The ESOP Association New South ESOP Chapter Fall Conference St. Pete Beach, Florida October 6-7, 2010 Changing the Rul

1. 1 The ESOP Association New South ESOP Chapter Fall ConferenceSt. Pete Beach, FloridaOctober 6-7, 2010Changing the Rules of the GameMaking the Right Calls

2. 2 Agenda Case Law Developments Indemnification of ESOP Fiduciaries Fiduciary Duty/Disclosure Recent “Stock Drop” Decisions Other Case law Developments Regulatory Developments

3. 3 Case Law Developments Indemnification Johnson v. Couturier, 572 F.3d 1067 (9th Cir. 2009) This decision involved the defendants’ claim to enforce contractual indemnification agreements with the company to advance their costs of defense. The defendants in this matter are the plan fiduciaries who are alleged to have breached their fiduciary duties to the ESOP. Company was 100% ESOP owned, then sold – the company’s plan of liquidation calls for the payment of all remaining sale proceeds to ESOP participants as shareholders. The District Court ruled that ERISA preempts indemnification agreements under state law and any proceeds advanced from the company’s remaining funds is “tantamount to asking the ESOP participants to pay for the defendants’ defense costs...”

4. 4 Case Law Developments Fernandez v. K-M Holdings Co., Inc., 646 F. Supp.2d 1150, (N.D. Cal. Aug. 21, 2009) This decision involved a successor ESOP trustee seeking to enforce its contractual indemnification agreement against claims of liability for failing to cure damages from acts of prior fiduciaries. Company was 42% ESOP owned and was still operating and in business. The District Court ruled that the indemnification agreement was invalid because “If [the company] were forced to indemnify [the successor trustee] against a sizable judgment for breach of fiduciary duty, it would almost certainly decrease the value of [the company] and, by extension, the ESOP shares. The ESOP . . . would thus shoulder a large part of the burden of indemnification.”

5. 5 Case Law Developments Rounds v. Beacon Associates Management Corp., 2009 WL 4857622 (S.D.N.Y.) Dec. 14, 2009 This non-ESOP related case involves a claim for indemnity and advancement of legal fees by the principals of an investment fund. The Beacon Fund placed approximately 70% of its investments with Bernard L. Madoff Investment Securities, LLC. These investments included assets it had received from employee benefit plans governed by ERISA. The District Court refused to enforce the indemnity and advancement provisions contained in the investment fund’s Operating Agreement at this stage in the proceedings based upon the ambiguity of the provisions. The court also noted that the enforceability of these provisions under ERISA may eventually have to be considered.

6. 6 Case Law Developments Johnson v. Couturier, 2010 WL 682336 (E.D. Cal.) Feb. 24, 2010 This most recent decision in this matter involved a Motion to Intervene filed by a non-party shareholder in opposition to the settlement funds in this matter being paid directly to the ESOP, rather than the company. Bruce Couturier became a shareholder of company stock outside of the ESOP by exercising stock options that were part of his compensation package. Mr. Couturier did not exercise his stock options, however, until after both the company’s assets were sold and after this lawsuit was filed. The Court ruled that Couturier had no standing to oppose the settlement as (i) his interests as a beneficiary of the ESOP were adequately represented in the settlement, and (ii) he was not a shareholder at the time that the acts complained of in the lawsuit were committed.

7. 7 Case Law Developments Fiduciary Duty/Disclosure Business decision to sell company assets not subject to ERISA fiduciary standards. Peck v. Chopp, 2010 WL 2472757 (W.D. Michigan, June 14, 2010) Northwest Tool & Die, an automobile supplier, went through bankruptcy and emerged as a 100% ESOP owned company. CEO and directors discussed sale of company with several prospects and ultimately sold business assets to one buyer and plant, physical facilities and equipment to another buyer. ESOP participants sued CEO and directors for breach of fiduciary duty under ERISA §404 alleging they failed to maximize stock value by the manner in which the sale of assets was negotiated.

8. 8 Case Law Developments Specific allegations included: a. Failing to follow a fair and reasonable process to consider proposals and purchase offers from groups other than the leading prospect. b. Extending the no-shop agreement with lead prospect even after they knew there were potential competing bids for the company. c. Failing to disclose the terms of any potential purchase offers from the lead prospect to the shareholders. d. Failing to act in the best interests of the shareholders by refusing to open the sales process for bids. e. Refusing to review overtures for purchase of the company from other groups or individuals.

9. 9 Case Law Developments Court granted defendants’ motion to dismiss finding: Fiduciary obligations imposed by ERISA (§404) are implicated only when an employer acts in its fiduciary capacity. Purely business decisions by an ERISA employer are not governed by §404’s fiduciary standards. A court must examine the conduct at issue to determine if it constitutes “management” or “administration of the plan, or merely a business decision that has an affect on an ERISA plan, but not subject to fiduciary standards. The decision to sell corporate assets is a business decision not regulated by ERISA fiduciary duties, and although the business decision to sell affected the value of plaintiffs’ ESOP shares, that affect does not render defendants’ actions subject to ERISA’s fiduciary duties.

10. 10 Case Law Developments Failure to disclose true financial condition of company actionable as breach of fiduciary duty. Balsey v. Delta Star, 2009 WL 4823196 (N.D. Cal., Dec. 10, 2009) Company officers/ ESOP trustees told ESOP participant that if he did not take lump-sum distribution being offered, it was likely cash would not be available in the future to buy back his shares and lump sum offer would not remain open. Participant owned 58,910 shares and took the lump sum payment when stock value at end of 2006 was $22.38. Company experienced record sales and stock value went to $142.45 at end of 2007. Difference to participant would have been about $7 million. Officers/trustees were aware that company was experiencing record profits before participant took the lump-sum distribution.

11. 11 Case Law Developments Trustees argued failure to disclose the financial performance not actionable as breach of fiduciary duty under ERISA because undisclosed information related only to company operations and was not “with respect to the plan”. Court found omission to disclose record sales actionable as breach of fiduciary duty because Balsey was encouraged to accept lump-sum based on representations that Delta Star had a questionable financial future that might preclude lump sum payment. Those intentional representations by CFO when he had knowledge of actual financial outlook of the company made failure to disclose true financial condition potentially misleading and actionable as breach of fiduciary duty.

12. 12 Case Law Developments ESOP trustee may have duty to sue himself for inappropriate corporate actions Blankenship v. Chamberlain, 695 F. Supp.2d 966 (D. MO. February 1, 2010) Defendant was company’s sole shareholder who sold all of his shares to ESOP for $3 million. Purchase agreement required employment agreement with defendant retaining him as president/CEO and sole trustee of ESOP until ESOP loan was repaid, then company could terminate his employment. For initial few years after stock sale, CEO ceased active management of company, company was profitable, accelerated loan payments, and anticipated payoff 5 years early. Prior to loan payoff, CEO returned to active management (removing the 3 VP’s who had been running the company as directors) and arranged the refinancing of ESOP loan and extension of payoff date .

13. 13 Case Law Developments ESOP participants allege purpose of extending loan maturity was to defer date company could terminate his employment. They also alleged he took a number of actions exceeding his authority: paying excessive salary, receiving distributions of profits, using company funds for personal expenses, and doing one-sided real estate deals with company for his benefit. Defendant moved to dismiss action claiming the alleged breach of fiduciary duty arose only out of actions he took in a corporate managerial capacity, not in his capacity as trustee (defendant’s prior motion to dismiss granted for this reason in May 2009 prior action in this case) Motion to dismiss denied (this time) with court finding that when a fiduciary becomes aware of corporate action that would give rise to a derivative claim, the decision to bring a claim – even if defendant would be the fiduciary himself- is subject to ERISA’s fiduciary duties. Even if trustee shows alleged bad acts taken in corporate, rather than fiduciary capacity, he remains liable as ERISA fiduciary if he does not challenge the actions through a derivative suit.

14. 14 Case Law Developments Bacon, et al. v. Stiefel Laboratories, Inc., et al., 677 F.Supp.2d 1331 (S.D. Fla. 2010) This decision on the defendants' Motions to Dismiss allows the plaintiff's claims for breach of fiduciary duty under ERISA, as well as violations of federal securities laws to proceed. On January 1, 2009, the plan sponsor terminated its stock bonus plan and offered the participants the right to put their shares back to the company at a price of $16,469.00/share. At the time of this offer, the plan sponsor was engaged in undisclosed merger talks with GlaxSmithKline, and a merger was closed shortly thereafter at a price of $68,515.00/share. In denying the Defendants' Motions to Dismiss, the Court held that while under normal circumstances ERISA fiduciaries have no duty to disclose merger discussions, when those fiduciaries are sending communications to shareholders reporting the price of the stock while knowing that the price is inaccurate, such merger discussions constitute material information that must be disclosed.

15. 15 Case Law Developments Stock Drop ESOP/KSOP fiduciaries have no obligation to divest employer stock if there is no market for it, but may have liability for continuing to offer and purchase stock. Wilson v. Venture Financial Group, Inc., 2010 WL 2028088 (W.D. Wash. May 18, 2010. Bank failed and was taken into receivership by the FDIC. Bank had a KSOP and ESOP, both of which owned bank stock which represented the primary holdings of both plans. Participants’ allegations, among others, included claim that defendants responsible for investment of the plans’ assets breached fiduciary duties by failing to prudently and loyally manage the plans’ investment in bank stock. (stock went from $18 at end of 2007 to $.025 at end of 2008. Bank closed Sept. 2009).

16. 16 Case Law Developments Specifically, plaintiffs claimed it was imprudent not to: (1) divest the plans and (2) continue to offer company stock in the plans. Court specifically declined to follow the “Moench Presumption” which held that fiduciaries of ESOP’s are presumed to have acted consistently with ERISA in their decisions to invest assets in employer stock. Defendant’s moved to dismiss on divestiture claim on basis that it was impossible due to stock not being publically traded creating absence of any market in which to readily sell the stock. Court granted motion finding plaintiffs did not allege facts to establish defendants could have divested stock in plans even if they wanted to. However, although granted on divestiture issue, defendants’ motion to dismiss was denied as to the decision to continue to offer and purchase bank stock in the plans (case does not indicate how much, if any, stock was acquired by plans during the catastrophic drop in value).

17. 17 Case Law Developments Plan fiduciaries not liable for breach of fiduciary duty on basis of decision to offer employer stock as investment in defined contribution plans (non-ESOP) when mandated by the terms of plans. In re ING Groep, N.V. ERISA Litigation, No. 1:09-CV-0400 (N.D. GA, March 31, 2010) Participants in plans brought suit for breach of fiduciary duties under ERISA for allowing participants to purchase shares of ING. Plans specifically required that ING stock be included as an investment option so there was no discretion or authority to eliminate ING stock from list of investment alternatives. Court found defendants could not be liable for a breach of fiduciary duty on the basis of their decision to offer ING stock because they did not exercise discretionary authority, control or responsibility – it was mandated by the plans’ terms. Fiduciaries’ compliance with the plans’ terms is presumed to be prudent and did not involve exercise of discretion and so could not violate any duty imposed by ERISA.

18. 18 Case Law Developments Investment of plan assets in employer stock despite its “dire financial situation” constitutes a breach of fiduciary duty overcoming Moench presumption of prudence. Crocker v. KV Pharmaceutical Company, 2010 WL 1257671 (E.D. MO., March 24, 2010) Profit sharing plan of publicly traded pharmaceutical company was substantially invested in employer stock. Company had been subject to several FDA warnings and investigations since 2003, but all SEC filings indicated there was unlikely to be any adverse affects and numerous press releases gave glowing reports of increasing sales of its products and ‘record revenues”. November 2008 SEC filing disclosed investigation into FDA regulatory matters, a second quarter 2009 loss, and second quarter revenue decline of 16% causing a 59% one day drop in stock price ($14.26 to $5.90). In January, 2009 company had to suspend manufacture and sale of all of its products due to regulatory issues. Stock then had declined to $.51/share.

19. 19 Case Law Developments Plan participants claim breach of fiduciary duty for keeping plan invested in employer stock. Court acknowledged that the Moench presumption had been extended to all EIAP’s (by the Third Circuit in Edgar v. Avaya, Inc. 505 F.3d 340 (2007)) and not just ESOPs. However, court held that the Moench presumption was overcome by plaintiffs’ showing there was a “dire situation” at company which would require plan fiduciaries to disobey plan terms to invest company stock so that they might satisfy their prudent investment obligation to participants under ERISA.

20. 20 Case Law Developments Anti-Cutback Rule Hoffman v. Tharaldson Motels Inc. ESOP, et al., 2010 WL 749788 (D.N.D.) Feb. 26, 2010 This decision granting the defendants' Motion for Summary Judgment affirmed the validity of a stock cash-out feature for terminated employees of an ESOP sponsor. The plaintiffs in this case were former employees of the plan sponsor, who claimed that the amendment of the plan document that required terminated plan participants to liquidate their ESOP accounts and select either a cash distribution or re-invest in a stable value account was a violation of ERISA's "anti-cutback" rule. The Court held that the "anti-cutback" rule served to protect against the erosion of accrued benefits under a plan, not expected benefits. The Court also cited the IRS's 'safe harbor' provision in ruling that the cash-out requirement was permitted by law and actually served to protect participants' accrued benefits under the plan.

21. 21 Case Law Developments Deference to Plan Administrator Conkright, et al., v. Frommert, et al., 130 S.Ct. 1640 (2010) In this decision, the United States Supreme Court held that an ERISA plan administrator's interpretation of plan benefits is entitled to deferential treatment, despite a mistake in its prior interpretation of the plan. The plaintiffs in this case were participants in an ERISA pension benefit plan, who had left the employer, received lump-sum distributions from the plan, and were subsequently rehired by the employer. They filed this action for improper calculation of their pension benefits following their re-hire.

22. 22 Case Law Developments The District Court ruled that the plan administrator's interpretation of the plan and corresponding calculation of the plaintiffs' benefits was unreasonable. The Court of Appeals for the Second Circuit upheld the District Court's ruling and remanded the case for a new determination of benefits under the rules of the plan. On remand, the District Court refused to accept the plan administrator's revised interpretation of the plan, and instead implemented an alternate interpretation, which was upheld by the Second Circuit. The Supreme Court rejected the Second Circuit's "one-strike-and-you're-out" analysis and held that the District Court should have deferred to the plan administrator's new interpretation of the plan on remand. The Court reasoned that a single, honest mistake was insufficient to strip a plan administrator of deference otherwise owed.

23. 23 Case Law Developments Recovery of Overpayment from ESOP Heimsoth v. Ghobrial, 682 F. Supp.2d 849 (N.D.Ill. 2010) This is an action by an ESOP trustee for the recovery of an overpayment of benefits to a former plan participant. The defendant in this matter tendered her resignation on January 21, 2005, and under the plan document, was entitled to a distribution of her ESOP account based upon the December 31, 2004 valuation. Rather than waiting for the 2004 valuation to be completed, the ESOP distributed 70% of her account value based upon the December 31, 2003 stock value. The plan sponsor's stock value decreased significantly in 2004, and as a result, the defendant's account value was worth less than the distribution she received. The trial court granted the ESOP trustee's Motion for Summary Judgment and ordered the defendant to repay the amount of the overpayment.

24. 24 Case Law Developments Zell Case Update Neil, et al. v. Zell, et al., 2010 U.S. Dist. LEXIS 80744 (Aug. 9, 2010) In this decision, the District Court grants Defendants Sam Zell and EGI-TRB, LLC's Motion for Judgment on the Pleadings with regard to plaintiffs' claims for restitution and disgorgement. The plaintiffs in this case are ESOP participants, who were attempting to recover funds paid to defendants Zell and EGI-TRB by the plan sponsor, and cited the 2009 Johnson v. Courturier decision in support of their claims. The defendants argued that the funds in issue were received from the company, not the ESOP, and as such are not recoverable by the plaintiffs. The District Court ruled that since the ESOP-owned company is not a party in this case (unlike Courturier), then it could not order relief in the form of the repayment of funds that originated with the company.

25. 25 Regulatory Developments ERISA §408(b)(2) Interim Final Regulations Key dates July 16, 2010, DOL published Interim Final Regulations Addresses disclosure of compensation and services See 29 CFR 2550.408b-2(c) Effective July 16, 2011 Background ERISA §404(a)(1) creates plan fiduciary standard Act solely in interest of participants and beneficiaries To provide benefits To defray “reasonable expenses of administering the plan” DOL seeks to ensure sufficient information available to make informed decisions

26. 26 Regulatory Developments ERISA §406(a)(1)(C) Prohibits fiduciary contracting for furnishing goods, services or facilities Must find exemption to prohibition ERISA §408(b)(2) provides service exemption “No more than reasonable compensation” may be paid Contract must be reasonable Services must be necessary for plan establishment and operation

27. 27 Regulatory Developments The Final Regulation Applies to “covered plans” Defined contribution plans ESOPs 401(k) Profit sharing Defined benefit pension

28. 28 Regulatory Developments Does not apply to Governmental plans Non-electing church plans Unfunded excess benefit plans SEPs Simple IRAs IRAs

29. 29 Regulatory Developments Applies to “covered service providers” that Enter into contract or arrangement with covered plan Expect $1,000 or more in compensation (direct or indirect) Time period not defined Two categories of “covered service providers” defined

30. 30 Regulatory Developments Directly compensated group, including: Fiduciaries Registered investment advisors (“RIA”) Record keepers, TPAs and brokerage service providers in participant directed plans Fiduciaries to investment vehicles That hold plan assets In which plan has direct equity investment

31. 31 Regulatory Developments Indirectly compensated group, including: Same list as above, plus Accounting, legal, banking, consulting (i.e., monitors), insurance, valuation The bundled service providers Basically, bundled services must be broken out by cost and service What must be disclosed initially? Description of services Whether fiduciary or RIA services expected to be provided Description of all compensation, direct or indirect In aggregate or by services Compensation for transaction based fiduciary services Termination fees and prepaid amount to be refunded Reasonable and good faith breakdown of bundled recordkeeping service fees Description of how services billed and/or collected Investment disclosure information

32. 32 Regulatory Developments Timing of Information Initially, reasonably in advance of contract or arrangement, or its renewal Change of information--within 60 days of change becoming known Request of information to comply with reporting--within 30 days of request Impact of Regulations Service provider has prohibited transaction if fails to comply Relief for fiduciary if: Did not know of failures to disclose Upon discovery, requests information Notifies DOL if information not provided within 90 days

33. 33 Regulatory Developments Section 1042 QRP and Divorce (PLR 2010 24005) Facts Taxpayer sold stock to ESOP and elected §1042 deferral treatment Timely acquired qualified replacement property (“QRP”) Proposed to transfer the property to spouse incident to divorce Holding Proposed transfer of QRP treated as “gift” under §1042(e)(3)(C) Taxpayer need not recapture deferred gain on QRP Analysis Section 1042(e) provides for recapture of deferred gain if QRP disposed of Section 1042(e)(3) provides exceptions to recapture: Certain reorganizations Death of person electing §1042 Gift (the key here) Another §1042 transaction IRS said legislative history supports a finding of gift status