This month we’re joined by our very first guest on the podcast, Mike Flesch of Alerus Financial. In his role with Alerus, Mike serves as the independent and institutional trustee for a number of employee-owned companies, and he stopped by the studio (office) to talk with Chris Kramer about what an ESOP trustee does, how to select a trustee if you’re planning to implement an ESOP, and some of the ways leadership teams and trustees can work together to help their companies maximize the benefits of an ESOP.
Transcript
Chase:
Hello, and welcome back to What’s Next, hosted by Acuity Advisors, the show where we help middle-market business owners understand and monetize the value of what they’ve built. I’m your host, Chase Hoover. For today’s episode, my co-host Chris Kramer sits down for a chat with Mike Flesch, an institutional ESOP trustee with Alerus Financial and a frequent collaborator of ours to discuss the role of an ESOP trustee and walk through some common questions that business owners have about trustees when they’re considering an ESOP. I hope you enjoy this conversation. Without further ado, here’s Chris and Mike.
Chris:
I’m joined today by my good friend and collaborator, Mike Flesch. We’re here to talk about the role of a trustee and try to get a number of questions answered and maybe some misconceptions straightened out for you. I think it’ll be a good lively discussion here for the next 20 to 30 minutes. Good morning, Mike.
Mike:
Morning, Chris.
Chris:
How are you doing today?
Mike:
I’m doing well, thanks. How are you?
Chris:
Doing great, Mike. Thank you. Hey Mike, why don’t you just start with a quick background and let our audience know who you are and how you came to be an institutional ESOP trustee?
Mike:
Well, I’m a Managing Director at Alerus Financial. Alerus is a regional bank and trust company. They’re headquartered in Grand Forks, North Dakota, but have offices in several states throughout the country and really are principally headquartered out of the Minneapolis-St. Paul region. I, however, work on the West Coast out of an office in Orange County, California. I help to serve our West Coast base of clients, although I’m involved with all of our ESOP client relationships.
I can speak a little bit more about Alerus a little later, but for my personal background, I went to law school after graduating college and really focused on business and corporate law, estate planning, and taxation. Those are my three primary focus areas. After I finished law school and took the bar exam, instead of practicing law, I wanted to jump right into a career in business. My first job was at a large bank and trust company headquartered in Chicago. I worked in their personal trust department and I was there for five years.
You got a solid understanding of fiduciary services, more on the personal side of the ledger. But after five years, I had a good core understanding of the fiduciary world and the opportunity arose for me to join Alerus in their up-and-coming ESOP practice. This was in 2012. Alerus had been serving as an ESOP fiduciary since 1986, but in 2006, they formed an actual ESOP trustee practice. I was the third member to join that group. I’ve been there since. When I started there, I started in the Minneapolis office and we had built up a very solid client base on the West Coast. In 2019, it made sense for us to diversify geographically, so to speak, so I moved to Southern California in 2020 and I’ve been living here happily ever since.
Chris:
You’ve retired your snow shovel along the way.
Mike:
Yeah. I sold the snowblower and left the winter coats behind.
Chris:
That’s great. So I guess I’d like to start, Mike, by asking you…well, let me set the table for a minute. Lots of folks have heard about a trustee. They’ve heard about the term independent fiduciary, institutional trustee, internal trustee. There’s a lot of names for different, I think, the same role if you will. But let’s just start by telling our audience what is a trustee and what do they do in an ESOP transaction? Maybe we just start there.
Mike:
Well, the trustee essentially steps into the proverbial shoes of the ESOP and by extension, all of the collective ESOP participants. Oftentimes in a new ESOP, these are the participants who will become participants because the ESOP has not quite been formed. But the primary role of the trustee is to, again, step into the shoes of the plan and negotiate the terms of that transaction. By transaction, we’re assuming a purchase by the ESOP of shares and it could be 100% of the shares or it could be any sliver beneath that mark. Our job is to act as an outside buyer because these transactions need to be conducted at an arm’s length basis. We need to act independently on behalf of the plan, not just as a service provider for the plan sponsor.
Chris:
Is it fair to say you actually are the buyer? You become the shareholder and as part of that, you have basically a fiduciary obligation to make sure that the ESOP doesn’t “overpay” and the transaction is fair?
Mike:
Correct. Yeah. That’s very important. We are the buyer. We do think of ourselves as the shareholder. In fact, the trustee holds title to the share. In that sense, the trustee is actually the shareholder. Yes, that’s important. We can’t buy those shares for any more than fair market value. Also, the transaction has to be fair to the ESOP.
Most of these transactions don’t just involve a simple purchase of stock. There are typically many more bells and whistles that come with it that could include financing terms with the selling shareholder, oftentimes there are executive compensation arrangements put in place for management, and the trustee needs to take all of that into account when making that ultimate purchase decision. Of course, we don’t go at it alone. We hire our own independent financial advisor like Acuity. We have a very short list from which to draw upon for that.
Then we also would engage a separate independent legal counsel to help us navigate the ERISA waters and really make sure we’re not going to run afoul of the law. That forms what we call the trustee team. That team, we try to keep ourselves out of trouble, and really we use the team to keep ourselves out of trouble because the buck stops with the trustee when it comes down to this type of transaction.
Chris:
We’re trying to get a transaction accomplished, but we’re trying to stay within the bounds of the regulatory authority, which primarily is the Department of Labor subsequently and as part of that also, the Internal Revenue Service has got some oversight. I guess the question I have is if I’m a seller, what should I be prepared for because as the seller, I’m actually in my role as the CEO.
Or on the board, I’m retaining you before this ESOP transaction. If I’m saying to myself, “Hey, I’m thinking about this ESOP transaction. Everybody’s telling me that we need this thing called a trustee,” how do I decide who’s the right trustee or who to pick?” What are the factors that I should be considering? Then I would turn it around to you, what would make you and Alerus the right trustee in a given situation if you will?
Mike:
Well, first and foremost, if you’re choosing a trustee, you want to choose somebody who is a primary role that they play with respect to their role as a fiduciary.
Chris:
So you want expertise in ESOP.
Mike:
Correct.
Chris:
It’s not just a random trustee from a banker or some other institution that doesn’t make their business in that world.
Mike:
Exactly. It could be a bank like Alerus, but it could also be an independent trustee. There is plenty of non-bank independent trustees and plenty is probably an overstatement because there’s actually a very limited pool of professional trustees.
Chris:
Plenty of them, but not very many that are ESOP qualified if you will. Right.
Mike:
But I’d say another important factor would be how well-connected they are to the industry. Can they draw upon the talent that’s out there? Are they connected enough where they can engage a team that’s going to be effective? They’re not going to be learning on the job. You don’t want their advisors learning on the job because if they are they would just be slowing down the overall process. That’s not what a selling shareholder wants. A selling shareholder, when they make the decision to sell to the ESOP, they want it to go off as seamlessly as possible, so finding a trustee who knows what they’re doing and can pull in advisors who know what they’re doing and will play nice in the sandbox with the selling shareholder’s advisors, finding again, the shortlist of banks and independent trustees out there.
If you’re talking with people in the industry, you’re going to find out who those names are. Of course, there are resources online with the NCEO and the ESOP Association as well. But really, experience is probably the most important. We’re often asked about insurance coverage or our history with litigation or DOL enforcement and those are other factors that you may want to look at too. But I would say first and foremost, experience. The more transactions a trustee has done, the more they know how to do transactions. It’s just like any walk of life. The more you do something, the better you get at it.
Chris:
We get this ESOP transaction completed and now you’re the shareholder. The company or the selling shareholders have sold the stock to the ESOP. What happens or what’s your role post-transaction? How does that work?
Mike:
Good question. We pivot a little bit, not to say that the transaction is an adversarial process, but we are on different sides of the table. Post-transaction, we’re all sitting at the same table and you could say we’re all on the same side essentially. There’s essentially no conflict. That doesn’t mean that there can’t be because there are probably situations that could arise where the board and/or the management team may have different ideas than the trustee has. We can talk about that in a little while. I’ll try to address that dynamic here in a few minutes. So we’re a service provider obviously and our job there in that regard and for newer ESOP companies is to really assist them through the process of learning the ropes so to speak. We’re there as a sounding board to answer any questions they may have about the ESOP related to plan administration or the annual reporting requirements or the new ESOP loan structure that’s just been put in place.
There’s that element, but then there are two primary roles that we would play on the trustee side. One would be the annual valuation. Every year as of the plan year-end, which is usually matched up with the fiscal year-end, although it need not be, the shares need to be valued because the participants are going to need to get a statement that reflects the value of their balance in large part based on the value of the shares. We would hire a financial advisor to help us work through that process. What the financial advisor ultimately does is recommend a per-share price and there’s a valuation report that backs it up. There are a lot of processes that go into that in terms of due diligence and just getting an understanding of where the company is and where it thinks it’s going.
But essentially the appraiser will recommend the value to us as the trustee. We then will either accept it or reject it in good faith and reject is a harsh word. But usually, when there’s an issue there, there’s somewhat of an iterative process and that’s rare to begin with. But essentially the trustee is the one that’s accepting the value.
Chris:
The trustee sets the value is my understanding, right?
Mike:
Yeah.
Chris:
Not the valuation appraiser.
Mike:
Right. That’s why we have to be not as involved as the appraiser because they’re the ones that are doing the math, but we’re involved with the entire due diligence process. We’ll be involved in the management interview. Then, of course, we’ll review all the same materials that the appraiser does just so everything matches up and feels right when we finally do accept that value. The evaluation’s a big-ticket item.
Then another would be the election of the board. There are two ways that that can go about. We’ll call it an ongoing trustee and it can either be in a directed role or a discretionary role. A directed trustee essentially takes its direction from the plan sponsor. The plan sponsor would say, “Here’s a slate of directors. We’re directing you to vote the ESOP shares for these directors.” As long as there’s no one. We used to say, Bernie Madoff. As long as Bernie Madoff isn’t on the list.
Chris:
He would not be a good choice for a director.
Mike:
Correct. We have to follow any direction unless it conflicts with ERISA or the terms of the plan. Well, the plan usually doesn’t say who can and can’t be on the board. But ERISA would say somebody like Bernie Madoff can’t be on the board. In actuality, that situation has really never arose for us. There have been times when an independent director had to be appointed to the board and an individual on the slate wasn’t independent. We said, “Look, you can add that person, but you also need to add an independent director.” That would be the closest we got to rejecting a slate.
But in the discretionary context, we don’t get a direction. It almost works the same way in that company management or the board will say, “Here is a list of proposed directors.” We do a little extra due diligence than we would in a directed context. Whereas in a directed context, we look at bios and might have a brief telephone conversation. But in a discretionary, we’re going to dig in a little bit deeper, do our own due diligence, and have a little more extensive discussion with the company. Then ultimately we’re not taking a direction, we’re just in our discretion, electing the board.
Chris:
So you’re not forcing a director on someone.
Mike:
No.
Chris:
Or you’re not imposing or placing your own people on the board because one of the issues that comes up is a selling shareholder who maybe doesn’t fully understand how it works and their concern is around control It’s around the board, it’s around corporate governance, it’s around being told what to do. What I always tell prospective clients or people that are considering an ESOP is that we want to dance with who brings us. In other words, we want and need the leadership team that built the company to sustain it and to basically help pay down the debt and generate the benefits for the employees well beyond the transaction.
In a non-ESOP context, corporate governance goes like this. The shareholder appoints the board of directors, the board of directors appoints management, management runs the company. That’s the way it works unless there’s some reason to upset that. The other thing I would say is in most businesses, not most, but many smaller businesses, let’s say, sub 50 or 100 million or so, not often do you see outside directors. We typically see or often see a captive board if you will. In most transactions, we put provisions in for one or two outside directors to be added to round out that suite, and frankly, those board members should be and are if they’re selected, resources. They’re helping grow the company, helping set direction. But I guess my question for you is if I’m a selling shareholder, should I be concerned about this notion of control in that Alerus or Mike Flesch is going to intervene in the operations of the company and tell me what to do?
Mike:
No, I wouldn’t be. Now, when we say control, however, if you are a shareholder and you’re looking to sell your entire business to an ESOP, you will be giving up control because now the ESOP is the controlling shareholder of the business. So if push really came to shove, the ESOP through its trustee could replace the entire board. In our experience, we’ve never had to do that. It’s always been a very collaborative process when it comes to appointing the board because our area of expertise is in ESOP fiduciary services and none of our clients specialize in ESOP fiduciary services. Which is to say our clients who are in manufacturing, construction, engineering, food service, it runs the gamut, that’s their area of expertise.
We’re not in the best position to say, “Oh, gee, we think this person would be a better board than that person.” Now, that’s not to say we can’t make recommendations because we have a fairly extensive Rolodex and we can refer some people who work with our clients to other clients and there are recommendations we can make, but we’re never going to jump in there and force a board member onto a particular company. Again, if things really got out of hand and we haven’t had this happen, we would have to act and any trustee would have to act. Any shareholder, whether or not there’s an ESOP involved, would want to make changes because they’re the shareholder.
Chris:
They’re the owner, right. Frankly.
Mike:
Exactly.
Chris:
Aside from the fiduciary obligation, which you have as the trustee, you would have some moral obligation, but some business judgment obligation to act in the best interests of the company.
Mike:
Correct.
Chris:
Whoever you were.
Mike:
Where our role comes into play with respect to how the company is being operated, I’d say we’re more of a referee. If the company is looking to make a very large acquisition, we will be a little bit more are involved in that and take a closer look. We’d engage a firm like Acuity to help us take a look at that. Just because they’re looking at an acquisition, they’re going to spend a lot of money or they’re going to take on some debt to do it, if there’s anything on its face that could be very disruptive or detrimental to the ESOP down the road, then we should try to ascertain that upfront and be involved from the get-go on that. So there’s that. Then perhaps, if it’s anything relating to equity, changes to the equity capital structure, we’re probably going to take a closer look. But our job would be to object to certain decisions made by the board, not to actually intervene and make those decisions ourselves.
Chris:
Right. So really a true oversight role if you will.
Mike:
Correct.
Chris:
So material corporate event or decision, which would come to the board, may then extend to coming to the shareholder, depending on the facts and circumstance. My experience with control or exerting control, and this is from both personal investment and ESOP and ownership and the like, is, for the most part, I don’t want to be in control if you’re doing a great job being in control. A great job could even be poor performance in light of the circumstances, but you’re still doing as good a job as can be done.
I haven’t seen ESOP trustees displace boards or replace board members, except in rare, rare circumstances where there’s a moral issue or there’s some discord at the board level or something material. In other words, if the company underperforms, you’re not likely to come in and start firing board members or not reelecting them. You may, because of your role, I’m guessing, participating at the board level, hear about their plans for maybe replacing management. But how often do you as a trustee actually exercise a right to either reject a board member or block a transaction, et cetera? Does that happen a lot?
Mike:
No. Very rarely. Really the only time we’ve ever made a wholesale change to the board, and this was over a decade ago, we were engaged as a result of a company, they were going through a DOL investigation and they didn’t have an external trustee at the time. The DOL said, “Well, we want to see the board change. We need some changes to the board and you’re going to need an independent trustee to help you with that.” We were brought in as a result of that. This was again, well over a decade ago, we came in. We didn’t come in and say, “Okay, we found these five people for your board. Have fun.” We said, “Okay, well, what are you guys looking for in terms of a board?” It wasn’t a complete wholesale change of the board. Just some had to come off and some had to come on.
But we worked with the existing board and the management team to come up with a new slate. It really did set the company on a good path and they’ve been a high-performing company since that time. That would be the closest. I know that’s somewhat of a unique situation, but what I’m trying to convey is that it was a very collaborative process. It wasn’t adversarial at all. We valued the company’s feedback and what they wanted the board to look like more so than our own opinions. We were able to bring our opinions and have our suggestions that were married with the company’s ideas. But in the end, we weren’t bullies when we came in. I think we got a very good result.
Chris:
So I guess my last question or topic is around selling a company that’s owned by an ESOP. Let’s just take the owned 100% by the ESOP scenario. Obviously, we’re in a very active M&A market, companies get approached all the time. I’ve had clients say to me, “How do I fend off these inquiries? Do I have to entertain them? Does the trustee get involved?” All those kinds of questions. Help us understand, high level, the process if either somebody is approached, a company is approached, or if a company for various reasons determines or decides that it’s time to sell.
Now, remember ESOPs have been in place since or around since 1974 so some clients, some companies, have been ESOP owned for 30, 40, or more years. Let’s face it, in some cases, companies run out of leadership, options, they get an aging workforce, they get other factors that might cause them to want to sell. If I’m approached by a buyer, or if, at the board level we’re thinking it might be time to take advantage of a hot M&A market, how do you get involved and when do you get involved and what’s your role in those situations?
Mike:
That’s a question we’re going to ask our clients periodically. Has anybody come and kicked the tires? Do you get inquiries from potential buyers? A very common response is, “Sure. We get the occasional phone call,” or, “I get these faxes,” if people still get faxes. Then, of course, there are the more serious ones where it’s somebody in the industry and they pick up the phone and they call the CEO or the CFO and say, “We’re just wondering if you’ve been thinking about selling.” From the standpoint of the CEO or CFO who gets those communications, I think it’s always helpful to report those to the board just to say, “Hey, there are some companies out there showing some interest in buying us. I’ve been telling them we’re not interested.” That’s an okay response.
You’re not under any obligation to go down that path with anybody. If somebody says, “I want to buy you,” but they don’t back it up in writing and it doesn’t come in the form of a letter of intent with an actual proposed purchase price, there’s really not a lot of action that has to be done. I always would suggest being somewhat cordial in your response because it’s always good to have those options. I should also add it doesn’t hurt to let us know in those situations where you had somebody pick up the phone and call you and ask if you were looking to sell. Well, you don’t need to tell us about every single instance because we’re going to probably ask on a periodic basis, but where it gets a little bit more serious, if they send an indication of interest which isn’t quite to the level of an LOI, you definitely want to inform the board, and it would also help to inform the trustee.
We might have a short conversation just to see, “Hey, are you interested in going down this path?” If you don’t want to at that point and maybe you are, but at that point, at least we’re on notice. It is a board decision first and foremost. Let’s say it ripens to something called a letter of intent, which is a little bit more serious. Well, I think at that point, if you haven’t informed the trustee, you definitely want to because the sooner, the better. Really, if you have an independent trustee, you want to leverage them as much as possible. You can only leverage them if they are informed of what’s going on. If you do something and you don’t inform your trustee, your trustee’s off the hook unless they should have known. That’s a question we don’t really need to get into, but if you inform your trustee and then they don’t do anything and you carry through, somebody could look back to the trustee and say, “Well, you were aware that this was going on. Why didn’t you object?” Or, “Why weren’t you more involved?”
At that point, you could point to the trustee and say, “You should have been,” and therefore you’re off the hook, more of the blame could fall to the trustee. But if the letter of intent comes in, definitely inform your trustee. Then it goes to the board and the board and the trustee should all get on the same page. Even at that point, you’re not under any obligation. The board could have plenty of reasons why it doesn’t want to sell the company. The forecast could be very rosy in the offer, may not be as rosy, but there are plenty of factors out there. The trustee only can consider the financial aspects of the transaction. At the letter of intent, we’re not at the point where we’re going to make a decision to sell the company or not because we’re not signing that letter of intent.
It’s only after that’s signed where obviously we’re headed towards that result, so we’re going to really need to dig in and vet it out. But we’ll be collaborating with the company the whole way through, whatever the decision the board ultimately makes. I really can’t think of many situations where if the board ultimately said, “We’re not interested in selling, even though this offer is 10 times our current value,” that might be a situation where we would say, “Hold on a second. This is a once-in-a-lifetime opportunity for our participants. We have a duty to let you know that we think this is something you really should explore further.” But that situation, as I say it, sounds absurd, 10 times your current value. It’s not to say that doesn’t happen, but it’s obviously a very rare, almost hypothetical situation.
Chris:
Right. What I’m hearing you say is again, it’s really a board-level decision. Probably starts off with a discussion with a member of management, CEO, or somebody like that, and they take it to the board. When it gets a little bit more serious or more well developed, then they might inform you, and then there’ll be a plan to see if it’s something that really gets pursued. That makes a lot of sense. Well, Mike, I’m out of questions. Is there anything you want to tell the audience in closing that they should know?
Mike:
No. I would say, our industry has evolved. I should say ESOPs, just the nature of ESOPs and how they’re regulated. The regulatory environment really is what I’ll frame has evolved to a point where internal trustees are…it sounds self-serving, but there are benefits to having an independent trustee, especially upfront when a selling shareholder is announcing to his or her employees that they’ve sold the company to an ESOP or to them. There’s a little bit more credibility when you can tell them that there was an independent trustee involved in that process and that it wasn’t just the seller who is acting as the selling shareholder and the trustee because that is still allowed to happen and used to happen quite a bit.
But it’s that type of arrangement that helped lead to our current regulatory environment. There are plenty of benefits to an institutional trustee. You don’t give up a lot of control over the day-to-day operations of the business. We view ourselves as a business partner, not as an adversary to any of our clients. I think our clients would echo that sentiment as well. Instead of putting the risk that comes with being a trustee on one of your employees or perhaps yourself if you’re a selling shareholder, then probably best to consider putting it onto a professional instead.
Chris:
In that way, it really functions a lot like an insurance policy. You’re doing your risk management across all aspects of the business. When you’re engaging in a transaction, this is one more level of risk that you can decide how you want to mitigate. That’s great. Mike, I really appreciate you coming in today. It’s been a great discussion.
Mike:
Thanks for having me.
Chris:
Oh, you’re very welcome. With that, I’m Chris Kramer, and we will see you next time.
Chase:
All right. Thanks for tuning in everybody. Hope you enjoyed that conversation with Chris and Mike and hope you found it useful and illuminating. Quick fine print. This podcast is for general informational purposes only. It does not create an advisor-client relationship between Acuity Advisors and the listener or reader and is not intended as advice for a specific situation. As always, we’d like to thank our wonderful and accommodating sponsor, Acuity Advisors, as well as our guest Mike Flesch and his firm, Alerus Financial. Tune in next time everyone. Take care.