EP48 - To be or not to be - the choice to be an ESOP internal trustee

Good day everyone. This is the ESOP guy and we are on a journey to an ESOP. Wanted to start off this podcast today with this. Hi, how can I help you today? Hi, I can't seem to leave a wink for someone. OK, I'm looking at your profile. You left a lot of this stuff blank. Well, I haven't really been anywhere noteworthy or mentionable. Have you, have you done anything noteworthy, mentionable? We have ahead of us. So if you don't recognize that, that's an opening of a movie called The Secret Life of Walter Mitty. Today's podcast episode is going to be entitled The Risk of being an internal Trustee for an ESOP. So the question we're going to have and we're going to talk through the issues or risks related to what it means to be a trustee for the ESOP. Does it even make sense to have an internal trustee? Should you hire an independent trustee or an external trustee? So these are things that that come out when you are thinking about going through the process of becoming an ESOP company and it's a decision that you will need to think about and make and there's going to be pros and cons. So I'm excited to bring this podcast to you. If you like what you hear, please subscribe to the podcast and you might want to help a friend who's thinking about going through an ESOP and share it with them. Please, if you are on Apple Podcast, um, go ahead and rate and review the podcast. It's very helpful for others to consider this as a potential resource for them looking to get more information on ESOPs. So with that, I wanted to start off with to be or not to be. That is the question whether tis nobler in the mind to suffer the slings and arrows of outrageous fortune or to take arms against a sea of troubles and by opposing in them to die to sleep no more and by a sleep to say we end the heartache and the 1000 natural shocks that flesh is heir to, tis a consummation devoutly to be wished to be or not to be. That is the question today, whether, whether or not it is, this is going to be internal trustee versus external trustee. But the gist of that from Shakespeare is, is really about life and death. And, and I'm that kind of makes it a little more extreme than it needs to be. But when you get down to it, When you're choosing to do to become a trustee, there's all sorts of information out there and it can feel like you're making a life and death decision. And so I'm, I think this is going to be a very important podcast. So as we go into the beginning, I wanted to start off with that if you haven't seen this movie, Secret Life of Walter Mitty, it is absolutely my family's favorite movie. Starts off with this crazy scene where I started to play where he, right after the phone call, he goes and he jumps through a window of a building to save a dog for a woman that he really likes and comes out the hero. Then you find that he really was just daydreaming, and he has these crazy daydreams in the movie, um, even one invoking the issues related to Benjamin Button, who, which is another movie, um, and all of it is very hilarious. So, Walter Mitty really has to what he has to do is he has to connect to reality and finally choose to be in or to be out. And what I mean by that is, he's a highly risk averse person. He hates risk. And there are very strong reasons in the movie behind that. He's, he loses his father when he's young, uh, he has to go work for Papa John's. I mean, all these different things happen to him. And so because he hates risk, um, it's really difficult for him to make this decision in the movie. Um, but he feels compelled and what, what's compelling him is that he's done such a good job his whole career. But now, finally, there's this photo that um is sent over in a, in a, um, In a wallet, and then it's, and it gets stuck with this photo negative gets stuck. So he's got to make a decision to go find the, the photographer and in, in kind of like one of the, the, you know, coolest scenes in the movie, well, I don't wanna say coolest scenes because it was kind of a, a difficult decision that he made is he has to, um, you know, he meets this drunk pilot and he has to decide to get on the helicopter with this drunk pilot to go to the boat where this photographer is supposed to be. And so just kind of going through that whole scene, he's, he's contemplating what he should do. And he finally just makes the decision, you can see it in his face, he's like, yeah, I'm gonna just go for it. And anyway, so it's kind of cool. So it made me think about this idea when you're making a decision. To become an internal trustee, whether or not, um, is it, is it, is it worth it? And so we're going to talk about some of the things uh related to what that what that worth it means as we go through it. I wanted to start off with just some definitions so that we're all in the same place when it comes to what we mean by an ESOP trustee. Um, and the first I wanted to start off with is, is this is really contemplating. Um, after the transaction is completed. So the, the title of this podcast is Journey to an ESOP. So everything we talk about for the most part is going to be around in this podcast around the, the difficulties or complexities or the debunking the myths related to um what it looks like for an ESOP transaction. Once the ESOP transaction is closed, and there are other issues. Now, I would, I just want to start off with, with in the journey to an ESOP in that, in this time period, really, we're always going to recommend on a leveraged transaction that we use an independent trustee for the negotiation because that's the right thing to do. Now, after the transaction is closed, now there's a choice to, to have an internal trustee or an external trustee. So I hope that makes sense. When we talk about a trustee, we're always going to talk about the idea of fiduciary, you know, the fiduciary responsibility. So, um, I got this out of um an article, but it basically says the trustee of an ESOP, which may be a board of trustees or several members, so this could be like a committee of of trustees, is very likely to be a fiduciary with the meaning of ERISA. And at least in part this is because a trustee will typically exercise at least some authority or control respecting management or disposition of the ESOP's assets. This makes this person or persons a fiduciary under the definition of the term set forth in ERISA Section 321A. So anyway, those are the technical terms. And, and so the ability for them to control and, and, uh, you know, make decisions on behalf of the assets held in the trust, you know, basically, Give them the fiduciary responsibility, so that makes them a fiduciary. Now, When we talk about internal trustee versus external trustee. What I mean by internal trustee is usually the sellers themselves, so they're not in the, they sold off their shares and they're no longer an owner anymore, or another company in the or another employee in the company. Um, because of the company's interest that must be independent, what we talked about earlier is, um, the, the internal trustee can't do the transaction, but they can, um, be the internal trustee after the transaction. Um, but they need to be independent of the ESOP's interests and guidelines and they need to make sure that they are, um, carefully following what those are. So we're going to get into that a little bit more. On the external side, that just simply means you're an independent trustee and that could be Um, an individual independent trustee or it could be an institutional, um, independent trustee, but they're external. And the, the thing to point out with that is, is, is there are very important due diligence steps when you're finding the right trustee and you don't want to do that too quickly. So I want to get into the complexities of being a trustee, and I'm pulling out kind of the extreme at the very front end, which is this article called um DOL sticks it or sticks to its tough ESOP litigation strategy, I'm sorry, DOL sticks to its tough ESOP litigation strategy. In this article, which is going to go through a case study of that that actually happened, and it's going to go through a case study of issues related to the Department of Labor dealing with the trustees specifically. So in the article, it points out that the, uh, despite the criticism of the ESOP community, the Department of Labor is not abandoning its litigation prone approach toward ESOPs. And looking at, and they're gonna use this, this uh lawsuit to, to kind of like work through that, that idea or that main idea. So as we go through the fine points of the article, it really does reference um how the trustee violated its fiduciary duties. So I think that's that some of the value of this is to really understand how they, how they violated the fiduciary responsibility. What does it mean, um, when you think about fiduciary, so this will be helpful. The trustee failed in this case to negotiate. In good faith as to the price and the terms and scrutinize the evaluation underlying the transaction. So that was what the DOL was was looking, looking at and claiming. And one of the things I want to start with is, is, should the DOL really care about the underlying valuation? I mean, is it really that important? I mean, and I obviously, that's a loaded question because I, I'm just going to say for everybody in the ESOP world is going to say to you, yeah, heck yeah, that's really important. The valuation is, is key and it's critical to the whole transaction. So in this case, there's an apparel company that hires an investment banking firm that specializes in ESOP. And one of the things I want to point out as we go through this article are the parties that are involved. And the interesting part about this is this really the main responsibility of the whole transaction is going to rely and rest on the trustee. And so when you look at this, I, I do think that there's gonna be aspects of, you know, uh, experienced professionals helping a client that all have some level of, of culpability or, or guilt related to what happens in the, in the final analysis of this article. So, so just keep that in mind. So when I think about this investment banking firm that special specializes in ESAP, one of the things that we point out in this podcast over and over is Hey, if you're gonna use an advisor that has, you know, you want to make sure they have experience. And so this is kind of one of those classic yes, but um, yes, we want them to have experience and be experts, but we also want to know whether or not the character of the investment banking firm um is really solid and sound. And I'm, and I point this out because I, I can't look at this article and not think. That there's some level of, hey, I knew what we were doing in this from an investment banking firm standpoint. Um, they clearly set up the transaction and, and they were really the quarterback of all of it. And so, you know, yes, it's gonna, we're going to get to the trustee, but I want to make, I want to make sure, as we point out, Um, and it's not even just to, you know, get too down too far down a rabbit hole, but it to really understand that the parties you deal with in the ease up transaction are all significant and they all matter. So, You know, so it's a bit of a sidebar, but um I just want to kind of point out that as, you know, we go through this case, it all really starts with the investment banking firm, and their initial, having the initial appraisal done. So, obviously, when we do the appraisal, that very first step, the idea is that we need the value of the business and I'm gonna absolutely agree that, that they made the right choice there. I mean, you, you have to start off with the client and have them aware and understanding what their business is going to be worth in a potential ESOP transaction. So they, they can knowingly walk through the next steps um to hire the right people and, and go through it. However, independence at this step. is paramount. I mean, I'm, it's so important that there's no conflict of interest in that the, the valuation firm that they hire um should be completely independent at each one of these steps. So, so we're gonna get into this a little bit. So, however, as we look at the investment banking firm. Now, we get through this, this first initial exploratory evaluation and then they hire the the trustee. Um, you know, going into the trustee side, they're going to interview multiple trustees and evaluate every trustee on the merits of independence, experience, cost. They're gonna do their own due diligence of, of course, to find the right trustee. So we have to realize that the beginning step, the client is not going to have the experience or the client's not going to have the background to really properly vet a trustee or even know who the evaluation firm should be. So they're completely relying on the investment banking firm, um, unless they've had other experience doing ESOP transactions, which is most likely not the case. So as the DOL investigates this case, they end up claiming that the trustee failed to evaluate the prior relationship the evaluation firm had with the client that violated their independence. What happened in this case is that the valuation firm that did the exploratory evaluation at the very front end, which was brought in by the investment banking firm, was the same valuation firm that the trustee used to do the transaction. So it makes me think like something really is wrong about this transaction and, and, um, you know, as we go through it, and we finalize, you know, what's the conclusion. You know, the blame is going to be on the trustee's shoulders, because the, the DOL is going to find that the trustee was remiss in its duty to thoroughly review, analyze and question any evaluation report on which it relied. So, the trustee, and that is absolutely true, and the trustee absolutely should be doing all that, and they definitely made a, a mistake. Um, at the end of this, the investment banking firm was not found liable for anything. And the reality is, they probably got paid a humongous fee for this transaction. And I it's not to slam an investment banking firm, it's just to say that, that the parties you use are very important. And I think everybody in this transaction as we go through the article really was um not doing what they should have been doing for the client's best interest. So in the end, the DOL basically asked the court to order the trustee to restore all losses to the ESOP and return to the ESOP all fees earned from the contested transaction and subsequent work as ongoing ESOP trustee. So big claim in big punitive fines. So the question as we get through this first article is, hey, Who would want to be a trustee if you're gonna be dealing with the potential ESOP claim against, you know, the DOL and all these different things coming out. And that is something that most professionals are gonna say, you know, it's, you know, there's a fiduciary responsibility and there's a risk. So that's one of the reasons I wanted to do this podcast because I think there's a lot of conversation that goes along in this, and I think it'll be, it's helpful to kind of explore that together. So with all that, I want to go into another article, and this article is called Internal versus External Trustees, The Good, the Bad and the Ugly written by Edward Willis. And what Edward does is he points out a really great article. It's very, it's very good if you want to get it, just go Google that, um, internal versus external trustees, the good, the bad and the ugly. Um, and just go through this, but I'm gonna go through each of the, uh the points that he makes and I think just kind of like discuss some of the things that I think are really important when you're thinking about. Um, what a trustee does, and then whether or not you should be an internal versus external. So, going through a trustee, a, a good trustee or somebody that must uphold the highest fiduciary standards, which we kind of talked about already. Um, needs to observe the following requirements. First, the trustee needs to meet the prudent expert standard, standard, meaning that he or she must possess the knowledge and skills required to create and maintain the plan and must carry out the plan duties prudently. This is why a lot of times we find ESOP trustees to be have an attorney background, a legal background, because when we get down to the idea of the um plan, it's going to be built around the plan document. So I would advise on this, if you're thinking about becoming an internal trustee, is to do some ESOP fiduciary training. Um, one of the sites that I went to early on was a site called ESOP Training.com. Um, you can sign up for online classes, very helpful, um, very thorough training, and you can kind of go through different modules, very helpful. So if you're thinking about doing this, go to that website, very helpful. Um, and second, the trustee must be independent of the owner and the board of directors. So clearly what independence means is it's there's no conflict of interest. The independent fiduciary replaces insiders, typically corporate management when conflict of interest either preclude them or render it too risky for them to make decisions about the plan's assets. And have to be acting solely in the interest of the plan's participants, as the law requires. So independence is a very big deal and if you feel conflicted in any way, then just don't do this at all. Um, and as you go through the, the process of becoming an internal. Truste at some point in time where if you felt conflicted, you should definitely step down from that role. Um, I can't think, you know, I think partly it's just the right thing to do, but when you get down to it, um, there really is a is a necessity of this to be completely separate from the other roles that you might play in the company. The trustee must follow the plan document. So in this case, there needs to be a strong familiarity with the plan document. Uh, you get this through working, you know, in reading the plan document, but I think you get it mostly from working through a normal cycle, a timeline of the valuation being ordered, working with the TPA, um, reviewing the participant statements and, and all the things that go into, um, you know, the things that you're going to be involved with in the company. So an internal trustee is, is somebody normally that's going to be in the company. So the trustee must be willing and able to devote time and effort needed to create and maintain the ESOP ending. This is a great point. It's a big point. I think sometimes we overload ourselves if we have the capacity, it's going to take. To become and do all the things that are required as as a trustee, um, then I think great, but one, but if you're biting off more than you really can chew, then I think you need to slow down and say, you know what, maybe we give it a year and kind of watch what happens and then we take over later. Um, I think that's a good way to go as well. The trustee must act solely in the interests of the plan participants and their beneficiaries, which I talked about within the conflict of interest and the independence. The trustee must diversify plan investments and pay only reasonable plan expenses. So, the trustee needs to be um managing the plan and the costs related to the plan. So thinking about this, there are some real positives to becoming an internal trustee, as Edward points out in this article. Um, the first is, it really does avoid the cost of paying an external or corporate trustee. In fact, ERISA prohibits a fiduciary who is a beneficiary of the plan from being compensated by the plan. So there's definitely a cost benefit of the uh company having an internal trustee. The internal trustees typically are, again, they're employees of the company, they're usually very knowledgeable about the company. They're knowledgeable about the employees and the culture and all sorts of aspects of the company that will help them um to really think about what the best thing is for the company when they're thinking through those steps. I think that the opposite of this is true with, you know, is that the external trustees probably not as connected to the company, um, as much as they may try or be really good at what they do. And again, the third thing is, hey, this is actually legal. So ERISA is OK with this, it's legal, legally permissible. So that's a, that's a good point. On the trust of the external trustee side, um, there is professional experience and qualifications to meet the prudent expert standard rule. And as I said before, a lot of them have a background as attorneys. So reading and understanding the plan documents and understanding ERISA, um, they're very skilled at that. And so they bring a lot to the table when it comes to advice and understanding the knowledge behind what they need to interpret the plan document. External trustees also have time because this is what they do, and this is usually all they do to focus on all the changing rules and regulations of the governing ESOPs. So, clearly a great benefit of being an independent trustee, um, they're generally backed, a lot of them are backed by institutions, um, so they also have a team of people behind them that can help with their knowledge and expertise as well. Um, and normally that, you know, the trustees you talk to, they're usually having a lot of different plans and clients. So they, they can draw from all that experience and, and have, you know, again, um, just a better wealth of information. They're not guessing on a lot of things. Um, and obviously, an internal choice you you should really never guess. They should ask and get advice from other people, um, as a, as a point of recommendation. But at the same time, The independent trustees gonna have a lot of that background to support what they're doing. Now, on the bad side, on the, the negative side for an internal trustee, it really kind of depends on the nature of their business. Internal trustees may lack experience and expertise, as we pointed out on the good side for external trustees, um, required to run the plan. And so, if they're really guessing on a lot of stuff, I think they're putting their, their participants in harm's way and even potentially the company and themselves. Um, there's no as as an internal trustee, there's no delegating of trustee responsibility. So if the trustee remains active in the company while serving as trustee or she will be stretched very thin. So it's very um difficult sometimes to have enough time to do that job really well. Um, on the negative side for having an external trustee, um, the author points out that there are obviously costs related to it, and those could be seen as negative, so the fees associated with hiring the external trustee on an annual basis. Um, one of the negatives they point out is that because the trustees don't have a personal relationship with the workforce. Um, then they may feel misunderstood. Um, the work, they, they may feel like there may be disconnection between the two. So I think that, that might be, um, you know, it's very interesting. Now, he points out the ugly in, in this article, and we kind of covered this a little bit, but, um, clearly, um, if something goes wrong with the ESOP transaction, or the maintenance of the transaction or the maintenance of the ESOP, an external trustee has the resources and infrastructure to respond and address the difficulty. And they're, they're, if they've have gone through that before, they also have um experience in dealing with those types of situations. So in the event that we talked about above, that was, you know, obviously for the transaction itself. And I think, you know, as I point out, kind of some of the things I see when people, when I interview people I talk about the trustee role, is most of the time what we're talking about is a problem in the transaction. So, I don't want to steer anybody towards the positive or negative. I just wanted to point out the pros and cons that these are, these are available to you. If you didn't know that you could be the internal trustee, then, um, then I want to make sure that that's something that you um realize that is definitely a possibility. But at the same time, um, you know, understanding some of the pitfalls that you might be getting into, um, when we looked at our case example, um, that was really primarily driven around the transaction being overvalued. And I think that as I talked to a lot of trustees, that's typically the issue that we find. So after the transaction is completed and everything is done, um, then the plan is being maintained. I think there's potentially a great opportunity for companies to have internal trustees. So I would just advise you to do your homework. Um, read as much as you can, be very involved in the ESOP community and CEO, the ESOP Association, um, you know, network with other professionals and other trustees at your level. Uh, that's really going to be helpful because you can ask questions, uh, definitely of your peers for other companies that are, that are internal trustees. Um, I think that's one of the greatest things about the associations that they allow us all to network with each other and really is important. Unfortunately, with all the COVID and virtual, it's really not the same, but hopefully next year we get back to some of that. So I wanted to finish with this as we think about becoming the ESOP trustee or the internal trustee, the question that we have is, should I stay or should I go now? Should I stay or should I go now? If I go, there will be trouble. And if I stay, it will be double. So come on and let me know, should I stay or should I go? I just like that. It comes from an English punk rock band, The Clash, from uh 1981. So awesome song, but for you, should you stay, should you go, should you be the internal trustee or the external, or get an external trustee? So anyway, with that, I wanted to say thank you again for listening to our podcast. I hope everything is going well this year for you and if you um have an interest in our other episodes, please go to our website at journey to an ESOP.com. Look forward to next time and taking our next step on our journey.