. It is in this regard that the development of a Business Transition Plan is of paramount importance. The development of a Business Transition Plan involves multiple steps:

  1. Identifying the owner's financial and timing objective for the transition out of the business.
  2. Assessing the business and personal resources available to help contribute to the owner's objectives.
  3. Developing and implementing strategies that will contribute to maximizing and protecting the value of the business.
  4. Evaluating the opportunities for ownership transition of the business to third parties.
  5. Evaluating the opportunities for ownership transition of the business to inside parties.
  6. Developing business continuity measures to protect the business and the owner's family from the loss of a key owner or employee.
  7. Developing a post-transition plan for the owner that aligns with their Legacy objectives, including lifestyle objectives, estate planning, philanthropy and family relationship enjoyment.

Let's look at each of these in greater detail.

Identifying the owner's financial and timing objectives for the transition out of the business: For most business owners, the transition out of their business will be the single, most significant, financial event of their life. Identifying when and how much the owner desires is the first step in the planning process.

Assessing the business and personal resources available to help contribute to the owner's objectives: In order to evaluate if the owner will be able to meet his or her financial objectives, we believe we must start by developing a personal financial plan for the owner(s). This plan takes into account the reality that both business value upon transition and personal wealth accumulated during the operation of the business, combined, will together finance the lifestyle of the retiring owner. The more efficiently a person manages their non-business wealth prior to exiting the business, the less pressure it places on the value obtained from the business upon exiting.

Developing and implementing strategies that will contribute to maximizing and protecting the value of the business: In my many discussions with business owners, I often conclude that the owner believes their business is worth more than it really is. One of the most beneficial things a business owner can do to maximize and protect business value is operate in a constant state of planning and operations as if their business is “For Sale.” By evaluating all of your company's planning and operations in alignment with this premise, an owner can proactively manage the investment in their business. These planning and operational strategies often include:

  • Development of non-owner management.
  • Implementation of Buy-Sell Arrangements between owners helps protect owners, and their heirs, from the termination of employment, death, disability, or divorce of an owner. Though not every risk in a business can be insured for, death and disability can and often should have insurance policies implemented to finance the buy-sell.
  • Business Dashboard Metrics of sales and profitability.
  • Task functionality planning within the business.
  • Maintaining sufficient capitalization within the company for growth and banking purposes.
  • Maintaining appropriate amounts of key-person insurance on valuable company personnel to protect the company from the loss of an owner, or key-employee, and the financial burden that can result. Examples of this burden can include loss of revenue, reduction in profitability, cost of hiring a replacement, or default of or risk to credit facilities. In the midst of a crisis, I don't believe it's possible to have too much cash.
  • Formalizing appropriate compensation agreements with executive management, including golden-handcuff incentive compensation plans.
  • Maintaining a certain level of outside audits of the company's financials.
  • Recognizing when family should not be running the business and hiring professional outside management.
  • Consistently reviewing customer contracts to maintain the most favorable terms for your company.
  • Maximizing tax reduction planning opportunities on corporate profit, and at the time of a business ownership transition.

Evaluating the opportunities for ownership transition of the business to third parties: Many businesses are good candidates for a sale to a third party. These third parties often come in the form of a Strategic or Financial Buyer. The Strategic Buyer is often a competitor, or non-competitor that desires to enter your geographic market or industry, and sees your company as a lower cost or more rapid pathway to entry. The Financial Buyer typically comes in the form of a private equity group that owns another company that, when combined with some aspect of your company's offering or value, can acquire or joint venture with your company's offering to multiply the value of both companies within the private equity group's portfolio.

Either of these alternatives can produce an excellent financial transition windfall to a selling business owner, assuming the selling owner's company is clean. When an acquirer performs its due diligence, if it finds that the company hasn't been operationally managing itself in a professional manner as mentioned, hasn't applied consistent accounting principles, doesn't have a deep management bench, or depends upon the owners for ongoing revenue or profitability, the value it will pay in a transaction plummets.

Evaluating the opportunities for ownership transition of the business to inside parties: Whether your transition intentions are to transfer ownership to heirs, key employees, or the employees as a whole through an Employee Stock Ownership Plan (ESOP), assessing the skills and leadership capabilities of your successors is as important as the development of your ownership transition plan.

A successful transition plan requires the implementation of both Leadership Succession Planning and Ownership Transition Planning. One without the other greatly increases the potential for a failed transition. Once both have been designed, it is then important to evaluate what ongoing role the current owners will maintain through the transition, and the timetable of the transition.

Unlike a 3rd party sale, with an internal transition, the owner's gradual departure often helps facilitate the smoothest transition of Leadership Succession, while the owner can ease into retirement with the benefit of continuing to receive compensation during the transition, distributions of profits, implement gifting strategies, receive seller-financed note payments, or benefit from other strategies, thus lightening the burden on the owner's personal financial assets post departure.

Developing business continuity measures to protect the business and the owner's family from the loss of a key owner or employee: Despite the implementation of intentional planning, life can bring surprises. The premature death of an owner or key-employee, a disability or incapacity, the recruitment of a key employee by a competitor, can all derail the good planning, revenue stability, or corporate profitability.

Every good transition plan should address the need for Buy-Sell Agreements to protect owner personal finances, cash out the family of key-employee minority owners, permit the next generation to purchase the company from the previous owner at its current value before it grows further, reap the benefit of any Step-Up in Basis deceased owner's estates receive at the time of death, and benefit from the income and estate tax-free liquidity that properly designed and owned life insurance policies can provide the business and its family owners.

This planning can also present an excellent opportunity to utilize life insurance liquidity to fund the buyout of next generation family heirs who may not desire to stay in the family business, but otherwise the business might not have the funds to initiate these realignments of ownership.

Developing a post-transition plan for the owner that provides for their post exit Income and Wealth Management needs, and aligns with their Legacy objectives, including lifestyle objectives, estate planning, philanthropy and family relationship enjoyment: For many owners, their lifestyle, hobbies, net worth, and self-esteem is wrapped up in the business. The transition out of the business can be a stressful one.

Many of our clients find this transition to be an opportunity to develop a new personal life mission statement, having experienced great success in life, now focusing on what they desire their Legacy to be. This Legacy planning may involve an increased participation in philanthropy, spending more time with family, possibly even stepping into a new “missional” career. This change in life focus is only possible if post retirement Wealth Management provides for ongoing stable income, which we believe is more important in creating financial independence than a client's net worth.

However, the long-term potential threat of inflation, current low interest rates, increasing U.S. Federal debt, deficit spending and stimulus spending can present major obstacles for the retiree to generate sufficient income when developing a “traditional” post-retirement wealth portfolio. It is for this reason that we approach personal financial planning from a “non-traditional” perspective as we evaluate and recommend investment options beyond stocks, bonds, mutual funds and ETFs and also focus on the tax-efficiency of Wealth Management as it is not “how much you make,” as much as it is “how much you keep.”

An Overview of Audits, Lawsuits, And Insurance Issues For Internal ESOP Trustees

There are two primary areas of concern for Employee Stock Ownership Plan (ESOP) fiduciaries:

  • Department of Labor (DOL) investigations and enforcement actions; and
  • Civil litigation

The Employee Retirement Income Security Act of 1974, as amended (ERISA) provides that each plan must have two types of fiduciaries. Each plan must have a trustee for the plan’s assets and each plan must have an administrator. The administrator is often referred to as the plan administrator and may be the committee appointed by the company or may be the company itself if the employer hasn’t appointed a committee or individual to serve this function. Some of our comments below provide some insight into who should be serving in these capacities and how they should comport themselves to minimize exposure in these areas.

Department of Labor (DOL) Investigations And Enforcement Actions
Contrary to a common misperception, the DOL does not “audit” retirement plans. The IRS audits plans. The DOL investigates plans. This distinction is important because a DOL investigation is the front line action for the DOL’s regional offices of its Employee Benefits Security Administration (EBSA). The DOL’s regional offices investigate plans to determine whether there are ERISA violations. In brief, the DOL:

  • Can compel compliance with the statute to cause ESOP fiduciaries to correct fiduciary breaches, prohibited transactions, or to improve their plan operations to prevent potential problems.
  • Does not unilaterally “impose” penalties for noncompliance, such as the IRS may impose taxes, penalties and interest for Internal Revenue Code violations.
  • Derives its ultimate enforcement ability from litigation it may bring to enforce ERISA provisions. In such actions, the DOL is represented by the Department of Justice Office of the Solicitor (Solicitor). After investigations have closed without a satisfactory result in the DOL’s view, the Solicitor’s regional office in the given DOL region will be called upon to represent the DOL in litigation.

Although litigation may be brought to enforce the provisions of ERISA, the DOL looks for or demands voluntary compliance in the overwhelming majority of situations. In fact, only a limited number of cases are referred to the Solicitor’s office each year. However, the DOL may request assistance from the Solicitor’s office where certain legal issues are involved in an investigation or where the Regional Director wishes to negotiate forcefully from a posture that suggests litigation may be imminent if the DOL does not achieve the results it seeks.

Handling DOL Investigations
All trustees and plan administrators should be aware that DOL investigations are not a certainty, but may result from either a complaint filed by a plan participant or as a result of DOL initiatives. If an investigation is opened involving your plan, it is important to understand the DOL’s procedures and their “script” for conducting the investigation. The EBSA manual for handling investigations is available on-line via the DOL’s website. Reviewing the manual will help fiduciaries understand the objectives and tenor of investigations as well as a sequence of steps that the investigators follow to complete their review and interact with plan representatives. Even though the uncertainty of an investigation can be maddening, it’s important for fiduciaries to do what they can to manage the process and provide themselves a feeling of understanding, if not control, over the process. Being proactive and being prepared helps plan fiduciaries assume the posture that their performance is complete. The potential next steps in the investigation are then more understandable, if not predictable. We advise our clients to push as hard as they can to stay on top of the DOL’s process and ensure that the investigation doesn’t languish.

“We’re From The Government And We’re Here To Help”
Communications and correspondence with the DOL should be cordial and cooperative. A confrontational approach to an investigation does not facilitate the process. There are a handful of things that you should keep in mind, however:

  • Document Requests. Generally, what they want, they get. The DOL is entitled to get anything they want from plan fiduciaries or other related parties or service providers regarding the plan’s operation. The DOL has the ability to issue a “desk subpoena” to compel the production of documents without seeking a subpoena from a court. It is one of only a few federal agencies with this type of authority. It is very difficult, if not impossible, to prevent documents from being produced. We recommend responding to the DOL’s document request in a thorough, complete and organized fashion. Provide everything, if at all possible, all at once. Index, organize and retain duplicates of everything sent to the DOL to ensure that there are no issues of nondisclosure.
  • Fiduciary Communication. Keep in mind that there is generally no attorney/client privilege between an ERISA plan fiduciary and the fiduciary’s attorney when a fiduciary is being advised on plan matters. As a result, all of your attorney correspondence can be obtained and must be produced for the DOL if it relates to plan advice. Advice your attorney may give the corporation or a nonfiduciary regarding plan matters may be protected. Also, advice given to a fiduciary by defense counsel may be privileged. Consult with your attorney as to what advice is provided to which party and for what purpose. It may be advisable for you either to have separate counsel or to have your counsel clearly demark their client’s files and engagement agreements (including conflict of interest disclosures) to keep fiduciary representation and advice separate from corporate or plan sponsor advice.
  • Past Actions And Transactions. Review these with counsel carefully in preparation for your interview. Since the investigation will likely deal with transactions that have happened years ago, and may have involved other individuals at the corporation or predecessor trustees, your recollection of the facts and the motivations will be hazy and will require re-examination. It is always important to understand what is contained in the documents that you produce for the DOL, since it will likely be the subject of a fiduciary interview later. More on this below.
  • Trustee Minutes And Records. The law does not specifically require trustees to keep minutes of meetings; however, they are very useful and desirable. Trustees will typically adopt resolutions in connection with plan transactions or significant administrative decisions, but perhaps not on a regular year in and year out basis. Don’t be surprised if you are asked for such documents in your interview and you are unable to produce them. This will not prevent the DOL, however, from asking what you did or what you intended in making decisions for the plan.

When The DOL Comes To Call — The Interview
In almost every investigation, the DOL will interview the plan fiduciaries. Expect the interview, be prepared. Have all of the documents you produced for the DOL present in the interview in an organized and indexed fashion. The DOL will ask open-ended questions seeking a narrative from you. Make the DOL ask specific questions so you are sure what they are asking and what they are asking about. The purpose for this advice is not to hide anything from the investigator. Rather, it ensures that the interview stays on track and that your time and effort in the process are focused and potentially minimized. If necessary, refer to the documents in the interview to see what they provide so that your responses aren’t based on vague recollections which might conflict with the documents and the written record of your prior decisions. Bear in mind that the DOL’s objective is to protect the best interests of the participants and beneficiaries. This is your role as fiduciary to the plan as well. Therefore, it’s best to keep in mind that you are on the same team as the DOL in this objective, even though you may not always agree with the details of their positions. We encourage you to have an attorney present during the interview. The EBSA manual specifically allows for a fiduciary’s attorney to be present. However, the investigators are instructed to withdraw from the interview if the attorney attempts to take over or control the interview.

DOL Voluntary Compliance Letter
At the close of the investigation, the DOL will issue a “voluntary compliance (VC) letter.” This VC letter contains the results of the investigation and the Regional Director’s position and findings. There should be no surprises as to what the letter contains. The letter usually asserts one of three conclusions. It may assert that the investigation is closed and no further action is being taken. It might assert that the DOL believes:

  • You “may” have violated certain provisions of ERISA, but at this time, the DOL is taking no further action.
  • The VC letter might assert that the DOL is of the opinion that you “have” violated certain provisions of ERISA and that certain corrective actions are required.

You should strive in the investigation to not receive this last form of letter. If items are discovered in the investigation that are not to the DOL’s liking, you should work with the DOL to ameliorate the issue. You may not see eye-to-eye 100% of the time with the investigator or the District Director, but all fiduciaries need to work out solutions that are in the best interests of participants. If such a letter is issued even after lengthy discussions, negotiations and attempts to resolve the issues, then you should engage counsel (if you haven’t already!) to evaluate whether or not the DOL is likely to refer the matter to litigation. It may be possible to resolve the situation even after receiving this letter, but further steps shouldn’t be taken without obtaining the advice of counsel. Often this letter is issued due to the fact that counsel has not been involved in the investigation and the fiduciaries have not understood the process or what the DOL’s objectives and intentions were. There should never be any surprises about what is being issued in a letter from the DOL, and, therefore, you should use counsel, as necessary, in the process to avoid any allegations of breach of duty.

Civil Litigation
There are generally three types of civil litigation that may be brought against you as a plan fiduciary:

  • Benefits claims
  • Fiduciary breach claims
  • Retaliation claims

Benefits Claims
These are the most common forms of confrontation with plan participants. Participants may file a claim with a plan administrator asserting an entitlement to benefits or requesting a clarification of their employee benefit status. DOL regulations require detailed benefit claim procedures to be stated in the plan documents and summary plan descriptions. In the event a claim is filed, the plan administrator should follow the plan’s claim procedures to the letter. The plan participant will also be required to follow the procedures to the letter if he wishes to file a claim in court if the dispute is not resolved in his favor. It is possible to have a provision in the plan’s benefit procedures requiring a plan participant to file a claim form in order to formally initiate and perfect his benefit claim. This helps avoid the issue of when and whether a participant has made a claim for benefits and when the time line for response and appeal begins and runs.

Handling The Benefit Claim
Plan administrators should provide claim forms and also should promptly respond to all document requests from the plan participant. If documents are not provided in a timely fashion (30 days), then penalties ultimately may be assessed against the plan administrator in the context of litigation. There is a list of participant available documents in the statute. This includes the plan document, summary plan description, annual report and any other instruments under which the plan is administered. You should seek advice from your counsel as to whether the ESOP’s appraisal report is available upon request to the participant. This may vary depending upon the federal circuit in which the plan and employer are located.

All responses to benefit claims should be in writing. The plan administrator should cite the time frame for its reply. If an extension of the response time is required, the plan administrator should notify the participant of the need for an extension of time. If the benefit is denied and the participant appeals, the plan administrator must engage in a “full and fair investigation” of the appeal. Ultimately, the plan administrator should issue a detailed written appeal decision which includes the relevant law and facts and terms of the plan under which the appeal is decided.

Legal v. Administrative Decisions
If the benefit claim ultimately proceeds to court, the court will view the plan administrator’s decision differently depending upon whether it is a plan interpretation or a legal decision that the court is reviewing. Plan interpretations are viewed by the courts as presumptively correct, unless the plan administrator made an “arbitrary and capricious” decision to deny the benefit. This presumption applies, as long as the plan specifies that the administrator has the absolute discretion to interpret the plan. Benefit decisions that are legal decisions will be reviewed “de novo” by the courts. No presumption is given to the plan administrator’s legal decisions. Finally, a modified level of deference is provided for plan administrators who are under a conflict of interest when they make the benefit decision. Note that some benefit claims will involve decisions of law and interpretive decisions. Be clear in your appeal decisions and consult with counsel regarding the basis for determination and the conclusions in the appeal.

What Is An Abuse Of Discretion?
A number of factors are taken into account by the courts in this regard. It is important for the plan administrator to demonstrate that there was a consistency with:

  • The terms of the plan
  • The past precedent of dealing with benefits for participants that are similarly situated
  • The applicable statutes and regulations

Overall, the thoroughness of the process that the plan administrator applies to the decision and the thoroughness and the detail of the appeal decision will be critical. It is also important that there is no evidence of bias or conflict of interest in the decision.

Fiduciary Breach Claims
Suits may be filed for fiduciary breaches by either a plan participant or the DOL. In these cases, there is no need for a plan participant to follow an administrative claims procedure prior to initiating litigation. However, as a practical matter, these types of claims are typically coupled with a benefit claim because a benefit denial will often be alleged to be a fiduciary breach. This is because a plan fiduciary is required to adhere to the terms of the plan document as a fundamental aspect of its duty of prudence. Historically these types of suits have required plan participants to sue on behalf of the entire plan, and not just to recover the benefits in their individual accounts. With the recent decision of the U.S. Supreme Court in LaRue, it is now possible for a participant to bring a suit, individually, to recover losses to his individual account.

Retaliation Claims
These claims are brought for interference with the exercise of the participant’s rights under ERISA. These claims typically are coupled with a wrongful termination suit because the participant is alleging that the reason for termination was because he either raised a complaint regarding a fiduciary’s behavior or regarding his rights under the plan or benefit entitlement. These claims are very similar to wrongful termination claims from the perspective of who carries the burden of proof and what facts will be looked at to determine whether the discharge was wrongful or was related to aspects of the participant’s ERISA rights.

Attorney’s Fees
The ability to recover attorney’s fees in ERISA litigation is an important issue to plaintiffs, as well as fiduciaries, in defense. For plaintiffs, this is important as very few attorneys will take an ERISA case on a contingency basis because the damages sought are the participant’s benefits in his account. There is no availability of punitive damages or other consequential damages. The federal courts apply a “five factor” test for determining whether to award attorney’s fees. There is a presumption in favor of a prevailing plaintiff that he should be awarded his attorney’s costs and fees. However, it is not necessary for a plaintiff to prevail on the merits to have his attorney’s fees awarded. The federal courts do not want to discourage plan participants from asserting his rights under the statute. In contrast, there is a great hesitation by the courts to award fees for the defense, even if the defense is successful on the merits. Even though there is not a multitude of attorneys who spend a significant amount of time litigating benefit claims or fiduciary breach actions against retirement plans and ESOPs, those attorneys who take these cases typically understand the likelihood of being awarded attorney’s fees, or not, in connection with a particular case. It is also possible for fees to be awarded on an interim basis as litigation progresses at critical points in the litigation.

Indemnification is the payment of a party’s costs or damages by another party that assumes the responsibility by the terms of its contract or agreement. Plan fiduciaries are typically provided indemnification by the plan or by the employer under the terms of the plan document. The plan or the corporation may fund the indemnification by purchasing director’s and officer’s insurance (D&O), or fiduciary insurance. It also is possible to simply fund the indemnification out of corporate assets. Note that there generally is a limit on indemnification in ESOP cases where funding the indemnity would damage the stock price of the corporation sponsoring the ESOP. Also keep in mind that if fiduciary insurance is purchased by the plan out of plan assets, the law requires that the insurance coverage gives the insurance company recourse against the fiduciary to recover damages resulting from the breach. Therefore, it is advantageous to have the corporation purchase the insurance coverage since this is not a required term of an insurance contract under ERISA.

Fiduciary insurance coverage and D&O policies should be carefully reviewed. Some D&O policies have gaps or “carve outs” that specifically exclude coverage for matters relating to an ERISA employee benefit plan. For these policies, a specific “rider” or additional policy must be purchased to provide the ERISA fiduciary coverage. This leads to the question of how much insurance coverage you should purchase to protect your plan fiduciaries. Also, when should you consider buying fiduciary coverage for your ESOP fiduciaries? Since coverage is typically most valued for covering the cost of the defense and not always for potential penalties resulting from the litigation, the amount of coverage may be a fraction of the ESOP’s overall stock value. However, the more complex the plan or transaction, the greater the policy limit that is desirable. Note that some policies will not pay for the actual plan losses or benefits that are payable to the plan participant.

An Ounce Of Prevention Is Worth …
Consider the following suggestions for proactive risk management:

  • Get It In Writing. Get any available answers to your technical questions or advice from your advisors in writing. Seek planning memos and written analyses of issues of fiduciary responsibility and liability for plan decisions and transaction decisions. Try to have your advisors and attorneys make clear: the unique situation, who bears the burden of the decisions, what the legal standards are for making the decisions, and what the process should be for reaching conclusions. Written guidance will help you better document the actions that you are taking.
  • Cross-Communications. Are your advisors, including your third party administrator (TPA), certified public account (CPA), corporate counsel, and ESOP counsel communicating with one another? In ESOP transactions and in ESOP planning situations, it is absolutely critical for all of your advisors to be in the loop on the advice being given. It must be clear which advisors are assuming responsibility for which issues. With specific acknowledgements among the advisors, a fiduciary client can help ensure that he is getting the right advice from the right professional. It is not unusual for a specific advisor to disclaim responsibility for advice as long as another advisor is reaching the conclusion and making the appropriate recommendations. Team communication will avoid gaps in your advice.
  • Documentation On Calculations. It is important, to have the particular advisor that is responsible for or controls the issue to provide the documentation for the rationale and conclusions that are being reached. The same is true for calculations that affect the administration of the plan. The CPA and the TPA should be in close communications so that the tax returns and the plan’s administration agree and are completely accurate. Finally, if there are tax positions that are being taken which may affect your income tax return, be sure that your attorney and CPA are identifying who is the “preparer” for purposes of that issue on the return. It is possible for your attorney to be considered a return preparer if the attorney’s advice is being relied upon for a reporting position on the return.

What To Do?
It is a challenge for plan fiduciaries to understand and minimize their risk from the government regulators and from conflicts that could result in civil litigation. The appropriate starting point is understanding the different categories and types of conflict situations and what issues are typically in dispute. Most importantly, fiduciaries should ensure that their risks are insured and their process for reaching conclusions are well thought out, well advised, and well documented. It is impossible to always be completely prepared. An acceptable level of exposure exists in all these areas. We don’t think that you should beware of these exposures. Rather, we advise that you be aware of what can be an important element of exposure in any of these areas in advance and be prepared.