ESOP Legal and Fiduciary Update 28th Annual Ohio Employee Ownership Conference

April 24, 2014

Ken Serwinski Prairie Capital Advisors 630-413-5588 kserwinski@prairiecap.com

James G. Steiker SES Advisors, Inc. 215-508-5643 jsteiker@sesadvisors.com

Tim Jochim Schatz Brown Glassman Kossow 614-324-3344 tjochim@esopplus.com

Tracey Woolsey Senior Vice President Horizon Trust 219-874-9235 twoolsey@accesshorizon.com

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Agenda

• Recent DOL complaints affecting ESOPs

• Recent court decisions affecting ESOPs

• IRS and DOL rulings and decisions • DOL fiduciary and valuation initiatives • IRS regulatory guidance initiative

• Response of the ESOP professional community to DOL recent activity

What’s Happening? (Big Picture)

• Numerous DOL-initiated lawsuits against ESOP fiduciaries following high level of DOL audit activity

• High-profile settlements of DOL claims • Some private plaintiff lawsuits against ESOP fiduciaries and

other parties to ESOP transactions • Continued uncertainty as to whether Company assets in an

ESOP-owned company are “Plan Assets” • Malpractice actions against ESOP advisors primarily related to

bad tax advice • Little new tax or ERISA guidance from IRS or DOL • Continuing development of voluntary correction programs

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What the DOL Sees and DOESN’T LIKE

Conflicts of Interest

• Sellers acting as Trustee •Appraiser independence

Valuation Problems

•Control premium but no transfer of control

•Untested assumptions and projections

• Failure to incorporate appropriate discounts

•Out-of-date financials •Discount to financing

arrangements (“mark to market”) as part of transaction valuation

Seller Financing

• Fabricated structure of Seller financing to avoid reasonable rate of interest test under exempt loan regulations

•Unreasonable rate of interest

Current Fiduciary Issues

• Indemnification Language – DOL Position vs. Court Decision (Solis v. GreatBanc Trust Company,

Sierra Aluminum Company and The Sierra Aluminum Company Employee Stock Ownership Plan)

• Focus - Large Number of Cases Being Filed both by DOL and

Private Sector – Committee Reviewing more cases.

Current Fiduciary Issues

• Higher scrutiny approving law firms and valuation firms.

• Buy side transactions “Stress Testing” projections • Interest Rate being used during transaction. Interest Rate

Opinion from valuation firm.

• Review of conflicts of interest with valuation firms

• Documenting more, have more procedures

Recent DOL Complaints

• Solis v. First Bankers Trust Services, Inc., Maran, Inc., and Maran Employee Stock Ownership Plan (S.D. NY, 11/29/12) – Alleges ESOP overpaid for stock because ESOP valuation unreasonably

relied upon aggressive growth projections prepared by Company advisors, did not properly discount for the Company’s dependence on Wal-Mart, and used inappropriate comparable companies

• Solis v. First Bankers Trust Services, Inc., Frank Firor, and Rembar Employee Stock Ownership Plan (S.D. NY, 11/28/12) – Alleges ESOP overpaid for stock because ESOP valuation ignored

replacement cost of departing CEO, applied too high a control premium, and relied upon an inappropriate capital structure assumption

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Recent DOL Complaints

• Solis v. Webb, et.al. (N.D. CA, April 25, 2012) – Alleges ESOP overpaid for stock because valuation firm ignored $12mm

deferred compensation liability owed by company and other valuation defects

• Solis v. First Bankers Trust Services, Inc., Dipano, & SJP Group, Inc. Employee Stock Ownership Plan (D.NJ, July 7, 2012) – Alleges ESOP overpaid for stock because valuation firm used over-aggressive

projections and did not anticipate real estate downtown

• Solis v. GreatBanc Trust Company, Sierra Aluminum Company and The Sierra Aluminum Company Employee Stock Ownership Plan (C.D. CA, September 28, 2012) – Alleges ESOP overpaid for stock based on aggressive projections, improper

discount for seller notes, unreasonable view of capital expenses and projected growth

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2013 DOL Complaint on Nonfiduciary Liability

Harris v. Roorda, et al. (DSS ESOP) • Non-fiduciaries may be liable where they

knowingly participate in a fiduciary breach. • Roorda merely plan auditor; however, his name

appears in several earlier complaints against other fiduciaries.

• Potential avenue to address valuators even if no fiduciary rule change.

• Financial advisors to sellers may take on fiduciary role if determining other fiduciaries.

• See Solis v. First Bankers Trust, et al., (The Maran ESOP) and Solis v. First Bankers Trust, et al., (Rembar ESOP)

Recent DOL Complaints (cont.)

2013 DOL Complaint on Seller Financing

Perez v. PBI Bank (Miller Health ESOP) • “First, ERISA categorically bars all direct and

indirect loans between parties in interest and plans (such as an ESOP, ERISA § 406(a)(1)(B), 29 U.S.C. § 1106(a)(1)(B), unless such loans are to an ESOP in connection with an ESOP stock purchase and only if the loans are “at an interest rate which is not in excess of a reasonable rate.” ERISA § 408(b)(3)(B), 29 U.S.C. § 1108(b)(3)(B).

Here, the selling shareholders’ indirect loan to

the ESOP at 12% was far in excess of a reasonable rate of interest…. This unreasonable rate disqualified the loan from the requirements for the exemption under ERISA § 408(b)(3)(B)."

Recent DOL Complaints (cont.)

Seller Financing

Company

ESOP

Bank

Shareholders

Company obtained $40M bridge loan from bank at 8.25%

Repay $40M bridge loan

ESOP pays $40M cash for 100% of company stock

$40M loan to ESOP

(“Inside Loan”)

At 5%

PBI Bank Transaction Structure

Seller Financing and Exempt Loans

• See Peek v. Comm’r, 140 T.C. No. 12 (May 9, 2013) • In Peek, the owners of participant directed IRAs (fiduciaries due to their role in

directing the investment of the IRA – i.e. discretion over plan assets) that held stock in the Company guaranteed notes of the Company. The IRS argued, and the Tax Court agreed, that the Owners (interested parties) provided an indirect extension of credit to the Plan (which owned the Company) by guaranteeing notes of the Company.

Dudenhoeffer v. Fifth Third Bank (Fifth Third Bancorp ESOP)

Moensch Presumption Moensch Presumption – Because an ESOP is designed to invest in employer securities, where plan language requires investment in employer securities, fiduciaries decision to invest plan assets in employer securities will be presumed prudent absent dire circumstances (or some other similar language)

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DOL position • Prudence requirement

same regardless of hardwiring

• One not two prudence standards under ERISA

Recent DOL Cases

• Solis v. Webb, (N.D. CA, 2012) – Directed trustees and company officers subject to fiduciary liability

where they had direct knowledge of other fiduciary’s breach

• Harris v. Greatbanc Trust Co., (C.D. CA, 2013) – Indemnification of fiduciary in advance of final judgment by 100%

ESOP-owned company permitted under ERISA and not improprer use of plan assets

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Recent Private Plaintiff Decided Cases

• Chesmore v. Alliance Holdings, Inc. (W.D. Wisc. 2012) – Court found Trustee and officer of ESOP holding company liable for

prohibited transaction and self-dealing based upon spin-off of subsidiary for more than adequate consideration and significant “bonus” for accomplishing transaction

• Coulter v. Morgan Stanley & Co., (S.D. NY 2013), In re GlaxoSmithKline, 2012 , In re Citigroup ERISA Litigation, 662 F.3d 128 (2d Cir. 2011), Lanfear v. Home Depot, Inc., 679 F.3d 1267 (11th Cir. 2012), Schmalz v. Sovereign Bancorp, Inc., 868 F. Supp. 2d 438 (E.D. PA 2012), contra. Dudenhoefer v. Fifth Third Bancorp, 692 F.3d 410 (6th Cir. 2012) – Stock drop cases where court found “presumption of prudence” and

no fiduciary liability for failure to sell employer stock during downturn

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Recent Private Plaintiff Decided Cases (cont.)

• Enneking v. Schmidt Builders Supply Inc. (D.C. KA, 2013) – Statute of limitations extended past six years if “fraud or active

concealment” of fiduciary breach

• Kronzer v. Hintz (9th cir. 2012) – Participation of fiduciary as individual in sale transaction does not

create new right to information about the company and the fiduciary’s action absent allegation of fiduciary breach

• Sexton v. Panel Processing, Inc. (E.D. Mich. 2012) – Employee terminated after threatening to report ERISA violation not

“whistleblower” protected by statute unless actual report or governmental action

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Recent Private Plaintiff Decided Cases (cont.)

• Rodgers v. Mattingly Foods, Inc. (S.D. OH, 2013) – ESOP participants permitted to bring shareholder derivative action

against company officers in state court

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Malpractice Actions

• Olson v. Sovereign Bancorp, Inc., (D.C. Mass. 2012) – Potential investment custodian liability for botched 1042 investment

• Undisclosed – Malpractice action settled against law firm and accounting firm for

botched 1042 investment

• Antioch Litig. Trust v. McDermott Will & Emery LLP, (S.D. OH. 2013) – 2009 claims regarding 2003 transaction time-barred under Ohio

malpractice statute of limitations

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Current Valuation Issues -- Projections

• DOL concern that projections are overstated – Surfaced as a result of company performance during recession

• Projections are an integral part of valuation process

• Absolute need to correlate past performance with future

performance

• Special emphasis need to be placed on Revenues, Gross Margin, Operating Margin, CAP EX, Working Capital and other issues – Anomalies must be thoroughly explained

Current Valuation Issues -- ESOP Exploratory Committee

• Anecdotally, DOL doesn’t like this approach to initiating ESOP implementation

• There is a drive, by some, to include sell-side representation in every deal – Problematic in under $10.0M deals

• Can an ESOP Exploratory Committee be “OK” by developing

“Best Practices”?

Current Valuation Issues -- Control Premium/DLOM/

DOL/Trustees

• Is a control premium in transactions appropriate?

– Trustee – Does ESOP ever have operational control?

• If ESOP is a ghost owner – whose fault is it?

• Imagine a world where we convince 100% shareholders to sell 100% at a minority price – DOL planting a seed to reduce number of ESOPs?

• Proposition: If the ESOP shouldn’t buy company stock with a control premium then the trustee should not require a control price when selling a control block of stock

• Is the DOL asking Trustees to take more operational control or pay more attention to governance?

• At what point does the valuation firm find itself not independent in its philosophy but rather directed by non-business types with no experience in the corporate finance world?

DOL Proposed Fiduciary Definition

• Regulation Proposed by DOL on October 22, 2010 • Public hearing March 1st and 2nd, 2011 • DOL received hundreds of public comments • Withdrawn September 19, 2011 • Originally expected to be reissued in 2012 • Now expected to be reissued in July 2013

DOL Proposed Fiduciary Definition (cont.)

• Advisory Opinion 76-65A

– Prior to October 22, 2010. – Valuation of securities alone is not considered as rendering

“investment advice”.

• October 22, 2010 Proposed Regulation’s Preamble – Incorrect valuations are a common problem identified by the DOL in

the ESOP Enforcement Project. – Proposed Regulation is intended to supersede Advisory Opinion 76-

65A.

DOL Proposed Fiduciary Definition (cont.).

• 29 CFR 2510.3-21(c)(1):

– Except as provided in paragraph (c)(2) of this section, a person renders ``investment advice'' for a fee or other compensation, direct or indirect, to an employee benefit plan, within the meaning of section 3(21)(A)(ii) of the Employee Retirement Income Security Act of 1974 (the Act) and this paragraph, if:

• (i) Such person-- (A)(1) Provides advice, or an appraisal or fairness opinion, concerning the value of securities or other property,

DOL Proposed Fiduciary Definition, cont.

• 29 CFR 2510.3-21(c)(2), Limitations: – For purposes of this paragraph (c), a person shall not be considered to

be a person described in paragraph (c)(1) of this section with respect to the provision of advice or recommendations if, with respect to a person other than a person described in paragraph (c)(1)(ii)(A), such person can demonstrate that the recipient of the advice knows or, under the circumstances, reasonably should know, that the person is providing the advice or making the recommendation in its capacity as a purchaser or seller of a security or other property, or as an agent of, or appraiser for, such a purchaser or seller, whose interests are adverse to the interests of the plan or its participants or beneficiaries, and that the person is not undertaking to provide impartial investment advice.

Tim Jochim

Tim Jochim, Partner, Schatz Brown Glassman Kossow, LLP • National authority on employee stock ownership plans (ESOPs) and business succession. He also has expertise in

corporate finance, merger/acquisition and employee benefits. • Adjunct professor of corporate finance at the Capital University School of Law, Columbus, Ohio. • Member of corporate boards and frequent speaker to business and trade organizations. • Author of Employee Stock Ownership and Related Plans (Greenwood Press, 1982), and of articles published in Ohio

Business (October, 1988), The Journal of Employee Ownership Law and Finance (Fall, 1998), Taxation for Accountants (July, 1998) and Taxation for Lawyers (September-October, 1998).

• Co-founder of the Ohio Chapter of The ESOP Association and a member of the legislative committee of The ESOP Association.

• Recognized as an expert attorney on ERISA and ESOP law and its application to closely held businesses by Chambers

USA and received Martindale-Hubbell Rating of AV.

Schatz Brown Glassman Kossow, LLP 20 South Third St., Suite 210

Columbus, OH 43215 Ph 614-324-3344

tjochim@esopplus.com

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Ken Serwinski

Ken Serwinski, CEO, Prairie Capital Advisors, Inc. Kenneth Serwinski is chief executive officer and co-founder of Prairie Capital Advisors, Inc. Mr. Serwinski has dedicated the whole of his vast experience to providing closely held companies with the guidance and expertise needed for some of their most critical business decisions. Today, he continues to grow Prairie Capital Advisors’ reputation as the most widely-respected firm of its kind, designing and implementing customized ownership transition strategies, including the private sales, MBOs, ESOPs and more, for businesses nationwide.

As a lifelong educator and respected industry expert, Mr. Serwinski is widely published in a variety of formats and is a frequent speaker around the nation on subjects including valuation, ESOPs and ownership transition planning. Whether across the table from clients or publicly at workshops and seminars, he strives to ensure business owners have the complete, accurate information they need for confident decision making. Mr. Serwinski sits on the board of directors of three businesses– a design manufacturing firm, a healthcare solutions provider and a billion dollar bank. He also is the former Chair of the Advisory Committee on Finance for the ESOP Association in Washington, D.C. Mr. Serwinski has hosted and attended numerous technical seminars emphasizing topics such as employee stock ownership plans, valuations, mergers and acquisitions, accounting for acquisitions and leveraged buyout transactions.

Prairie Capital Advisors, Inc. One Mid America Plaza, Suite 1000, Oakbrook Terrace, IL 60181

Ph 630.413.5588 kserwinski@prairiecap.com

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James G. Steiker is Chairman and CEO of SES Advisors, Inc. and Founding Partner and Chairman of its sister law firm, Steiker, Fischer, Edwards & Greenapple, P.C.

Jim is a corporate, pension and tax attorney and financial advisor with more than 25 years of experience in Employee Stock Ownership Plans (ESOPs) and other employee ownership matters, focusing primarily on ESOP design, transactions and compliance in entrepreneurial companies.

Jim is the immediate past Chair of the Finance Committee and currently servies on the Board of Governors of The ESOP Association, a trustee of the Employee Ownership Foundation and a member of the Board of Directors of the National Center for Employee Ownership. He is also a frequent speaker and author on ESOP matters and serves as a director of eight ESOP companies.

Jim is a graduate of New York University School of Law, where he was a Root-Tilden-Snow Scholar, and of Wesleyan University.

James G. Steiker

SES Advisors, Inc 10 Shurs Lane, Suite 102 Philadelphia, PA 19127 215-508-5643 jsteiker@sesadvisors.com

Tracy Woolsey

TRACY E. WOOLSEY is a Senior Vice President of Horizon Trust & Investment Management located in Michigan City, IN.

Among her Responsibilities, she oversees the retirement services division of Horizon Trust which

includes administration of all types of employee benefit plans; Retirement Plan design, implementation, development, research and compliance; Employee education and retirement planning seminars. Over the years, Tracy has worked extensively with ESOPs, initially doing the third party administration then representing Horizon as a trustee on both a transactional and on-going basis and as a participant in an ESOP. Tracy is committed to ESOPs and has worked with many companies to maintain compliance. She has also authored articles on the topic of employee ownership and spoken at many seminars on ESOPs. She is currently a member of the NCEO, OEOC and the ESOP Association where she is serving as the President of the Indiana State ESOP Association and on the ESOP Association’s Interdisciplinary Fiduciary Committee and the Employee Ownership Culture Committee.

Horizon Trust & Investment Management 515 Franklin St

Michigan City, IN 46350 219.874.9235

twoolsey@HorizonBank.com

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