Once Again, Strong Process and Substance Matters

There is not much love lost by the Department of Labor for ESOP transactions.  The skepticism, even antipathy, is somewhat justified.  Some ESOP transactions don’t pass the smell test (see my prior post:  ESOPs: Common Sense Required).

And yet, ESOP transactions continue.  Notwithstanding the bad deals, there are economic benefits to ESOP structured transactions.  Fortunately, however, ESOP fiduciaries now can operate with clearer direction from the Department of Labor.

At the beginning of the summer, the Department entered into a Settlement Agreement in Perez v. GreatBanc Trust Co with respect to an ESOP maintained by the Sierra Aluminum Company.  This Settlement Agreement afforded the DOL the opportunity to issue guidance which has the look and feel of regulations, without having to go through the long process of issuing regulations.

In short, DOL requires that the fiduciary be an active participant in an ESOP transaction.  The fiduciary must determine that financial projections are reasonable, take steps to assess the accuracy of financial data, review the selection and valuation process of the expert appraiser, and generally assure that a prudent process has been followed and documented.  This is far from a passive role.

At Harrison Fiduciary Group we have drafted a set of fiduciary policies and procedures which closely adhere to the terms of the GreatBanc settlement.   In general these procedures focus on the following:

  1. Valuation Advisor — review of qualifications, selection process, no conflicts of interest, analysis of valuation work-product;
  2. Financial Statements — reasonable reliance on financial statements;
  3. Fiduciary Process — written documentation of processes, and reliance upon valuation report; and
  4. Miscellaneous — Preservation of documents, purchase or sale of securities for fair market value (debt not to exceed fair market value of securities), consideration of a claw-back.

In light of the GreatBanc settlement and the general enforcement pressure being brought to bear by the DOL on these transactions, some institutional fiduciaries are exiting the ESOP marketplace.  They are unwilling to assume the risks highlighted by the Department and the Courts. This market disruption might cause concern for some service providers, but at HFG we view this as a significant opportunity.   Our competency and expertise as fiduciaries should give comfort to both plan sponsors and to the Department of Labor.  As is true for each of its fiduciary engagements,  HFG rigorously complies with its own policies and maintains contemporaneous written documentation of its process. ESOP engagements will fare no differently.

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Is it a Good Deal?

Employee Stock Ownership Plans (ESOPs) present an attractive financing tool and ownership structure for both publicly and privately held businesses.

ESOPs can be very complex.  There are many moving parts.

Lawyers, investment bankers, consultants and other advisors love complexity.  In fact, professionals often thrive on complexity.  Somehow complexity conveys an aura of expertise, and of course, expertise demands high fees.

However, the structuring of an ESOP and the decision-making process undertaken by the various stakeholders (plan sponsors, plan fiduciaries, advisors, etc.) should not overlook very simple questions:  “Is this a good deal?”  “Do the economics work?”.

In transactions of this nature, there is lots of pressure to “get the deal done.”  Pressure by selling shareholders and pressure by the bankers can all be significant.  But, it is a fiduciary’s job to ask the simple questions.

In Fish v. GreatBanc, a recent decision by the Seventh Circuit, the Court outlines what amounted to a bad business deal.  Although the precise issue decided by the Court focused on the application of the relevant statute of limitations, the underlying business deal was not pretty.

As noted by the Court, and repeated by other bloggers, Steve Rosenberg, What Happens to Company Owners Who Get Overaggressive When Selling out to an ESOP?, outsider advisors to the independent fiduciaries characterized the transaction as “the most aggressive deal structure in the history of ESOPs.”

Wow.  When an advisor puts that warning in writing it is best to pay attention.  (Remember, it will be part of the record if the deal heads south.)

While many lawyers have commented on the legal issues, I’d like to provide a practical perspective, as an Independent Fiduciary.

At the outset, it is important to note that “aggressive” –taken by itself — is not necessarily a negative or a bad thing.

Many “aggressive” investments may still be prudent. But, in the parlance of modern portfolio theory, an aggressive, or high-risk investment, must be compensated for by a higher rate of return.  High risk.  High Return.

In addition, the risk of an investment must be assessed in the context of the composition of an entire investment portfolio.  High risk investments must be balanced with lower risk investment so that the overall portfolio reflects an appropriate risk level.

ESOPs present a unique challenge when it comes to risk.  That is, the company stock held by the ESOP is the sole asset held by the plan (other than some cash).

In the context of Fish, once the deal was characterized as “aggressive”, it was then the fiduciary’s responsibility to dig in.  What gives rise to the nature of the aggressive nature of the deal?  Are there ways to mitigate the aggressiveness?  Can the plan be adequately compensated for the risk inherent in the transaction?

This analysis must be a collaborate effort, undertaken by the fiduciary, the plan sponsor, and the selling shareholders.  The analysis is not intended to kill the deal.  To the contrary, the analysis is designed to enhance the deal, to afford protections to everyone involved, not the least of whom are the plan participants who must get a fair deal.

ESOPs can be very compelling structures for all stakeholders:  owners, plans and plan sponsors.  However, it is the fiduciary’s responsibilities to make sure that the risks and rewards are prudently shared.

As an Independent Fiduciary, it is my job to exercise discretion as a “prudent expert”.  While prudence includes following various processes and procedures, it also demands me to ask, “Is this a good deal for the plan?”   Financial advisors and investment bankers, it is your job to persuade me that, in fact, it is a good deal.

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