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109: Internal & External Trustees Revisited

As the global pandemic continues to play out, we revisit the differences and similarities between internal and external trustees, explain inherent conflicts of interests faced by internal trustees, and why companies hesitate to retain external trustees. This excerpt is from Episode 26, which originally aired on March 19, 2018.


Episode 109 Transcript

Bitsy McCann: 00:03 Welcome to The EO Podcast, where we amplify and celebrate all forms of employee ownership.

Bret Keisling: 00:12 Hello, my friends. Thank you for listening. My name is Bret Keisling and as it says on my business cards, I'm a passionate advocate for employee ownership. As many listeners know, from 2012 to 2019 I was cofounder and managing director of Capital Trustees a boutique firm providing fiduciary services to ESOPs. As the world faces much uncertainty related to the COVID-19 pandemic. I find myself looking at the past and hope that this unprecedented crises will not lead to the significant ESOP-related litigation that came about after the great recession of 2008/2009. In Episode 26 of The ESOP Podcast, which was originally published on March 19th, 2018, podcast producer Brian Keisling, my son, and I talked about the differences and similarities between internal and external trustees. Today we're going to revisit that episode. You'll hear us discuss the fiduciary liability that all trustees share, whether they're internal or external, inherent conflicts of interest faced by internal trustees, and the reasons companies give for being hesitant to switch to an external trustee. As this episode was recorded more than two years ago, please remember that some of the specific references are outdated. For example, neither Brian nor me, nor even the podcast are with Capital Trustees any longer. You can find the entire Episode 26 as well as all of our archived episodes at I hope you'll find this conversation helpful.

Brian Keisling: 01:52 The whole internal versus external trustee topic is sort of a recurring theme at conferences, especially when you're presenting. And so we thought it would be a good idea to just go over that a little more in depth because it comes up all the time.

Bret Keisling: 02:07 Let's start with definition of terms Brian, and some of this will be very elementary, for those who may not have familiarity with ESOPs, but an ESOP company, employee owned company, even though we all colloquially say that it's employee owned. The fact of the matter is that the shares of the company are owned by a trust to the benefit of employees and every trust must have, Brian?

Brian Keisling: 02:33 A trustee.

Bret Keisling: 02:34 That's right. Whether it's an educational trust, a family might set up a trust to a favor grandchildren or children, or an educational trust if someone wants to endow a seat at a university, or a trust that runs a hospital, every trust has a trustee. Then there are two types of trustees in the ESOP world, an internal trustee and an external trustee. An internal trustee is any trustee that works for, or has a relationship with, a company and then an external trustee is the opposite of that, but there are several categories. External trustees can be large institutional trustees that, for example, banks that besides doing trustee work also handle deposits, et cetera, et cetera. There are boutique trustee firms like Capital Trustees and others in the field, and then one or two individuals that you know, individuals may serve as trustees as well. So all of those are the external trustees.

Brian Keisling: 03:29 Okay. So, if a company has an internal trustee, what kinds of things might make them want to make a change to an external trustee?

Bret Keisling: 03:36 There are a number of reasons, Brian, that a change might occur. Some are very specific to a situation. It is well understood now that if a company's going to have a transaction and the transaction could be either if the trust doesn't own 100% and is buying additional shares or if there's going to be a releveraging, that sort of thing, if there's any act that could re result somehow in a dilution of value of the trust, those types of transactions, everybody's pretty much in agreement that you need an external to do them. There are too many conflicts of interests.

Brian Keisling: 04:14 What kinds of conflicts of interest might an internal trustee face?

Bret Keisling: 04:18 Well, there's an inherent conflict of interest, Brian, with internal trustees because of the nature of the fiduciary duty. A trustee has a fiduciary duty to all participants. In very simple terms, that means that they treat the assets of the trust as if it were their own funds with that level of responsibility and seriousness. Not that they treat it with their own funds so they can go do whatever! Different company members have different fiduciary duties. Board of directors have a fiduciary duty to shareholders, sometimes that's the trust, sometimes there are other shareholders involved. Management might have, or does have, fiduciary duty to the company itself and the company employees may not all be participants. So right off the bat if an internal trustee is wearing multiple hats, there are different fiduciary duties that apply at different times. And it's difficult for an internal trustee to say when I was acting as a trustee setting share value or making decisions that affect the share value that they only were wearing the hat of the trustee and not any of the other hats. So that's a building conflict of interest right there.

Brian Keisling: 05:41 And presumably an internal trustee is not necessarily at the very top of their company. So they would also have to take into account how will my bosses feel about this? Will they wish that I as trustee made a decision that would have been more beneficial if I was making that decision as a manager or as a vice president, which could obviously create another conflict of interest because now you're not just making a decision as a trustee, but you're also thinking, how will my bosses feel about this down the line?

Bret Keisling: 06:10 Well, that's exactly right, Brian, and when I have conversations with internal trustees or management or board members, we point out one of the most important functions a trustee can do internal or external trustee during the valuation process is to really understand and question frankly, the company's forecasts and projections. Is the company being overly optimistic? Is the company being overly pessimistic, does it track with historical trends? To the extent that it varies from historical trends, is there a quantifiable reason why the company thinks it's going to do better or worse? Inherent in this is the problem that if management, and by the way this is not implying wrongdoing at all, but if management has a very conservative nature and they're doing extremely conservative forecasts, that's going to bring the value down perhaps artificially. Coincidentally it would also lower the repurchase obligations. If the internal trustee is the CEO, the DoL may be skeptical that the CEO questioned his or her own projections or the projections of a subordinate. But if the subordinate is the trustee, to your point, Brian, even if everything is done above board, it's more difficult to make the argument that you argued with your boss about projections and particularly if you can't show the changes to the projections came as a result of the give and take. The trustee is going to be in a difficult position with the Department of Labor, potentially.

Brian Keisling: 07:54 So, it sounds to me kind of like this idea of you shouldn't represent yourself in court. You could do it, but at some point down the line, something might come up that you don't see because you're too close to the decisions that are being made and that might make you miss something, or at least for appearances sake with the Department of Labor, it could come across as questionable in terms of some of the choices that you make as the trustee slash CEO or whoever else you are.

Bret Keisling: 08:24 You raised a pretty good analogy, Brian, and it brings up two different aspects of it. First of all, if you do everything above board, you absolutely can prove to the Department of Labor if there's a claim, if there's eventually a complaint, that you didn't have any conflict and that you didn't preach your fiduciary duty because of the conflict of interest. But as an external trustee, I don't have that conflict of interest. No external trustee does. So you can prove that you didn't have a conflict at $50,000 in attorney's fees or $100,000 in attorney's fees or $5,000 in attorney's fees. You, and let's face it, it's probably not $5,000 in attorney's fees, but you can prove it. We don't even have that argument. The other challenge with the internal trustees is connected with that education and how thorough an internal trustee can do their job. Capital Trustees last year between our ongoing engagements and the transactions that we did, we were involved in about 62 valuations. So we have reviewed them, we've analyzed them, we have a sense of what the marketplace, how they treat various issues, how the valuation processes are used and we also have a sense of what's acceptable to Capital Trustees or not. An internal trustee by definition only has one valuation that they do. So they don't have the vast array of other valuations to compare it to. They don't know what's in the market. Some trustees are using the same valuation firm that they might've been using for five, 10, 20 years, and they don't even know any different from that one valuation firm. So we also you know, in terms of education and experience the internal trustee is at a downside. The relevance there again, is that the Department of Labor in the event of an investigation, will look at a trustee's experience and the trustee can show that they do have a wide enough range of experience just as an external trustee would have to show the Department of Labor, but I'm able to show it using 61 valuations versus one.

Brian Keisling: 10:50 Well, it sounds like an issue that could come up with that is that an internal trustee might run the risk of being too self-contained and not be as ready as an external trustee might be to pay attention to the larger ESOP world and what's going on there and to stay up to date with what the current best practices are and that sort of thing. So even if you're doing everything the way you're supposed to be doing it as an internal trustee, you might miss some major settlements or other sorts of current events in ESOP world that would otherwise inform how you do your job as trustee.

Bret Keisling: 11:28 You're exactly right. Brian and one of the things that we need to pause and acknowledge is that there are a number of companies, a lot of companies with internal trustees, who are very active in NCEO or The ESOP Association. Their internal trustees come to the conferences, they learn, they present. They are absolutely on top of the changes to expectations or requirements for trustees. The conversation that we're having is actually directed to the internal trustees who maybe have never attended an association event, never done any of that outside knowledge.

Brian Keisling: 12:09 Yeah. Well, that brings into question for me as an internal trustee, what sort of risks do you run, even if you're doing everything properly, what are you putting at stake as an internal trustee and is that different or how does it compare to the risks of being an external trustee?

Bret Keisling: 12:30 And that's a great question, Brian, because the risks are exactly the same. It's how you mitigate the risk, how you do risk abatement, that that generally is different. Any trustee, whether it's an external, such as Capital Trustees or my partner and I, for our acts, or an internal trustee have fiduciary liability, personal fiduciary liability for the decisions that they make. So for example, year ago just about a year ago now, a case came out that's known as the SJP case and external trustee, verdict was against the external trustee. There was a nine and a half million dollar judgment and one of the things that I joke is that a nine and a half million dollars would have a material effect on my cashflow. If that were me, that would have been my judgment - and by the way, Brian, as my son, there is no nine and a half in my cashflow. [Laughter.] I'm sorry, pause to my beneficiary. [Laughter.].

Bret Keisling: 13:36 But the internal trustee has that exact same liability. So the problem is the risks are exactly the same. You potentially are responsible for the decisions that you make and personally responsible. So, first of all, when Capital Trustees is doing a transaction, Rich Heeter and I often will say, is this a transaction we want to risk our homes on? Because we want to remind ourselves that it's that serious. But the other big difference, Brian, in terms of risk abatement is Capital Trustees carries fiduciary insurance for us as fiduciaries. Several millions of dollars worth of insurance. Most internal trustees don't have the fiduciary insurance. We as part of our engagements, that we'll talk later, have indemnification language with our clients. Internal trustees don't normally have that.

Bret Keisling: 14:30 But the other problem is that with all of the hats an internal trustee wears that it's not clear. You know, they may think there's D&O coverage [Directors and Officers Liability Insurance] for board members. It wouldn't apply to the trustee. So if there's a problem, they don't necessarily have the resources of insurance that we do. One other thing about insurance, Brian, is that the way to sum it up, and there are people in the ESOP world who actually refer to external trustees as 'an added insurance policy'. And I don't love that description because insurance is an actual thing and an external trustee is not an insurer. But the reason it's apt is, you know, all of the different problems and fiduciary liability issues that could come up. If you hire an external trustee, nobody in the company faces those fiduciary challenges. So to the extent that you have an external trustee and that you have followed a process to hire the external trustee, it's kind of in the sense that, you know, is every company going to have a claim? Absolutely not. Only a couple of small percentages are. Is every claim going to lead to a settlement or charges? Absolutely not. Only a small percentage of the claims lead to that. But is your plant going to catch on fire tonight? Not likely. You have fire insurance. You know, it's not, you pick the day so you can't get an external trustee. So very broadly, for me, a way to just take out any conflict of interest, any problems, et cetera, with the external trustee, that's a great reason to get an external.

Brian Keisling: 16:12 So talking about that risk actually reminds me of the most recent Great Lakes conference in Sandusky, Ohio where Capital Trustees had our table set up with information about us with all the other companies that are at the conference. And this man came up to our table and he said, I'm an internal trustee. I'm just looking around. I gave him my card, we chatted for a little bit and it was great. And I offered him your card and Rich's card and just said, these guys are external trustees. They'll help you if you want to make the switch from internal to external. And he said, no, I'm fine, I'm good. And then he went to your presentation where you talked about the risks that an internal trustee faces. And he came back right after to our table and said, you know what, your dad scared the mess out of me, let me get his card! And I don't know if he ever called, but it's sort of, you could tell it hit home with him that he was realizing, wow, I'm on the line here with any potential mistake that I make and that sort of thing. And it was interesting to me, because I was still pretty new to conferences and to trustees broadly speaking, to see him change his attitudes so quickly was fascinating. And it purely came from finding out that information about the risk that he faces as an internal trustee.

Bret Keisling: 17:42 You know, the funny thing Brian, is that at a lot of conferences people are hearing for the first time some of the information and it's not designed to "scare the mess out of people" to quote you I guess but a lot of internal trustees and again, the ones who don't really immerse themselves in ESOP world don't understand the liability and they don't understand, oftentimes the trustee is a tiny little part of their job and some internal trustees treated as a tiny little part of their job without realizing it's the only part of their job that could put them personally on the hook with the government. And you know, to a certain extent, if that were to occur, let's just say things could get messy because on the one hand you've got your internal trustee hat on, on the other hand, you need your paycheck et cetera, et cetera.

Bret Keisling: 18:39 So why wouldn't a company want an external trustee?

Bret Keisling: 18:43 There are a number of reasons, Brian, that we hear. Some of it might be the expense, although in my mind, you know, I don't want to give quotes, but I mean we do annual engagements for as low as 10 grand a year. Capital Trustees I imagine they can get much more expensive, the bigger of the size. And I have no idea what the large institutionals charge, although I'm generally happy to compete against them on fees. So cost is a factor, but the reality is that there is a perception that an external trustee is somehow going to steal the company. And I actually felt bad. I got a call from a potential client last week and he said, just like without any context whatsoever, so what's going to keep you from stealing the company? [Chuckle.] And I laughed because everybody that's the concern that they have.

Brian Keisling: 19:40 It's always an underlying concern. But he just came out and said it.

Bret Keisling: 19:44 And there was no buildup. There was no... It's just so. And first of all, let me explain that theoretically, here's the argument. The external trustee, I said that wrong. The trustee is responsible for voting in the board of directors. So the concern is that the trustee could somehow elect their own board of directors, fire management, take the control of the company, et cetera, et cetera. And I'd get exhausted trying to explain in how many different ways that can't happen. First of all, theoretically, absolutely. Legally they are correct. Trustee votes for the board of directors and theoretically, presumably a trustee could elect their own people and take over the management. A couple of flaws with it. First of all Capital Trustees has three and a half dozen ongoing clients now. We can't run all of the clients that we have. A second of all our fiduciary duty is to increase or at least protect shareholder value. And I'm not sure my partner and I installing ourselves in the CEO suite of any of our companies would be the best way to protect or increase shareholder value. From a contractual point of view, you know, for example, our engagements make clear that although they are annual engagements, we can resign with 30 days notice and the company can terminate us with 30 days notice. So to a certain extent, I would imagine if there were maneuvering by the trustee, management and the board could act appropriately. So on a practical matter for Capital Trustees, just in terms of electing of the board members, we have only ever voted for board members that have been nominated for by the company.

Bret Keisling: 21:43 Capital Trustees does not maintain any board seats for quote unquote, our own directors. We're not like activist shareholders that people read about where we're agitating with management. Hey, can you go from 4% to 5% revenue or margin? What we do is elect the board that the company feels will best serve the company's need. We do make sure from a fiduciary perspective that they are appropriate to serve on boards. For example, are there any fraud charges in their background? Anything like that that would disqualify them. But then we just want to make sure that they have good basis to be on the board. And so we're only electing folks that get nominated. The bottom line is if a company were so poorly run or there were problems in a management perspective, absent fraud, at which point an external trustee would take serious action. But if it was just, we didn't necessarily have faith in management, we'd be more likely to, to resign and leave a report for the next trustee. It doesn't do the participants any good to get in board fights.

Bret Keisling: 23:01 And with that, we're going to wrap up today's episode of The ESOP Podcast. Thank you so much for joining us. I want to extend my appreciation to Brian Keisling. He did a wonderful job as producer of the podcast and listening to this conversation. I'm just so proud and happy that I was able to work with him for a couple of years at Capital Trustees. As I said, at the top, you can find the entire Episode 26 that this clip came from at I hope you'll join us Friday for The ESOP Mini-cast. And meanwhile as we maneuver through the pandemic, I hope you're taking care of yourself. I hope you're help to anybody you're able to who might need it and I do have faith that we are going to get through this together. Thank you so much for joining me. This is Bret Keisling. Have a good day.

Bitsy McCann: 24:00 We'd love to hear from you! To contact us, find us on Facebook at KEISOP, LLC and on Twitter @ESOPPodcast. To reach Bret, with one "T", email, on LinkedIn at Bret Keisling, and most actively on Twitter at @EO_Bret. Again, that's one "T". This podcast has been produced by The KEISOP Group, technical assistance provided by Third Circle, Inc. and BitsyPlus Design. Original music composed by Max Keisling, archival podcast material edited and produced by Brian Keisling.

Standard Disclaimer: The views expressed herein are my own and don't represent those of my own firms or the organizations to which I belong. Nothing in the podcast should be construed as guidance or advice of any kind in any field and the fact that I mentioned an organizational website or an advocate or a company on a podcast does not reflect an endorsement, but if you've heard your name or your group's name mentioned on this podcast, I'd love to have you come on and talk about it yourself.


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