EP27 - Interview with ESOP attorney Jason Ray from Dallas, TX

Welcome back. Thanks for tuning in. I'm the ESOP guy, and we are continuing on this journey to an ESOP. So this podcast was created to really help people that are thinking that they might want to consider an ESOP for their business. And if it is your first time joining us, welcome and thank you for joining. And there are multiple episodes of this podcast. If you go to journey to an ESOP.com, you will find those. Uh, the title today of this podcast is Interim Valuations during COVID-19. It is going to be really about the effects of the COVID crisis on ESOP companies as it relates to their year-end valuations. And to do that today, we are honored to have the privilege of interviewing Jason Rae. Jason is an ESOP attorney in the Dallas office of Morgan Lewis and Bacchus. Jason has over 20 years experience in implementing ESOPs, including seller financed ESOP implementation, as well as day to day consulting and other legal issues that arise quite often in the life of an ESOP company. Now Jason's firm has one of the largest ESOP practice groups in the country. They do ESOP litigation, corporate governance, as well as transactions. And they also have the largest, the largest employee benefit practice group in the country. So, Jason and his team come with a lot of experience. Jason, it's an honor to have you on the podcast today. I am delighted to be here, Phil. Thank you for having me. Great. So kind of jumping right in, Jason, um, when we're looking at the COVID crisis, what are you seeing, you know, on a day to day basis with existing ESOP companies really as far as issues go with managing through the the change in the economy? Yeah, well, that's a good question, Phil, and it's, it's really been all over the map. Um, we have some ESO clients that, uh, their, their business is considered an essential business. So, of course, they've been doing very well and uh haven't experienced any sort of cash flow concerns, but the, the bulk of our ESOP clients, unfortunately, Uh, like so many of the rest of the country are already feeling the effects of the COVID crisis, and um some of the issues that have been brought to mind, um. are dealing with how do we try to preserve our cash flow. And specifically uh for ESOP companies that have required diversification to be made this year or distributions that have to be made this year. Or, or even don't have to be made this year. Perhaps the company has set a precedent over the past years of just paying people out. Um, in the year following the year in which they terminate, even though they could wait longer to pay them out, they're dealing with communications issues to their employees about how to communicate. Hey, we're, we're kind of in a financial crisis already and um We, we may have to, uh, extend or delay your, your distribution, um, and, and, and also just contacting those who are eligible for diversification and asking them. Uh, are you sure you want to diversify this year? Um, uh, you don't have to diversify. Perhaps you can wait next year. So it's really trying to feel their way into a dark abyss that is unprecedented. It's really, it really is unprecedented. And I know some, some of them have gotten the PPP loan and you know, as a comment towards that, that have helped preserve some cash flow. But the key is, like you said, they, they have to try to maintain sustainability for the ease up for the, for the long term. And nobody can anticipate something like this happening. When you get down to the, um, you know, the issue here too, it's like, Uh, one of the things that as we're gonna, we're going to get into as we talk about it is the effect of this downturn on the company's uh valuation. And so finishing up the calendar year of 1231-19, nobody, nobody could anticipate what was going to happen in 2020. Um, when you do a evaluation, you know, you can't take into consideration, even if you're doing it in the middle of March or April, um, for 1231, 19, you can only really do the evaluation according to the numbers that you have in front of you. Um, so with that, you know, the issue is that a lot of these valuations for ESOP companies are going to have the potential to be overvalued. Um, from your perspective, can you explain the issues that really would arise or might arise from ESOP companies having now higher evaluations than they really are, um, currently valued at? Yes, uh, you, you're absolutely right, Phil, uh, unless an ESOC company is an essential type of business right now, more than likely, It's experienced a downturn in profits. I know that a lot of my non-essential business EO clients have certainly felt the effects of the COVID crisis. Um, and as you mentioned, a calendar year ESOPs, your evaluation can only take into consideration facts and circumstances that were known or knowable as of December 31, 2019. So the economic impact of the COVID crisis will not and cannot be reflected in the evaluation report that has already come out in 2020 or is about to come out for for a lot of our clients. So, therefore, the year in evaluation, of course, took into account financial projections that may not materialize this year. So that year in valuation that was performed for December 31, 2019. will be much higher than what as we now know, projections may have warranted. And realizing the importance of the need to preserve cash right now, as long as possible throughout the duration of the COVID crisis, many ESOP companies are considering having an interim evaluation performed for purposes of making distributions and diversifications that are due later this year. Yeah, we had, um, there's, you know, some ESOP companies along that front have, um, are also dealing with warrants that might mature this year and, you know, it's kind of the perfect storm because those warrants are gonna be valued at the 123119 number. And next thing you know, they're gonna, they're, you know, they're gonna be paying out at a much higher amount. And um it's just kind of Uh, exacerbates the, the, the issue of, of cash flow and, in those kind of situations. And not, I'm not sure if you're seeing that with your clients, but we've seen that as well as being an issue on, on that front. Yeah, you know, it's, uh, that's another good point you bring up. A lot of, um, our ESOP clients have. Um, uh, an executive, uh, incentive plan or management incentive plan in place that Provides for either stock appreciation rights or phantom stock awards or both. And um like the warrants, um, those awards are tied into this yearly ESOP valuation. And so to the extent that a payout of awards are are based on the most recent ESOP valuation, Um, doing an interim evaluation could also tie in any executive incentive plan or management incentive plan or warrants. Or any other deferred compensation plan that is tied to the stock valuation. and bases the value of the settlement of award payments. Of the most recent ESOP valuation. So kind of that, I mean, as we get into that, we can kind of really, I think we've really explained like that, here's the problem, guys, you have, you know, this bigger evaluation and you really are valued for less when you look at the numbers and the, the suggestion here is that you might wanna, you know, look at it, you know, the, the actually the solution behind the problem is, is getting an interim evaluation, you know, conducted, um, so that you can, um, you know, look at that from a realistic standpoint. So from You know, your perspective, um, can you kind of go into a little bit deeper? Why do you think getting an in evaluation would be a good idea for these types of ESOP companies that are dealing with this issue? Well, I think it's a good idea to at least uh contact the valuation firm. That does your yearly valuation and at the very least, if, if you think that Um, an updated valuation would reflect a vastly reduced value per share. It may be a good idea to at least have your valuation firm um delve into sort of a pro forma type of back of the envelope type of valuation is to give you. To give the company a rough idea of of of what's in front of them, um. And then use that as a basis to determine, well, yeah, I think an interim evaluation is certainly warranted, yes. If a uh uh an eyeball valuation. Uh, would reflect just maybe a slight difference right now, then I think the EO company has to really consider, well, do we want to do um an interim valuation. And deal with communications to participants and the price of evaluation, uh, but oftentimes, um, from my experience already, from what I've heard from ESOC companies is that an, an interim evaluation performed this year would reflect a significantly reduced price per share value. Yeah, so it sounds like a A solid way to maybe look at that that issue, and I, I think what you're saying too is. Having that relationship with your evaluation firm is important to talk through the idea and maybe even talking about, you know, uh what your numbers look like to see if it's gonna work. So as, as far as when I, when I take that concept and say, OK, now, like take it into a practical, uh, you know, approach to an ESOP company. When you look at their plan documents for an ESOP, is it OK then for the ESOP trustee just to order another evaluation, you know, mid-year because, um, you know, that's what they think is the best thing to do, um, or is there an issue with the way the plan documents are written, or do they need to really look at that as, as part of the um steps that they need to go through to make that decision? Yeah, and that's another great, great question, Phil. You certainly want to check the terms of the ESOP document and the trust document first. Um, if the documents already provide for an interim valuation to be performed. There's little or no issue at all in terms of having an interim evaluation performed. However, if the documents don't provide for an interim evaluation, it's, it's more of an issue. Uh, the reason being is that there's there's established case law out there, uh, that, that implicate protected benefits and raise issues of potential anti-cut back concerns, even though the IRS's position is that Any decrease in accrued benefits due to performing an inter valuation does not violate the anti- cutback provision of the code. There is case law out there that are premised on sort of a breach of a contractual obligation by the company. Um, and they, they state that when a participant, uh, has done all that they can do. To receive an expected accrued benefit and they don't get it specifically terminating employment and their and their value is set as of a certain valuation date. Uh, performing an interim evaluation date by virtue of amending the plan to do so is sort of a breach of a contractual obligation by the employer. So that's the reasoning for having concerns if your plan document, um, doesn't already provide. For an interim valuation to be performed. So let me just say it makes life a lot easier if your documents already provide for an interim valuation. That being said, however, if the documents don't already provide for an interim evaluation. And your ESO company is on life support or is about to be on life support. You just do all that you can to keep the doors open, including many that you saw to provide for an interim. Yeah, it's kind of like you're going to do, you're going to be doing the right thing, um, and by doing that, the, the one thing I would comment, and this is, this is what I love about this podcast is, you know, again, it's kind of designed for people that actually aren't ESOPs yet. Um, it's kind of like, now that we have this environment, you know, as, as we sit there and we, and we, you know, we're talking to people that may be creating ESOPs this year. Um, the best advice here at this point, you know, when you get into the legal issues that you have is certainly take note of this issue and make sure in your plan document that hasn't been created yet, but that will, that you make, you make it very clear that interim evaluations will be accepted and just so that you're. You know, the goal of this, of an ESOP company, uh, you know, whether it be the, the selling shareholders or the existing key management is that this is a sustainable um entity and has to be able to be flexible through downturns as well as, as, um, the things that are easier. So, so just that's a point of advice, that's what I like about this, this, um, this opportunity to kind of talk through issues. That we, that we get, um, we get into. Hey, I hate going through the legal issues when you have to, but you, in some cases, you're, you're just gonna have to really go through that from an attorney's standpoint. Um, and now, keeping with that, there's also this sense of fiduciary responsibility that kind of comes out of this conversation. So from your standpoint, Jason, who, who is actually, when we talk about fiduciary responsibility, who is making the decision to say we're going to do an interim evaluation? Can you get into that a little bit deeper? Yeah, and uh you'll need to again look at the plan documents to see who has that authority to choose and decide whether to have an interim valuation performed. Oftentimes, it is the plan administrator, which is either stated as the company or a separate committee. If it is the company, then it really is the members of the board who are the ERISA fiduciaries of the ESOP for certain purposes. Um, and the plan administrator is, is usually a named fiduciary, and that's a capitalized term under ERISA. Um, and, and your plan document will always have to say who the name fiduciary is, and 99% of the time, it's going to include the plan administrator. So, as a fiduciary of the ESOP, the plan administrator must discharge his duties with respect to the ESOP solely in the interest of plan participants and beneficiaries. And has to do so in a prudent manner and in accordance with the terms of the document. And that duty is found in ERISA Section 404A. Pursuant to Section 405A of each member of the board is jointly and severally liable for any breaches of the fiduciary duty. Um, in, in your right field, the decision to choose an interim evaluation. And choose The evaluation date is a fiduciary function. Uh, because the, the reasoning being is that function is found in ERISA. A Section 321 and it provides for three categories of fiduciary conduct. 1, it's administering the plan. 2, it's providing investment advice for a fee. And number 3, it's exercising discretion in managing the plan or with respect to the plan assets, choosing an interim choosing to do an interim evaluation and choosing an interim evaluation date, arguably fit under both number one, administering the plan and and uh number 3, exercising discretion. In managing the plan or with respect to the plan assets. So, it is a fiduciary responsibility, and it's a fiduciary decision. So, ERISA being a, a process statute, um, you'll definitely want to document, uh, your, your determination process of choosing to have an interim evaluation done. The decision to choose an interim evaluation. It is defensible in my opinion, because the plan administrator will be following the terms of the plan document. And is arguably acting prudently and solely in the best interest of all participants and beneficiaries. Including current and future participants, not just the former participants who are due a distribution this year. Uh, the reason for this is that planned fiduciaries owe a duty to the plan as a whole, and with that comes a duty of impartiality to all participants and beneficiaries, past, present, and future alike. For example, um, active participants. May question a planned administrator's decision and prudence at paying out former participants based on a valuation, the December 31, 2019 valuation. That is now known to be flawed and artificially inflated due to COVID-19. And these active participants could potentially um consider bringing class action against the plan administrator, which could be the company or a committee. A for breach of fiduciary duty. Um, so the plan administrator will want to carefully document the decision, uh, for, uh, having an interim evaluation done and document the date that it chooses, just back it up for reasons. Again, ERISA is a process statute. You don't always have to be right, but you have to document your decisions and your rational thinking. Um, for being, for being prudent. Right, which means you have to be, I mean, obviously there's a logical stepping process you go through and documenting the process. When you say plan administrator, is it, and this is just a a question what what you said, is it the is it typically the trustee that is the plan administrator of the plan that that makes the decision? No, no, it won't be the trustee, um, sometimes you're Your documents could say that the trustee could choose an evaluation date, and that's fine. It's, you know, the trustee's always going to be a fiduciary. The plan administrator is going to be either the company or a delegated individual or a committee that was established pursuant to board action, um, but it's, it's never going to be the trustee. Now, the trustee. We always have to approve uh the, the evaluation, including any interim evaluation and, and that being said, if you do an interim evaluation, um, the trustee doesn't necessarily have to approve it. Uh, they could look at the interim evaluation. And say no, we, we don't agree with that interim evaluation, uh, price. Uh, it's always going to be the trustee that that that approves that price per share value. Well, which, which makes it a little more difficult too, because, I mean, I don't know why they wouldn't approve it, but say they don't, and it's a lower value and then the 1231 19, and that creates another can of worms that has to be done. Yeah. One thing I'd I'd like to add about this, this whole interim evaluation, whether to do an evaluation or not to do an interim evaluation that ESOP companies need to keep in mind that arguably it's less risky to pay out former participants based on an interim valuation. Because legally, Um, whatever argument that they proffer, um, would be a benefits claim, and the former participants have to first exhaust their administrative remedies under the plan, the claims procedures protocol, uh, before they could bring a cause of action. Um, and that would always just be a cause of action that says, hey, you didn't give me what I was owed. Um, Current active participants could just bring a class action breach of fiduciary claim. So it's easier to defend against the former participants for a benefits claim and, and, and address them one by one as they come in rather than a breach of fiduciary class action. Well, which comes back to, I think, you know, from a practical standpoint for an existing ESOP company, it really does, it really is important for them to communicate really well. Through these types of, of downturns so that people as participants feel like they're being heard and being treated well and, and understand the process of, of, of what's happening so they're not um slighted in that sense, if you can. Um, so kind of just one last question on the plan administrator, just to make sure that the listener understands. So do the plan administrator actually, there, are they part of the board at all or are they outside of the board, just a company representative or a committee? If the company designates. Well, if, if the plan administrator is defined as the company, which a lot of plans do define the plan administrator as the company. Then it is the board and the individual members, um, could be jointly and severally liable for any breach of fiduciary. OK, cool. Great. Thanks for the clarity on that. Um, so going in like now the other practical question is, OK, I've decided to do it. As far as the costs go, because now I've already ordered one and paid for it. Um, is, if it is a full report, it will be like they ordered two reports, that'll be double the cost. Do you know if they can order a limited report for the trustee to feel confident or for the, as we talked about the plan administrator, to feel confident for the new amount that they're gonna be spending? Yeah, and that's, that's a question that I've been getting a lot from, from a lot of our ESOP companies that are considering doing an interim evaluation. The question is, well, we got this 1231-19 valuation that came in a week ago, and now we're, we're wanting to do an interim evaluation. Can we just get a breakdown letter? Um, that, uh, that we can rely on for the distributions and diversifications. And the a lot of times, a breakdown letter, of course, as you know, Phil, is is perfectly fine for a lot of um different transactions. Um, a lot of reasons, but for this particular issue, um, it's in my opinion, it's not going to work and a lot of these practitioners share my sentiment on that, um, that a full blown valuation will be needed for an interim evaluation. A limited report or a bring down report or a bring down letter. It really is done because it contemplates that not much has changed since the last valuation date, that since 1231-19, for instance. And our argument here is that a lot has changed a full blown report unfortunately will be warranted to defend your prudence and your reasons for for doing one. Yeah, that I think that's, that makes logical sense. And I think it's such a significant um issue, business issue anyway. So I think when you get a real significant issue, you're just going to have to Spend the money and do it the right way and not have, you know, real big question marks on what, what they did, especially when you think about the fiduciary component of this, that they did everything in their means, you know, reasonable means to make sure that they've handled it prudently. um Yeah, and, and a lot of our ESOP companies are, are looking at the cost of doing a full blown. Valuation, but it, it pales in comparison to the cost of the repurchase obligation for these distributions and diversifications. Um, so it's, you know, 99% of the time, your full blown valuation is right now, for a lot of our clients, it's gonna reflect a drastically reduced per share value. That um is, is going to trump any sort of cost of the evaluation to be performed. It's, it's just not even close. Right. Yeah, it's just gonna, it's just gonna make sense. So, um, kind of as we move to the closing here, what is your advice on the timing of ordering an interim evaluation, you know, because we're not really out of the storm or we're really not sure, you know, when we're going to be out of the storm. Yeah, and I think, well, of course, there's just so much uncertainty right now. I mean, we're almost done with half of the year. Um, the coronavirus is, is slowing down a little bit in in in most states, some states are not, it's not slowing down at all. Texas, where I'm at is being one of them. Um, so that it fosters continued uncertainty. And, and it's hard to predict when we're going to stabilize uh this year. So I think a lot of our companies are, are sort of taking a kind of a wait and see approach to see if this economy is gonna start stabilizing somewhat here soon. Um, but we are running out of daylight here. Um, so if an ESOP company has distributions and diversification due this year, I, I think it's a good idea for the ESOP company to at least contact its valuation firm. To see about timing of getting a full blown valuation done and what that, that's how long that's gonna take, um, choosing a date, of course, is critical and um I, I don't know if valuation firms or if it's gonna take them as long as it took to do the 1231-19 valuation. I just don't know. Um, I don't think it would, but that's, that's just my guess. But I think it is a good idea for the company to figure out, OK, if we, if we choose a date of June 30th, for example, we've got to get all the information to the evaluation firm that could take them two months to do a full blown valuation. So now we're at the end of August. And now you've got to redo your allocation reports, contact your GPA. Uh, get those allocation reports that could burn a month. So, um, now you're, you're certainly within the last 90 days of the year. And, you know, diversification, eligible participants, um, they need time, uh, you know, they need at least 90 days in an election period. So now you got to think about, OK, our diversification forms. And distribution forms, they're going to go out and now these folks are going to have. Uh, maybe 30 to 60 days to, to make a decision. Of based on an interim evaluation that they weren't expecting, um, Now you're gonna have to have that waiver language and your diversification forms and distribution forms. So, as you know, Phil, I mean, uh, A month, 60 days can go by very quick, and I think if, if an ESOP company is waiting to see what October is going to look like, I think it's gonna, it's gonna be very hard for them to get an interim valuation done, allocations done, notices sent out, forms sent out, so, um, it's. I think time is of the essence to make a decision. Yeah, so I'd agree, I'd agree with that completely. So as we kind of close out, I would just like to kind of final comments to say that as we look at this issue, and again, a lot of the listening audience is, they're not yet ESOPs, but take into consideration the planning side, um, with your adviser on these kind of issues and and sometimes people ask me questions about, you know, what happens with a downturn. Um, one particular issue here that's, that's gonna come out is how do you actually look at your forecast and when you're, when they're resubmitting their information for an interim evaluation, you know, how do you, how do you actually look at this downturn and, and for each company, they have to decide when they feel like, you know, what, whatever the, the blip is gonna be, if it's a blip or if it's a little bit more than a blip, you know, representing that in the forecast is gonna be important um to be thinking through, um, and, and that's a hard decision, so. Um, so from, from your perspective, Jason, any final comments? Um, you know, I, I think we're learning a lot of lessons through This pandemic, um, it just comes out of nowhere, but I think it really, um, has, has been a um Uh, a learning experience about For your, your perspective, the ESOP company, uh, on, on planning, drafting ESOP and And also for for ESO companies to really um try to forecast properly for the unexpected, which is, which is hard to do, but I think it's been a lesson learned because I've had ESO clients tell me, well, gosh, you know, this precedent I've set for paying people who terminated immediately, um, maybe now they're they're taking a second look at that and Relying on the internal revenue code provisions that pertain to ESOP distributions and saying, gosh, I think I You know, cash is king. I wish I had waited. Kind of save some cash for that. That's and that's, and that's a really for any business that's going through a downturn, that's going to be universally true. So just wanted to say thank you, Jason, for your time, your insight, um, from an ESOP attorney's perspective. I think given the the topic of interim evaluation is is really a good one and just listening to this whole time that we talked, I just, I know that there's some, some key aspects of for, for companies to really look at this and um and plan accordingly. Um, so with, uh with that, I wanted to kind of like to just say, you know, check out Jason's um firm's website. It's www. W.MorganLewis.com um to find out more about their firm and want to remind you, you know, with, if you like the podcast, please subscribe and, and share it with a friend. Have a great day and a safe day, and we will look forward to next time.