In Practice March 20, 2017

J.D. Power Polling Reveals Investor Opinions on Faulting Fiduciary Rule

Market forces may drive some of the reforms the Department of Labor sought to achieve under the Obama presidency—but a cadre of investors also remains committed to commissions. 
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A new J.D. Power investor survey analysis, published by Michael Foy, the ratings firm’s wealth management practice director, argues the uncertain fate of the DOL fiduciary rule has not necessarily slowed the impetus for change in the ERISA advisory industry.

“Some of these changes have the potential to significantly disrupt the way investors save and plan for retirement,” Foy suggests. He warns that data show advisory staff and leadership alike must “address the attrition risk faced by firms,” which will be more or less severe depending on “how they change their products and pricing.”

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Similar to a significant volume of recent research, Foy draws the conclusion that market forces may very well naturally drive some of the reforms the Department of Labor (DOL) sought to achieve under the Obama presidency. Even with the likelihood of some or all of the Obama-driven rulemaking being halted by the new administration, 33% of investors currently in commission-based accounts say they “probably will” use more fee-based approaches in the near future, and 8% “definitely will.” While 40% “probably will not” and 19% “definitely will not” shift away from commissions, Foy warns the group that is moving away from commissions could just be the first wave.

Zooming in on the individual retirement account (IRA) market is particularly revealing. According to Foy’s analysis, “IRA assets represent an overall market of nearly $8 trillion in the United States and while the industry has been directing more of those assets into fee-based accounts for years … the rule would impact about $3 trillion in client assets and [many billions] in wealth management industry revenue.”

Given the fact that many firms are continuing to review and shift their product and fee models, investors in IRAs may soon be faced with a choice, Foy speculates. “Stay at their firm and switch to a fee-based model; find another full-service firm that will continue to provide a commission-based full-service option; move to a self-directed service model and continue to pay commissions, potentially with access to some limited advice and guidance through a centralized (e.g. call center) firm representative; or they can move to a digital advice model … that will provide automated portfolio management based on investor-provided goals and risk tolerance for a lower fee than a traditional adviser would charge.”

Foy observes the “intuitive hypothesis that current fee-based investors are generally more satisfied with what they pay their firm than those who pay commissions” continues to ring true. But the findings of J.D. Power’s DOL Special Report “also show there is significant resistance among commission-based clients—especially the high net worth—to being forced to migrate to fees.”

Foy’s full analysis is available here. 

Compliance March 17, 2017

Decision Finds Wilmington Trust Liable for ESOP Damages

The firm has been deemed liable for violations stemming from a “rushed” ESOP valuation—although some claims of wrongdoing leveled against the firm at trial were denied.
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Following a bench trial in a complex employee stock ownership plan (ESOP) lawsuit, a district court has held that Wilmington Trust is liable for violating Section 1106(a)(1)(A) of the U.S. Code, but not liable for violating parts (a)(1)(B) or (b) of that section.

The lead plaintiff in the case is a former employee of Constellis Group, Inc., and a former participant in an employee stock ownership plan (ESOP) created and terminated by the private security firm. Defendant Wilmington Trust N.A. “was the trustee for the ESOP in connection with Constellis’ creation of the ESOP.”

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Background included in the text of the decision, handed down by the U.S. District Court for the Eastern District of Virginia, shows that creating the ESOP involved the purchase of 100% of Constellis’ voting stock in December 2013. Less than a year after the ESOP was created, according to the decision, “all its stock was sold.”

Plaintiffs alleged that the 2013 purchase “involved transactions and payments prohibited by the Employee Retirement Income Security Act of 1974, 29 U.S.C. § 1106, resulting in the ESOP paying an inflated price for the Constellis stock.” Specifically, plaintiffs alleged that the $4,235 per share paid in 2013 “was not the fair market value of such stock, resulting in the ESOP overpaying for the stock by $103,862,000, which plaintiff seeks to recover for the ESOP.”

In the end the court ruled that Wilmington is liable for causing nearly $30 million in damages to the ESOP—far below what participants claimed they were entitled to, but a significant result nonetheless.

Case documents show the ESOP in question was created through an extensive process of projections and analysis, which included discussion of multiple potential approaches and wide swings in valuation projections made by contracted experts. 

NEXT: The shortest lived ESOP on record? 

The lengthy text of the decision outlines the recent history of the company, explaining how equity ownership had transitioned within the firm prior to its acquisition by another competitor. After some early shifts and reorganizations, the company approached its general counsel about forming a new ESOP in June of 2013. Leadership at the time apparently viewed the ESOP both “as an exit strategy while being consistent with the vision of Constellis as a company focused on taking care of its employees.”

The company leadership, according to the text of the decision, debated whether to pursue a traditional ESOP structure or a structure under which 90% of the shares would be sold to the ESOP, while the remaining 10% would be exchanged for “equity-like warrants.” The warrants would be “financial instruments entitling the sellers to buy back equity in Constellis at a designated price, known as the strike price, during a certain period of time.” This would allow the sellers as warrant holders to retain significant elements of control over the company, most notably the ability to appoint a majority of the board of directors. Under the proposed plan, the ESOP was to borrow from the sellers to buy their stock, meaning the sellers would also become the company’s creditors.  

For its services as trustee, Wilmington charged Constellis a flat fee of $150,000 to be paid regardless of whether or not the ESOP transaction closed. If the transaction closed, the firm would also receive a minimum payment of approximately $80,000 per year in fees for serving as ongoing trustee. The court finds no evidence these were unreasonably assessed.

Problems arose when it came to the step of valuing the closely held company, according to the decision. One early estimate received by the firm pegged its value at just $165 million. However more generous estimates of $290 million and $345 million were also made, and the final settling price paid by the ESOP was close to the top end of these estimates. A significant portion of the bench trial was apparently spent dissecting the various methods used by various contracted experts to reach the final figure.

In the end the court found that Wilmington “rushed its evaluation of the Constellis ESOP, failed to follow its own policies, and failed to adequately vet [other valuators’] conclusions.” This became a pressing issue for employees when company leadership terminated the ESOP just seven months after its creation, during the subsequent sale of the company to another organization, ACADEMI, for a total purchase price of $281 million. The transaction resulted in the termination of the ESOP and thereby cemented significant participant losses compared with the previous valuations.

The full text of the decision is here. 

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