EP11 - Pearl Harbor - DOL invasion for an ESOP transaction with redemption versus sale

Can you believe it? It's like already March in 2021. We are cranking through the year and hopefully that's good news for everybody. And as we think about the future in 2021, I'm excited about what we have planned on the ESOP Guy podcast. And if you have been following us, I wanted to say thank you, um, as we go through this journey to an ESOP together. And the podcast for those that are that are tuning in for the first time has really been designed and produced to try to help individuals that are thinking they might want to incorporate some type of employee stock ownership plan, either in their succession or exit plan of their company. There's a lot of ways to use an employee stock ownership plan. In some cases, it's really a good idea, you know, even just from a growth strategy standpoint. So with that, there's a lot to know and, and one of the nice things about the podcast is it provides episodes to just look at compartmentally different types of topics and you'll, you'll find all those as well as a bunch of different interviews on our website at journey to an ESOP.com. So again, thank you for joining us today and we're going to start off with this. December 41 A date which will live In infamy The United States of America was suddenly and deliberately attacked. By the Empire of Japan. Yes, so the topic, the title of the topic today is Pearl Harbor, Be Prepared for the Invasion of the Department of Labor, Using redemption versus sale. So this is a, this is basically going to help understand first off, we're going to talk a little bit about the the way the Department of Labor functions and why some, in some cases when you start looking at history. Um, that you might be alarmed by, hey, the Department of Labor might review the transaction and might find an issue with the way the transaction was structured. And in some cases, that was definitely warranted. And in other cases, they're, they're looking at all types of situations. So there's a, there's a sense now with putting an ESOP transaction together that could be Something that you're a little um alarmed by or maybe even concerned by. So this, this episode's gonna really focus in on, on that issue and then the, the topic of what is a redemption versus a sale of to an ESOP. I also wanted to mention before we get started, the ESOP Guy live webinar series is kicking off March 31st. So if you have an interest in that, I can go to our website at journey to an ESOP.com and you can register. I'm finding that um and as we start the process of the first webinar, I'm finding there are already questions coming in. Um, so it's nice to be able to do a podcast, but it's also very nice to be able to have an opportunity to engage with folks on a live webinar. So be looking for that if that's something you're interested in, please register. There will be future series or future topics as we go, but I'm excited to do that in conjunction with the podcast. As always, if you like what you hear, please subscribe to the podcast. If you think it might be helpful for somebody that you know that's going through this process, please share it with them. And if you have the ability, go ahead and rate and review the podcast. I think it's very helpful for people to understand, you know, what's out there for them in terms of an employee stock ownership plan. So with that, I wanted to kick off with this is just kind of the history of what I think is such a good movie. In in a lot of ways, what I like about it is just it gives us the, you know, the history that I think all Americans need to remember, and I think all people do really. And I love, I love movies about historical fiction because it just helps us to think about what, what really does happen and helps us to remember things that are really important. Pearl Harbor is a US naval base near Honolulu, Hawaii and This was the scene of a devastating surprise attack by Japanese forces on December 7, 1941. Just before 8 a.m. on that Sunday morning, hundreds of Japanese fighter planes descended on the base where they managed to destroy or damage nearly 20 American naval vessels, including e8 battleships and over 300 airplanes. More than 2400 Americans died in the attack, including civilians and another 1000 people were wounded. The day after the assault, President Franklin D. Roosevelt asked Congress to declare war. So all of this, as we said, makes, you know, for a good movie, right, because there's so much going on in this movie itself is another Ben Affleck movie. Um, again, I'm not trying to promote Ben Affleck or anything, but I did another podcast on Accountability, the Accountant, which I do think was a, it was a really good Ben Affleck movie. Um, I think this movie overall is pretty OK. I think it's, it's got, you know, a lot of the different parts and pieces that you would, you'd want to watch as a movie. And, but I think the most part, as I mentioned, I think it really does help us as Americans to think about the history and I think we need to look at, you know, these kind of things when we think about it, you know, as a country, what is important is that we will always have some type of enemy and, and that's just the way history is, right? But we need as we pull together, work together to avoid war at all costs, I think we also always have to be prepared to fight when it's, when it's necessary. And the key to Pearl Harbor and as it transitions into my topic is really. They, we weren't ready. And it is one of those great American history tragedies. We just weren't ready for, um, what was going to happen and, and the plan itself that that the Japanese have wasn't, you know, just brilliant plan. It was bold, and we never thought, I think at that time people, they would come and attack us because maybe we were just too proud, but The key is, is being, being ready for what's coming. And as I, as I connect the dot there, the dots to an ESOP transaction, one aspect, as I mentioned, of putting an ESOP transaction together is the risk of the Department of Labor. And if I want to be dramatic about it, the risk of a department of labor invasion, which just means hey they're they're coming after you. Is someone going to get in trouble for this deal? You know, who's that somebody? I mean, most of the time when we say that, who is that somebody we're going to always go ahead and point the finger to the transaction trustee, um, who's the primary fiduciary in an ESOP transaction. And what are they getting in trouble for? Well, the DOL is going to find if they're going to find that the company In the transaction sold for too much. This is primarily what they would be in trouble for is they, they, as the trustee purchased the company on behalf of the ESOP and they potentially purchased it um at a higher price than they should have. So they have overpaid for the company. And so some of the cases that I threw, I'm going to throw out to you just as As background and history on this is in 2010. In Acosta versus Vinoski, the US District Court for the Western District of Virginia, um, awarded the Century Equipment Erectors Inc. employee stock ownership plan $6.5 million for the ESOP's overpayment for the funding of shareholders, 52% interest. The selling shareholders and the ESOP trustee were held jointly and severally liable. So, not great news, once you've put your ESOP deal together and then you're going back and having to be assessed, um, those types of penalties. In 2017, the US Department of Labor and First Bankers Trust settled ESOP lawsuit and they agreed to a $15.75 million recovery um for the ESOP. So in this case, First Bankers Trust Services um was found as the trustee to be liable to pay $15.75 million to the plans and reform its procedures for handling ESOP transactions. The Department of Labor um filed suit against FBTS in 2012, um, and the Southern District of New York and District of New Jersey courts, um, both found them to be, um, You know, needing to be paying the $8 million to the ESOP plan for one ESOP, and then $6.6 million to another Moran ESOP, and another $1.1 million to the Remud ESOP. So, Again, what's happening there is they, they basically put together the transaction and the uh the courts found that the transaction was being, was, was not an adequate consideration. Um, it was over fair market value and it was overpaying. Um, in May of 2020, just last year, the Secretary of Labor reached an agreement with Wilmington Trust, requiring it to pay around pay combined $80 million to 21 employee stock ownership plans. For which it served as trustee and an $8 million.08 million dollars to the government. Wilmington Trust has also agreed to reimburse sponsors of the ESOPs for legal costs and expenses advanced in connection with the Department of Labor's investigations and litigation. So these are, these are kind of scary things. And as I mentioned before, there's obviously the trustee is wrapped up in it, um, the, as a fiduciary, the selling shareholder can be wrapped up in it, and the fines and the penalties are, are pretty large. So, You know, and I, and I wanted to kind of stop and say the, the point of this podcast was to really, you know, throw out those, those cases and, you know, think about that from the standpoint. If it's, if it's a, an issue that you're thinking about, Hey, I don't really want to have a problem with the Department of Labor, so I don't want to mess with an ESOP. Um, I don't want to, I do not want to, you know, throw that out for that purpose. I just want you to be aware that those are things that have happened in the, in the, in the past, and that they're real issues. And there there are definitely ways and thoughts to to structure the transaction. Um, one of the things I wanted to cover as well is in an article that was entitled Recent Decisions Cast Doubt on Stock Drops as a basis to state a claim against ESOP trustee. The article really is in summary, pointing out how as an ESOP, Complaint happens as a plaintiff comes and says, hey, we're, we're not happy with, with the way that ESOP was structured. Um, how the courts can kind of look at this and shift what we were going to call the burden over to um the trustee. So in this case, the plaintiff adequately pleads that an ESOP fiduciary paid more than adequate consideration for the company stock. And We, we look at the specifics of it, um. What's happening is, is that there is a, this idea that the plaintiff can say, hey, I'm, I'm not happy with this, the way this is going, and suddenly instead of proving it, the burden completely shifts to the trustee. So, um, this happened in a recent case from the district court in Eastern District of North Carolina in a case called Lee versus Argent Trust Company. Uh, the Eastern District of North Carolina recently came to the conclusion that that it badly asserted that an ESOP overpaid for the employees stuck, and it does not shift the obligation to the ESOP fiduciary to prove that the plan didn't pay more than adequate consideration. So I think this is kind of in favor of, you know, just having anybody raise their hands and say, hey, we are, um, you know, we're, we're damaged here, we have an issue here, and then suddenly the trustee has to Go fight um and prove that they didn't um actually do more than adequate consideration. So, So if you look at like some of these cases, it's like, definitely there was an issue, I think the Department of Labor, you know, as again warranted to go look at the issue and found him guilty. In other cases, as they brought him up. I think the key is, is that there's, there's definitely more more case precedents about thinking about how um the burden itself is going to be, should be. That it needs to be proven, but at the same time, it does make us a little uneasy when we start thinking about, wow, that's a lot of potential litigation and all these different things happen. Leverage transactions, you know, for, for ESOPs really means what's happening is you're, you're buying, uh, it's being purchased with debt. So there's an existing owner who is selling their stock over and it needs to be sold under ERISA, um, under adequate consideration. So ERISA. Um, Section 318 defines adequate consideration with respect to a security for which there is no generally recognized market as the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with the regulations, so. Adequate consideration as defined as that is really, is really just the fair market value. So if we start thinking about what the trustee's role here is, it is to, um, when you enter into this stage of an ESOP transaction, what's happening for a leverage transaction is the trustee has the fiduciary responsibility to hire the right valuation firm. And I mean, right, I mean somebody that is experienced at ESOPs. Experience within the industry of their what they're valuing to determine what they believe is the real fair market value so that an adequate consideration can be offered and negotiated in a real transaction. And so, I think as long as that is followed, there's not like major issues, but I think there also is a sense of, of hesitancy sometimes. And so how do, how do you look at that? And so I'm going to also then borrow an article that was written by Harvey Katz and it's entitled The Redemption. Distribution transaction, a new paradigm for risk-free ESOP transactions. So, so as in summary, the article is really about how could, could you structure an EOP transaction to have say less risk of the DOL um coming after the the trustee and other issues with the selling shareholders. So the concept of this is that uh the ESOP fiduciary risk when it comes to having the Department of Labor, um come and investigate the trustee and other fiduciaries. Um, they have, they, they have the um the responsibility to come and look at the due diligence and really understand what type, what type of negotiations happened. And to address the issue as they, as they, as we look at it. There is a technique instructuring an ESOP transaction that utilizes corporate redemptions, um, which will basically are the company redeeming the stock prior to or in advance of the ESOP sale. So let's look at an example. Um, for instance, you have a company that's selling their business for $20 million and they're looking at a 100% ESOP transaction, which just means they're, they're selling 100% of the stock. In this case, the ESOP is borrowing the entire $20 million from the company, the $20 million is then repaid through company contributions to the ESOP. So as the principal of the loan is repaid, then the shares are released from the ESOP and contributed to the participants, i.e. the employees or specifically the employees. Contributions to ESOP are limited by the 25% 404 rule um in the internal revenue code. So that just means as your whole payroll is structured, the amount of the payroll, we can only contribute on an annual basis up to 25% of the total payroll. And so there's There's a lot there, we've done 404 podcast before, but just, that's the limitation. So as Harvey points out, you know, however, the transaction could be structured with redemption. So prior to the ESOP transaction, say $15 million of this of the $20 million valuation is redeemed by the company, and then the ESAP could purchase the remaining $5 million. So what that does is it shifts the bulk of the redemption or the bulk of the sale over to the $15 million of the $20 million and then we have a much smaller ESOP sale. And then he kind of goes and points out, which I think is interesting, is that the redemption then could, um, I don't mean interesting, I think it's, it's really important in, in terms of understanding of the way that this might actually reduce the risk of a transaction. The redemption then could include 99.9% of the stock, and the remaining portion could be then an EAP purchase. And so what this would do is virtually eliminate the sale of the, to the ESOP entirely. Um, as a question of the Department of Labor based on potentially overvaluing the shares, because there's technically no ESOP sale. In this case, the shares would be contributed to ESOP on behalf of the company. Um, this also then creates a transaction that is not leveraged, having no acquisition loan. So this really provides one less thing that the Department of Labor could evaluate. From the article, Mr. Katz points out that this will create an issue of having all of the shares allocated on day one, therefore, having no shares to allocate to participating employees who become eligible in subsequent years. So that's an issue. And he really kind of looks at that and he says, OK, now, but what you could do to solve this issue is that the company could then contribute new treasury shares to the ESOP in subsequent years or later down the road. And that this would be these new shares would be coordinated in time correctly with the payments that are happening with the original redemption note and balances. Um, this, this would minimize the potential swings in value. So if the company just dumped a bunch of new, a bunch of new stock into the basket, then that would basically dilute the other value and we'd have, we have a valuation issue. So, um, so I think that's a really interesting point. And the idea behind this is that really understanding the idea of what a redemption is versus a sale is important. And getting into the complexities of this, and I think we're we're just kind of scratching the surface in this topic, is to really understand that, you know, as we go back to the very beginning of what we started talking about, um, these structures and these types of transactions, when you're employing, um, advisors that are experienced with these types of, of different techniques. Definitely can mitigate the potential risk of what it might look like, you know, for maybe we didn't structure it correctly, um, but I want to kind of say this, and I, and I think what we're doing in this, in this redemption versus sale and really understanding the DOL's involvement is we're just scratching the surface, and I think there's going to be more to come on this issue. And there's, there's definitely a lot of, you know, questions, technical questions as we went through that summary pretty quickly. But I wanted to kind of over give you a quick overview as we start thinking about This transaction being the, you know, a a subject to a department of labor. You know, review and further down the road investigation to make sure everybody's done the right thing. And I don't want to just kind of pass that by so quickly and say, yeah, don't worry about it. We'll just structure redemption versus sale and you don't have to really worry about any of that. Potential issue because I think, for sure, even with the redemption and the stock sale, there's still, um, there's still issues related to how the company was valued. And there's definitely issues as they start to think about the Department of Labor will start to think about these two components being integrated as one. So I'm not, I don't want to kind of say in this podcast that hey, you're not going to have any risk if you structure it this way. There's always transaction risk for an ESOP. Um, but I also don't want to say, you know, on the other side, you know, that you shouldn't do it and you shouldn't even go into it because you're, you're, you know, you're afraid of the potential consequences. I think this brings us back to one of the points that we make with a lot of these episodes is that it's very important to find and, and make sure that you're using ESOP advisors that really understand. And one of the hopes that I have with this, with this podcast in general, Is that you will have enough information. To ask the right questions at the very beginning and throughout the process. And so the concept of having a redemption versus stock sale is something that I want you to be, um, you know, not obviously you don't have to be an expert at it, but I want you to be understanding what that is, so you can ask the right questions and maybe structure, hopefully structure your ESOP where you don't have, you know, any issues down the road. Um, I think the other side of this is thinking about what your business is worth. And understanding that and uh an ESOP transaction is going to be negotiated at fair market value. And fair market value, when we think about it as a valuation person, is not a strategic valuation. It's not a multiple, uh, in, you know, within your industry that is in excess of what your actual financial valuation is. Um, so it's very important that the work you do early on in the process. Establishes a fair market value concept around the actual financial data that your company has historically, and more importantly, also in the forecasted financials. And I think you got to spend a lot of time there upfront to feel like you've got a number that is within the range of of of of fair market value that it would that it would negotiate for. Um, I think that's so important because if you do that, And you really have the right people helping you with that process, then I think what you can kind of get comfortable with is, as long as that's there, then and you're in the right place with what you're trying to do with the structure of the ESOP. I don't think that there's a ton of, of issues and anxiety related to this concept of structuring with this technique. Um, I think the technique's important to understand, but I think the bigger picture is understanding that you're, as you move into an ESOP transaction. You're gonna be best served by doing that upfront work and being very comfortable with what, what the real valuation should be. Um, so be, you know, looking at those, there are some episodes that I've done on business valuation that I think are very helpful if you go back and review some of those. That would really help you ask the right questions. If somebody actually do is doing an upfront valuation for you, I do want you to be prepared to ask questions about the valuation to make sure that you're, um, you're, they're working on it the right way and they're not overselling the ESOP potentially, um at a number that's, you know, higher than it it really should be. So I think that's kind of the main thing I want, I want you to be thinking about. You know, the issue related to Pearl Harbor and it just sticks out in my mind as they just weren't prepared and it was devastating. And I think when some look at some of these court cases, I would, I mean, I would imagine, you know, from a financial standpoint, it's it's absolutely devastating. um. Not just to not just to from a financial perspective, but I think one of the things that I always look at is the ESOP company in the future and how they might, you know, really try to envision what that looks like from a cultural standpoint. If something like this happened for the company itself, and there's a big lawsuit, what do you think that does to the employees' morale? What do you think that does to the, to the, the key management that's, that's been there and working so hard? I think it really does, um, You know, it's bigger than just a financial problem. It's, it's more about the value of that ESOP going forward, that the the people that are there and committed to the future of that ESOP company. So, so I point that out because I think sometimes when we think about, you know, the big, you know, lawsuits and all the money, we kind of forget about the impact that these kind of things have, you know, have on the employees. And that's why I think it's so important to As you're thinking about your journey to an ESOP, you really think about and get comfortable with what you think that the true value is going to be. Um, I can't tell you, I think I can't honestly, the evaluation piece for me, um, is so critical and foundational to all the steps that are going to happen. So that's why for, for what I do in the ESOP process that I have, I really do stop and do a lot of work on the upfront part of that to make sure. That the client fully understands not just what the numbers are, but why the numbers are we, why we put them together the certain way we do, and really what's behind that forecast, I think you can't spend enough time there really understanding that because that is going to be the basis of of really the the rest of the transaction. So with all of that, I wanted to say thank you so much for listening today. Um, as I mentioned, we are kicking off our ESOP guideline webinar on March 31st, so please check that out. Go to our website at journey to an ESOP.com. Um, if you can rate and review the podcast, if you think it's um helpful for others, please subscribe and share it with a friend. We will look forward to our next step on this journey. Thank you